The Map and the Territory

by Alan Greenspan

  LENDING AND BORROWING

  In the United States, of necessity, all lending ex post must be somebody else’s borrowing. Hence, the sum of each must be identical.30 That is true, however, only if we include foreign lending as borrowing by U.S. residents. Because all transactions with foreigners have both an American and a foreign counterpart, it is possible to view the current account balance of payments (deficit or surplus) solely from the American side (which, of course, must be identical to the foreign side, with sign reversed). Thus, having classified our transactions with foreigners as a domestic sector, the borrowing and lending between Americans is always equal, and the difference between the two always zero. Since net borrowing is also equivalent to investment less savings, it follows that, with net borrowing for the United States as a whole always zero, ex post, savings must always equal investment. All this necessary balancing derives from the nature of double-entry bookkeeping (see Box 9.3).

  BOX 9.3: DOUBLE ENTRY

  Because every market transaction has both a buyer and a seller, there are two sets of books—double entry—but only a single set of transaction values. For a market transaction to occur, both sides must agree to the same terms—for example, the price and value of the exchange. Hence, added up separately, the various aggregates from the two sets of books must yield identical results. Gross domestic product, for example, must equal gross domestic income,31 and when we limit the summations to capitalized transactions32 only, savings must equal investment. It is those equalities that lock the two sets of matching accounts together.

  However, were the widely differing intentions of people to invest or save (or their equivalent, to borrow or lend) recorded as they enter the marketplace, they would exhibit no such equalities. In general, ex post prices tend to be higher than consumers would prefer and lower than suppliers would prefer. Market negotiations pit “bids” against “asked” until agreement is reached between buyers and sellers. Counterparties come together on the specific terms of their transaction and in the process set prices of products and assets, as well as interest and exchange rates.

  Double-entry bookkeeping has the real world role of preventing internal inconsistencies in forecasts. Inconsistencies can exist for ex ante demand and supply, but not once market forces set the terms of transactions to a point where agreements are reached and market transactions are completed. Double entry merely recognizes such agreements. It is a requirement that, for transactions to have occurred and economic activity to have taken place, supply equaled demand. That result cannot be altered by outcomes of other equations in the model; it is what economists call an “identity”—that is, definitional equality. Markets reset all prices (for products and assets) and interest and exchange rates until the allocation of lending and borrowing (savings less investment) among sectors sums to zero. Thus, for sectoral balance to be achieved, given a rise in federal deficits, for example, some other sector must have been crowded out.

  The end result of double-entry bookkeeping transactions is a set of accounts that are tied together by the terms of agreements already reached. The accounting merely records the same set of transactions from two different perspectives. Gross domestic income is equal to gross domestic product because the former is merely a set of accounts that identify the nature of the income claims to each reported good and service that makes up the GDP. Because what is measured is the same thing but from different perspectives, the sum of each separate account must be identical.

  IT MATTERS

  These tautological relationships would be of little interest outside of accounting formalities if it weren’t for the fact that the federal government, when funding its deficits, preempts part of the supply of private savings; households and/or business, once their transactions in the marketplace are complete, must have borrowed less than they intended and lent more than they intended. For this to happen, one or more private sectors must experience some form of crowding out, either interest rate crowding out or self-imposed corporate culture–induced crowding out.

  In the former case, the interest rates borrowers are required to pay render the investments that the savings are supposed to fund unprofitable. Interest rate crowding out is, of course, not uniform across business and households. AAA or even A credits rarely get crowded out. Most of the projects that are put back on the shelf because interest rates are too high are those of less than investment grade businesses or subprime home mortgage borrowers.33

  PRIVATE SAVINGS

  While overall gross private savings as a share of GDP has shown a remarkable stability, the same cannot be said for the proportion of its major components: households and business. Since 1965, and especially since 1984, gross household savings as a share of GDP have declined and gross business savings as a share of GDP have risen as an offset (see Exhibit 9.4). The latter has occurred owing to ever rising depreciation as a share of GDP. The household savings rate declined largely as a consequence of social benefit consumption crowding out household saving.

  There is always a great deal of transferring of funds in both directions between government and the private sector: the government—federal, state, and local—takes in tax receipts from households and businesses and makes payouts to households and businesses. When the federal government receives contributions for social insurance from employees who save little of their income, and then turns around and sends checks for comparable amounts to beneficiaries who also save little, the overall effect on the gross domestic savings rate is negligible. But when tax receipts from upper income savers are transferred to lower income beneficiaries, gross domestic savings decline by the amount of the transfer, times the difference between the savings rates of the taxed upper income groups (high) and that of the social insurance beneficiaries (low).

  But determining the size of the crowding out of savings by benefit spending is not a simple matter of comparing the average savings rates of taxed households and that of beneficiaries. It is their marginal rates that matter. For example, a modest cut in income tax rates for a millionaire household is apt to have little to no effect on its level of spending on consumer goods and services. Hence, almost all, if not all, of the tax cut would go to savings. The marginal savings rate at that income level is thus close to, if not at, 100 percent.

