[Economic Report of the President (2003)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]


 
CHAPTER 1

Macroeconomic Performance in 2002

The U.S. economy solidified its forward progress in 2002, with the
third quarter of the year marking the fourth consecutive quarter of
economic growth.
This progress followed a contraction in 2001 that was deeper and
longer than initial data suggested, but still mild by historical
standards. Real gross domestic product (GDP) declined by 0.6 percent
during the first three quarters of 2001, about one-fourth the average
percentage decline over the previous seven recessions. Growth resumed
in the fourth quarter of 2001--despite the terrorist attacks in
September--and real GDP rose at an annual rate of 3.4 percent in the
first three quarters of 2002 (Chart 1-1). Although economic
activity probably weakened in the fourth quarter, the ongoing
improvement in productivity growth, together with lean inventories,
foreshadowed a return to more normal levels of production and job
growth in the quarters ahead.

The economic recovery of 2002 resulted from a constellation of
factors, including the resiliency of the economy after the terrorist
attacks and the



lagged effects of stimulative monetary and fiscal policy in 2001.
Although the Federal Reserve lowered the Federal funds rate only once
in 2002--by half a percentage point on November 6--the
475-basis-point reduction over the course of 2001 continued to
stimulate the economy throughout the year. (A basis point is 0.01
percentage point.) Monetary stimulus was complemented by fiscal
stimulus, in the form of the tax rate reductions included in the
Economic Growth and Taxpayer Relief Reconciliation Act of 2001
(EGTRRA) and the investment incentives in the Job Creation and
Worker Assistance Act (JCWAA) of 2002. In the long run, EGTRRA's
reductions in marginal tax rates will raise potential output by
increasing labor supply and encouraging the entrepreneurial activities
that are the building blocks of economic growth. In the short run,
however, the tax cuts buoyed disposable income and helped keep
consumption high. Robust consumption, in turn, was a crucial
locus of strength in the overall economy, contributing an average
of 2.1 percentage points to real GDP growth during the first three
quarters of the year. Additionally, the tax incentives in JCWAA,
which the President signed in March, provided needed support to
investment at a time when stability in this component of final demand
was especially important.

In 2002 discussions of both economic activity and economic policy paid
particular attention to the valuation of the economy's stock of
productive assets. One of the more favorable developments for many
Americans in 2002 was the continued appreciation of their most
important investment: their home.
Housing prices rose 6.2 percent from the third quarter of 2001 to the
third quarter of 2002, following an 8.7 percent increase in the same
period a year earlier. As discussed below, housing values were buoyed
not only by low mortgage interest rates, which reached levels not seen
in more than a generation, but also by rising demand, continuing
strength in purchases of second homes, and ongoing improvements in
mortgage finance. Strength in housing values contributed to robust
increases in residential investment, providing another important
impetus to final demand in 2002.

In the aggregate, however, the appreciation in housing wealth was
overshadowed by continued losses in the stock market. Like those
for all of the world's major equity exchanges, U.S. stock indexes lost
ground in 2002, continuing a general slide that began in the spring
of 2000. From the market's high point in the first quarter of 2000
to the fourth quarter of 2002, stockholders lost nearly $7 trillion
in equity wealth. These losses continued to weigh heavily on economic
growth and job creation in 2002, by reducing the wealth of consumers
and raising the cost of equity capital for investing firms. The
precise reasons for the bear market of 2000-02 are subject to debate,
but the market's 3-year slide was probably influenced by two general
factors: a decline in expected profit growth and an increase in the
premium that investors required to hold risky assets. These factors
continued to play important roles in the first three quarters of 2002
as the stock market continued its decline. Specifically, corporate
accounting scandals called into question the reported profits of some
firms, while risk premiums (as measured by the difference, or spread,
between the yields of corporate bonds and those of U.S. Treasuries)
rose to near-record levels. Although some observers attributed most
of the market's decline to the corporate scandals, it is worth noting
that equity prices fell around the world, even in countries with
different accounting systems and governance institutions.

The stock market's decline has caused some to question the
productivity improvements of the late 1990s. Yet even though
investors may have over-estimated the value of particular
technology-intensive investments, it would be a mistake to infer that
technological improvements hold little promise for future economic
growth. Detailed analyses of the sources of productivity growth
indicate that the post-1995 productivity improvement owes much to the
U.S. economy's ability to profit from technological innovation. If
technology continues to progress at its recent pace, rising
productivity will continue to bring about improvements in living
standards that compare quite favorably with the more modest gains of
only one or two decades ago.

In the short run, however, economic growth is determined by demand
factors as well as by the economy's technology and potential to supply
goods and services. The next section discusses the individual
components of GDP from the demand side. There and elsewhere in the
chapter, the discussion pays particular attention to the links between
asset markets (which set the prices for stocks, bonds, and houses) and
the components of real aggregate demand (consumption, investment,
government purchases, and net exports).

GDP and Its Components in 2002

Consumption

Consumption continued to be the prime locomotive for the recovery in
2002, rising at an annual rate of 3.0 percent over the first three
quarters of the year. (GDP data for the fourth quarter were not yet
available as this Report went to press.) Expenditure on consumer
durables was especially strong, in large part because of strong motor
vehicle sales. Zero-percent financing offers and other aggressive
sales promotions sent automobile sales soaring to more than 18 million
units at an annual rate in July and August. (Automobile sales were
also especially strong in December.) Largely as a result, expenditure
on consumer durables accounted for more than 1.7 percentage points of
GDP growth in the third quarter. Consumption of nondurable goods
was especially strong in the first quarter, rising 7.9 percent at
an annual rate, but tailed off afterward. Finally, consumption of
services remained robust, accounting for about 1 percentage point
of GDP growth in each of the first three quarters of the year.

Disposable Income and Consumption

In 2002 strength in consumption resulted in large part from strength
in purchasing power, as low inflation, tax relief, and steady nominal
income growth kept real disposable incomes high. On the price side,
financing incentives reduced the effective cost of new cars, allowing
motor vehicle sales to be a main driver of final demand in the middle
of the year. Other categories with favorable price developments for
consumers included food and beverages, where prices rose only 1.5
percent in 2002, and apparel, where prices declined 1.8 percent. On
the income side, nominal personal income rose at an annual rate of
4.5 percent during the first three quarters of 2002, and tax cuts
enacted the previous year allowed consumers to keep more of their
income gains for themselves. The passage of EGTRRA in 2001 reduced
Federal tax liabilities by about $56 billion in calendar year 2001
and about $78 billion in 2002, helping disposable personal income,
or nominal income net of taxes, to rise at a robust annual rate of
9.0 percent during the first three quarters of the year. Taken
together, low price inflation and healthy growth in nominal
disposable personal income meant that real disposable personal
income grew at an annual rate of 7.0 percent during the first
three quarters of 2002, which compares well with past recoveries.
Ultimately, the strong growth in real disposable income is a
reflection of the high rate of productivity growth that the Nation
continues to enjoy.

The Stock Market and Consumption

One of the most closely watched influences on consumption in 2002
was the stock market, as many observers feared that continued
retrenchment in equity values would dampen consumers' willingness
to spend. One link between the stock market and consumption arises
from the market's role as an informal measure of the strength of
the economy. Because consumers often look to the stock market for
information about the health of the economy, consumer attitudes
from survey data have long been closely correlated with stock indexes,
and that correlation remained robust in 2002. Yet the stock market
is much more than an informal economic barometer. Because equity
holdings are an important component of household wealth, changes in
the stock market affect consumers' ability to purchase goods and
services, not just their views of the future.

Economists have long been interested in precisely how changes in stock
prices affect consumption decisions. As a matter of accounting, an
increase in an individual's wealth (equities as well as other assets)
must ultimately bring about an increase in his or her consumption,
unless the extra wealth is to be passed on to heirs as a bequest. The
important empirical question is whether the increase in consumption
occurs quickly enough for wealth to affect consumption at short
horizons. The empirical relationship between aggregate wealth and
the average propensity to consume out of disposable income suggests
that the answer is yes, at least according to evidence through 2000.
Chart 1-2 shows that as household net worth rose in the late 1990s
(primarily because of the increase in stock prices), the average
propensity to consume increased to levels not seen in half a century.
In more sophisticated analyses that take other determinants of
consumption into account, aggregate data on wealth and consumption
suggest that a one-dollar reduction in stock market wealth eventually
reduces yearly consumption by 3 to 5 cents.

Although economic theory suggests a direct, causal impact of stock
market wealth on consumption, patterns in aggregate data do not by
themselves prove that this impact exists. Wealth and consumption might
move together over time because both are determined by some third
factor, such as expectations about the future. Indeed, the aggregate
relationship between wealth and consumption does not appear to have
been very strong in the past 3 years, as wealth has declined yet the
average propensity to consume has remained stable. However, recent
empirical analysis using individual-level data is generally supportive
of the theoretical link between wealth and consumption (Box 1-1).



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Box 1-1. Measuring the Effect of Stock Market Wealth on Consumption

Economists have long recognized that a close relationship between
wealth and consumption exists in aggregate data, but until recently
attempts to find microeconomic evidence isolating a true causal
relationship between the two variables have had limited success. Part
of the reason is the general difficulty of finding evidence for
macroeconomic relationships in microeconomic data. Data on individual
consumers are often noisy, in that period-to-period changes in their
consumption are influenced by a number of idiosyncratic factors.
For example, a family's decision whether to buy a new car might be
influenced by an increase in stock market wealth, but also by the
arrival of a new baby or the decision of one family member to take a
new job. The noise problem is compounded when available datasets
measure certain crucial household variables imperfectly. Most
individual-level datasets are adapted from surveys or administrative
data that were not expressly designed to test economic theories, and
so they often omit important information, such as precise measurements
of wealth holdings or consumption choices.
The noise problem in microeconomic data becomes less important if
the underlying changes in macroeconomic variables are large relative
to any background idiosyncrasies and measurement errors. As an example,
the large runup in stock prices before March 2000 gave researchers a
valuable opportunity to observe the link between wealth and
consumption at the individual level. One such study found that, from
1983 to 1999, U.S. households that owned stocks did tend to consume
more when stock prices rose, whereas households that did not own
stocks left their consumption patterns unchanged. A second study used
another dataset and focused on the second half of the 1990s, when the
increase in stock prices was most pronounced. This study attempted to
identify, from a number of demographic factors, those U.S. households
that were likely to hold stocks, and it found that these households
were the ones that increased their consumption the most during this
period. Studies such as these suggest that the aggregate relationship
between wealth and consumption reflects at least in part a true causal
component, so that the decline in aggregate stock market wealth would
be expected to slow consumption growth somewhat after the market began
to decline in 2000.
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If one takes the midpoint of the range noted above for the
relationship between changes in stock market wealth and changes in
consumption (3 to 5 cents per dollar), the $7 trillion reduction in
equity wealth since early 2000 would be expected to eventually lower
yearly consumption by about $280 billion. A reduction of this magnitude
would have represented nearly 4 percent of consumption and almost 3
percent of GDP in 2002.

