Today's date:
Fall-Winter 1984-1985

Thurow: America's Prosperity

In this interview, one of America's most respected economists discusses the range of economic issues - productivity, international competition, fiscal and trade deficits - that will face us in the coming decade. Lester Thurow is Professor of Economics and Management at the Massachusetts Institute of Technology and a member of the Institute's Board of Advisors.

NPQ: During the election campaign, Senator Howard Baker asked "why does an America that works need Walter Mondale?" One might ask why a prosperous America needs an industrial strategy or other economic policies you have promoted?

THUROW: There are two questions. To what extent are Americans prosperous - some economists argue yes, others no - and to what extent are Reagan's policies responsible.

At the moment we are enjoying a classical Keynesian recovery. We had a severe maxi-recession in 1981-82, and we are now having a demand-stimulated recovery. In this sense, Ronald Reagan is the great rehabilitator of Lord Keynes.

Now, the problem with Keynesian economic policy is not that it doesn't work. The problem is how do we get out of maxi-recession and move towards full employment without that inevitable inflationary shock? How do we continuously run a modern industrial economy for a sustained period at high employment without inflation breaking out and becoming politically intolerable? This fundamental problem remains unsolved. It is not a problem for 1984. It may not be a problem for 1985, but somewhere out there, in 1986 or 1987, it becomes a problem.

There is a second issue that is even more of a problem. We are enjoying the equivalent of the "Mexican Fiesta" based on borrowed money Mexico had in 1981 and 1982. Our balance of trade deficit is $100 billion a year which means we have to borrow approximately $130 billion. That is fine as long as the rest of the world is willing to lend us that kind of money. In the case of Mexico, the rest of the world said on August 18,1982, "we won't lend you anymore", and the whole thing, the peso and prosperity, crashed.

The United States is much wealthier than Mexico. We can obviously borrow much larger sums of money, but there is nonetheless a limit. If we look at our current borrowing, we will move from being a net creditor to being a net debtor nation sometime in mid-1985. If we do just a bit of simple arithmetic it is easy to understand that the situation is unsustainable.

Last year the deficit was $60 billion. This year it is $130 billion. Let's assume the number only goes up by $30 billion a year. This year we borrow $130 billion but next year, the deficit is $160 billion. Then we've got to borrow $160 billion, plus we also have to borrow an additional $15 billion to pay interest on the previous year's loan. The year after that, we've got a $190 billion deficit, but we've got to borrow $16 billion to finance the previous year's borrowing, $13 billion to finance the year before's borrowing, and in two or three years the amounts are so large we know the rest of the world isn't going to lend it.

In this sense, the current recovery is unsustainable because it relies too much on borrowed money.

NPQ: Our present prosperity, then, is the result not of Reaganomics, but of classical Keynesian demand-stimulation policies aided by international borrowing?

THUROW: Anything Reagan does is Reaganomics. The honest thing to say is that Reaganomics changed. It changed at the time of the incipient Mexican default in August, 1982.

When Reagan came into office, Reaganomics meant restricted growth of the money supply, and supply-side tax cuts designed to stimulate savings and investment. What Reaganomics became was abandonment of monetarism. Since

August, 1982, the money supply has grown quite rapidly. Since Reagan came into office, the savings rate has fallen. Instead of saving money, Americans have spent it and that turned supply-side economics into demand-side economics. So, we have Reaganomics I and 11. Reaganomics III will have to deal with the two problems I have described: how to stay at full employment without reigniting high inflation, and how to handle international competitiveness with huge deficits.

NPQ: Inflation is a problem for all the industrial nations, not just the U. S.

THUROW: I agree that most modern industrial economies cannot operate at full employment without inflation. I say "most" because Japan didn't have any inflation in the last five or six years.

In every modern economy there will be periods when a noninflationary environment can be maintained if real wages fall. During the second OPEC oil shock of 1979, we in the United States paid 2% of the GNP for imported oil. After the second OPEC oil shock it cost us 5% of the GNP. During this time neither the GNP nor productivity grew. This meant that at the end of the year there was only 97% as much to be divided among Americans because 3% had to be taken away and given to the owners of OPEC oil.

