Is Deficit Matter

In financial markets, Black Monday is the name given to Monday, October 19, 1987, when the Dow Jones Industrial Average (DJIA) dropped by over 500 points (about 25%), the largest degree in the stock market history. A degree of mystery is associated with this 1987 stock market crash. But one underlying reason is the securities overvaluation as a result of Reagan's economic policy to prop up dollar, restrict inflation and control deficit. Unfortunately, the deficit is one of the biggest disappointments of Reagan's economic recovery plan.

The Reagan era, like the current Bush presidency, began with an economy in recession. But unlike the mild downturn of 2001, the 1981 version was severe, with soaring unemployment and plummeting output. Under such serious situation, in 1981, Reagan proposed four main strategies: (1) Reduce the growth of government spending, (2) reduce the marginal tax rates on income from both labor and capital, (3) reduce regulation on companies, and (4) reduce inflation by controlling the growth of the money supply. These major policy changes, in turn, were expected to increase saving and investment, increase economic growth, balance the budget, restore healthy financial markets, and reduce inflation and interest rates.

One will sure ask that how much of the expected economic effects were realized? Actually, Reagan delivered on each of his four major objectives, though not to the extent that he or his supporters expected. First, tax reduced 3152 billion in 3 years from 1982 to 1984. The estimated after tax family revenue increased by USD600~900 in 7 years (1981~1988). Helped by big tax cuts, America boomed. In 1982-84, America real GDP increased 16.65% (exhibit 1), against less than 3% in Europe and 5% in Japan. Inflation was under control, CPI dropped from 12.4% in 1980 to 3.9% in 1982. Unemployment rate steadily decreased to a reasonable level. In 1988, the unemployment rate had dropped to 5.49% (exhibit 3).

However, Reagan failed to achieve some of the initial goals of his initial program. Among which the biggest disappointment is the serious federal deficit. A deeply look into the policy tell us why the deficit accompanied Reagan's presidency and the whole 1980s. Firstly, the federal budget was substantially reallocated--from discretionary domestic spending to defense, entitlements, and interest payments--but the federal budget share of national output declined only slightly. So the government spending reduction effect was offset. Secondly, Reagan increased military expenditure as a necessary national safety outlay to contend with the military power of Soviet. Moreover, the growth of defense spending during his first term was higher than Reagan had proposed during the 1980 campaign, and since economic growth was somewhat slower than expected, Reagan did not achieve a significant reduction in federal spending as a percent of national output. Federal spending was 22.9 percent of gross domestic product (GDP) in fiscal 1981, increased somewhat during the middle years of his administration, and declined to 22.1 percent of GDP in fiscal 1989.Thirdly, sharply tax reduction on personal and company return lead to a immediately tax revenue decrease. But tax return did not bring an immediate economic growth and bigger tax bases. Finally, high interest rate and a strictly monetary supply control as an aim to control inflation. High interest rate forms an attractive capital market for foreign investors. Large capital inflow, though, in one hand spurred America economic growth, in another hand also impaired the competitive advantages of America product in international market, bring large trade deficit and cause dollar devaluation. Thus, government paid more interest to the money borrowing than it originally should. (Exhibit 4 shows the national debt increase)

But, does this deficit really a big problem to America economy in 1980s? When we borrow money to invest, we know debt is not a bad thing since we make profit by borrowing money and we have the ability to pay it off. So if deficit is used to generate economic growth and Federal government can continually pay the interest and mature principle, why does deficit matter?

Let's see where the deficit goes and how much is the profit earned by the investment. In the expansion of the US military budget up to 1986, the fastest growth has been that of 'investment' (weapons research and acquisition, bases and infrastructures), that increased from 36 per cent of the US budget in 1980 to 47 per cent in 1986. These 'investments' have been concentrated in high-technology sectors: tanks, ordnance, missiles, shipbuilding, aircraft and engines rapidly increased their military production between 1982 and 1987. However, the fastest growth of military production took place in the computer industry with a 141 per cent increase between 1982 and 1987. 'Here the Reagan military buildup will reverse a 20-year trend in which commercial demand consistently outpaced military output growth in the electronics and computing industries'. The investment also plays an important role in bringing about economic recovery and creating job opportunity. Again you can see the data on exhibit 2 for the increase GDP. Reaganomics even had long term effect on the Bush period in early 1990. As for the employment opportunity, the result is that half of all the job growth since 1981 can be attributed to the direct or indirect effect of these fiscal policy initiatives. More important, government deficit was paid gradually by the economic growth it invested. In 1992, deficit finally turned to surplus.