Empirical findings also suggest that the response of consumption to
changes in stock market wealth is drawn out over time, and this has
crucial implications for the precise path of consumption over the next
few years. Because one would expect that the appreciation of equities
before 2000 would still be increasing consumption today, some of the
implied $280 billion drop in consumption after 2000 may simply
represent a ''cancellation'' of a consumption increase that had not
yet taken place. Moreover, positive influences from the other
determinants of consumption (such as current income and the continuing
appreciation in housing wealth) are likely to offset the stock market's
negative effects on personal spending. For these and other reasons,
private forecasters predict that actual consumption will continue to
grow in the years ahead, along with GDP.


The Housing Market and Consumption

Along with healthy growth of disposable income, another positive
determinant of consumption growth in 2002 was the strength of the
housing market. (The sources of this strength, discussed in more
detail below, include record low mortgage rates and continued growth
in housing demand, fueled in part by high immigration and the demand
for second homes.) Housing wealth is more widely distributed among
American families than stock market wealth, and housing equity
continued to rise in 2002. A common way for this equity to support
consumption is through borrowing against home equity: the
outstanding value of revolving home equity loans at commercial banks
rose from $155.5 billion in December 2001 to $212.3 billion in
December 2002. Another way that homeowners can tap the equity in
their homes, for higher consumption or for spending on home
improvements, is by refinancing their outstanding mortgages
when interest rates have fallen. Of course, simply refinancing a
mortgage at a lower interest rate can reduce monthly mortgage payments
and free up extra cash. Many refinancers, however, choose to remove
equity from their homes by taking out a new mortgage with a larger
principal than the amount outstanding on the original mortgage.
These ''cash-out'' refinancings boomed in 2002 as a result of the
continued appreciation in housing prices and declining long-term
interest rates. According to the Federal Home Loan Mortgage
Corporation (Freddie Mac), holders of conventional, conforming
mortgages liquefied about $59 billion in equity in the first three
quarters of 2002. It is impossible to know for certain how this money
was allocated among consumption, home improvements, the paying down
of nonmortgage debts, and the purchase of other financial assets.
Some survey research suggests, however, that about half of this $59
billion would be allocated toward consumption and home improvements
(two sources of aggregate demand), which would have raised GDP by
about 0.4 percent above its baseline level through the first three
quarters of the year (Box 1-2).


Finally, housing equity can also be liquefied from the sale of an
existing home. Typically, the buyer of a new home takes out a mortgage
that is larger -----------------------------------------------------------------------------

Box 1-2. Measuring the Effect of Mortgage Refinancing on Consumption

Mortgage refinancings boomed in 2002 as interest rates fell and housing
prices rose. Many refinancers chose a ''cash-out'' option that left
them a pool of funds to spend after they retired their original
mortgage. A key question is how consumers used these funds: spending
on consumption or home improvements would add directly to aggregate
demand, whereas paying down debts, making a purely financial
investment, or paying taxes would not. Some new data released in 2002
showed that the potential effect of cash-out refinancing on aggregate
demand was large. According to Freddie Mac, holders of conventional,
conforming mortgages cashed out $110 billion through the first
three quarters of 2002, and they used about half of the proceeds
($51 billion) to pay down second mortgages or home equity lines of
credit. (A conforming mortgage is one that falls within the acceptance
limit for securitization by Freddie Mac or Fannie Mae, which was
$300,700 in 2002.) This left a maximum of $59 billion that could be
used for spending that would boost aggregate demand. The amount of
funds freed up by cash-out refinancing among holders of larger
mortgages is not known precisely but would add to this total.

To learn more about how this liquefied equity is being used, the
Federal Reserve has sponsored occasional surveys of households to ask
how they spent funds obtained through cash-out refinancing. The most
recent survey covered refinancings in 2001 and early 2002. The survey
found that about 16 percent of liquefied equity was used for
consumption and 35 percent for home improvements, for a total of
51 percent that would add to aggregate demand. (Another 26 percent of
the funds was used to pay down nonmortgage debt, and the remaining 23
percent was used to fund investments in private businesses or
financial securities or to pay taxes.) These percentages are almost
identical to results from an earlier survey that covered
refinancings in 1998 and early 1999, which also found that about half
of liquefied equity added to aggregate demand. Allocating 51 percent
of the $59 billion in cashed-out equity to demand in the first three
quarters of 2002 suggests an increase in GDP of about 0.4 percent.

One reason that only a portion of the liquefied funds added to
aggregate demand is that many consumers do not need to borrow against
their houses to finance their spending. By taking out a nonmortgage
loan or by drawing down savings, these consumers are free to adjust
month-to-month spending as they see fit. Some evidence that only
''liquidity constrained'' consumers spend much of the funds freed up
by refinancing comes from another survey, which follows a sample of
families over time and has often been used to study income dynamics
in the United States. In addition to its standard questions on income
and spending patterns, this survey has included some questions related
to refinancing activity. Using these data, researchers found that,
among those who refinanced from 1991 to 1994, spending increases were
far more pronounced among families that were likely to have trouble
borrowing from other sources.

-----------------------------------------------------------------------------

than that retired by the seller. The increase in net debt is often
close to the seller's capital gain on the house. From the economy's
point of view, such a transaction allows the capital gain to be
turned into liquidity, although the seller often uses this liquidity
to purchase another home. If so, this type of equity liquefaction does
not raise the seller's consumption of other goods, although it may
raise residential investment if the new home purchase by the seller of
the original house results in a net increase in housing construction.

Nonresidential Investment

Nonresidential investment was one of the weakest components of demand
in 2002. In the first three quarters of the year, business fixed
investment declined at an annual rate of 3.1 percent, in large part
because of a precipitous 17.8 percent fall in investment in
structures. The other, larger component of business fixed investment,
equipment and software, fell at an annual rate of 2.7 percent in the
first quarter of the year, but then rebounded to rise at an annual
rate of 5.0 percent in the second and third quarters. In light of
the weak investment performance, many observers wondered whether
the economy suffered from a capital overhang, built up by excessive
investment in the years immediately before the 2001 recession. As
discussed in last year's Report, this possibility is hard to verify,
because it requires an estimate of the ''correct'' amount of capital
relative to the economy's output, a figure that is hard to know with
certainty. Yet as the 2002 Report also noted, some empirical evidence
had emerged in 2001 indicating that a modest overhang had developed
the previous year for some capital goods, notably servers, routers,
switches, optical cabling, and large trucks. However, evidence that
a widespread overhang continues to hinder overall investment outside
of a few particular industries is harder to find. In any case, the
growth rate of capital services has fallen sharply over the past 2
years, from an average of more than 5.9 percent a year from 1998 to
2000 to 3.6 percent in 2001 and about 3.4 percent in 2002. This low
rate of growth means that any general capital overhang that had
developed by 2000 is likely to have been significantly reduced by the
end of 2002.

Another important business investment development in 2002 was the
change in business inventories. In 2001 firms drew down $61.4 billion
in real inventories (in 1996 dollars), but real inventory investment
turned positive in the second and third quarters of 2002. Although
the level of inventory investment remained modest, the change in
that investment after the drawdown of 2001 added several percentage
points to GDP growth, especially in the first quarter. As the year
drew to a close, inventory-to-sales ratios remained close to their
lowest levels in years, suggesting further room for inventory expansion
in 2003.

Although the short-term outlook for investment in both inventories and
equipment and software is positive, the outlook for investment in
structures is more uncertain. One potential positive influence on
structures investment going forward is the Congress' passage of a
terrorism risk insurance bill in late 2002, which will facilitate the
construction of projects that are difficult to insure privately against
terrorist attacks. Yet vacancy rates for both office and industrial
space remained high in 2002, suggesting that the rebound in structures
investment may not begin for some time.

The Stock Market and Nonresidential Investment

As noted above, one of the factors depressing business investment in
2002 was the stock market. However, the link between the stock market
and investment differs from that between the stock market and
consumption. An individual firm's equity value is linked to its
investment not because of wealth effects, but rather because stock
prices and investment are both forward-looking variables. Technically,
the stock price represents the value of the future stream of dividends
to be paid by the firm, discounted by a required rate of return that
is appropriate for risky assets. A firm with strong future investment
prospects will attract investors hoping to share in the profits
generated by the firm. As these investors bid up the stocks of
companies with the best investment prospects, these firms will come
to have the highest stock values. Indeed, in the simplest model of
business finance, stock prices and investment potential are so closely
correlated that no other information besides a firm's stock price is
needed to predict its investment activity.

In such a world, a firm with a high stock price can easily fund its
investment projects by issuing more equity, which investors willingly
absorb if they believe that the firm's investment prospects are good.
In what amounts to the same thing, firms may also borrow in the capital
markets to finance investment, because lenders will be able to
recognize firms with favorable prospects as good credit risks. In fact,
in this textbook case, the choice between equity financing and debt
financing does not matter to the value of the firm. It is true that
equity financing is more flexible than debt financing, because the
payment of dividends is under the control of the firm, whereas the
schedule of interest payments on debt is fixed at the time of the
borrowing. But if individual stockholders as well as firms can borrow
and lend freely in credit markets, a firm will be unable to increase
its overall value simply by changing its mix of debt and equity
financing. For example, a firm can raise its expected earnings per
share by repurchasing some of its outstanding shares with borrowed
money. But increasing the firm's exposure to credit markets in this
way makes ownership in the firm riskier, which reduces the willingness
of investors to hold equity in the firm. The net result is that the
overall value of the firm does not increase. The firm's debt-for-equity
switch affects only the fraction of its cash flows allocated toward
creditors rather than shareholders. The firm's ability to carry out
''real'' investment projects is the same as before.

Although the U.S. stock market does provide useful signals for overall
investment, the real world diverges from the textbook model in
important ways. One set of complications arises because managers of
the firm are typically better informed about the firm's prospects
than outside investors. The resulting informational asymmetry prevents
investors from attaching values to firms that perfectly reflect the
firms' investment prospects, so that the close correlation between
stock market values and investment found in the textbook model is lost.
Another consequence of informational differences is that firms must
often fund investment from internal sources (such as retained earnings
or cash flow) rather than external sources (such as issuing equity or
borrowing in credit markets).

