Clinton Greenspan Policy Mix

Clinton - Greenspan Policy Mix in the USA When Bill Clinton was elected president at the end of 1992, he faced a tough macroeconomic problem. The federal budget deficit was 4.5 % of GDP – the second largest percentage since World War II – and there was a wide consensus that something should be done about it. At the same time, the U.S. economy was just coming out of the 1990-1991 recession; while we now know that output growth was positive in 1992, many economists at the time worried that the recession might not yet have ended. The problem facing Clinton was clear: As desirable as a deficit reduction might be, implementing it might lead to a decrease in demand, and perhaps put the United States back into recession. In terms of the IS-LM model, a shift of the IS to the left might lead to a decrease in output, to a recession. Yet, five years later, in 1998, the federal deficit was gone, replaced by a surplus of 0.8 % of GDP, and the U.S. economy was in the seventh year of sustained expansion. (Table 1 gives the basic numbers for the budget, output growth and interest rates, from 1991 to 1998.) Table 1 - Selected Macro Variables for the United States, 1991-1998 1991 Budget surplus (% of GDP) (minus sign = deficit) GDP growth (%) Interest rate (%) 3.3 0.9 7.3 1992 4.5 2.7 5.5 1993 1994 3.8 2.3 3.7 1995 2.7 3.4 3.3 1996 2.4 2.0 5.0 1997 1.4 2.7 5.6 1998 0.8 0.3 3.9 5.2 3.7 4.8 How did Clinton do it? He did it with the help of Alan Greenspan, and with some luck. Even before the election, Alan Greenspan had stated that he was worried about the size of fiscal deficit. When Clinton was elected, Greenspan made it clear he would be happy to help. While not stating this explicitly, he indicated that if Clinton were to embark on a path of deficit reduction, the Fed would be willing to counteract the adverse effects of a fiscal contraction on output with a more expansionary monetary policy. In terms of the IS-LM diagram in Figure 1, the Fed agreed (that is, implicitly: nothing was signed of even written down) that, if deficit reduction took place (leading to a shift to the left of the IS curve, from IS to IS’), the Fed would shift the LM curve down (from LM to LM’). In effect, it agreed to offset the adverse effects of fiscal contraction on activity, to get the economy to go from A to A’ rather than to B (which is where the economy would have gone, absent monetary expansion). One the basis of this implicit understanding, in February 1993 Clinton sent a deficit reduction plan to Congress. This plan was intended to get the deficit slowly down to 2.5 % of GDP by 1998, with the reduction coming in roughly equal parts from tax increases and spending decreases. The limited size of the deficit reduction was due to the worry that, even with help from the Fed, too fast a deficit reduction would lead to a recession. As this deficit reduction package was implemented, the Fed delivered on its implicit promise: Interest rates, which had already been reduced in 1991 and 1992, were further decreased in 1993 and 1994. The interest rate in 1994 was 3.3 %, down from 7.3 % in 1991. The result of this policy mix (fiscal contraction and monetary expansion) was a steady output expansion in the face of deficit reduction. Was the expansion of output from 1992 to 1998 only due to a smart policy mix? No, it was also due to luck. Especially from 1995 on, various factor s, from unusually strong consumer and firm confidence, to a strong stock market, led to favourable shifts of the IS curve, and in turn to strong output growth (which lasted until year 2000). This had two implications:  First, the Fed did not have to decrease interest rates further; shifts to the right in the IS curve were enough to sustain activity. Indeed, from 1994 on, the Fed had to slightly increase interest rates, so as to prevent the economy from “overheating”.  Second, the mechanical effect of this strong expansion was to further reduce the deficit: When an economy grows, tax revenues (which depend directly on output) tend to increase while spending is largely unaffected: The deficit is automatically reduced. (A useful rule of thumb for the United States is that every additional increase in the growth rate of 1 % per year leads to a decrease in the ratio of the deficit to GDP of 0.5 %.) Thus, the mechanical effect of sustained growth was a much larger reduction of the deficit than had been anticipated, even by the Clinton administration. Figure 1 - Deficit Reduction and Monetary Expansion