There were two ways of delivering the bad news. One would have been to cut everybody's income by 3%. Then there would have been a match between incomes and the goods and services to be divided. The other way was to do what we actually did. Each of us got a 9% wage increase, but we got it on top of the price of oil. That generated a total 12% rate of inflation. Of course, twelve from nine is minus three. So we ended up with a 3% cut in our standard of living, but it was delivered via inflation rather than a straightforward cut in our salaries. Politically, there was no way around the predicament. Now, in Japan in 1979, because they were on the bonus system and because they import more of their energy, they actually cut everybody's bonus by about 30% which amounted to an 11% wage cut for every single Japanese worker. They sailed right through 19179 without a blip. We could have done that.

NPQ: How does the bonus system work?

THUROW: Here is the way it works in Japan. About a third of one's annual income comes as a twice-a-year bonus instead of coming as a weekly or monthly wage. In 1979, the bonus was in fact reduced. Now human beings are more willing to see a bonus cut than they are to see a weekly wage cut, because! you program the weekly wage into the family budget. They think of the bonus as something you use for luxuries so when it gets smaller it isn't a disaster.

That's an example of an institutional innovation that makes the Japanese economy a lot less inflationary than the U. S. economy. Technically, we could move to the Japanese system, but politically it would be difficult because people would be forced to take a risk. But they are taking a risk anyway. If we again end up in the same situation we had in 19179, every American family will find its income cut either because we cut wages or because the rate of inflation is higher than the rate of wages gained. It is hard to face up to that kind of fundamental algebraic issue. It isn't even a political issue, it is just an algebraic reality. Of course we all like to pretend that algebra isn't true when it delivers news like that.

Productivity and International Competitions
NPQ: What is the root of the inflation problem?

THUROW: Productivity growth is so low that the average American family can't get a big increase in real family income without causing inflation. In the U. S., a 1% rate of growth in productivity means real wages can't rise faster than I% per year without reigniting inflation. In Japan, a 6% rate of growth in productivity means real wages can rise 6% without inflation. If we try to have a 6% wage gain in the U. S.. we'll end up with 5% inflation.

NPQ: Productivity, then, is the central problem?

THUROW: Yes, in combination with international competitiveness. The two go together. If we have low productivity relative to the rest of the world, we will not be competitive on world markets unless there is a perpetually failing dollar. For example, some economists recently calculated how much the dollar would have to fall to have a balance in our balance of trade. The answer was that there would have to be a one time fall of about 35%. Then, after that the dollar would have to fall by 1/2% forever. Now, 1/2% doesn't sound like much, but it means by the end of the century we've got a standard of living half that of Japan.

NPQ: Why is our productivity growth so much slower than Europe's or Japan's?

THUROW: It's not one magic thing. If we want to have a good economy all the inputs have to be good. At the moment, if we compared the fundamental inputs into the economy - the amount of investments, the quality of the management, the quality of the work force, the level of research and development - with similar activity in the economy of our competitors, we would have to conclude we don't quite have inputs at a world class level.

The place where this is easiest to measure is investment. We invest about half as much as the Japanese and two-thirds as much as the Europeans. It doesn't take a genius to understand that if we invest half as much for twenty years we fall behind. The same thing is true about the quality of the work force.

About 7% of U. S. seventeen-year-olds will test out as functional illiterates. In Japan, it is one half of one percent. The average American seventeen -year-old knows half as much mathematics as the average Swedish seventeen -year-old. We can't compete knowing half as much mathematics as the rest of the world.

If we look at research and development spending on civilian products we now spend about 1.5 % of the GNP. France and Germany or Japan spend somewhere between 2 and 2.5% of their GNP. We spend less on research than our competitors and they're just as smart as we are, so we lose.

In the case of management, American managers have a short run orientation. If American managers always focus on the next 2.8 years and Japanese managers are focusing on the next 10 years, the Japanese managers will do those fundamental things now, so they can be successful six years from now, that American managers are not doing.

And so, I think there are comprehensive problems right across the board. Those problems are not going to be solved in Washington, D. C. They require changes at all levels, at the level of the family, at the level of the schools.

