Dr. Martin Regalia

Last month I promised to write another column about the alternative minimum tax (AMT). I've decided to save that topic for a later date in order to give the various AMT reform proposals percolating in Congress time to come into clearer focus.

This month I'd like to draw a contrast between my short-term economic forecast with the possible economic scenario a few years down the road. Our near-term forecast remains relatively positive. We see solid, albeit nonspectacular, growth over the remainder of this year, with some slight acceleration in early 2008. Job growth should maintain a modest pace, and core inflation should continue to moderate. Interest rates remain steady at the short end of the yield curve, but we expect to see some increase among longer-term rates as risk is once again priced into the markets. Of course, this assumes that the housing market doesn't pitch into the abyss and, instead, begins to improve by early next year.

While this short-term outlook is benign, there are storm clouds gathering over the horizon that, should they coalesce, could precipitate a significant economic downturn. At the outset, let me emphasize that this is not a forecast. I am merely laying out a number of issues for discussion.

The duration of the last two economic expansions, the two longest on record, averaged about 81/2 years. The current expansion, which began at the end of 2001, would reach this age in the middle of 2009. While I don't believe that economic expansions die of old age, or even become more vulnerable with age, their mere longevity means that they are exposed to more policy decisions and unforeseen shocks-any of which could prove problematic. The bottom line is that it may be unreasonable to expect to set a new record for longevity with each ensuing cycle.

The Bush tax cuts are set to expire completely by the end of 2010. If this occurs, it would represent the largest tax increase in American history. By comparison, the record Clinton tax increase in 1993 was estimated to raise taxes by about $240 billion over five years. Expiration of the Bush tax cuts would result in a tax increase of almost $200 billion per year or more than $1 trillion in five years-about four times the previous record. Moreover, the current Democratic majority in Congress adopted a PAYGO (pay as you go) policy whereby any new tax cut, or extension of an expiring tax cut, must be paid for by a corresponding tax increase. Even if Congress chooses to extend some expiring provisions, there would be a commensurate tax increase.

Now, some may say that even old age and a huge tax increase may not be enough to tip our economy into recession. After all, we had some very good years of growth after the Clinton tax increase. However, I believe that growth following the Clinton tax increase was not the result of the tax increase but rather was due to a very important third factor, namely, productivity growth. At the beginning of the Clinton presidency, productivity growth was running about 1% and grew relatively steadily to just under 3% by 2000. This increase in productivity was worth more than $125 billion of real GDP growth on average each year, clearly swamping the negative effects of Clinton's tax increase.

Productivity growth has remained above 3% in the 2000-2005 period but has slowed dramatically in the last year and a half to about 1.5%. Unless we see a marked resurgence of productivity growth between now and 2010, the enormous tax increase embedded in the expiration of the Bush tax cuts would not be the beneficiary of a huge productivity offset but, instead, would occur in a period of slow productivity growth.

Another factor affecting the economy over the next few years is the low rate of national saving-not just at the personal level but more importantly at the national level where we see continued forecasts of government deficits. The current shortfall in national saving has forced the United States to borrow heavily from abroad to finance domestic investment. We have essentially financed this borrowing with large and growing trade deficits, which have, in turn, led to a weakening dollar. At some point, our foreign lenders may not want to hold an ever-growing amount of deteriorating dollar-denominated assets and will either reduce their dollar holdings or demand higher interest rates.

In the short run, I believe that we can manage these twin deficits. The budget deficit has been improving more than many expected in the last couple of years as a relatively strong economy has generated significant tax revenue and the divided government has led to lower growth in expenditures. But the future is not as bright. The budget submitted by the Democratic Congress calls for significant new spending, and the tax increases needed to pay for these expenditures will tax economic growth to the limit. Without growth, the needed tax revenue will not be forthcoming. The aging population will put further strain on entitlement spending.

While the current outlook for inflation is benign, lower productivity growth and a weaker dollar may trigger more inflation down the road. Slower productivity growth tends to raise unit labor costs, which ultimately raise core rates of inflation. A weaker dollar makes imports more expensive, which also tends to push up inflation. At some point, the Fed may feel the necessity to raise interest rates to combat the impending threat, regardless of the state of economic growth. Moreover, the current Fed is more likely to address this threat before it becomes a reality rather than to delay and allow inflation to become embedded in the economy as happened in the late 1970s.

So the plot of this economic "Perfect Storm" would go something like this. An aging economy sets sail on a relatively tranquil economic sea, only to be beset with gale force headwinds of a tax increase, building seas from lower productivity growth, a hail-storm of Fed interest rate increases, and a final tidal wave of currency problems. As I said at the beginning, this isn't a forecast (or even a good movie plot), but it is something to think about, especially if you are running for president in 2008.