  CALCULATING MARGINAL SAVINGS RATES

  The marginal savings rate for upper income quintile households (calculated from the sample BLS Consumer Expenditure Surveys) is shown for 1984 to 2011 in Exhibit 9.9.34 After adjusting those data to be consistent with BEA savings levels (also shown), the marginal savings rate averages 46 percent over the time frame, but has not trended upwards.*

  I then estimate the extent that taxation of upper income households finances social spending (and hence contributes to the decline in both household and total domestic saving).* Between 1979 and 2009, according to the CBO, the upper quintile’s share of total individual tax liabilities, driven by our rising degree of income inequality,35 increased from 65 percent in 1979 to 94 percent by 2009, the latest available data.36

  Gross domestic savings declined from 22.04 percent of GDP in 1965 to 12.88 percent in 2012 (see Exhibit 9.3). Of the decrease of 9.16 percentage points, 2.51 points (27 percent) was contributed by direct taxation of upper income quintile households, diverting savings from investment to consumption. In addition to estimating federal individual income tax liabilities attributable to upper income quintile households, the CBO also estimates the ultimate tax incidence of corporate, payroll, and excise taxes of upper quintile earners. Those taxes are levied before incomes are paid to households rather than on income already received. I estimate that the reduction of savings of the upper income quintile through this channel accounts for an additional decrease of two percentage points of GDP, or 22 percent of the decline in gross domestic savings over the past half century. Taxation directly or indirectly of the upper income quintile thus accounts for almost half of the decline in gross savings since 1965. The remainder of the decline is attributable to incr
eased benefit spending unmatched by tax receipts.

  FUNDING CAPITAL INVESTMENT

  Only savings can create a claim on productive capital assets. It is only when income exceeds consumption that a household has a surplus and must determine whether it uses the surplus to pay off debt, increase home equity, or accumulate bank deposits and other financial assets. Banks or other financial intermediaries will reinvest their newly acquired inflow of monies to fund some of the economy’s fixed capital assets and inventories. Household consumption, on the other hand, by definition, leaves no further imprint on household balance sheets.

  Only because we borrowed savings from abroad were we able to limit the decline in domestic capital investment (as a percent of GDP) to 5 percentage points—from 21.4 percent in 1965 to 16.2 percent in 2012—little more than half of the decline in gross domestic savings (Exhibit 9.3). Yet as I detail later in this chapter, even this decline was enough to slow the rate of growth of nonfarm output per hour (productivity) from the relatively stable 2.2 percent per annum that prevailed on average for a century (1870 to 1970) (see Chapter 8), to a 2.0 percent rate between 1965 and 2012—a consequential difference.

  THE PRICE OF BENEFITS

  Thus, the benefits surge that began in 1965, while clearly a huge political success, appears to have lowered the growth rate of real gross domestic private nonfarm business product by 0.21 percent per annum. That may seem small, but cumulatively, over the past half century, 0.21 percent per annum had created a gap (hypothetical less actual) by 2011 of almost a tenth of real gross private nonfarm business product and somewhat less for real GDP (see Statistical Appendix 9.1). That counterfactual projected GDP gap amounted to approximately $1.1 trillion by 2011, half the rise in social benefits payments of $2.2 trillion that occurred between 1965 and 2011. The evidence suggests that the resources required to augment the benefits of the elderly came largely at the expense of the lower income quintile households, almost wholly through suppressed wage rate gains. Profit margins were not materially affected.37

  A hypothetical loss of a never-experienced standard of living, of course, is not comparable to a visible and painful setback, such as the evaporation of retirement assets during the stock market collapse of 2008. If the properties of silicon and integrated circuits were never discovered, would we be mourning the loss of a never-existing Internet?

  These calculations indicate that if social benefits as a percent of GDP had stayed unchanged after 1965, the resulting gains in GDP would have yielded an annual increase in nonfarm output per hour of 2.2 percent between 1965 and 2011 (compared with the actual 2.0 percent), the same rate of growth that prevailed between 1870 and 1970. That result reinforces the hypothesis that productivity growth would not have slowed down materially from its century-long uptrend had benefits’ share of GDP not increased after 1965.38 Average production worker wage levels would certainly have been higher than those engendered by the tepid increases that have prevailed in recent years. (Productivity growth still would have been significantly slower, however, relative to the initial postwar rise between 1948 and 1965 that averaged an impressive 3.1 percent per year.)

  From 1992 to 2008, we borrowed an ever-increasing share of GDP from abroad to help fund our domestic capital investment, ballooning our current account deficit to 6 percent of GDP in 2006. With the collapse of domestic investment during 2008, the need for foreign borrowing has slowed. But as recently as 2011, annual borrowing remained large, mainly from China ($315 billion), Japan ($82 billion), and the Middle East ($45 billion), out of a total current account deficit of $466 billion (3.1 percent of GDP). We are borrowing resources from our children and the rest of the world to be repaid . . . when?