Take schools, for example. Why do foreign schools tend to be so much better'? That's a complicated problem, but one of the simple answers is kids in Japan go to school 240 days a year, while kids in the U.S. go 180 days. That means a kid in Japan is working one third harder than a kid in the United States. We therefore shouldn't regard it as a tremendous surprise that the kid in Japan scores better.

NPQ: As time goes on and these problems aren't addressed, doesn't it become more difficult to resolve them'?

THUROW: Certainly, the farther we are behind, the more effort it takes to catch up.

NPQ: On the other hand, our society doesn't seem to have the structural rigidity Europeans have in terms of making changes.

THUROW: Well, that's true on some levels and not on others. For example, one of the reasons why the rest of the world saves more money is that they have very restrictive provisions on consumer credit. In Canada, you can't deduct your mortgage interest payments from your taxes. In Germany, you can't deduct your car interest payments from your taxes. In Japan, you need a 40% down payment to buy a house. In Norway, you need an 80% down payment to buy a car. So, if you asked how willing America is to crack down on consumer credit, the answer is that we have a society very unwilling to change.

NPQ: Perhaps we are getting to the crux of the matter, namely, that since the Second World War the American Dream has come to mean the individual pursuit of consumption.

THUROW: That is certainly true. But when we talk about changing these things, we are not talking about lower consumption forever. If we were to save at a Japanese 20% savings rate, our consumption could grow faster. The pain is in getting from here to there. The transition period would be five to ten years. So, we're not saying we have to convince Americans to give up their consumption dreams forever. We are saying they have to postpone or delay those dreams a little bit because if they don't, then they won't be competitive in the world market and they won't get to realize any of their consumption dreams.

Fiscal Deficits and International Debt
NPQ: How do we deal with the fiscal deficits and international debts in the coming years'?

THUROW: A lot of the discussion about fiscal deficits is wrong. It assumes we're going to wake up Sunday morning and there is going to be a fiscal crisis. If we look at it that way, we'll never be able to understand what's wrong with a $200 billion deficit. What's wrong is that it creates two gradually accelerating problems.

One is that a $200 billion deficit may be the right thing to have in 1982, when we are in a maxi-recession. As we get closer and closer to full employment it becomes the wrong thing to have because it creates inflationary pressures. Of course, what's interesting about the Keynesian economics of President Reagan is that he is not practicing the conservative part. Lord Keynes said that when we get close to full employment, the deficit should be gradually reduced.

The second thing that is wrong with a large deficit is that we are borrowing private savings to finance public consumption. It means we'll invest even less than we used to. Over a five or ten year period we will be comparatively worse off than we would have been if we hadn't had a large deficit.

Apparently we can't respond to anything but crises. When people ask what we're going to do about the deficit in January, the answer I give is, nothing. We are going to talk about it, but the basic reaction is going to be, "if it ain't broke, don't fix it". Since the economy ain't going to be broke in January, we ain't going to fix it in January even though repair is necessary now if we want long run success.

NPQ: And our international debt?

THUROW: Our international debt is going to show up as a crisis. In Mexico it happened in one day; it probably will take more than one day in our case, but not more than a month. The rest of the world will decide they've lent Americans too much money. Then the dollar will fall very, very rapidly because the last person out the door loses the greatest amount of money.

NPQ: But where's the money going to go? To socialist France? To uncertain Argentina?

THUROW: We're not speaking about investors buying properties or factories. We're talking about buying government bonds. It's relatively difficult for foreigners to buy and sell bonds in Japan, so the next best country is Germany. If you want to buy a Porsche, buy it now.

NPQ: What kind of event is likely to set off the flight of foreign investors?

THUROW: The fundamental thing that will cause flight is world concern that it has lent America too much money. The precise trigger can be a trivial event. We know there are going to be dramatic headlines in the middle of 1985 which will say, "For the first time since World War II, the United States is now a net debtor country." If that is, or is not a sufficient trigger we will see, but it certainly is going to get the attention of the world.

NPQ: How do we reduce the deficit given the limitations on revenue from the Reagan tax-cut program passed during his first administration?