A second set of complications in the financing of investment is due
to the income tax. Firms are allowed to deduct interest payments as
part of the cost of doing business, but dividends paid to stockholders
are not granted equal treatment. As a consequence, dividend income
is taxed twice, once at the corporate level and again at the level
of the individual dividend recipient. This double taxation of
dividends makes new equity financing less attractive to firms than debt
financing. Moreover, if investors and managers do not share the same
information, the resulting reliance on debt financing can have
damaging consequences for investment during economic downturns. One
concern is that the inflexibility of interest payments, relative to
dividends, means that a recession could cause widespread liquidity
problems among borrowing firms. A second problem is that, when
aggregate conditions worsen, lenders with incomplete information about
firms may reduce credit to firms that are good credit risks as well
as those that are bad risks. The resulting credit crunch may depress
business investment by more than the economic fundamentals would
warrant.

These general principles of investment and corporate finance help to
illuminate recent movements in both the stock market and business
investment. To start with, the correlation between the change in stock
prices and growth in business fixed investment was quite close after
1995 (Chart 1-3). Although the stock market has typically been
imperfectly correlated with investment over the past two decades,
both variables rose markedly from 1995 to 2000 and fell sharply
thereafter. One interpretation of this pattern is that although
informational asymmetries and other complications can generally
obscure the relationship between stock prices and investment, the rise
in both reflected a widely perceived increase in the value of physical
capital installed in firms after 1995. As many observers have noted,
investors may have overestimated the value of installed capital in
many industries, driving the stock prices of some firms to
unsustainable levels and thereby encouraging these firms to invest too
much. Even so, capital markets worked well in the late 1990s, in the
sense that the signals sent by market participants and manifested in
stock prices were received clearly by investing firms.



The boom in the stock market might have been expected to encourage firms
to finance investment by issuing equity, but it turns out that net
issuance of equity was actually negative in the late 1990s (Chart 1-4).
To be sure, many firms did issue equity in order to finance new
investments, through initial public offerings as well as the private
venture capital market, both of which surged through 2000. Yet these
gross equity issues were more than offset by share repurchases and
merger-based stock retirements at other firms, so that debt, not
equity, served as the major source of business financing during the
investment boom. Business debt rose steadily throughout this period,
with net issuance of long-term corporate bonds and short-term
commercial paper playing especially important roles (Chart 1-5). Of
course, a major reason for this pattern of rising debt alongside a
booming stock market was that discussed above: the bias toward debt
financing built into the tax code.

In a general sense, the decline in the stock market after early 2000
can be traced to both of the factors that determine equity prices:
expectations of future corporate earnings, and the risk premium that
investors require in order to hold equities. Evidence that
expectations of earnings growth were adjusted downward as the stock
market fell comes from surveys of Wall Street analysts who track
individual firms. According to one such survey,





5-year-ahead earnings growth forecasts for the firms in the Standard
& Poor's 500 index fell from a peak of more than 18 percent in
mid-2000 to slightly more than 13 percent by September 2002. Other
data provide evidence of an increase in market aversion to risk, which
lowers the price that investors are willing to pay for a stream of
uncertain corporate earnings. A common measure of the market's aversion
to risk is the interest rate spread between corporate bonds and U.S.
Treasury bonds, because corporate bonds are subject to default risk
whereas Treasuries are not. The widening gap between yields for
corporate and Treasury securities after 2000 coincided closely with the
decline in the stock market during this period (Chart 1-6). Spreads
continued to widen sharply in 2002, reaching near-record levels,
indicating that risk aversion played a key role in markets in the
months following September 11, 2001.

In addition to reductions in both earnings expectations and risk
tolerance, corporate governance was an often-cited factor in the stock
market's behavior in 2002. Well-publicized allegations of corporate
wrongdoing and questionable accounting practices may have caused
investors to doubt the reported earnings of some firms. One way to
gauge the seriousness of corporate governance concerns in 2002 is to
examine the interest rate spreads within the investment-grade
corporate bond market and, specifically, the difference between
interest rates paid by the highest-rated corporate borrowers and
those paid by firms with somewhat lower credit ratings. As Chart
1-7 shows,





this spread widened sharply in the closing months of 2001. Although
this period was one of heightened uncertainty over the pace of
near-term economic growth, it also featured a number of important
allegations of corporate misbehavior, and the widening bond spread
suggests that investors became less willing to tolerate relatively
high levels of risk at less-than-premium-grade firms as 2002 began.

Although the effect of these revelations on interest rates and bond
prices appears pronounced, their effect on broad equity price indexes
in 2002 is less clear. To be sure, the revelations of questionable
practices had important consequences for the stock prices of many
firms. Regarding the U.S. stock market as a whole, however, it is
important to recall, as noted above, that all of the world's major
stock markets lost ground in 2002. The precise determinants of these
movements are difficult to identify, but the uniformity of stock
market movements around the world suggests that a key driver of U.S.
stock prices in 2002 was a worldwide decrease in tolerance for risky
assets combined with lower projected earnings growth, and not
necessarily the corporate governance concerns specific to the United
States.

As discussed in Chapter 2, government plays an important role in the
regulation of corporate behavior, complementing the monitoring
mechanisms for invested funds that arise naturally in well-developed
financial markets. In March 2002 the President offered a 10-point
reform plan addressing a wide range of corporate governance issues,
and in July he signed the landmark Sarbanes-Oxley Act. The quick
response to the accounting scandals signaled by passage of this act
underscored both the seriousness of corporate responsibility issues
and the importance of maintaining confidence in markets.

Given the link between investment and stock prices discussed above,
it should not be surprising that investment softened considerably
after early 2000. A key question was whether the temporary slowing of
economic growth would combine with the business sector's reliance on
debt financing to engender a liquidity crisis or a credit crunch,
either of which would depress investment even further. By and large,
however, credit markets in 2001 and 2002 continued to function without
the sharp increase in the nonprice rationing of credit that is typical
of a credit crunch. Short-term business lending did decline in 2001
and 2002, as both commercial paper and commercial and industrial (C&I)
bank loans fell. (See Chart 1-5 above.) By itself, however, a decline
in lending is not evidence of a credit crunch, in which loans are no
longer allocated by price and creditworthy firms are denied loans at
posted interest rates. Although nonfinancial business debt as a
percentage of GDP has declined somewhat over the past year, this
decline has been less severe than during many other business cycles.
It is true that C&I loans and short-term commercial paper outstanding
have fallen sharply, but many firms have simply substituted long-term
bonds for commercial paper in order to reduce rollover risk and lock
in favorable long-term interest rates. Corporate bond issuance was
especially strong in 2001, before the increase in borrowing spreads
within the corporate sector (portrayed in Chart 1-7) raised borrowing
costs for firms that lacked the highest credit ratings. Another
factor leading to reduced bank lending was the general decline in
business loan demand that typically accompanies economic downturns.
Specific evidence for a decline in loan demand comes from an October
2002 Federal Reserve survey, which found that senior loan officers at
most domestic banks put a decline in loan demand, not restrictions in
loan supply, at the heart of the decline in bank lending to businesses.

The relative stability of the business debt-to-GDP ratio in the
aftermath of the 2001 recession contrasts sharply with the decline in
debt that followed the 1990-91 recession, when many feared that a
credit crunch had taken hold. As can be seen from Chart 1-5, the
earlier debt decline was strongly influenced by a sharp decline in
commercial mortgages. This drop in mortgage credit was, in turn,
prompted by an earlier change in the tax code that made commercial
real estate investments less attractive on a purely tax basis, as
well as by continuing weakness in the savings and loan industry.
Because these headwinds to debt accumulation are not relevant for the
current period, it is much less likely that a sustained deleveraging
of the corporate sector like that observed in the early 1990s now lies
ahead for the U.S. economy.

In summary, the link between stock prices and business investment has
proved especially strong since 1995. Both the stock market and business
investment reflected the optimism of investors in the late 1990s, and
both reflected the subsequent scaling back of expected profits as well
as reduced tolerance for risk. Yet even though the investment boom of
the late 1990s was funded primarily with debt and not equity, the
drop in equity values did not degenerate into a full-blown credit
crunch that hindered investment unnecessarily. As a result, rationing
of credit is not expected to hinder the investment recovery that
private forecasters predict for the coming year.

Residential Investment

In contrast to the softness in nonresidential investment, residential
investment grew briskly in 2002, sparked by the lowest mortgage
interest rates in more than a generation. After hitting a recent peak
of 8.64 percent in May 2000, interest rates for conventional,
fixed-rate 30-year loans fell to 5.93 percent by the end of December
2002, their lowest level since 1965. Low mortgage rates contributed to
the 6.8 percent increase in single-family housing starts over their
already high level of 2001, while boosting sales of new homes to
record levels near the end of the year. The strength of housing
construction during



the past 3 years stands in contrast to past business cycles, when
housing starts were not nearly as robust (Chart 1-8).

Strong housing construction is also a natural consequence of rising
housing prices, although that rise moderated to an annual rate of 3.4
percent in the third quarter of 2002 from an annual rate of about 9
percent in the first half of the year. The continued appreciation of
housing during the last several years has led some observers to contend
that the housing market is caught in a bubble, in which buyers pay
high prices for assets simply because they hope to sell those assets
to other investors at even higher prices, a scheme that collapses
quickly when no further purchasers can be found. Proponents of the
housing bubble theory noted that houses were particularly expensive
relative to rents, which indicated that high shelter costs alone
did not explain the entire rise in housing prices. Housing prices also
rose much more quickly than the median household income in 2001, which
left the price-to-income ratio at its highest level in more than two
decades.

Because it is difficult to know the precise motivations of the
millions of persons who buy homes (or any other assets), it is
impossible to know for sure whether any sharp increase in home prices
is a bubble. Yet the high transactions costs involved in selling houses
make a bubble in the housing market unlikely. Moreover, new sources of
housing demand have emerged in the past two decades to support the
fundamental value of owner-occupied houses. One is the growth in
purchases of second homes by baby-boomers, many of whom are now in
their prime earning years. Perhaps more important is the recent
surge in immigration into the United States. In the 10 years preceding
the 2000 Census, the number of foreign-born residents in the United
States rose by 11.3 million, or 57 percent, compared with an increase
of only 5.7 million in the previous 10-year period. As a result, the
share of foreign-born individuals in the total U.S. resident population
reached 11.1 percent in the 2000 Census. This is well above their 4.7
percent share in 1970 and comparable to the 13 to 15 percent shares
recorded during the golden age of immigration from 1860 to 1920.

