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William Vickrey, 1996 Memorial Nobel Awards in Economics

Otober 5, 1996

Many profess a faith that if only governments would stop meddling, and balance their budgets, free capital markets would in their own good time bring about prosperity, possibly with the aid of "sound" monetary policy. It is assumed that there is a market mechanism by which interest rates adjust promptly and automatically to equate planned saving and investment in a manner analogous to the market by which the price of potatoes balances supply and demand. In reality no such market mechanism exists; if a prosperous equilibrium is to be achieved it will require deliberate intervention on the part of monetary authorities.

In the heyday of the industrial revolution it would probably have been possible for monetary authorities to act to adjust interest rates to equate aggregate planned saving and aggregate planned investment at levels of GDP growing in such a fashion as to produce and maintain full employment. Generally, however, monetary authorities failed to recognize the need for such action and instead pursued such goals as the maintenance of the gold standard, or the value of their currency in terms of foreign exchange, or the value of financial assets in the capital markets. The result was usually that adjustments to shocks took place slowly and painfully via unemployment and the business cycle.

Current reality: The time is long gone, however, when even the lowest interest rates manageable by capital markets can stimulate enough profit-motivated net capital formation to absorb and recycle into income over any extended period the savings that individuals will wish to put aside out of a prosperity level of disposable personal income. Trends in technology, demand patterns, and demographics have created a gap between the amounts for which the private sector can find profitable investment in productive facilities and the increasingly large amounts individuals will attempt to accumulate for retirement and other purposes. This gap has become far too large for monetary or capital market adjustments to close.
On the one hand the prevalence of capital saving innovation, found in extreme form in the telecommunications and electronics industries, high rates of obsolescence and depreciation, causing a sharp decline in the value of old capital that must be made good out of new gross investment before any net increase in the aggregate market value of capital can be registered, together with shifts from heavy to light industry to services, have sharply limited the ability of the private sector to find profitable placement for new capital funds. Over the past fifty years the ratio of the market value of private capital to GDP has remained, in the U.S., fairly constant in the neighborhood of 25 months.

On the other hand, aspirations for asset holdings to finance longer retirements at higher living standards have increased sharply. At the same time the increased concentration of the distribution of income has increased the share of those with a high propensity to save for other purposes, such as the acquisition of chips with which to play high stakes financial games, the building of industrial empires, the acquisition of managerial or political clout, the establishment of a dynasty, or the endowment of a philanthropy. This has further contributed to a rising trend in the demand of individuals for assets, relative to GDP.

The result has been that the gap between the private supply and the private demand for assets has come to constitute an increasing proportion of GDP. This gap has also been augmented by the foreign trade current account deficit, which corresponds to a diminution of the stock of domestic assets available to domestic investors. For an economy to be balanced at a given level of GDP requires the provision of additional assets in the form either of government debt or net foreign investment to fill this growing gap. The gap is now tentatively and roughly estimated for the U.S. to be equal to about 13 months of GDP. There are indications that for the foreseeable future this ratio will tend to rise rather than fall. This is in addition to whatever role social security and medicare entitlements have played in providing a minimal level of old age security.
In the absence of change in the flow of net foreign investment, a government recycling of income through current deficits of somewhat more than the desired growth in nominal GDP will be needed to keep the economy in balance. Curtailing deficits will correspondingly stifle growth. A balanced budget, indeed, would tend to stop growth in nominal GDP altogether, and in the presence of inflation would lead to a downturn in real GDP and a corresponding increase in unemployment.

Depending in part on what may happen at the state and local levels, current programs for gradually reducing the Federal deficit to zero over the next seven years would in effect put a cap on total government debt at about 9 trillion dollars, implying that GDP would, in the absence of changes in net foreign investment, converge on a level of about 8 to 9 trillion, aside from short-run cyclical fluctuations. This compares with a full-employment GDP after seven years at 3% inflation of about 13 trillion. The balanced budget GDP of about 65% of this would correspond to a reported level of unemployment of 15 percent or more, in addition to unreported underemployment. Thereafter, if the strictures of a balanced budget amendment were to be adhered to, unemployment would continue to increase. Before this could happen, however, some concession to reality would probably be accepted, though not until a great deal of needless suffering would have been endured.