THUROW: President Reagan is wrong. We just can't grow our way out of a deficit given current tax laws. There are a lot of automatic growth factors in expenditures. The defense budget is going up 15% a year. Social Security will go up 6 or 7% a year. Indexing begins in 1985. That brings us back to cutting spending or raising taxes.

The cutting/spending problem also presents us with rather unattractive algebra:

- The defense budget spends $300 billion. If we cut $200 billion out of defense, we would have to cut by two thirds. Everybody agrees we can't do that.

- Social Security and Medicare spend about $250 billion. If we cut $200 billion out of these programs, we'd have to Cut every pension check in America by 75%. We can't do that.

The Justice Department tells us we can't legally cut interest on national debt. If these three things - defense, Social Security and interest on the debt - are uncuttable, the remainder of budget expenditures only amount to S200 billion. If we're going to cut $200 billion out of what's left, then we'd have to close down everything else: no roads, no national parks, no FBI, no Coast Guard, no weather bureau, no Supreme Court.

NPQ: That leaves taxes'?

THUROW: That brings us back to taxes, and the arithmetic is equally unattractive. The entire federal income tax only raises $300 billion. An income tax surcharge to make up the deficit isn't a 5% surcharge: it isn't a 10% surcharge; it's a 66 and 2/3% surcharge! This is why we won't do anything significant in January. We'll talk and make a lot of noise, but nothing will be done.

Military Keynesianism
NPQ: To what extent is so-called "military Keynesianism" demand stimulation by military spending - contributing to the recovery? To what extent is it a burden'?

THUROW: We did about $150 billion worth of tax cuts and about $150 billion in military spending increases. In this sense the recovery has been a 50/50 program.

NPQ: Would major cuts in the military be helpful to the economy'?

THUROW: Any cut is helpful. The question is where could we cut without sacrificing military preparedness.

If one believes in the hypothesis of the "nuclear winter", then there is quite a bit of room to cut. Since a very limited number of nuclear explosions would plunge us into unsurvivable cold and darkness, massive retaliation would have no military significance and there is no sense in committing massive resources into more missiles.

Thurow's Program
NPQ: Let's be specific. If you were on the Council of Economic Advisors, what would be your program'?

THUROW: In the long run, if we are going to cut the deficit there are ways to cut budget expenditures. In the short run, the heavy emphasis has to be on tax increases - some kind of value added tax and a gasoline tax as the best of bad options.

In the long run, we can cut expenditures two ways. On the military side we have to wrestle with this problem of, "what is enough?" On the civilian side the program that spends more money, than anything else is Social Security/Medicare. We have to talk about restructuring that particular program. I think one can make a good liberal argument for doing so.

Social Security and Medicare
When we originally invented Social Security and Medicare and when these programs got their upward push in the 1960s, all of the data showed that elderly incomes were about 60-70% of non-elderly incomes. By 1984, thosenumbers had turned around. Now the per capita income of the elderly is something like 110% of the non-elderly and their percentage of poverty is lower. When people paying their taxes have less money than the people who are getting the expenditures, that is a perverse transfer. We don't have as our social goal the creation of an elderly rich and a non-elderly poor, but that's what the current system is doing.

I would advocate a system where we scrub the current way of escalating Social Security benefits (a cost of living escalator plus a periodic increase). Instead, we should move to an escalator system where Social Security is tied to the per capita GNP. Then, if the per capita GNP goes up, the elderly get an increase. If it goes down, they don't. That way we're all in the same economic ship.

NPQ: But at the same time we tell the American people they have to sacrifice for the next decade to attain future prosperity'?

THUROW: If we have a five year period when we're getting growth in the economy of 2 or 3%, we don't even have to cut people's income. We just have to have a time when their income doesn't grow.

When we talk about these sacrifices, we should keep their magnitude in mind. We're not talking about Russia in World War 11, where everyone's consumption was slashed by three quarters. We're just talking a bit of restraint.

Equality and the shrinking middle class
NPQ: What about the issue of equality'?

THUROW: All the data shows that the American middle-class is getting smaller. We're getting a larger number of poor people and a larger number of upper income people. The arguments are about whether it is a permanent phenomena or the kind of thing that will turn itself around. There are sonic who argue it's a product of the baby boom generation and as the baby boom becomes middle-aged, the middle class will recover. There are others who argue that it has more to do with structural factors and we won't have an automatic recovery. I tend to be in the latter camp.

