The Heritage Foundation

Backgrounder #239 on Economy

January 17, 1983

January 17, 1983 | Backgrounder on Economy

Reaganomics: Making Gains

(Archived document, may contain errors)

239 January 17, 1983 I REAGANOMICS: MAKING GAINS INTRODUCTION Stay the course, urges Ronald Reagan. But so did the captain of the Titanic, retort critics of the White House. Are the implicit fears of su ch critics justified? Is Reagan steering the American economic ship of state to safe harbor or smack into icebergs? Navigators would have a hard time xeading the economic currents. On the one hand, a dramatic economic upturn might be signaled by the spect a cular advance of the stock market, the decline in interest rates, and the dampening o inflation On the other hand, unemployment remains high and the economy bobbles along in a trough statistics some key signs are unmistakable. During the first two years o f Reagan's term of office fundamental changes have taken place in the economy, which may have laid the foundations for a long period of growth and prosperity rate, for instance, is up nearly 30 percent from its 1981 low The stock market is at a ten-year hi g h industry has hit record heights. All this occurred in a year marked by a severe business recession. The surge of new capital has spawned a near record crop of new business incorporations especially in "high tech" firms, and a healthy number of new publi c stock offerings. Inflation is at a ten-year low and interest rates have been cut by one-third since Reagan took office. Such achievements profoundly affect consumers, businesses, and government Yet inside the tangled web of often confusing economic The p e rsonal savings The venture capital Even the dispiritingly high unemployment rate must be seen in perspective. Reduction in unemployment has always lagged behind economic recovery--especially when the economy is also undergoing profound changes. In additio n , comparisons of today's rate with that of earlier periods are dangerous. In the first 2 I place, unemployment insurance, welfare payments, and other factors have increased the "basic1I unemployment rate but,reduced the plight of the unemployed. According to one Department of Labor survey, the average unemployed family can still count on an annual income of approximately $19,000.1 Moreover, we should remember that the unemployment rate is the proportion of the active labor force which is seeking work witho u t success. It is not an indicator of the percentage of the adult population not working So we can have periods where the unemployment rate is high while the percentage of the adult population at work is also high. Today, when more than 56 percent of the a d ult population is employed (the "employment ratio is economy was booming and the unemployment rate was 3.5 percent and actually higher than in 1953, when unemployment was at.its lowest since World War 11. It means that a very high proportion of families s till have at least one breadwinner. In 1933, by comparison, the employment ratio was only 44 percent.

This does not mean, of course, that the laid-off auto worker in Detroit should feel cheerful. But it does mean that such a period. This is about the same as in 1969, when the I I Congress should not misunderstand the unemployment problem and stampede into I1actionlf that will undermine the key structural changes that are under way.

Lower taxes and lower inflation mean that once again economic conditions favor the saver over the debtor. Americans now have the incentive to cut their expenditures and work off their debts.

Indeed, consumer installment debt has declined- steadily throughout the recession from a high of 14.8 times personal income in early 1980 t o 12.85 in September 1982 This means that consumers are coming out of this recession with a lightened debt burden offers hope for a sustained recovery-in past recessions, consumers usually have plunged deeper into debt. Now, as Forbes magazine reports, we "have come through the 1982 recession with credit accounts in the best shape since early 1974.If3 Consumer credit defaults among New York banks are the lowest since the pre-1975 recession month of June 19

74. Forbes notes that IfConsumers have had the cap acity to buy throughout the 1982 recession; they are simply showing restraint This restraint is replenishing the capital coffers needed to finance investment and modernization It Thanks to fading inflation, households and businesses are shifting their res ources from the popular inflation hedges of the For a full analysis of the factors contributing to the unemployement rate see Peter Germanis Unemployment: What's to Blame?" Heritage Foundation Backgrounder No. 222, Octber 22,.1982.

