The United States of America is one of the richest nations of the world, with nearly a fifth of the world’s Gross Domestic Product emerging in the country. The US has the highest level of output in the world. The total GDP in the country in 2006 was 13. 2 trillion dollars. With a population now reaching 300 million people, the per capita income in the US now is nearly 45000 dollars per annum. In the last three years however, there have been concerns voiced about the health of the economy.
The chief concerns have been in the housing market, which many feel has been overvalued. The savings rate has been coming down and therefore impacting the growth rate negatively. Also the US budget has now seen a deficit on the current account as revenue expenditure has been growing faster than revenue growth. The deficit might get worse later in 2007 as the economy weakens further. Wage costs have traditionally been high, and in a tight situation have increased even more causing some amounts of inflation.
The Economic Intelligence Unit of the Economist has highlighted these problems faced by the US economy in recent times and also pointed to the falling exchange rate of the dollar with respect to the Euro as an indicator of the weakening American economy. The special report of the EIU released in August 2007 points out to the fact that the emergence of the European and Asian economies in the past have led to a fall in the pivotal importance the US economy had in the world economy. The report points to the recession in the US economy leading to a likely fall in growth rates in the country in 2008 and onwards.
It is in this context that it becomes important to look at the state of the economy in the US in the past three years. In the past, the US economy had been doing well, despite the slowdowns seen in the rest of the developed world. With low interest rates, high employment levels and a strong construction sector, the economy had seen balanced economic growth with a robust export performance in the decade of the nineties. Right at the outset it will be important to underline the role played by the free market operating in a democratic context.
The US has remained wedded to the concept of a free market economy governed under unwavering democratic principles. This has allowed a strong civil rights movement to flourish, consumer lobbies to argue strongly for anti monopolistic practices and a competition regulatory mechanism in place. It is indeed this fundamental strength that allows the US to remain the world’s most powerful economy in the democratic framework it works on and the political freedom the constitution guarantees. It is political freedom that enables the optimal use of resources in any country.
Interest groups exert pressure on governments and ensure widespread and sustainable growth. Free market based economies like the US work on the principles of rule of law, property rights and enforcement of contracts. This way growth is robust and is not vulnerable to shocks that are inherent in a globalized world. Lipset (1959) and Sen (1999) have argued that it is democracy that fosters economic growth across the world. Foreign trade and exchange rates After joining NAFTA, in its 1994 version and now with the revised agreement, the US economy is now increasingly integrated with the North American economy.
As a result any slowdown in the US economy have been balanced out by the growth seen in Canada and in Mexico. The economic policy in recent times is characterized by a relatively stable prime interest rate, the exchange rate falling gradually and a healthy foreign exchange reserve. With healthy increase in exports of more than 11% last year, US external trade is critical to the economy and that is the most important reason for the monetary policy aimed at keeping the dollar a floating currency.
A free float enables a currency to absorb shock. And countries that are so clearly exposed to external shocks need to be able to cushion external changes. Historically, the US’ monetary policy as regards the currency rate has been one where the state intervened in currency transactions and the central bank monitored the exchange rate. However this has now changed and the exchange rate regime follows a true floating mechanism that would change with the market situation as regards imports and exports.
In the year 2006 past, the trade deficit in trade in goods and merchandise has reached US$838bn in 2006. This is primarily on account of the huge trade deficit with China, and this could give rise to some protectionism in the US economy. The cheaper local currency that is being seen now will encourage exports and discourage imports taking the trade deficit towards a positive value. Monetary policy Monetary policy is often a toll that is defined and determined by the inflation rate.
In democratic countries, price rise is often politically unacceptable especially with frequent elections. Hence the central bank and the treasury tend to keep a close watch on the inflation and on the customer price index. On this front, the US economy has performed well with modest inflation helped by an interest rate that is stable. The low inflation rate might have an impact on domestic demand, as the aggregate supply curve would tend to flatten given stable prices. Also with a low unemployment rate and stable salary levels the demand curve too would be flat.
Therefore growth would be restricted to growth in external trade helped by a favorable exchange rate that is what the US economy is witnessing. As a result, the major factor that would impact the economy now is the business cycle. In economic theory, business cycles show growth in initial phases, then a stability followed by a decline. These are periodic swings that most economies pass through. During these cycles production and supplies go up due to price and demand increases and then as demand stabilizes, so do prices. Producer surplus comes down, and investment levels stabilize.
Then when the curve starts sliding down, prices reduce, demand levels fall and till the supply reaches a new equilibrium the economy goes downhill resulting in unemployment and retarded growth. Each country goes through such alternating phases of growth and stagnation, though the length of the cycle is very often uncertain and unpredictable. Economic expansion is the phase where the real GDP rises steadily and recession is the stage where the real GDP falls. This is followed by a phase of economic recovery. The US business cycles have not been any different from the rest of the world.