NPQ: Is this decline in the middle-class related to technological changes'? Some argue we are seeing a new division in the work force between high-skilled, high-wage professionals and low-skilled, low-wage laborers.

THUROW: If we look at the new high-growth technology, in the computer industry for example, it has a more varied distribution of wages than the automobile industry.

In the automobile industry, everybody has a middle-class job, from the guy who sweeps the floor on up. There are some wealthy Jobs but there are no poor jobs. In the computer industry, there are lots of people paid the minimum wage or slightly above, yet it has more designers and engineers who get high wages. Certainly the shift from automobiles to computers is the kind of shift that would create a decline in the middle-class.

Another factor in the decline is the role of female workers in the U. S. economy. If you are a middle-class male making average middle income and you're married to the average woman who works full time, that puts you up and out of the middle-class in a statistical sense. On the other hand, if you are a full-time working woman and have kids, and you get divorced, you fall out of the middle class. This pattern of family formation and family dissolution means we're getting a lot more dual earner families making it into the middle class. But we're also getting a lot more female-headed families falling out of the middle-class.

World Economic Integration and Protectionism
NPQ: How do all of these problems we've discussed affect the basic approaches of economic policy?

THUROW: The basic problem at the moment is the world economy has outgrown the world's willingness to cooperate. While the last twenty years have been a movement toward world economic integration, the next twenty years may be the opposite.

We're on that trend now. The more industry we protect, the more we withdraw from international trade into "managed trade". Autos aren't traded internationally anymore. Governments, not the market, decide how many automobiles get to come into the United States. That's managed trade.

The basic problem with the modern integrated economy is that we can't have the Germans stepping on the accelerator at the same time the Japanese are stepping on the brakes at the same time the French are stepping on the accelerator. We've got to have general coordination across the four or five big industrial economies. Thus far, governments haven't been willing to do that.

There are two ways to solve this problem. One way is to cooperate and have roughly similar economic policies. The other way is to go back and rebuild national economies that don't do much trade with the rest of the world.

NPQ: Is the latter really possible? We are already so integrated that the Latin American recession has reduced American exports to the tune of 500,000 jobs.

THUROW: Sure it's possible. We can gradually abolish international trade. We just put restrictions on more and more imports. Then the rest of the world will put more and more restrictions on imports, and we gradually reduce those import/export percentages and become a more domestic oriented economy.

Click above for larger image
Of course our standard of living will suffer. We won't have high-quality, inexpensive Japanese cars. Coffee will cost more. But it can be done.

We did it once before. The world was more integrated at the end of the 1920s than it was at the end of the 1930s. With the advent of the Great Depression, lots of countries thought they could solve their own depressions by prohibiting other countries' imports. We had a much more nationalistic economy in 1939 than in 1928.

NPQ: That's the path of the future as you see it?

THUROW: I make a distinction between what I think should happen and what will happen. We should work hard to build cooperative economic policies that make world integration possible. Each of us can have a higher standard of living by doing it; and by each of us, I don't just mean each American, but each Mexican, German, Brazilian and Japanese.

However, if you ask me as a Las Vegas gambler to bet, I'd say we will have a less integrated economy in 1990 than we do now. In 1980, 20% of the products made in America were protected with quantitative restrictions. Today, 35% are protected. We're not going to abolish world trade on a magic Monday morning. What we're doing is gradually nibbling it to death.

National Industrial Strategy
NPQ: Is there a realistic alternative to a shrinking middle-class, protectionism and industrial stagnation?

THUROW: The only way we will grow and prosper is if Americans become convinced we can compete on world markets without protection, through an industrial strategy.

An industrial strategy can mean two things. It can mean the broad inputs we spoke of into the family, schools and the general culture. It can also mean industrial policies in the narrow sense, like the National Science Foundation's role in basic research. We certainly need a strategy in the broader sense, but we will also need policies in the narrow sense.

Whether we're talking about strategies or policies, we have to be cooperative. It's not a case of government giving orders. It's a question of getting government and business together to do things that simply won't happen if they aren't together.

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