POLITICS JULY 1, 1985
What’s going on here? Only a year ago, the economy was racing along at the fastest clip in more than 30 years. Personal income was up, inflation was down, and to many Americans, if seemed positively churlish to deny that President Reagan had succeeded in "laying the foundations for a decade of supply-side growth."
Administration supporters claimed that as long as Federal Reserve chairman Paul Volcker was kept from sabotaging "the Reagan recovery" through an overtight money policy, the future looked bright. Long-term interest rates would gradually settle down to a more reasonable level. Lower interest rates would boost business investment and consumer demand, and also reduce the flood of foreign investment that was keeping the value of the dollar high. As the dollar fell, imports would become more expensive, and exports would become cheaper. This in turn would bring down the trade deficit, and, with luck, take even more pressure off interest rates. With interest rates lower, annual payments on the federal debt would fall, reducing future deficits, and making the Third World's debt more manageable.
That was the plan, anyway. But now, seven months after the election, just when we thought it was going to be "morning in America" for at least another four years, the forecasts are turning remarkably gloomy. First-quarter economic growth figures were virtually flat, raising fears of a "growth recession"—a period in which economic growth is so slow that unemployment increases anyway. In response, the Federal Reserve, which had been refusing to ease credit until Congress took a big bite out of the deficit, abandoned this high-stakes game of chicken and cut the discount rate—the rate at which it lends money to banks—to just 7.5 percent, the lowest rate since 1978. This prompted a drop in the prime lending rate, and cheered skittish Wall Streeters enough to push the Dow Jones average up above the 1,300 mark, a record high.
But it's hard to believe that the Fed's action alone will be enough to prevent another recession either late this year or early in 1986. Business capital spending plans for the rest of 1985 are way, way down, and for 1986 they look even worse. That's alarming, since capital spending on plant and equipment has been a crucial ingredient in the current recovery. The nation's factories are operating at just 80 percent of their theoretical "full capacity." This figure is far below what it ought to be this late in a recovery, partly because of the flood of imports. Business profits are down significantly from the peak of the Reagan boom. Overall industrial growth is nearly stagnant. Only the service and retail sectors keep the economy slogging forward.
Then there's the financial front. There are nearly 1,000 officially anointed "problem banks." All that keeps the battered savings and loan industry from bankruptcy are some questionable accounting practices and a few hasty interstate acquisitions arranged by federal regulators eager to avoid paying off depositors' losses. In Latin America the debt crisis is resuming, and in Western Europe the economic growth hoped for in 1985 has mostly failed to materialize, as short-term interest rates stay stubbornly high.
Is the economy about to fall off a cliff, as it did in 1981? Or is it simply going through a "soft landing," in the jargon of the trade, after which it will right itself and resume a steady upward path? Were the supply-siders right in 1984—has Reagan laid the foundations for a decade of supply-side growth? Or is the economy slipping back into stagnation and malaise? Before answering, let's back up a bit.
In 1981, when Reagan took office, the economy had clear problems: slow growth, flagging productivity, declining capital investment. Supply-side economics held that these problems were largely the result of a tax structure that was: (1) biased against savings and toward excessive consumption (by overtaxing income from capital); (2) biased against work and toward leisure (because of high marginal tax rates in general); and (3) biased against productive investment and toward unproductive paper entrepreneurship (by providing tax depreciation for capital assets that was lower than the actual rate of depreciation). The obvious response? Big tax cuts all around. As the old philosopher says, if all you've got is a hammer, the whole damn world looks like a nail.
The supply-siders made four claims. If taxes on capital income were cut, savings would rise. If taxes on capital investment were cut, capital investment would increase. If the Federal Reserve were supported in steadily reducing money growth, interest rates would fall. And finally, with investment increasing, productivity would rise, leading to a more competitive national economy and a higher standard of living.
On every front, the Reagan economic program has failed to deliver. Despite lower taxes and higher post-inflation returns, personal savings actually have fallen to the lowest share of disposable income in 40 years. At the same time, thanks to the big tax cut (which, remember, was supposed to increase savings), we have a federal deficit bigger than the pool of personal savings, meaning we have to rely on foreign investors to keep the economy afloat. Business investment as a share of GNP is up from the dark days of 1981, but still below Carter-era levels. And the composition of business investment is more distorted than ever by a tax system that leads business planners to pay more attention to the latest permutation of the tax laws than to real economic returns.