By itself, a surge in immigration would be expected to raise shelter
costs in general, but not necessarily the price of homes relative to
rents. Yet there is evidence that the timing of the immigration wave,
along with recent developments in mortgage finance, has raised demand
for owner-occupied homes separately from the demand for rental housing.
Some recent research has pointed out that immigrants who arrived in
the 1980s have only recently been able to make the transition to home
ownership, because it takes time to save for a down payment. Also,
developments in mortgage finance over the 1990s have made home
purchases more affordable by narrowing the spread between mortgage
interest rates and benchmark U.S. Treasury yields. The liberalization
of mortgage finance would be expected to exert a strong, independent
effect on home demand, by enlarging the pool of potential buyers of
any nationality. This liberalization could well have combined with
improvements in the financial positions of previous immigrants to
result in a strong source of housing demand in the past several years.
According to the 2001 American Housing Survey, sponsored by the
Department of Housing and Urban Development, foreign-born residents
have accounted for a sizable share of first-time home purchases since
1997, when the increase in house prices began in earnest. The survey
shows that there were more than 5.7 million foreign-born homeowners
in the United States in 2001, and more than 20 percent of them had
purchased their first house since 1997. Although many of these new
homeowners were members of minority groups, the rate of homeownership
among minorities still lags behind that of whites. To redress
this imbalance, in June 2002 the Administration announced an
initiative to add 5.5 million minority homeowners by the end of the
decade.

Net Exports

Although the output of the U.S. economy remained below potential in
2002, its growth rate still outpaced those of many other
industrialized countries. Slow growth among many of the United States'
major trading partners, in turn, contributed to slow growth in U.S.
exports compared with that of imports. Exports rose at an annual rate
of 7.4 percent during the first three quarters of the year, while
imports grew 11.1 percent. This discrepancy between the rates of
growth in exports and imports led to an increase in the U.S. trade
deficit, so that net exports exerted a drag on GDP growth in the first
half of the year. (Net exports were essentially unchanged in the third
quarter.)

Because changes in the trade deficit are often quantitatively
important for year-to-year changes in GDP growth, U.S. trade
performance is an important concern. Imports and exports both provide
benefits to consumers and firms. Imports provide U.S. firms with a wider
variety of low-cost inputs, and consumers with wider variety and lower
prices for goods. Moreover, competition from international producers
induces domestic firms to raise their productivity, which raises
incomes in the long run. Trade therefore boosts consumer satisfaction
at home and ensures that American producers remain competitive, by
increasing the size of the market in which they operate. In light of
the benefits of trade to both Americans and foreigners, the
Administration has made the expansion of trade a central policy
objective. Two important trade-related developments in 2002 were the
Congress' granting of Trade Promotion Authority to the President
(after an 8-year hiatus) and the launching of an ambitious initiative
to reduce barriers to agricultural trade, announced at the ongoing
Doha round of trade negotiations within the World Trade Organization.
These developments and others are described in more detail in Chapter
6, which discusses the importance of free trade measures in promoting
economic growth around the world.

Government Purchases

The war on terrorism continued to exert upward pressure on Federal
Government purchases in 2002. In late March the President requested
that the Congress provide an additional appropriation of $27.1
billion, primarily to fund this effort. More than half of this amount
was allocated to activities of the Department of Defense and various
intelligence agencies. Most of the rest was needed for homeland
security (mainly for the new Transportation Security Administration)
and for the emergency response and recovery efforts in New York City.
Although most of this spending was required for one-time outlays
only, it nevertheless contributed to the 6.4 percent annual rate of
increase in real Federal Government purchases in the first three
quarters of 2002. State and local government purchases rose at a more
moderate 1.7 percent annual rate during the same period.


The Labor Market, Productivity, and Real Wages

Although the labor market improved in 2002 after weakness in the wake
of the September 2001 attacks, most major labor market indicators
showed little progress over the course of the year. The unemployment
rate hovered between 5.5 and 6.0 percent throughout the year, after
rising 1.8 percentage points in 2001. Nonfarm payroll employment in
2002 was similarly weak, with 181,000 jobs lost during the year,
compared with 1.4 million jobs lost the previous year.

As in past business cycles, the decline in manufacturing employment
has been especially pronounced. Factory employment fell by 592,000 in
2002, following a decline of 1.3 million in 2001 and about 100,000 in
2000. Another feature of previous business cycles that has recurred
in the past 2 years is the increase in the number of workers who
report a long unemployment spell. Like the overall unemployment rate,
the number of workers unemployed for 26 weeks or more rose in 2001 and
remained high in 2002 (Chart 1-9). The rise in long-term unemployment
is one of the most troublesome features of recessions, because
long-term joblessness is costly to those unable to find work. Indeed,
the difficulties endured by the long-term unemployed were a key
reason for the passage of the Job Creation and Worker Assistance Act
in March, which extended unemployment benefits for many of these
workers. Yet, as Chart 1-9 shows, the pattern of long-term unemployment
observed in 2001 and 2002 was similar to patterns traced out in
previous postwar fluctuations.

In other ways, however, the recent behavior of the labor market has
been different from that in past business cycles. One difference is
the high fraction of job losers who reported a permanent rather than
temporary separation in 2001. In the government's monthly Current
Population Survey, each respondent who reports a job loss is asked
whether he or she expects to return to work with the same employer.
(Those who expect to return are typically on an explicitly temporary
layoff, although this need not be the case.) Research from the Bureau
of Labor Statistics found that, in the initial quarters of the four
recessions before 1990, slightly more than half of job losers were
permanently separated from their previous employers, with the rest on
temporary layoff. In the three quarters after the business cycle
peak of 1990, however, the share of permanent job losers rose to
almost three quarters, and the comparable proportion for the March
2001 peak is nearly 90 percent.

The rising proportion of job losers facing a permanent separation in
recessions may reflect structural changes in the labor market during
the past two decades, including the rise in temporary help employment.
A firm facing a transitory increase in demand may use a temporary
worker (formally employed by a temporary help firm) rather than add
staff to its regular work



force. When demand falls, the firm would then permanently sever the
relationship with this worker; in the past the firm might have placed
one of its own workers on temporary layoff. This explanation is
consistent with the sharp rise in temporary help employment over the
past 20 years as well as the sharp drop in 2001. Yet it is important
to keep in mind that the fraction of workers losing their jobs in 2001
remained well below that in recent recessions, because of the mildness
of the 2001 contraction. Although year-to-year fluctuations in the
labor market are of immediate concern, sustained improvements in the
living standards of American workers depend on more structural,
long-term factors. As discussed in Chapter 3, these factors include
the flexibility and dynamism of the American labor market, which
matches millions of workers with new jobs each month and provides
incentives for investments that make workers more productive. Indeed,
pro-growth labor market policies in the United States have helped the
economy achieve a sizable increase in labor productivity growth since
1995. When this increase began, many economists were skeptical that
it was permanent, because productivity growth in a given quarter or
year can be strongly influenced by the business cycle. Indeed,
macroeconomic research has long established the procyclicality of
productivity as a stylized fact, with output per worker rising faster
in expansions than in recessions. This productivity pattern can be
explained by the reluctance of firms to hire early in a recovery,
before they are sure that a robust recovery has taken hold. This
reluctance means that existing employees must work harder to fill
the higher number of orders when demand first begins to rise. The
resulting increase in worker effort causes output to rise faster than
hours worked, so that the data indicate an increase in productivity
even without any improvement in the underlying technology of
production. Economists therefore prefer to observe improved
productivity performance over an extended period before pronouncing
that a change in productivity growth has taken place.

As productivity growth has stayed high since 1995, the productivity
improvement has increasingly come to be seen as lasting. Data from
2001 and 2002 only strengthen this conclusion. During the seven
quarters ending in the third quarter of 2002--a period that includes
a recession and a recovery--labor productivity grew at an annual rate
of 3.2 percent, somewhat higher than the annual rate of 2.5 percent
from 1995 to 2000 and much higher than the 1.4 percent trend from 1973
to 1995. (A formal analysis of recent productivity data is presented
later in the chapter.) An improvement of only about 2 percentage
points in productivity growth may not sound impressive, but over time
even a small increase in productivity growth brings about a large
improvement in living standards. For example, growth in productivity
of 1.4 percent a year implies that productivity doubles every 50 years,
but growth of 2.5 percent implies a doubling every 28 years.

Strong productivity growth also helps to keep inflation down, by
allowing real wages to grow without an increase in unit labor costs,
which would drive up firms' costs of production and therefore push
output prices upward. Indeed, another bright spot in 2002 was the
behavior of inflation and real wages. The consumer price index (CPI)
rose 2.4 percent in 2002 (December to December), close to its 1.6
percent rate of increase in 2001. The core CPI, which does not include
the volatile food and energy components, rose 1.9 percent.

Inflation is difficult to measure, because of the dynamic nature of
consumers' choices (Box 1-3), and it is not directly linked to long-run
living standards. Nonetheless, low inflation is fundamental to a
healthy economy. High and variable inflation not only can cloud the
relative price signals needed to allocate resources efficiently, but
also can introduce other distortions through the income tax.
Additionally, bringing inflation down from high levels typically
requires sustained (and costly) increases in unemployment. The low
inflation observed in 2002 gave policymakers the flexibility to support
the fledgling recovery without being overly concerned that they would
increase price pressures in doing so.

Taken together, rapid productivity growth and low inflation meant that
real wages continued to grow in 2002. As measured by the employment
cost index, real compensation for private industry workers grew 2.1
percent over the four quarters ending in the third quarter of 2002.
This compares with

-----------------------------------------------------------------------------

Box 1-3. New Measures of Consumer Price Inflation

Following through on a request from the Congress, the Bureau of Labor
Statistics has developed a new measure of consumer price inflation.
Unlike the current official Consumer Price Index for Urban Consumers,
the new measure not only adjusts for consumer substitution between
goods in response to movements in relative prices, but also uses
current expenditure weights rather than weights that are several years
out of date. The fact that weights from different adjoining years are
''chained'' together gives the new measure of inflation its name:
the chained CPI, or C-CPI. The chained CPI is a supplemental series
and is not intended to replace the official CPI, versions of which
are used to index Social Security benefits, pensions, Federal tax
brackets, and many private contracts.