  THE NEED FOR CONTAINMENT

  Unless the upward momentum of entitlement spending is contained and turned around, the erosion of our gross domestic savings rate will almost surely continue to suppress capital spending, productivity, and growth in standards of living, as it has done incrementally for nearly a half century. Net domestic savings are now close to zero. Unless we increase our current rate of borrowing from abroad, additions to our productive capital stock will fall further.

  We have pretty much exhausted the low-hanging fruit that has helped fund the rise in benefits as a share of GDP, yet the bulk of baby-boomer retirements still lies ahead. The almost certain further rise in benefits, I presume, will be funded by additional reductions in discretionary spending, as some of our military and financial commitments continue to wind down. That will leave defense spending in 2019, as a share of GDP, at its lowest point since 1940, and nondefense discretionary federal spending (as a share of GDP) at the lowest levels in more than a half century. Social benefit funding from additional reductions in “discretionary” spending, both defense and nondefense, will thus become ever more difficult. Moreover, we are left with little buffer to fund unanticipated new military imperatives or major hurricane-related relief programs, for example, short of printing money—a policy that carries its own problems (see Chapter 13).

  OUR GLOBAL REACH

  We are the world’s reserve currency, which grants us special access to the world’s savings. That has given the United States an extraordinary degree of flexibility to act on the world stage. But our heavy borrowing from abroad since 1992 has brought our international investment position from a net credit in 1986 (and for many years earlier) to a net debt of nearly $5 trillion at the end of 2012. Presumably, we can continue to pawn or sell the nation’s capital assets to fund growing social benefit consumption, at least for a while. But there is a limit to a reserve currency country’s accumulation of foreign borrowings. Should the United States ever reach that limit and sources of new foreign funding dry up, social benefit spending will either be wrenched lower or, more likely, funded by printed money. Our status as the world’s leading financial power will be profoundly shaken.39

  Short of major entitlement reform, it is difficult to find a benevolent outcome to this clash between social spending and savings in this country. The answer, whenever it comes, will surely be political. The Great Depression of the 1930s brought us Franklin Delano Roosevelt. The economic “malaise” of the late 1970s and the financial distress that followed brought us Ronald Reagan and Margaret Thatcher.

  BOX 9.4: MONEY ISN’T EVERYTHING

  Budget appropriations provide money but not real resources to fund future benefits. There is no limit on the size of appropriations to fund ongoing or new social benefits. The fact that both houses of the Congress vote overwhelmingly for a new benefit, and the president eagerly signs the bill, does nothing to ensure that resources (people and products) will be available to fulfill the obligation. A continued decline in net domestic savings will shortly imply either a halt in the growth in our net fixed assets or increased funding from foreign savings. Net fixed assets, of course, are a major contributor to gains in productivity that, in turn, produce our standard of living, including the ability to meet the real resources requirements of our promises to retirees.

  We would do well to heed the caution offered in 1976 by former British prime minister Margaret Thatcher that politicians who are in the forefront of fostering large continual social financial transfers “always run out of other people’s money.”40

  Medicare, Social Security, and all other indexed programs are real entitlements whose funding burdens cannot be assuaged by general inflation. To implement Medicare and Medicaid in the decade ahead, we will need more physicians,41 nurses, hospitals, pharmaceutical companies, and other components of the large complex of medical services infrastructure. Making the problem all the more difficult, a significant number of experienced medical practitioners will be part of the wave of baby-boomer retirees in the years ahead. Social Security benefits, indexed to inflation, represent a general claim on the production of consumer goods and services. But in the end, they are just as real as the more specialized resources required to meet medical entitlements.

  STATISTICAL APPENDIX 9.1

  The r
elative stability of the sum of social benefits and gross domestic savings implies a near one-to-one tradeoff between benefits and savings. The probability that the relationship is purely accidental or owing to chance is exceptionally small. The R2 is a robust .75 and the t-statistic is highly significant (Exhibit 9.10). The short-term visual tradeoff depicted in Exhibit 9.7 appears even more persuasive than the formal regression fit.

  The hypothetical additional gross domestic savings that would have occurred in 2011 had benefits spending remained at 4.7 percent of GDP (its 1965 share) is nearly $1.6 trillion. Adding those lost savings to the actual amount of gross domestic savings in 2011, and then further adding savings borrowed from abroad ($467 billion in 2011), yields a hypothetical estimate for gross domestic investment $1.6 trillion higher than what actually occurred. Of total gross domestic investment, private domestic business has accounted for a relatively stable three fifths of total gross domestic investment. That yields a hypothetical addition to gross domestic private business investment in 2011 of $975 billion. I then adjust the hypothetical gross private nonfarm business investment into net investment by setting aside a proportion of gross investment to account for depreciation—that is, the wear and tear on the stock of capital assets. Finally, I deflate the hypothetical net investment figures into constant dollars.

  That enables me to employ the BLS’s multifactor productivity (MFP) paradigm (see Chapter 8) to translate labor input and the hypothetical real net domestic private business investment (converted to “capital services”) into hypothetical real gross domestic private nonfarm business product and output per hour.42