Meanwhile, unemployment is at a record high for this stage in a recovery, and promises to start rising again if GNP growth slips below an annual rate of three percent. International competitiveness has declined because of the overvalued dollar, and productivity growth is just limping along at an annual rate of 1.5 percent—less than half the rate of the 1950s and 1960s.
A pretty sorry show. The only real economic accomplishment of the Reagan era is the big drop in the inflation rate—from 13 percent to four percent. But even here, it's hard to give the Reagan economic program much credit, unless the president decides he's willing to fake responsibility for the deficit, which is keeping the dollar high, and for unemployment, which is keeping wage gains low. In short, the economy has precisely the same underlying problems if did in 1981: low savings, low investment, high real interest rates (particularly for long-term debt), low productivity, and poor international competitiveness.
All that blustery growth through 1983 and 1984 was nothing more than the pendulum swing of the business cycle, spurred along by record deficits and a Federal Reserve terrified of a long string of bank collapses. The actions of the Fed were particularly important. After driving inflation down to less than five percent in 1982, the Fed was suddenly forced to choose between further progress on inflation and the interests of ifs principal clients—the big banks. The key event was Mexico's announcement that it wouldn't be making any further payments on its $90 billion in foreign debt. (The Mexican government's economic program had failed to allow for any fall in the world price of oil.) Volcker saw that if this action was formally considered a default, the nine largest U.S. banks would be forced info bankruptcy, precipitating a world financial crisis of the first order. So Volcker masterminded a short-term solution to Mexico's immediate credit problems. But he also cut the discount rate and allowed money growth to accelerate. Market interest rates fell through the floor. Mortgage rates fell too, producing an enormous surge in housing investment, which accounted for more than half the increase in GNP during the first six months of the recovery. From the third quarter of 1982 to the second quarter of 1983, the money supply grew at an annual rate of more than 14 percent—the fastest rate in postwar history. With a boost from growing federal deficits (Reagan's unique brand of "military Keynesianism"), the economy finally came roaring back.
But Reagan has hardly abolished the business cycle. Sooner or later, we'll get another recession. The question is when. Every recession, like every unhappy family, is a bit different, reflecting its origin in odd bits of chance, poor economic policies, and the accumulated debris of previous recoveries. The recessions of the 1970s resulted from clear external events—the OPEC price explosions— combined with fears about future inflation. The recession of the early 1980s was simply the result of the Fed slamming down on money growth in the spring and summer of 1981.
The coming recession almost certainly will be the result of our big trade and fiscal deficits. No country has ever managed to run trade and budget deficits simultaneously and still sustain a recovery. We'll be no exception. Our trade deficit is growing worse, not better, as a result of last year's run-up in the dollar. The fiscal deficit, particularly over the next five years, will remain dangerously, recklessly high, despite a few timid whacks at it up on Capitol Hill.
How bad will the recession be? Just now it appears that it will be relatively mild, compared to the last few. Inflation is low, and fears of future inflation, though real, are less than what they were. So Volcker won't be clamping down on money growth, as he did again last spring and summer—driving Reagan campaign aides near to apoplexy.
On the other hand, the economy probably won't just bounce back, as it did in 1983. Why not? Because housing and business investment—the driving forces of the last recovery—won't be exerting nearly the same force. Housing investment won't be responding to such a large drop in mortgage rates, and business already has run through the onetime effects of the 1981 tax cuts. Indeed, in response to the flood of imports, which is idling factories and equipment already in place, capital spending seems sure to fall dramatically over the next year.
The likely result will be sluggish growth through 1986 and 1987, punctuated by at least a few quarters of absolute decline. This alone will cause more bank failures, a greater risk of a major default somewhere in the Third World, and continuing deterioration of the U.S. manufacturing sector. At the same time, the sluggish economy will push up the federal budget deficit, as fax revenues fall and social welfare payments shoot up. Higher deficits, in turn, will increase pressure on the credit markets.
