Anatomy of a Recovery

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Regrettably, a low rate of inflation is one of the few supply-side goals Washington has been able to achieve. The federal budget is anything but balanced, and government spending is now a higher percentage of the gross national product (24%) than when the supply-siders first entered the picture (22.5%). As a result, we've recently experienced some of the largest deficits in the history of the nation-deficits that are rapidly pushing the total national debt up toward an incredible $2 trillion.

And the American people are getting worried about this debt. There's a rising consensus that something should be done about the deficit. It seems that many of us have forgotten how the deficit got so huge to begin with. These deficits are, by and large, a result of tax cuts and increases in government spending (mostly defense spending) designed to stimulate the economy, which they did. Washington hoped that economic growth would eventually reduce the deficit, but it hasn't.

The tax cuts-which primarily benefited those in the upper income brackets-were justified by invoking the supply-side theory stating that these cuts would actually increase tax revenues by stimulating economic growth. Former budget director David Stockman had another name for it—the "trickle-down theory." This belief held that the good effects of the tax cuts would eventually "trickle down" to less wealthy citizens. Now, most of us would agree that there's nothing wrong with cutting taxes, but it shouldn't be done unfairly, and it especially shouldn't be done while the government is increasing expenditures. In a way, it's too bad that Washington did increase spending to help stimulate the economy, because now we'll never know if the supply-side tax theory worked.

While we've been waiting around for economic growth to reduce the deficit, some interesting things have been happening. Interest rates have remained rather high because of the deficit, prompting the Fed to create a little money to keep rates from getting too high and stalling the recovery. However, the high interest rates have already done quite a bit of damage.

First of all, these rates have combined with our recovery to attract a lot of foreign capital to the U.S. Much of this capital has gone toward the purchase of U.S. debt securities, which has helped ease the credit shortage caused by the deficit. At first, this may look like a good dealuntil it becomes evident how dependent we've become on foreign investment. If these overseas investors lose confidence in the U.S. economy, we could be in for some rough sailing.

As foreigners started demanding more dollars to invest in financial assets in the United States, the dollar increased in value (even money is susceptible to the law of supply and demand). In fact, there was such a demand for dollars that our currency actually became overvalued. The stronger dollar raised the price of American goods overseas and reduced the foreign sales of these goods. Our overvalued dollar also made imported goods cheaper here, which led to an increase in the sales of foreign products in this country. This gap between America's exports and imports has created record trade deficitslike the $123 billion debit in 1984—and has hurt, in particular, the nation's farmers, steelmakers, manufacturers of heavy machinery, and others who depend on export sales. For the first time in 71 years, the U.S. has become a debtor nation. The trade deficit caused by our overvalued currency is also one reason why unemployment remains stubbornly at around 7%.

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