Statement of Mark Zandi, Ph.D., Chief Economist, Moody’s Economy.com, West Chester, Pennsylvania

Testimony Before the Full Committee
of the House Committee on Ways and Means

January 23, 2007

Mr. Chairman and members of the Committee, my name is Mark Zandi, I am the Chief Economist and Co-founder of Moody’s Economy.com.  Moody’s Economy.com is an independent subsidiary of the Moody’s Corporation.  We are a provider of economic, financial, country, and industry research designed to meet the diverse planning and information needs of businesses, governments, and professional investors worldwide.  We have over 600 clients in 50 countries, including the largest commercial and investment banks; insurance companies; financial services firms; mutual funds; manufacturers; utilities; industrial and technology clients; and governments at all levels.  Moody’s Economy.com was founded in 1990, is headquartered in West Chester, Pennsylvania, a suburb of Philadelphia, and maintains offices in London and Sydney.

I will make four points in my remarks.  First, the economy, in aggregate, is performing well and is expected to continue doing so during the coming year.  Second, the benefits of the strong economy are not accruing evenly, as the industrial Midwest and Gulf Coast economies continue to struggle and lower income and less wealthy households fall further behind higher income, wealthier households.  Third, the economy’s long-term growth prospects are worrisome given the nation’s daunting fiscal challenges unless substantial changes are made to both tax and spending policies.  Finally, any policy changes must be considered from many perspectives, including examining them through the prism of the distribution of income and wealth.

Near-Term Growth

The economy is currently experiencing growth near its potential, it is operating close to full-employment, and inflation and interest rates are low by broad historical standards.  While growth will be slower in the coming year due to the ongoing housing correction and some spill-over effects into other parts of the economy, the economy will enjoy its sixth year of expansion.

Behind this optimism is record corporate profitability.  Profits have more than doubled since the 2001 recession, and profit margins have never been as wide.  Businesses have significantly pared their debt loads and are flush with cash, which they are using to repurchase stock, pay dividends, acquire and merge with other companies, invest overseas, and also to invest and hire here in the United States.  Businesses are unlikely to significantly pull-back on their expansion plans given their currently stellar financial situation.

The economy is also receiving a lift from robust global economic growth.  It is not unprecedented for all the globe’s major economies to be expanding in unison, but it is unusual.  Sturdy global growth combined with a weaker dollar is resulting in a narrowing in the trade deficit for the first time in a decade.

The housing correction is weighing on growth.  Previously soaring house prices combined with the Federal Reserve’s tightening efforts have undermined housing affordability, builders are working off a large amount of unsold inventory, and short-term speculators are being wrung out of the marketplace.  Home sales, construction, and house prices will remain weak throughout much of this year.  There will also likely be some spillover of housing’s problems into the rest of the economy, as lower housing wealth and surging mortgage delinquencies and foreclosures crimp consumer spending growth.  The housing correction is unlikely to devolve into a crash, however, given the sturdy job market, and thus while recession risks are elevated they remain low.

Economic Benefits

The benefits of the economic expansion are not accruing evenly, however.  The auto-producing areas of the industrial Midwest are in recession as the domestic vehicle producers cut production and jobs.  The Gulf Coast’s recovery from Hurricanes Katrina and Rita is disappointingly slow, with New Orleans employment still more than twenty percent below its pre-storm level.  Parts of the rural economy, particularly in the South,  are still suffering the ill-effects of ongoing job losses in manufacturing, and the economies of many of the nation’s urban cores are moribund.

Lower and lower-middle income households have not kept up financially in this expansion.  Real median household incomes are no higher today than they were at the end of the 1990s.  This reflects very strong income gains for households in the top half of the income distribution, but little or no gains in real incomes among those in the bottom half.  The distribution of wealth is becoming even more skewed.  Those in the top ten percent of the wealth distribution have median real household net worth of approximately $1 million.  Their net worth has doubled during the past decade.  The real median household net worth of those in the bottom half of the wealth distribution is less than $50,000 and it has barely grown during this period.

Globalization and the rapid pace of technological change have enormous economic benefits, and while both are vital to a strong economy, they have also been the principal driving forces behind the uneven distribution of those benefits.  Those with education, skills, and talent are now able to sell their wares into a large and fast-growing global marketplace, while those without are now competing in a much large global labor market.

Financially-pressed lower income households have been able to mitigate the impact of their constrained incomes on their living standards by significantly increasing their borrowing.  This has been facilitated by the steady decline in interest rates over the past quarter century and financial innovations which have substantially increased the availability of credit.  It is becoming increasingly difficult for lower income households to supplement their incomes with increased debt, however, as debt burdens are already at record highs, interest rates are no longer falling, and judging by surging mortgage credit problems, borrowers are increasingly unable to juggle their existing obligations.

Long-Term Concern

The economy’s longer-term prospects are also worrisome given the prospects for very large budget deficits in the decades ahead.  As articulated in recent Congressional testimony by Federal Reserve Chairman Bernanke, without any substantive changes to tax and spending policies in the near future, and making some very reasonable assumptions, the federal budget deficit will amount to nearly 10% of the nation’s GDP a quarter century from now.  Driving this worrisome outlook are the inexorable aging of the population and rapid growth in health care costs.

Mounting deficits will ultimately weigh heavily on investment, productivity growth, and the living standards of all Americans.  Lower and middle income households will be particularly hard hit, however, as they heavily rely on the Social Security, Medicare, and Medicaid programs; programs that will become insolvent during this period.  The debt burdens on these households will also become overwhelming, due to the higher interest rates engendered by the mounting deficits.

Policy Changes

These long-term fiscal and economic concerns should be addressed in the very near-term through a combination of what will be painful tax and spending policy changes.  Many factors must be weighed in determining the most appropriate mix of changes, including it implications for households, industries, regions, and the broader economy.  How these changes influence the distribution of income and wealth should also be considered.  It has long been anathema for economists and difficult for policymakers to consider policy through this prism.  But the ongoing skewing of the distribution of income and wealth has become so pronounced and will become even more so in the years ahead, that those who are being disenfranchised are sure work to short-circuit the process of globalization and technological change so vital to the long-term strength of our economy.  Policymakers must be resolved not to allow protectionist sentiment to boil over or to allow efforts to intervene in the job, product, and financial markets, but they must be equally resolved to consider all future economic policy in the context of what it means for lower and middle income households.