A globalized economy is prone to expansion and recession in the rest of the world. The first big recession was seen in 1929. However the economy stabilized soon after thanks to some tight monetary policies and a harsh fiscal policy, where the government taxed its citizens at high rates to keep the public sector functional and to provide social security to those hurt by slowdowns. Each slowdown affects jobs, growth and economic prosperity adversely. In the post war period, the economy has been relatively stable and has only passed through two serious recessions.
Since then, the US has seen a period of healthy economic expansion and prosperity, despite a slowdown in services trade and the internet bust that pushed the US into a recession at the turn of the century. Fiscal policy Fiscal policy is a tool the state uses to ensure that public expenditure is met through revenue mobilization using various taxes, levies and fees. Historically, it the monetary and the fiscal policy have been used by governments to run their economies and handle various pressures on expenditure, investment, unemployment rates and inflation.
Fiscal Policy is the tool that governments use to ensure an addition or reduction in expenditure and revenue levels so the economy can be steered in a particular direction. While fiscal policy focuses on changes in the governmnet level of expenditure and revenue mobilisation, monetary policy concentrates on the money supply in the economy and by giving incentives to the citizen, governemnts encourage or discourage the velocity of money flow in an economic system. The US tax structure has been criticized for charging high taxes on business.
However, over the years tax rates have been cut and now the federal corporate income tax rate is down. However, while US personal income tax rates are lower compared to most developed economies, corporate taxes, because of the various tiers of taxation are still comparatively higher. With the increase in government spending on welfare and old age pension plans, these tax rates are unlikely to reduce. The fiscal policy reflects the concerns of the political leadership in seeking to increase government revenue and expenditure.
The health system is huge and needs constant doses of capital to sustain itself. In addition to the health sector, the social security system and the education system too is largely subsidized and calls for higher tax rates. Increasing tax rates tend to dampen demand and slow down the growth rate as higher taxes lead to a slowdown in supply, which also gets affected by higher unemployment. However government revenue goes up and government expenditure can increase as a result of higher tax collections.
The business cycle then goes into a recessionary phase. But with increased government expenditure, public utilities get benefited. Therefore fiscal policies need to be well balanced and not cause an irreversible slowdown of the economy leading to spiraling inflation rates. In globalizing economies, the threat of borrowing slowdowns is as serious a concern as the opportunities that come through foreign expansionary phases in global business cycles. Fiscal measures tend to shore up the domestic economy in the face of external pressures.
The US fiscal policy in that sense has prudently tried to balance growth with inflation, and increase government expenditure whenever unemployment threatens to increase. Also, tax revenue has enabled the setting up of a health and education system that supplies most of the skilled labour force that works in the large service sector. When there is fall in money supply, this causes a decline in demand and hence a fall in prices. However, what could very well result is a slowdown or a stagnation of the economy that could give rise to job losses and high unemployment.
However, with inflation in check, the fiscal policy too has not been as drastic as it could have possible been. Conclusion The US requires a stable financial system that is able to meet the expectations of depositors, investors and the government. The democratic system and economic structure, which is heavily dependent on the world economy and the success of the WTO, presents many challenges to the formulation of its monetary and fiscal policy. It is important that the fiscal policy takes into consideration the key issues of public and government expenditures.
The monetary policy should be formulated accordingly so as to bring down the threat of fiscal deficits. Taking the need for institutional changes into consideration, there should be potential improvements in the economy in order to provide the right directions to the policymakers. It is felt that the quality of expenditures at federal and provincial levels has been deteriorating over the period of time; therefore it is very important for the government to have a rational approach towards these expenditures.
Expenditure restructuring must accompany expenditure control. Privatization combined with increased competition, plays a major role in reducing the fiscal deficits. Tax rates have to be brought down as the economy looks for increased investment. It is not feasible to have high tax rates in a world competing for global investments. Interest rates cannot be kept high for a long time and must compete with the interest rate mechanism in the rest of the world.
Aggregate supply and aggregate demand in the US is intrinsically tied up with supply and demand in the household sector, and apart from the construction sector, all other sectors of the economy now closely follow the business cycle that is predictable. The integration of the world economy impacts North America considerably, especially by way of rising oil prices, which have a way of impacting almost all sectors of the economy. A monetary policy that ensures a stable exchange rate, low levels of inflation and higher levels of employment along with a fiscal policy that tends not to dampen GDP growth, is what the future would demand.
1. Lipset S. M. (1959) Some Social Requisites of Democracy: Economic Development and Political Legitimacy. American Political Science Review. 2. Mansfield, E. (1982). MicroEconomics – Theory and Applications. 4th Ed. W. W. Norton and Company. 3. Ohmae, K. (1999) The Borderless World: Power and Strategy in the Interlinked Economy. New York: Harper Business. 4. Sen, A, (1999) Democracy as Freedom. Oxford University Press. 5. EIU, (2007). Heading for the rocks: Will financial turmoil sink the world economy? EIU Special Report, London.