Any consumer price index must somehow aggregate the many prices faced
by consumers into a single number. The official CPI aggregates prices
by using a fixed market basket. (Currently the basket reflects
consumption shares in 1999-2000 for 211 major categories of goods and
services.) The disadvantage of using a fixed-weight basket is that the
reflect the real locations that consumers make when relative prices
change. For example, if the price of chicken were to rise while that
of steak held steady, consumers might well buy more steak; then the
use of fixed weights would overstate the increase in the cost of meat
generally, caused by the increase in the cost of chicken. The new
chained index reflects this substitution, but at some cost.
Specifically, the new index requires data on consumer expenditure
before and after these substitutions have occurred. But whereas prices
are relatively easy to measure on a real-time basis, expenditure shares
are not, which means that current expenditure shares must be estimated
for the most recent periods.

Because it reflects substitution by consumers, the new measure uses
expenditure weights that are constantly changing as consumption
patterns change. As a result, the expenditure weights do not get out
of date as they do with a fixed-weight index. The difference that this
use of up-to-date weights makes is particularly important to the
contribution of computers to the cost of living, because the relative
price of computers has fallen during the past two decades even as the
expenditure share of computers has risen. A fixed-weight basket would
tend to understate the weight of computers in current consumption,
because its expenditure weights are typically years out of date. As
the price of computers has fallen over time, the underweighting
of computers in a fixed-weight index causes this index to overstate
the increase in the cost of living. The chained CPI does not suffer
from this problem, because its weights are constantly being updated.
------------------------------------------------------------------------------

real compensation growth of only 1.3 percent during the same period a
year earlier. Although increases in benefits (such as employer
payments for health insurance) accounted for much of the acceleration
in total compensation growth, annualized real growth in wages and
salaries also accelerated, from 0.9 percent to 1.7 percent across the
same two periods.

In short, the sluggish performance of the labor market in 2002 was an
unwelcome development for many workers and their families, as well as
a matter of concern for policymakers. But rapid productivity growth,
low inflation, and healthy real wage gains set the stage for future
improvements in both unemployment and job growth in the years ahead.


Macroeconomic Policy and the Budget Outlook

The U.S. economy has suffered a number of serious setbacks in the past
3 years, including the terrorist attacks of September 2001, the
significant loss of stock market wealth since 2000, and the recent
corporate accounting scandals. Yet the contraction of 2001 was one of
the mildest on record, with recovery proceeding steadily, if modestly,
in 2002. One reason for the economy's stability in the face of these
adverse developments was the stance of macroeconomic policy, both
monetary (set by the Federal Reserve) and fiscal (set by the President
and the Congress). This section analyzes the effects of monetary and
fiscal policy in detail, illustrating their likely impact on
macroeconomic performance in 2002 as well as the fiscal outlook for
the years ahead.

Monetary Policy

In 2001, faced with signs of a slowing of economic activity, the
Federal Reserve reduced its policy interest rate, the Federal funds
rate, 11 times during the year, from 6.50 percent to 1.75 percent.
The Federal Reserve then held the funds rate steady through most of
2002, until a further half-percentage-point cut on November 6 brought
it down to 1.25 percent. Although the Federal funds rate thus remained
constant for most of 2002, earlier rate reductions continued to
stimulate the economy throughout the year. Understanding the reasons
for this lag requires an understanding of the channels through which
monetary policy affects the economy. A lowering of interest rates
stimulates demand through four main channels: encouraging consumption
(particularly of durables), stimulating business investment (by
lowering the cost of capital), promoting residential investment (as
seen from the booming housing sector), and lowering the foreign
exchange value of the dollar (which tends to raise exports and lower
imports). All of these effects take time to be felt. Consumers must
plan how best to take advantage of lower borrowing costs, firms must
plan new investments, and importers and exporters must determine how
any change in the dollar's exchange value will affect their prices
and costs. Measuring the size of these effects as well as the time
needed for them to be fully expressed is an active area of
macroeconomic research. One method for measuring the effect of
monetary policy uses formal models of the economy, in which the
behavioral relationships governing consumption, investment, imports,
and exports are fully specified. After the researcher specifies a
time path for the Federal funds rate, the model supplies the likely
path for each component of aggregate demand, based on the behavioral
relationships embedded in the model's equations. In contrast to this
model-based method, a more data-based method for measuring the
effects of monetary policy omits any formal modeling of behavioral
relationships, instead using statistical techniques to measure the
past effect of funds rate changes on a few key variables, such as
output and the price level. An important goal of this method is to
take account of other factors, such as changes in fiscal policy and
temporary shocks to aggregate demand and prices, which may also have
affected the economy when a given change in monetary policy was taking
place. Although the precise channels of monetary policy are not
specified in the data-based method, it is hoped that the answers are
less sensitive to particular assumptions, which can differ across
large behavioral models.

Results from both model-based and data-based methods suggest that
monetary policy changes take effect only after a lag of several months,
but that these effects are long-lasting, so that the rate reductions
in 2001 are likely to have stimulated the economy throughout 2002. To
gain a sense of the magnitudes involved, one well-known model of the
economy predicts that, holding other factors constant, a
1-percentage-point decrease in the Federal funds rate raises real GDP
by 0.6 percent above its baseline level after 1 year. This effect of
monetary stimulus on real GDP rises to 1.7 percent after 2 years.
Data-based methods broadly concur with this assessment: one study
shows that the typical decrease in the funds rate raises output
steadily in subsequent quarters, reaching a maximum effect on output
after about 18 months. Both methods therefore imply that interest rate
cuts in 2001 continued to exert considerable economic stimulus in 2002.

Fiscal Policy

An important goal of fiscal policy is to promote growth by limiting
the share of output commanded by the government. In 2001 the Congress
and the Administration made major progress along these lines with
passage of the Economic Growth and Tax Relief Reconciliation Act,
which featured a broad-based cut in marginal tax rates. The long-term
benefits of such a policy are clear, as high marginal tax rates
discourage the entrepreneurship and risk taking on which the strength
of the U.S. economic system depends. Yet although the goal of EGTRRA
was to improve long-term living standards and limit the size of the
government, the legislation conferred important short-term benefits as
well, thanks to the way in which the tax rate reductions were set in
place and the timing of the act's passage. A new lower tax rate of 10
percent was introduced at the bottom range of the previous 15 percent
bracket, and taxpayers in 2001 were given an advance rebate on their
likely savings due to this reduction.

Rebate checks ($300 for most single taxpayers, $600 for most married
couples filing jointly) arrived in mailboxes in the summer of 2001.
The timing of the resulting $36 billion infusion of spendable income
into the economy could not have been more favorable. Although the depth
of the 2001 recession would not be known until revised GDP figures were
announced the next year, GDP had already declined by 0.6 percent at an
annual rate in the first quarter of 2001 and by 1.6 percent in the
second quarter. As estimated from the traditional relationship between
overall GDP and current income, the tax plan added about 1.2 percentage
points of growth at an annual rate in the third quarter. As a result,
without the checks, third-quarter GDP would have declined at an annual
rate of 1.5 percent rather than the 0.3 percent rate actually
observed. In the fourth quarter, tax relief continued to add 1.2
percentage points to the annual rate of real GDP growth, so that
instead of rising at an annual rate of 2.7 percent, GDP would have
risen by only 1.5 percent in the absence of the rebates.

The rebate checks mailed in 2001 represented only a small fraction of
the tax relief from the EGTRRA package. In addition to lowering
marginal tax rates, EGTRRA increases the incentives for saving, for
making bequests to heirs, and for investment. As a result, tax relief
from EGTRRA probably helped the private sector create 800,000 jobs by
the end of 2002 relative to the baseline level without tax relief,
while raising GDP growth by about 0.5 percentage point over the course
of that year. In March 2002 the President signed the Job Creation and
Worker Assistance Act, which implemented a tax policy especially
appropriate for the fledgling recovery. The act promoted investment
by allowing firms to immediately write off (that is, expense) 30
percent of the value of qualified investments in the year of purchase
for investments made through September 11, 2004. As discussed in
Chapter 5, government policies can significantly improve growth by
removing tax distortions that penalize investment or other productive
activities. For example, introducing expensing lowers the cost of
capital, thereby making more investment opportunities profitable on
an after-tax basis. The act stimulates investment by allowing partial
expensing through most of 2004. In addition to reducing the
tax-adjusted cost of investment, the act extended unemployment
benefits to workers who have exhausted their regular benefits. This
enhanced the role of unemployment insurance as one of the economy's
most important automatic stabilizers.

The Federal Budget

After 4 years of surpluses, the unified Federal budget recorded a
deficit of $158 billion in fiscal 2002, or about 1.5 percent of GDP.
The return of the deficit was primarily due to four factors: the
lingering effects of the recession of 2001, the stock market plunge,
increased Federal expenditure necessitated by the war on terrorism,
and the costs of homeland security. Recessions tend to increase budget
deficits because they lead to higher outlays (for unemployment
insurance, for example) at the same time that they reduce tax receipts
(because taxable income falls). The decline in receipts during the
most recent downturn in the business cycle has been especially
pronounced. Total receipts in fiscal 2002 were $1,853 billion, having
fallen $138 billion, or about 7 percent, from their level in fiscal
2001. This represented a much larger percentage decrease in receipts
than in previous, far more severe recessions. One of the most
important reasons for the dramatic decline in receipts given the
mildness of the 2001 contraction was the coincident decline in the
stock market. The stock market's decline reduced capital gains
receipts in addition to reducing taxes on wage and salary income for
workers whose jobs are closely tied to equity markets. More detailed
information on the precise sources of the decline in receipts will
not be available until the Treasury completes its regular annual
examination of individual tax returns. Even with the decline in
receipts, however, the budget deficit was relatively small as a
fraction of GDP compared with those seen in previous periods of war
and recession.

