The American Economic Problems of the 1980s

In the time of Reaganomics, questioning Washington's motives to heal the American economy, keep inflation low and reduce the deficit.
By Mark Rapp
January/February 1986
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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. Politicians in Washington D.C. tell us there are more people employed than ever before, but the rate of unemployment seems to have leveled off at around 7 percent, 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 percent 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 percent, 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.

So why hasn't the government used the budget process to reduce the deficit? Why has it become necessary for Congress to even consider passing the buck with mandatory budget cuts like those proposed in the late-1985 Gramm-Rudman bill? You see, during the 1970s Washington used a lot of created money and a little debt to finance our recoveries, but that made for some pretty wild inflation (OPEC didn't help). Now Washington has cooked up a new recipe: Mix a little created money with lots of debt.

And the new formula has made for a rather low rate of inflation. Of course, the present world oil glut has also helped keep inflationary pressures low here. Conservation has been one of the major factors contributing to the present oversupply of oil, and Americans are to be commended for their efforts to conserve energy. The worldwide recession of the early 1980s also helped to create the oil surplus, as countries in recession tend to use less oil. However, some of the other factors involved in the oil glut indicate that we could be headed for big trouble if we don't take action soon.

In the 1970s, anticipation of higher oil prices fueled a buildup of inventories, which only served to increase demand, which drove up prices, etc. In the early 1980s, there was a complete turnaround in market psychology. Anticipation of lower prices led to a continued depletion of inventories, thus constraining demand and driving down prices. It's now time to exercise a little caution, though, because a drastic decline in oil prices could easily rekindle the currently smoldering international debt crisis-particularly for such high-debt oil producers as Mexico, Indonesia, Nigeria and Venezuela. The international debt problem is one of the greatest threats to the stability of our economy.

It now looks as if recent oil trends are once more doing an about-face. Our commercial inventories of crude oil and gasoline are at their lowest levels in ten years. The 8 percent increase in U.S. crude oil and product imports in 1984 reflected revived domestic consumption, which exceeded domestic production. About one-third of our oil supplies now come from outside the U.S., the same portion as before the 1973-74 energy crunch. Continued economic growth will most likely increase our demand for foreign oil. Many energy specialists are warning that there may be trouble again in as little as two to four years — especially if events in the Middle East take another turn for the worse.

Back in the 1970s, OPEC controlled about 75 percent of the world's oil output. Nowadays it controls less than 35 percent, and its ability to determine prices has diminished accordingly. But, as nice as it would be, it doesn't look like OPEC is about to go away and leave us alone. The members of the cartel are more than willing to play a waiting game, because they know that the less of their oil we use now, the more we'll need from them later. Unless we invest in alternativeenergy resource development right now, we may well be sowing the seeds of our next oil shock. And once the price of oil starts rising again, it will become much more difficult for us to control inflation.

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 percent) than when the supply-siders first entered the picture (22.5 percent). 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 percent.

In light of all this, it's not surprising that many people are in favor of legislation to restrict "free" trade. But I believe that President Reagan is right on this one; protectionism is not the answer. We'd only be treating a symptom, not the real problem, if we went the route of protectionism, which would surely lead to retaliation from our foreign competitors. We might do well to remember that the trade wars of the 1930s had more than a little to do with the economic stagnation of the Great Depression. The creation of trade barriers could also weaken the financial status of heavily indebted Third World nations, which rely on exports to pay off their loans. Then too, inexpensive foreign imports have forced American manufacturers to keep their prices competitive, helping us to keep a lid on the inflation rate. Tariffs or quotas would very likely boost prices for American consumers and cost thousands of jobs in other countries, thereby decreasing the demand for American exports.

The real problem is that we need to reduce the federal budget deficit, which caused the overvalued dollar and the resulting trade imbalance to begin with. But this may not be as painless as it might seem. Taking some of the wind out of our overvalued currency would cause other currencies to rise in value relative to ours. This could aggravate U.S. inflation by boosting import prices. Furthermore, there's yet another catch that may prevent us from significantly reducing the budget deficit . . . it's still financing our recovery. It seems we've borrowed ourselves into a corner.

The severity of the farm crisis stems partly from the reduced overseas sales of farm products caused by our overvalued dollar. These reduced foreign sales also caused crop prices in the United States to fall. Lower prices for farm goods decreased farmers' net incomes and left farmers with larger amounts of debt unable to make their payments. The decline in market prices also intensified the drop in farmland values caused by high interest rates. Essentially, high real interest rates have dealt farmers a double blow by causing a decline in the price of farm products and lowering the value of farmland. As more and more farmers found themselves on the brink of bankruptcy, many of them asked Washington for some help. The response was basically that there wouldn't be much help and that farmers were foolish for running up so much debt that they could no longer pay it off. (A saying comes to mind here — something about a pot calling a kettle black.)

In early 1985 many rural banks were obviously in trouble, and the farm crisis was fast becoming a major problem. Washington decided to take action. Congress forwarded an emergency bill to provide financially pressed farmers with low interest loans, which President Reagan promptly vetoed. The trouble with this emergency legislation was that it would have increased the deficit, the same deficit that created the problem to begin with. The Federal Reserve Board temporarily eased credit requirements for agricultural banks-a move that helped many farmers. Some states set up special programs, such as "Operation All-Out" in Wisconsin, to help farmers with debt problems. Whether or not these measures will sustain farmers until crop prices rise again remains to be seen.

The forces behind our recovery can almost be summed up in one sentence: We have used debt to create the illusion of economic health. However, that same debt is now starting to cause some major problems. And exactly what can the people who got us into this fix do about it? My guess is that we'll see some minor cuts in the budget deficit to keep foreign investors from losing confidence. And I wouldn't be surprised if the Federal Reserve produces more money to make up for any negative impact the remaining deficit might have on our economy. By taking these steps, it may be possible for us to keep the recovery going for a while yet, although the Fed will eventually drive up inflation if it continues easing up on the money supply. Of course, this short-term "positive" outlook is based on a few assumptions: that oil prices stay low but don't go too low, that foreign investors don't get too nervous about the deficit or inflation, that the farm crisis doesn't get any worse, that protectionist sentiments don't lead to courses of action that do more harm than good, and that Washington doesn't do something incredibly foolish (like letting the deficit balloon).

Over the long haul, though, the situation looks less promising, but — if nothing else — we've bought ourselves some time with our debt-financed recovery. Perhaps we can use this time to devise solutions to the economic problems looming on our horizon. Unfortunately, unlike debt and complacency, solutions are in short supply these days.

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