Business Conditions Dige st U.S. Department of Commerce, Bureau of Economic Analysis, November 1982 p. 73 Priscilla Meyer An Old Game with New Rules Forbes, October 11, 1982 p. 238 3 1970s into productive assets, like stocks and bonds. For the real estate industry, the major infl a tion hedge of the middle class, 1982 was the hardest year since the 1969-1970 housing slump. Some of real estate's luster will undoubtedly be restored in the recovery. But the boom days of 10 to 20 percent growth may be gone as resources flow into nonhous i ng production. During the inflationary seventies, it made sense to put money into housing. The median home price soared from $23,000 in 1970 to 62,200 in 1980, a 170 percent increase.4 The Dow Jones Industrial Average, 'in comparison, increased by only 18 percent over the same period, not enough to keep pace with the 112 percent surge in the consumer price index.

According to the National Association of Realtors, home prices, after adjusting for inflation and concessionary financing actually fell at least 10 percent in the past year.5 Home Loan Bank Board Chairman Richard Pratt predicts that fewer Americans will buy houses in the 1980s than in the 1970s, primarily because they may not need "the hedge against inflation.'I6 Viewed in this way, softness in th e housing market is a positive, not negative sign. Housing industry sluggishness is evidence of the success against inflation.

Other inflation hedges and tax dodges have taken similar nose dives under Reagan. Diamonds, antiques and leisure goods are all in the doldrums. Sotheby Park Bernet, the nation's largest antique auction house, last year suffered its first loss since World War

11. The diamond market is near collapse. A one carat D-flawless white gem, a benchmark jewel, reached a peak of 64,000 in 1979-1980, but had plunged to $21,000 by the beginning of December 1982.

Bad news for inflation hedges, however, heralds.good news for the financial markets. In a recent study, Claremont economist John Rutledge finds that reductions in inflation have in past periods powerfully stimulated new capital formation. Extrapolat- ing h istorical trends, Rutledge estimates that "each percentage point drop in the inflation rate should send $100 billion of the tangible assets that people hold back into the financial market as increased capital supplies I7 With inflation expected to stabili ze at about 6 percent, the country soon should be awash with new risk capital. We'll see an increase in credit supplies Existing Home Sales 1981, Economics and Research Division, National.

Association of Realtors, Washington, D.C., 1982.

Dr. Jack Carlson, chief economist and executive vice-president of the National Association of Realtors NEWS, National Association of Realtors September 27, 1982 Bob Fick, "Need for House as Hedge Against Inflation Foreseen Declining Washington Post, September 25, 1982.

Jo hn Rutledge Why Interest Rates Will'Fall in 1982," The Wall Street Journal, December 14, 1981 4 of $400 to $500 billion, continued Rutledge. This into even lower interest rates and expanded savings traris 1 ates and invest ment just what the supply siders promised all along In short, Reaganomics works. In the thirteen months since it was redirected, the nation's rudder has been set firmly in place. The policies are paying off in a new crop of business enterprises, expanded savings, and reduced inflation. B ut the economy, like an ocean liner, changes course only in degrees.

Economic turnarounds are measured in years, not months. The important progress made so far, however, vindicates the supply side approach and should encourage the Administration to stay a course of lower money growth, tax reduction, and a freer market place 3 THE ATTACK ON INFLATION Reaganomics is not a scheme to redistribute wealth from one group to another, but one to benefit all Americans, particularly the poor, by inducing rapid and su s tained economio,.growth. A rising economy, Reagan often points out, pulls everyone up with it. Inflation and high taxes, however, tilt economic incentives in favor of consumption, debt, and leisure, thereby undermining the nation's productive capacity des i gned to restore capital-producing incentives so that the economy once again generates the jobs and wealth necessary to raise the standard of living of all Americans Reagan's economic policy is The President was convinced that a glut of newly printed money had stoked the inflationary fires .that blazed in the seven ties. He urged the Federal Reserve, the independent body charged with regulating the nation's money supply, to slowly but steadily reduce the'money supply so that inflation could be dampened.

Accordingly, from a high of 8.3 percent money growth (M1)in 1978 the Fed nearly cut off the money spigot in the first seven months of 19

82. The inflation rate correspondingly fell from 13.3 percent in 1979, a postwar high, to below 5 percent by the end of 1982.

But the Fed also has allowed the money supply to fluctuate erratically. From November 1981 to January 13,'1982, the money supply increased at the dangerous annual rate of 25 percent.

Then from January to August, the Fed apparently grew alarmed that it might reignite inflation, slammed on the monetary brakes, and reversed direction annual rate.