The President's Jobs and Growth Initiative

On January 7, 2003, the President proposed a plan to enhance the
long-term growth of the economy while supporting the emerging recovery.
At the start of 2003 the consensus of private forecasters predicted
accelerating growth in real GDP over the course of the year, which
would raise investment, reduce unemployment, and increase job growth.
This consensus view is reflected in the Administration's outlook,
discussed below. Yet the recovery in investment could be delayed by
weaker-than-expected profit growth, higher required rates of return
arising from geopolitical and other risks, or a prolonged period
during which companies focus on repairing their balance sheets. More
general risks to recovery in 2003 include an increased sense of
caution, which could lead households to pull back on their spending
plans, and the potential for further terrorist attacks. To insure
against these near-term risks while boosting long-term growth, the
President has proposed a focused set of initiatives. Specifically,
the President's plan would:

	Accelerate to January 1, 2003, many features of the
2001 tax cut that are currently scheduled to be phased in over several
years. These include the reductions in marginal income tax rates,
additional marriage penalty relief, a larger child credit, and a wider
10 percent income tax bracket
	Eliminate the double taxation of corporate income by
excluding dividends from individual taxable income
	Increase expensing limits for small business
investment, raising to $75,000 the amount that small businesses may
deduct from their taxable income in the year the investment takes
place
	Provide $3.6 billion to the States to fund Personal
Reemployment Accounts for unemployed workers. These accounts would
allow eligible workers to spend up to $3,000 to defray the costs of
finding or training for a new job. Workers could keep any unspent
balance in their account if they find work within 13 weeks of going
on unemployment.

Accelerating the marginal tax rate reductions would insure against a
softening of consumption by putting more money in consumers' pockets
through long-term tax cuts, which have been shown to be more effective
than temporary cuts in boosting near-term spending. Ending the double
tax on corporate income would increase the ability of corporations to
raise equity capital, providing near-term support to investment while
improving the long-term efficiency of capital markets. (For more on
how eliminating the double tax on corporate income would help the
economy, see Chapter 5.) The provisions also support investment by
small firms. Higher expensing limits would make it easier for small
firms to expand by reducing the tax-adjusted cost of capital; lower
marginal tax rates would increase growth incentives for small business
owners whose business income is taxed at individual rates. Finally,
Personal Reemployment Accounts, discussed in more detail in Chapter
3, would provide unemployed workers with a new set of incentives as
they look for work. Accounts of this type, which reward unemployed
workers for finding jobs quickly, have been shown in experiments in
several States to increase the speed with which unemployed workers
find new jobs. Moreover, by allowing workers a choice between using
the funds to support their job search and using them for job training
expenses, the accounts are well suited for the dynamic U.S. labor
market.

The Effect of Tax Relief on Interest Rates

One of the most widely discussed issues in fiscal policy concerns the
effect of tax relief on interest rates. It is widely agreed that, in
the immediate aftermath of a permanent tax cut, consumption increases
because consumers have more disposable income. This increase in
consumption raises GDP in the near term, especially if the economy is
operating below its potential, with large amounts of unused labor and
capital. In the long run, lower tax rates have somewhat complicated,
offsetting effects on GDP. On the negative side, if the reduction in
tax rates is not accompanied by spending reductions, it will increase
the budget deficit and may reduce national saving. Lower national
saving, in turn, will shrink the pool of loanable funds available in
capital markets, which increases interest rates and reduces investment.
Ultimately, lower investment leads to a smaller stock of productive
capital, resulting in lower wages, lower productivity, and lower
output. Offsetting this, however, is the positive effect of tax relief
that operates through improved incentives to work and take risks, for
example by creating a new firm or by making a new investment.
Incentives to undertake these activities improve after a cut in
marginal tax rates, because the tax reduction allows more of the
rewards to be captured by workers, entrepreneurs, and investors and
not by the government. When tax relief extends to capital income
(such as dividends), as proposed in the President's most recent jobs
and growth initiative, an additional positive effect arises through
stronger incentives to save. These positive effects on GDP operating
through improved incentives also have an impact on future budget
deficits and investment, because deficits will be less onerous if the
economy grows in response to the improved investment climate.

Assessing the ultimate effect of tax relief on GDP and future
government debt thus requires gauging both the negative effects that
arise through higher interest rates and the positive effects that
come from improved incentives. Unfortunately, measuring the effect
through incentive channels is difficult, because there have been few
episodes of large, broad-based tax relief during the last several
decades. Moreover, even these historical episodes occurred amid a host
of other economic developments, making it difficult to isolate the
direct effect of lower taxes on working and saving.

Obtaining a rough estimate of the interest rate effect is less
difficult, because widely accepted economic theory allows precise
predictions of how much an increase in the stock of debt should affect
interest rates. The first step in making this calculation is to note
that an additional dollar of government debt does not reduce the
capital stock by a full dollar. About 40 cents of the additional debt
will be offset by larger capital inflows from abroad, so that the U.S.
capital stock would fall by only about 60 cents. The next step is to
translate this 60-cent-per-dollar decrease in the capital stock into
an ultimate change in long-term interest rates. This is done by noting
that the interest rate on a bond should be closely related to the
marginal product that physical capital earns in the marketplace. This
is so because the two should converge to the point where investors
are indifferent between holding financial securities or holding
physical capital in their portfolios. Reducing the physical capital
stock will increase the marginal return to capital in the marketplace
by making capital scarce relative to other factors of production; the
key question is by how much this marginal return rises. Some
calculations (shown in Box 1-4) imply that interest rates rise by
about 3 basis points for every $200 billion in additional government
debt.

Given this relationship between government debt and interest rates,
concerns that higher interest rates would choke off the stimulative
effects of recent tax reductions seem unwarranted. For example, this
relationship implies that the $1.3 trillion in tax relief included in
EGTRRA would raise interest rates by only about 19 basis points--a
modest cost to be set against the long-term incentive-based benefits
expected from lower marginal tax rates.

The modest effect of government debt on interest rates does not mean
that tax cuts pay for themselves with higher output. Although the
economy grows in response to tax reductions (because of higher
consumption in the
------------------------------------------------------------------------------

Box 1-4. Calculating the Effect of Higher Government Debt on
Interest Rates

The effect of government debt on interest rates depends on the
productivity of capital in the economy, because additional government
debt ''crowds out'' capital, increasing its scarcity relative to labor
and thereby raising its return in the marketplace. The higher return to
capital also increases the required return on other assets, such as
bonds, which drives up interest rates. One can get some idea of the
productivity of capital in the United States by measuring how much of
total U.S. output is paid to suppliers of capital as opposed to
suppliers of labor. Gross capital income is usually about one-third
of total U.S. output, with the rest going to labor. Mathematically,
the constancy of the capital share implies that the marginal return
on each unit of capital is proportional to the output-to-capital ratio
(Y/K). This proportionality implies that the percentage change in the
marginal return to capital induced by a change in the capital stock
is the same as the percentage change in Y/K, which is simply the
percentage change in Y minus the percentage change in K. Some
additional calculations show that the constant one-third capital share
implies that output should fall by one-third of 1 percent for every 1
percent decline in capital. This allows us to write the ultimate
percentage change in the marginal return to capital as (percent change
in Y) - (percent change in K) = (-0.33 percent) - (-1.0
percent) = 0.67 percent. In other words, the marginal product of
capital rises by 0.67 percent when the capital stock falls by 1.0
percent.

Box 1-4.--continued

Government data show that the U.S. capital stock was about $28
trillion in 2001, so that 1 percent of the capital stock is $280
billion. Because one dollar of debt reduces the capital stock by
about 60 cents, an increase in government debt of about $467 billion
is required to crowd out 1 percent of the capital stock
($467 billion x 0.60 = $280 billion). Government data also
imply that the gross marginal product of capital is about 10 percent,
which implies that a 1 percent decline in the capital stock would
raise interest rates by about 6.7 basis points. A conservative rule of
thumb based on this relationship is that interest rates rise by about
3 basis points for every additional $200 billion in government debt.
------------------------------------------------------------------------------

short run and improved incentives in the long run), it is unlikely to
grow so much that lost tax revenue is completely recovered by the
higher level of economic activity. The small effect of debt on
interest rates does show, however, that attempts to stimulate the
economy by raising taxes in order to lower interest rates are likely
to be unsuccessful, especially if the taxes raised are those that
discourage private saving and investment. The resulting reduction in
interest rates will probably be too small to outweigh the negative
effects of tax increases that work through distorted incentives.
Further, the modest effect of increased debt on interest rates
suggests that policymakers should not be afraid to use fiscal policy
when doing so improves the long-run health of the economy. As long as
the change in fiscal policy does not bring about large, systemic
imbalances in the economy--such as a high debt-to-GDP ratio, or
rapidly rising interest costs as a share of Federal outlays--
policymakers should not be paralyzed by the fear that any benefits
from tax reductions are likely to be undone by the increase in interest
rates they bring about.


Developments in the Rest of the World

Growth in many of the United States' major trading partners was even
more disappointing in 2002 than was growth at home. Although growth
in Canada, America's largest trading partner, was a surprisingly robust
4.0 percent during the four quarters ending in the third quarter of
2002, growth elsewhere lagged far behind. The economy of the United
Kingdom grew only 2.1 percent over the same period; growth rates in
Germany (0.4 percent), Italy (0.5 percent), France (1.0 percent),
Japan (1.3 percent), and Mexico (1.8 percent) were even lower. Low
demand for U.S. exports combined with the emerging recovery in the
United States (which increased U.S. demand for imports) sent the U.S.
trade deficit to a record high in 2002.

Discussion of the U.S. position in international markets is often
framed in terms of the current account, a broader measure of
international transactions. In addition to the trade balance in goods
and services, the current account includes net investment income,
net compensation of resident alien workers, and net unilateral
transfers. Because the trade component is by far the largest in the
current account balance, the widening in the trade deficit in 2002
contributed strongly to the widening in the current account deficit.
The latter reached a record 4.9 percent of GDP in the second quarter
of 2002 before falling slightly, to 4.8 percent, in the third quarter.

One advantage of framing international finance discussions in terms
of the current account is that, as a matter of national accounting,
the current account balance equals the difference between net national
saving and net national investment. For example, if U.S. saving were
smaller than U.S. investment in a given period, the difference--the
excess of investment over saving--must have been financed by
foreigners. In the process of financing U.S. investment, foreign
investors obtain U.S. assets, either in portfolio form (that is, as
stocks, bonds, or other financial securities) or though direct
controlling ownership of physical capital. These assets then generate
investment income in the form of dividends, interest payments, and
profits that can be repatriated to the investors abroad. Balance of
payments data therefore resemble a ''sources and uses of funds''
statement for the Nation as a whole, providing useful information on
the amounts of internal and external investment financing. High
levels of investment in the late 1990s meant that the U.S. capital
stock grew quickly in the late 1990s, but the accumulation of past
current account deficits requires an increasing portion of the income
earned by this capital to flow abroad. Over the past year, the U.S.
current account deficit has widened because net investment has been
essentially flat while net saving has fallen (Chart 1-10).