So far in the Reagan era, we've managed to meet our domestic credit demands, including the huge federal deficit, with a fairly steady current of foreign investment (about $85 billion a year), and a precipitous drop in net foreign lending by big American banks (from $75 billion in 1981 to just four billion dollars in 1984). As a result, no interest rate spike has burst the economy's big balloon. But even if foreign investment continues at its current pace (and it will, so long as the dollar stays strong), it's hard to believe that the banks will keep liquidating their foreign loans, and borrowing from their European affiliates, to finance our trade and fiscal deficits. At their current rate of U.S. investment, the banks have just enough money left abroad to keep things going at home for another two years. Something's got to give.
There is still a chance that today's "growth recession," if that's what it is, can be transformed into tomorrow's "soft landing." But we need new policies—and soon. Most important, we need easier credit. Given the enormous slack in the economy, interest rates are still too high, and money growth is still too low. With unemployment above seven percent and factory capacity utilization at just 80 percent, there is hardly a risk of reigniting inflation. The recent drop in the discount rate to 7.5 percent ought to be followed up with further reductions.
Where do you stop lowering short-term interest rates? You stop at the point where long-term rates start moving back up in anticipation of future inflation. No one can say where this point is, including Paul Volcker. Volcker has quite a bit of latitude here to fry out lower rates—seven percent, six percent—since the financial markets trust him to keep inflation in check. If someone like Preston Martin—a Reagan crony out of the thrift industry who is now vice chairman of the Fed and a rumored successor to Volcker—were cutting the discount rate, long-term rates already would be shooting up like mad. The markets would assume that the battle against inflation was taking a backseat to promotion of short-term economic growth. It is a great tribute to Volcker that no such assumption is now being made.
As for fiscal policy, what we need most are long-term spending reductions. Unfortunately Congress still shows little inclination to come to grips with long-term spending pressures, especially in the House, where the Democratic leadership has assembled a budget-reduction package that consists of phony savings, onetime savings, and simple shifts from direct spending through outlays to indirect spending through tax loopholes. Our goal should be to get the deficit down to about two percent of GNP by 1990. Not next year, or even the year after. Right now the economy needs all the stimulus we can give it. Any big reductions in current spending could have just as bad an impact as a big tax increase.
What's nerve-racking is that with each successive recession, the U.S. economy seems to require greater and greater deficits, or bursts of monetary stimulus, to get going again. This ominously suggests that the economy has a bias toward stagnation rather than toward growth, even now, in the Age of the Entrepreneur. Clearly there are limits, even if we haven't reached them yet, to the amount of juice we can apply the next time we need to jump-start a stalled economy. Deficits cannot be expanded infinitely, or money growth either, without the cure proving worse than the disease. This is our central economic problem, and Reaganomics has done nothing to solve it.
What might all this mean for the politics of the next four years? To begin with, the Democrats should not count on the economy falling off a cliff—at least in the next year or two. Unemployment may drift up slightly, but no more. Volcker doesn't want to replay the 1981-1982 recession any more than Ronald Reagan or the rest of us do, and with inflation low, he doesn't have to. Even if Volcker doesn't take my advice and lower the discount rate even more, it's too late for economic disaster to help the Democrats in 1986.
As for 1988, the sluggish growth we're likely to get for the next two or three years increases the chance that some external event could precipitate a more severe economic downturn. Argentina, for example, could turn into a small lump of bad paper. One or more major financial institutions could collapse.
The other big question mark is who will succeed Volcker at the Fed. It's very likely that, come 1988, there will be someone like Preston Martin sitting atop the sluice gates of the nation's credit markets. If Martin or another appointee showed his gratitude to Ronald Reagan by making easy money the order of the day, this would quite properly reignite all the old fears about future inflation. But not in time to exert much influence on the election. The model here is Arthur Burns. As Fed chairman in 1972, Burns gave an enormous goose to the economy just in time to ensure Richard Nixon's reelection in 1972. The inflation didn't come until later. A similar flood of money in 1988 would produce a great burst of euphoria (just like last year's), and wipe away any lingering memories of the Big Slowdown of 1985-1986.
This article originally ran in the July 1, 1985 issue of the magazine.