Orthodox Investment vs. Government Spending: Two Contrasting Models for the 1990s

Abstract

The dominant orthodoxy today has developed a quite clear macro model for the U.S. economy in the intermediate future. We propose here to specify quantitatively this model's assumptions and to appraise its goals and plausibility. We shall limit the discussion to the major domestic real spending streams and productive factor inputs. It is contrasted to a model using expanded government spending to produce high rates of real growth. The results of the expanded government model are shown to produce many results expressly desired by the orthodoxy, like an increased share of going to investment. It is also more consistent with the postwar behavior of the economy. This orthodox model's expectation is that real noninflationary potential can grow at only about 2.5 percent a year. This or lower rates of growth for potential may be found in the works of many representatives of orthodoxy such as: The Congressional Budget Office (CBO, August 1989; January 1990, pp. 24-25; and February 1990, p. 17); former Chairman of the Council of Economic Advisers Herbert Stein (Stein, 1988); The Federal Reserve System (cited in CBO, August 1989); several of the Federal Reserve Banks including Cleveland, (January 1989) and Richmond (Fall 1989); Charles Wolf of The Rand Corporation (Wolf, 1988); and some of the works of Robert J. Gordon published by the Brookings Institution (Gordon, 1973). These can be thought of as the makers of Paul Krugman's Diminished Expectations (Krugman, 1990). Gordon calls potential real natural real GNP, which he defines as the level of real consistent with no change in the inflation rate. He has regularly published his estimates of natural real GNP for every year of the twentieth century in his textbook, Macroeconomics. In the latest edition (Gordon, 1990) the rate of growth of natural real GNP for 1975-1988 is 2.54 percent, and for every year for 1981 through 1988 it is 2.36 percent. We believe that the work of Gordon and his colleagues at Brookings is the probable origin of this pessimistic number, a 2.5 percent potential growth rate. This rate is a good half percent below the actual for the twentieth century, (including the Great Depression) and three quarters of a percent below the actual real growth from 1948-1988. In our judgment it is an unrealistically low policy variable; consequently, we call the whole model restrictionist. The model is also conservative and orthodox in its sluggish desired growth in all-government purchases of goods and services. It is solidly based in the anti-big government tradition. Orthodoxy also is very much alarmed about an alleged fall in the U.S. savings ratio. Accompanying the alarm is an attack upon American consumers for living high on the hog in the last decade or so. Consumption must be cut to create more saving, which will presumably stimulate more investment. Investment is the only major spending and input category that the model does not wish to rein in. Indeed, in good traditional fashion, the sky is the limit so far as investment is concerned. In our quantitative specification of this restrictionist model, for simplicity we will ignore net foreign investment as utterly unforecastable and inventory investment change as both insignificant and comparatively stable in the intermediate period. What should be concentrated upon is business nonresidential fixed investment. This is the dynamic, technology-embodying, capacity-creating component of private investment. It is the darling of the restrictionists. Residential investment, though quantitatively of some importance, we shall also subordinate by allocating to it an estimate upon which we can probably all agree. Let us construct a hypothetical restrictionist model, incorporating magnitudes for the major variables that to us appear to reasonably represent the goals of the orthodox group. We concentrate upon real aggregate demand flows using the following simplified, closed economy statement: GNP= C + |I. …