In the last thirteen weeks, the Fed has been revers ing course again and the money supply appears to be surging ahead at a 16.7 percent annual rate annual mon ey supply growth this year to 8 percent, far above the Fed's target of 2.5 to 5.5 percent The money supply grew by only a 2 percent The recent increase pushes up If not corrected, it threatens to set off inflation, destabi lize economic activity, exacerba t e unemployment, and sap the Fed's credibility. 5 Lower money growth brings with it the short-term side effects of lower output and employment. According to some studies, it may take eighteen months for these side effects to be overtaken by reduced,inflati o n and sound economic growth administrations have reacted to the upswing in unemployment by stoking the fire of inflation through easy money and government programs. There have been four bouts with inflation in the last fifteen years; each was lost because political and economic leaders did not have the courage to see the anti-inflation fight through to the finish. After each failure, unemployment rose above previous peaks, economic growth often fell below previous Goughs, and inflation bounced off a higher plateau In the past Each monetary fix has been but a temporary palliative. Ever larger doses are required to pack the same stimulative wallop bringing with it higher inflation and eventually higher unemploy ment. Historical and international evidence clea r ly shows that there. is no long-term trade-off between inflation and unemployment The question is: Can the President withstand the political pressure to Itdo something" about unemployment? Can he resist the loose money seduction and persevere until recove ry.begins? In the last fifteen years, no president has had enough courage and confidence to resist these pressures.

Reagan has vowed, that he will continue to attack high unemployment by getting at its root, high inflation, and riding out the inevitable wi thdrawal symptoms. Cutting inflation and keeping it down is still the key to breaking the inflation recession cycle. The current withdrawal symptoms are the price paid for the many mistakes of the past. If the course against inflation is maintained, the U . S. will soon enjoy for the first time in fifteen years a recovery untarnished by a new burst of inflation CLEAR SIGNS OF SUCCESS I The underlying benefits of this course and the confidence it engenders are becoming clear. There are convincing signs of a d r ainatic expansion of the capital pool, an increase in risk taking, and a surge of investment in productive ventures 1. The Stock Market Surge The fortunes of the stock market ebb and flow each day. A soaring stock market is traditionally a precursor of ec o nomic recovery. And for good reasons. Rising stock prices open a rich source of business capital, increase household wealth, and generate profits for pension plans, insurance funds, and other institu tions that include substantial holdings of stock in the i r portfo lios At present, the stock market has surged to its.highest level in ten years. The Dow Jones Industrial Average at the end of 6 1982 stood around 1,000, almost 25 percent higher than the average in June. The rise in prices has added perhaps 120 b illion to the wealth of American households, according to Allan Sinai of Data Resources, Inc. A study released by the Congress's Joint Economic Committee (JEC), estimates that if the Dow Jones Indus trial Average reaches 1,150, the increase in per capita wealth will be $8

75. Sixty percent of this is in the form of direct increases in household wealth, with 40 percent indirect, through the holdings of private and public pension funds.8 significant development,Il explains Committee Vice-Chairman Roger Jepse n, "is that 46 percent of that wealth increase is going to families with incomes of less than $25,000 per year.Ilg A rough rule of thumb, according to the report is that "every 10 percent rise in stock prices over their August 1982 low, adds $175 to per c apita wealth holdings.

The recent stock market rally is especially good news to public and private pension Eunds with substantial stock holdings.

Private pension-funds have 40 percent of their assets in stocks The recent 30 percent rise in the price of corporate equities reported Dr. Lowell Gallaway, author of the Joint .Economic Conuhit tee study, !Itranslates, roughly, into a twelve percent increase in the assets of private pension progruns.lfl0 -Publ i c pension plans hold less stock, but the recent stock rally also significant ly enhances their assets Thus, the recent 'bull market' may have pr0vided.a six percent increase in the value of assets supporting public retirement systems adds Gallaway. In all those dependent on public and private pension systems have had their wealth increased by perhaps an additional $85 billion nearly $400 per capita due to the recent stock rally.