The relationship between the current account deficit and net investment
by foreigners in U.S. assets also makes clear how changes in
international



demand for U.S. assets can affect the trade balance, and vice versa.
Consider an increase in foreigners' demand for U.S. assets. Their
resulting accumulation of U.S. assets can affect international trade
flows through an appreciation of the dollar, because foreigners must
obtain dollars in order to purchase U.S. assets. Appreciation of the
dollar tends to make imports cheaper for U.S. residents, and U.S.
exports more expensive to consumers abroad; both these effects move
the trade balance (and the current account) toward deficit.

In light of the large number of trade-related and financial forces
operating on the current account, it is impossible to label a current
account deficit of a given magnitude either good or bad.  As noted
above, recent current account deficits result from U.S. investment
outpacing domestic saving. One factor contributing to high U.S.
investment relative to saving is the rapid increase in U.S.
productivity relative to that in many other major countries, which
makes the United States a good place to invest. Because productivity
growth is ultimately responsible for rising living standards, the
current account deficit reflects at least in part some very good news
about the American economy.

Even so, a current account deficit indicates that the United States
is consuming and investing more than it is producing. As Chart 1-10
shows, the U.S. current account has typically been in deficit for the
past two decades.
As a result, the net international investment position in the United
States (the value of U.S. investment holdings abroad less that of
foreign holdings in the United States) has moved from an accumulated
surplus of slightly less than 10 percent of GDP in the late 1970s to
a deficit of almost 20 percent of GDP in 2001 (Chart 1-11). Recent
increases in the current account deficit have led to some concerns
that continued current account deficits (and the increase in the
United States' international debt that would result) might not be
sustainable. Clearly, debt cannot increase without limit. Because debt
has to be serviced by the repatriation of capital income abroad, the
ratio of a country's debt to its income has to stabilize at some point.

Yet the United States today is far from the point at which servicing
its international debt becomes an onerous burden. In fact, until last
year, more investment income was generated by U.S. investment in
foreign countries than by foreign investments inside the United States,
even though the net international investment position of the United
States moved into deficit almost two decades ago (Chart 1-11). Given
the United States' negative international investment position, the
fact that, until 2002, more investment income flowed into the United
States than flowed out of it implies that the



rates of return on U.S. investment abroad were higher than the returns
enjoyed by foreign investors in the United States. (Further analysis of
international investment data indicates that these differences in
rates of return are especially pronounced for direct investment, and
less so for portfolio investment.) Although debt service became a net
transfer from the United States to the rest of the world in 2002, this
debt service is unlikely to amount to a significant portion of U.S.
output in the foreseeable future.

Near-term developments in the U.S. current account depend on a number
of factors. One of the most important is the rate of economic growth
in the rest of the world. Faster growth abroad raises the demand for
U.S. exports, which reduces the trade and current account deficits. A
second factor affecting the U.S. current account is the propensity of
U.S. residents to save. As Chart 1-2 showed, saving rates fell sharply
in the 1990s; as noted above, this may have stemmed from the strong
appreciation in the stock market, which allowed wealth to grow quickly
without any increase in active saving out of disposable income. The
retrenchment in asset prices that began in early 2000 may encourage
some consumers to increase their active saving to pre-1995 levels.
For any given level of domestic investment, an increase in the saving
rate lessens the need to borrow from abroad and thereby reduces the
current account deficit. In any event, it is far preferable to reduce
the current account deficit by saving more than by reducing investment,
because lower investment results in slower growth in the capital stock,
a lower growth rate of labor productivity, and slower growth in living
standards.

A third factor affecting the evolution of the current account is the
future demand by foreign investors for U.S. assets. To the extent that
foreign investors reduce their demand for U.S. assets and substitute
holdings in other countries for those assets, the real exchange value
of the dollar will fall, holding other factors constant. Conversely,
the real value of the dollar will rise with an increase in the demand
for U.S. assets. Such an increase in demand might result from
continued productivity growth in the United States or from an increase
in the perceived safety of U.S. assets relative to the rest of the
world.

Moderate changes in foreign demand for dollar-denominated assets need
not have large disruptive effects on the U.S. economy. Gradual shifts
in the terms of trade would engender offsetting increases or decreases
in the growth of consumption and imports, leaving real GDP little
affected. In fact, if productivity growth remains relatively high in
the United States while inflation remains low, a moderate shift in
global demand away from U.S. assets and the subsequent decline in the
real value of the dollar may not even require a change in the nominal
exchange rate, because the real value of the dollar falls with a
constant nominal exchange rate when inflation at home is lower than
inflation abroad.

Moreover, history has shown that even a substantial decline in the
value of the dollar need not result in sharply lower prices for U.S.
stocks, bonds, or other assets. From the fourth quarter of 1985 to
the fourth quarter of 1990, the real, trade-weighted exchange value of
the dollar fell by nearly 24 percent while the current account deficit
shrank from more than 3 percent of GDP to less than 1 percent. At the
same time, however, stock prices rose by about 47 percent while
long-term interest rates (which move inversely to bond prices) fell
by more than 1 percentage point.

In the end, the key determinant of the sustainability of the U.S.
international debt position is continued confidence in the economic
policies of the United States. As long as the United States pursues
its current market-oriented, pro-growth policies, there is no reason
to believe that the current account deficit represents a problem for
continued economic growth.

The Economic Outlook

The economy continues to display supply-side characteristics favorable
to long-term growth. Productivity growth remains strong, and inflation
remains low and stable. Real GDP is expected to grow faster than its
3.1 percent potential rate during the next 4 years, and then to grow
at a 3.1 percent annual rate during the balance of the budget window.
The Administration's projections are shown in Table 1-1.



Near-Term Outlook

The Administration expects that aggregate economic activity will have
weathered a quarter of weakness at the end of 2002, following which it
will gather strength during 2003, with real GDP growing 3.4 percent
during the four quarters of the year. The unemployment rate, which was
5.9 percent in the fourth quarter of 2002, is projected to edge down
about 0.3 percentage point by the fourth quarter of 2003.

As discussed earlier, real GDP growth in 2002 was accounted for by
solid growth in consumption, a modest pickup in exports, and an
increase in inventory investment. Although investment in equipment and
software was slow, it stabilized during the first quarter of 2002 and
began to grow in the second and third quarters, foreshadowing one way
in which the composition of growth is projected to differ next year:
the growth rate of equipment and software investment is projected to
pick up in 2003. (Another difference is that the contribution of
inventory investment is projected to wane.) Several factors are
expected to lead to a rebound in equipment and software investment.
Any capital overhang that might have arisen during the late-1990s
investment boom has been reduced, because the level of investment
fell in 2001; expectations of future GDP growth have stabilized after
falling during 2001; and the replacement cycle is approaching for the
short-lived capital goods put in place during the investment boom of
1999 and 2000. At the same time, the financial foundations for
investment remain positive: real short-term interest rates are low,
and prices of computers are falling more rapidly than they did in
2000. (Computer investment accounted for a third of all nonresidential
investment growth from 1995 to 2000.) Less bright is the outlook for
nonresidential structures, which still appears weak even after 2
years of decline. Even so, structures investment is projected to
stabilize around the second half of 2003, as the maturing recovery
generates higher occupancy rates for office buildings and greater
demand for commercial properties. The recent passage of legislation
for terrorism risk insurance may unblock some planned investments in
structures that were held up because of lack of insurance.

Real exports, which turned up in 2002, are projected to improve further
during 2003, reflecting the widely held expectation of stronger growth
among the United States' trading partners and the lagged effects of
the past year's decline in the dollar. Although real imports and
exports are expected to grow at similar rates during the four quarters
of 2003, the United States imports more than it exports, and therefore
the dollar value of imports is expected to increase more than the
dollar value of exports. As a result, net exports are likely to become
more negative during the course of 2003.

Less change is expected for the largest component of aggregate demand,
consumption, which is expected to remain robust in 2003. The negative
influence of the stock market decline on household wealth, and thus on
consumption, is expected to wane as this decline recedes into history.
Consumption growth will also be supported by fiscal stimulus and the
lagged effects of recent interest rate cuts. Finally, low interest
rates will continue to support the purchase of consumer durables, just
as they did for much of 2002.

Inflation Forecast

As measured by the GDP price index, inflation fell to 0.8 percent
during the four quarters ending in the third quarter of 2002--down
from 2.6 percent during the same period a year earlier. This
broad-based index of prices of goods and services produced in the
United States is expected to rise somewhat faster, at 1.4 percent
during 2003, as the restraining effects of falling energy prices and
low food price inflation subside and the economy strengthens.
Inflation is expected to remain low, however, as the unemployment rate
is now above the level that the Administration considers to be the
center of the range consistent with stable inflation, and capacity
utilization in the industrial sector is substantially below its
historical average. Inflation by the GDP measure is projected to edge
up to 1.8 percent by 2007 and to stay there for the remainder of the
budget window.

As measured by the CPI, inflation during the 12 months ended in
December 2002 was 2.4 percent; core inflation was 1.9 percent. The
CPI, which differs from the GDP price index both in its methodology
and in that it includes only consumer goods and services, is projected
to rise 2.0 percent in 2003, close to last year's core rate.

The difference between the CPI and the GDP measure of inflation has an
important effect on Federal budget projections. A larger difference
increases the Federal budget deficit because cost-of-living
adjustments for Social Security and other programs that are indexed
for inflation increase with the CPI, whereas Federal revenue tends to
increase with the slower growing GDP price index. For a given level
of nominal income, increases in the CPI also cut Federal revenue
because they raise the thresholds of income tax brackets and affect
other inflation-indexed features of the tax code. Of the two indexes,
the CPI tends to increase faster, in part because it measures the
price of a fixed market basket. (See Box 1-3 above on the new
chain-weighted CPI.) In contrast, the GDP price index increases less
rapidly than the CPI because it reflects the choices of economic
agents to shift their purchases away from those items with increasing
relative prices and toward items with decreasing relative prices. In
addition, the GDP price index includes investment goods, such as
computers, whose relative prices have been falling rapidly. Computers,
in particular, receive a much larger weight in the GDP price index
(0.7 percent) than in the CPI (0.2 percent).

During the 7 years from 1994 through 2001, the difference between
inflation in the CPI-U-RS (a version of the CPI designed to be
consistent with current methods) and the rate of change in the GDP
price index averaged 0.5 percentage point a year, and it was 0.8
percentage point during the four quarters ending in the third quarter
of 2002. The difference is expected to shrink to 0.6 percentage point
in 2003-04 and to revert to its recent mean of 0.5 percentage point in
2005 and beyond.

