Recession, Tax Cuts and Budget Deficits

The economy was experiencing the start of a boom in the early 1990s, before Clinton took office. Clinton decided early in his first term that debt reduction, rather than tax cuts, was the best way to preserve this economic growth. Footnote here

In 1993, President Clinton and Congress made an effort to cut the deficit. They enacted a five-year deficit reduction package of spending cuts and higher revenues. The law was designed to cut the accumulated deficits from 1994 to 1998 by about $500 billion.

In 1998, the Federal budget reported its first surplus ($69 billion) since 1969. In 1999, the surplus nearly doubled to $124 billion. As a result of these surpluses, Federal debt held by the public was reduced from $3.8 trillion at the end of 1997 to $3.6 trillion at the end of 1999.

The booming US economy brought economic benefits right across the income spectrum. The unemployment rate dropped by half, to 4%, a 40-year-low, while the economy created 15 million jobs.

Unemployment graph/chart here

The stock market grew even faster – by more than three times – creating thousands of millionaires among middle class stockholders and employees of fast-growing tech companies – before the NASDAQ fell back sharply in 2001.

Stock market Graph/chart here

But the growth was not evenly distributed. The US has the highest rate of inequality of any industrialized country, and that inequality increased during Clinton’s years in office. It was only in the last few years of the boom that economic growth percolated down, as average wages began to rise and unemployment fell among minority communities.

Some of the policies Clinton embraced, such as the expansion of the earned income tax credit, were designed to redistribute money to working families. But others, such as welfare reform, meant that even less government support was likely for poor people at the bottom of the income distribution. Footnote here

Overall, the decade of the 90’s was a period of low inflation, low unemployment, and record budget surpluses.

Did Clinton have anything to do with the shift to surplus?

Clinton was President during a time of rapid business cycle expansion. The reasons for the rapid growth include a change in policy at the Federal Reserve and the stock market bubble.

The Fed abandoned the theory that 6% unemployment was the best that the economy could do without accelerating inflation. Unemployment was allowed to fall to 4% and growth continued beyond the point at which the Fed, in the past, would have pulled the plug. Footnote here

The stock market bubble, a 14 trillion increase in stock holdings over the last decade caused many upper income households to spend freely. This spending, even if it was based on paper increases in wealth that soon disappeared, provided a considerable stimulus to the economy – much the same as we would get from a large increase in deficit spending by the federal government. Footnote here

The economic policies for which Clinton can claim responsibility – e.g., NAFTA, the creation and expansion of the World Trade Organization – served primarily to prevent the majority of Americans from sharing in the gains from economic growth. And then there was welfare reform, which threw millions of poor single mothers at the mercy of one of the lowest-wage labor markets in the industrialized world. Footnote here

In short, Clinton’s policies continued the upward redistribution of income and wealth that were the hallmarks of the Reagan era. It was not until 1999 that the median real wage reached its pre-1990 level, and it remains anchored today at about where it was 27 years ago.

Real Wage Graph/chart here

Many observers credit Alan Greenspan, the Fed chief, rather than President Clinton, with the careful management of the economy during the Clinton years. Footnote here

The New Millennium

Recession of 2001

After the great run of the 1990s, the U.S. economy was hit with a recession that started in March of 2001 and ended in November 2001.1 The start of a recession is when the economy reaches a peak of activity. The National Bureau of Economic Research mainly looks at four activities, which are determined monthly, to gage the start of a recession; current employment, current industrial production, real manufacturing and trade sales, and current real personal income less transfers. The start of the 2001 recession was marked by a slight decline in the current employment and a large decrease in industrial production compared to previous recessions. The figure below shows the decrease in industrial production after mid 2000.

Current Industrial Production

The dark line shows the movement of industrial production in 1999-2001

and the dashed line the average over the past 6 recessions.

