Anatomy of a Recovery

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During the past few years, the American economic scene seems to have become a jumble of contradictions. We appear to be in the midst of an economic recovery, yet the national debt is rapidly approaching $2 trillion. Washington tells us there are more people employed than ever before, but the rate of unemployment seems to have leveled off at around 7%—which was once considered high. The defense industry is booming while farmers suffer through their toughest years since the Great Depression.

The confusion all started several years ago when it became apparent that Keynesian economics, or demand management, didn't seem to be working out so well. Double-digit inflation, high unemployment rates, and record high interest rates all fueled the nation's hunger for something different. So, we decided to give supply-side economics a try. Since no one, including the experts who favored the plan, was 100% sure that supply-side theories would work, we all became involved in a great experiment.

Supply-side proposals included tax reductions which would supposedly generate enough of an increase in economic activity to make up for the loss of revenue resulting from the reduced tax rates. Supply-siders also hoped to cut federal spending as a percentage of the gross national product, to eventually balance the federal budget, and to control inflation by stabilizing the growth of the money supply.

Indeed, several of the key proposals were put into effect soon after President Reagan took office, and the new supply-side nostrums combined with an excessively tight money supply to spawn the worst recession since the Depression. With unemployment reaching 10.7%o, a federal budget deficit of $110 billion in fiscal 1982, and a projected deficit of about $200 billion for fiscal 1983, it was obvious something had to be done. So, the Federal Reserve System eased up temporarily on the money supply to stimulate economic activity, causing a number of economists to question the effectiveness of supply-side measures. Then, just when quite a few of the experts had become openly skeptical of supply-side economics, our recovery got under way.

Of course—in any field-experts don't like to be embarrassed, especially when they know deep down that they're right. Therefore, several of these economic wizards pointed a warning finger at the deficit and told us that, in time, interest rates would be pushed up and force either a new recession or renewed inflation. Washington argued that economic growth would significantly reduce the deficit, but that never happened.

Fortunately for us, foreign investment kept interest rates fairly stable for a while, until the deficit forced interest rates higher in the first half of 1984. As a result of that rate hike, the U.S. economy slowed down and the Fed once again loosened up on the money supply to keep the recovery going, thereby increasing the chances for renewed inflation.

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