Long-Term Outlook

The Administration forecasts real annual GDP growth to average 3.4
percent during the first 4 years of the projection. As this is
somewhat above the expected rate of increase in productive capacity,
the unemployment rate is projected to decline as a consequence. In
2007 and 2008, real GDP growth is projected to continue at its
long-run potential rate of 3.1 percent. The growth rate of the economy
over the long run is determined by the growth rates of its supply-side
components, which include population, labor force participation,
productivity, and the workweek. The Administration's forecast
is shown in Table 1-2.



The Administration expects nonfarm labor productivity to grow at a
2.1 percent annual average pace over the forecast period, virtually
the same as that recorded from the business cycle peak in 1990
through the third quarter of 2002. This projection is notably more
conservative than the nearly 2I percent average rate actually recorded
since 1995. The cautious projection of productivity growth guards
against several downside risks:


	Nonresidential fixed investment has fallen about 12
percent since its peak in mid-2000. The slower pace of investment
means that the near-term growth of capital services is likely to be
reduced from its average pace from 1995 to 2002, leading to a lesser
contribution to productivity growth from the use of these capital
services.

	As discussed in Box 1-5, about half of the post-1995
structural productivity acceleration is attributable to growth in
total factor productivity (TFP) outside of the computer sector. This
growth is due to technological progress, better business organization,
and other factors that are hard to identify. Although there is no
reason to expect this process to slow, the Administration forecast
adopts a cautious view of the pace of TFP growth, setting it near its
longer term average rather than at the higher post-1995 pace.

------------------------------------------------------------------------------

Box 1-5.  Accounting for the Recent Strength in Productivity Growth

The most important macroeconomic characteristic of the late-1990s
boom, rapid productivity growth, remains intact. Annual productivity
growth has averaged almost 3 percent during the past 2 years, a period
that includes a recession (when productivity usually slows) and the
early stages of a recovery (when productivity usually rises rapidly).
This growth, moreover, has occurred despite a roughly 12 percent
decline in nonresidential investment spending since 2000.

Table 1-3 presents the results of an analysis of some of the factors
that influence productivity growth and compares their influence in
two periods:
1973-95 and 1995-2002. According to a model constructed by the Council
of Economic Advisers that is designed to capture the cyclical
behavior of productivity growth, the productivity acceleration after
1995 would have been 0.30 percentage point a year stronger but for
the delayed hiring needed to accommodate increases in aggregate demand
that occurred before and during 1995 (second line of Table 1-3).
Productivity adjusted for this cyclical effect, or structural
productivity, has accelerated by 1.73 percentage points since 1995
(third line of Table 1-3). Cyclical factors held down productivity
growth by 1.8 percentage points in 2001, as the economy entered a
shallow recession, and then boosted

Box 1-5.--continued

productivity growth by about 1.5 percentage points in the early stages
of a recovery in 2002. (These figures average to -0.15 percentage
point, as shown in the table.) Thus during 2001 and 2002 structural
productivity is estimated to have grown 2.8 percent and 3.6 percent,
respectively. This estimated pace is similar to that for the 1995-2002
period as a whole and well in excess of the 1.4 percent annual pace
during the 1973-95 period.

In the accounting system adopted here, productivity increases can
arise from any of four sources: growth in the amount of capital
services per worker-hour throughout the economy (capital deepening),
improvements in the skills of the work force (labor quality), total
factor productivity (TFP) growth in computer-producing industries, and
TFP in other industries. TFP growth is the increase in aggregate
output over and above that due to increases in capital or labor inputs.
For example, TFP growth may result from a firm redesigning its
production process in a way that increases output while keeping the
same number of machines, materials, and workers as before.

As can be seen in the fourth line of the table, capital services
per hour contributed 0.52 percentage point more to productivity
growth after 1995 than before, with information technology accounting
for most of this acceleration. But in the wake of the drop in
investment during the past 2 years, one might think that this growing
contribution of capital deepening could not be sustained. Growth in
capital services, which had averaged 5.5 percent annually from 1995
to 2000, dropped to about 3 1/2 percent during the past 2 years. The
drop in information capital services growth has been more pronounced:
from a 16 percent annual pace before 2001 to 8 3/4 percent annually
in 2001 and 2002. This slowdown has been completely offset, however,
by the decline in hours in 2001 and 2002, with the result that
capital services per hour has grown even faster than in the late
1990s.

The Bureau of Labor Statistics measures labor quality in terms of the
education and experience of the work force. The agency uses
differences in earnings paid to workers with different characteristics
to infer relative differences in productivity. Measured in this way,
labor quality has risen as the education and skills of the work force
have increased. However, the increase occurred at about the same rate
both before and after 1995, so that labor quality does not account for
any of the post-1995 acceleration of productivity.

The rate of growth of TFP in computer-producing industries has been
rising, as evidenced by the rapid decline in computer prices relative
to prices in the rest of the business sector. Relative computer prices
fell at a 26 percent annual rate during 1995-2000. Although this rate
of decline has slowed a bit in the past 2 years--to 21 percent--it
remains impressive. Calculations using relative computer prices as an
indirect measure of productivity growth in the computer-producing
industries indicate that the annual contribution of computer
manufacturing to productivity growth in the private nonfarm business
sector accelerated 0.13 percentage point, to 0.31 percent, during
1995-2002 on average. However, that contribution has edged back down
during the past 2 years to 0.21 percentage point a year.

The final contribution comes from accelerating TFP in the economy
outside the computer-producing industries. This contribution is
calculated as a residual; it captures the extent to which
technological change and other business and workplace improvements
outside the computer-producing industries have boosted productivity
growth since 1995. This factor accounts for about 1.08 percentage
points of the post-1995 acceleration in structural productivity,
or about 60 percent of the total. Taken at face value, it implies
that improvements in the ways capital and labor are used throughout
the economy are central to the post-1995 acceleration in productivity,
but because it is calculated indirectly, as a residual, it is equally
an illustration of the limits on our ability to account for the
acceleration.

In summary, structural productivity growth remained almost as strong
in 2001 and 2002 as in the years immediately preceding. Growth in
TFP likewise continued strong, with industries outside the computer
sector making substantial contributions.
------------------------------------------------------------------------------



In addition to productivity, growth of the labor force (also shown in
Table 1-2) is projected to contribute 1.0 percentage point a year to
growth of potential output on average through 2008. Labor force growth
results from growth in the working-age population and changes in the
labor force participation rate. The Bureau of the Census projects that
the working-age population will grow at an average annual rate of 1.1
percent through 2008.

The labor force participation rate is expected to be roughly flat
through 2008, although it may begin to decline around that year, which
is the year that the oldest baby-boomers (those born in 1946) reach
the early-retirement age of 62.

In sum, potential real GDP is projected to grow at about a 3.1 percent
annual pace, slightly above the average pace since 1973. Actual real
GDP growth during the 6-year forecast period is projected to be
slightly higher, at 3.2 percent, because the civilian employment rate
(line 4 of Table 1-2) makes a small (0.1 percentage point) and
transitory contribution to growth through 2006. This contribution
then ends as the unemployment rate stabilizes at 5.1 percent.

Interest Rate Outlook

Following a large decline in 2001, the interest rate on 91-day Treasury bills
fell an additional 50 basis points in 2002 and ended the year at 1.2 percent.
These reductions reflected the Federal Reserve's efforts to stimulate the
economy, which left real short-term rates (that is, nominal rates less
expected inflation) close to zero. Real rates are not expected to remain this
low once the recovery becomes firmly established, and nominal rates are
projected to increase gradually to 4.3 percent by 2007, which would leave the
real interest rate on Treasury bills close to its historical average.

The Administration projects that the yield on 10-year Treasury notes,
which was 4.2 percent when the projection was finalized at the end of
November, will stay at that level for 2003 and then rise very slowly,
reaching 5.6 percent by 2008. At that time their yield will be 3.3
percentage points above expected CPI inflation--a relationship that is
consistent with the historical average since 1959. From 2005 onward the
projected term premium (the premium of the 10-year rate over the 91-day
rate) of 1.3 percentage points is in line with its historical average.

Income Forecast

One important purpose of the Administration's forecast is to estimate
future government revenue, which requires a forecast of the components
of taxable income. The Administration's income-side projection is based
on the historical stability of the long-run labor and capital shares
of gross domestic income (GDI). During the first three quarters of
2002, the labor share of GDI was on the low side of its historical
average of 58.0 percent. From this starting point, it is projected to
rise to its long-run average and then remain at this level over the
forecast period. The labor share consists of wages and salaries,
which are taxable, other labor income (that is, fringe benefits),
which is not taxable, and employers' contributions for social
insurance. The Administration forecasts that the wage and salary
share will decline while other labor income grows faster than wages.
This pattern has generally been in evidence since 1960 except for a
few years in the late 1990s.

The capital share (the complement of the labor share) of GDI is
expected to fall slightly before leveling off at its historical
average. Within the capital share, a near-term decline in depreciation
(a consequence of the decline in short-lived investment during the
past 2 years) is offset by a rise in economic profits, which averaged
7.5 percent of GDI during the first three quarters of 2002, a bit
below the post-1973 average of 8.0 percent. Economic profits are
expected to rise to roughly 8 percent of GDI and to remain flat at
that level for the duration of the projection period. The pattern of
book profits (known in the national income and product accounts as
''profits before tax'') reflects the 30 percent expensing provisions
of the Job Creation and Worker Assistance Act. These expensing
provisions reduce taxable profits from the third quarter of 2001
through the third quarter of 2004. The expiration of the expensing
provisions increases book profits thereafter, however, because the
fraction of investment goods expensed during the 3-year window will
not be eligible for depreciation thereafter. Other taxable income
(the sum of rent, dividends, proprietors' income, and personal
interest income) is projected to fall, mainly because of the delayed
effects of past declines in long-term interest rates, which reduce
personal interest income during the projection period.


Conclusion

The Administration believes that the economy is likely to grow
somewhat faster than in the projection presented here, as the long-run
benefits from the full reductions in marginal tax rates and the
dividend exclusion are felt. These should lead to increases in labor
force participation and increased entrepreneurial activity. The
Administration, however, chooses to adopt conservative economic
assumptions that are close to the consensus of professional
forecasters. As such, the assumptions provide a prudent, cautious
basis for the budget projections. Yet the Administration's policies
are designed to enhance U.S. economic growth, not just maintain it.
The remaining chapters of this Report illustrate ways in which
pro-growth economic policies can improve economic performance at home
and abroad, by striking the right balance between the encouragement
and regulation of firms, by promoting flexibility and dynamism in labor
markets, and by reducing tax-based disincentives to economic activity.