Another method to determine when the economy is in a recession is to look at the U.S GDP. The problem with GDP is that it is determined quarterly as opposed to monthly. Historically, a recession is a decline in the GDP over two quarters. The figure below shows percent change in the U.S. GDP from the preceding quarter. 2

From 1994 to 2000, the economy grew around 4 %; then in Q3 2000 the economy contracted and again in Q1-Q3 of 2001. The red circle marks the recession.

The potential causes of the recession are many. A few of the reasons include the decline in stock market wealth, increases in energy costs and increases in interests. It is beyond the scope of this paper to analyze all of the potential causes. Instead, the burst of the stock market bubble and the subsequent decline in business investment will be discussed.

During the late 1990s, the stock market saw gains like never before. There was much hype about the new economy and everybody thought the economy is going to grow forever. Next, the unthinkable happened. Investors started to realize that new companies could not generate profits and started selling their investments. The figure below shows the value of the NASDAQ starting in 1998.

The NASDAQ peaked above 5000 and fell back to pre 1999 levels by the time the economy entered the recession. The drop in stock values meant that people lost a lot of stock wealth. The meant there was less capital available to invest in businesses.

On a related note, businesses were ramping up capital investment during the 1990s to prepare for the Y2K problem. The next two figures show how the capital investment ramped up during the late 1990s and fell after 2000.3 The first figure shows the gross domestic private investment in billions starting in 1996. There was steady growth from 1996 to 2000 and then a substantial decline. The start of the decline coincides with the bust of the stock market bubble.

The other figure shows the percent quarterly change in nonresidential private fixed investment starting in 1996. Except for a few quarters, there was over 10% growth in investment from 1996 to 2000. Again, coinciding with the stock market bust, there is a sizeable decrease in the private fixed investment. In fact, there is decrease in private investment starting in 2001 and extends until mid-2003. The stock market bubble and decrease in business investment helped to fuel the recession.

A result of the recession was higher unemployment. The figure below shows how the unemployment decreased during the late 1990s to 4% and then rose up to 5.7% right after the recession and approached 6% in future years. Usually after a recession the unemployment rate starts to decrease and inflation starts to increase. One peculiar item about this recession and subsequent recovery is the unemployment rate is not dropping; in fact, some economists are calling this period “The Jobless Recovery” and are calling for reforms to stimulate job growth.4 The figure below shows the increase in unemployment and decrease in inflation after the recession.5

The decline in private sector jobs is greater than in any of the past three recoveries. This high unemployment is leading to lower standards of living for most families. But the trend of higher unemployment and low inflation follows the Phillips curve.

Use of Monetary and Fiscal Policy to Stabilize Economy

Monetary Policy

The Federal Reserve board tries to cool down hot economies by trying to raise the intended federal funds rate. The converse is also true; if the economy is in a recession the FOMC will lower interest rates to encourage new investment and increases in planned autonomous spending. The following figure shows the intended federal funds rate from 1994 to current.6

When the economy was heating up during 1999-2000, the FOMC was starting to raise interest rates to slow down the economy. Then in 2001, the economy went into recession and the FOMC started to decrease interest rates rapidly. In fact, it dropped from 6% in January of 2001 to 1.75% by December 12th the same year. That is a remarkable drop.

Fiscal Policy

The other method to help the economy is to use fiscal policy.

The tax relief bill of 2001 was introduced by president Bush immediately after his instatement in office, and was approved by congress and signed into law in late May. The bill consisted of four major parts, two of which were characterized by new nomenclature to add a political “spin:”

1. Reduction and restructuring of base-level income taxes

2. Phase-out of the estate tax (referred to by the Bush administration as the “Death Tax”)

3. Increase of the child credit

4. 10% deduction for married couples (referred to as elimination of the “Marriage Penalty”)

The income tax changes consisted of tax cuts throughout most income brackets. It also added a new bracket at the bottom of the income scale (bracket 1 in Table 1). This bracket will be phased in by 2008, and will have an upper limit of $7,000 for childless singles, $10,000 for single parents, and $14,000 for married couples. The upper and lower limits of the other brackets remain the same, and the percentage changes to them were made retroactive to 2000 through an immediate refund.