By exerting such a powerful effect on household wealth stock market rallies us ually play a significant role in fueling economic expansion. The Joint Economic Committee study discovered that stock price increases encourage households to shift the composition of their wealth away from tangible assets to more liquid financial assets. B oth factors, the study concludes, will stimulate consumption and saving simultaneously And the most But will the bull market continue? And what is the reason for the upsurge in stock and bond prices? Many economists argue that success in the fight against inflation has buoyed business prospects and made it easier for investors to 'estimate future business profits. Stanford University economist John Shoven, for example, argues in Business Week that "The market has been held 8 Dr. Lowell E. Gallaway Economic Impact of the 1982 Bull Market a staff study prepared for the use of the Subcommittee on Monetary and Fiscal Policy of the Joint Economic Comittee (JEC Congress of the U.S October 25, 1982, p. 9.

JEC, Press Release, November 5, 1982 lo Gallaway Economic Impact p. 12.

UUWIl Uy U UUDUAC: WL LleyULAVe eApeGLC&LAU&la. DUL Cia YUU YeL UUL UJ that bubble the market really could explode MIT economist.Franco Modigliani concurs that disinflation is a tonic for stock market prices of inflation stop rising, stock pr ices must start. to rise,1112 argues.Modiglian

1. How high can the stock market go? If stocks were only valued at replacement cost of assets the stock market could still shoot up by another 600 points in the DOW, according to Boston College's John Cicc010 The moment that the expectations 2 A Revival of Initial Public Offerinqs The equity markets have recently bloomed with new financing for smaller, more risky firms and businesses making their first public offerings In light'of the lingering recession, the new issues market in 1982 is surprisingly buoyant. New public offer ings for 1982 are estimated at $1.2 billion, using the Initial Public Offering Reporter figures for the first eleven months of 19

82. This would make the 1982 total about the same as 1980 , and far above most years in the capital starved seventies Many experts think that after ten years of stagnation, the stock market is becoming a fertile source of new business risk capital. New public offerings in 1981 reached a record high of 3.2 billio n, a total of 448 new initial public stock sales.

That'was a whopping 130 percent increase over the robust 1980 dollar figure and more than 60 times larger than the depressed 1974. total. l4 This comeback stems from two major public policy changes: the cap ital gains tax cuts of 1978 aid 1981 and lower monetary growth.

Experts blame the 1976 capital gains tax hike (from 24 percent to a maximum 49 financing to a trickle.lF This scarcity of new stock financing reverberated throughout the economy and contribut ed to lowered investment, innovation, and productivity ercent) for choking new public stock The more favorable tax treatment for new stock issues since the 1978 capital gains tax cut, however, has caused the number and dollar amount of initial offerings t o come roaring back l1 l2 Ibid.

Business Week, September 27, 1982, pp. 56-57 13 G l4 Kevin Farrell, Venture magazine, April 1982, pp. 29-33 October 1982, D. 86.

See also Venture, l5 Ibid See Also Peter J. Ferrara, Economic and Investment Observations Capi tal Gains: A Painless Tax Cut H.C. Wainwright Company Economics Boston, Massachusetts, July 6, 1981, See also "Government-Industry Cooper ation Can Enhance the Venture Capital Process," General Accounting Ofice AFMD-82-35 Washington D.C 1982).

Y 9 Stanley Pratt, editor of Venture Capital Journal, is bullish Since the end of 1977 he exDlains, "we have seen an increased strengthening of demand in the- marketplace for the offerings of smaller companies going public for the first time Such offerings are not f o r every company, cautions Pratt, but "Public financing has become a viable alternative for the well-managed smaller company exhibiting an above average.growth rate and having the prospect for continued growth over the years ahead.1f16 3. Business Starts a t a Near Record Entrepreneurship is the key to a dynamic, growing economy.

Entrepreneurs are the creative thrust behind invention, factory starts, and new jobs. Their risky initiatives jolt businesses from complacency, undermine calcified business practice s, and infuse the marketplace with competitive verve. High levels of entrepreneurial activity in high tech firms have brought prosperi ty to areas such as Houston, and Boston's beltway.

Small businesses generate most of America's new jobs.

Birch and Susan McCracken, of the MIT Center on Neighborhood and Regional Change, estimate that two-thirds of the new jobs were generated by businesses with fewer than 20 emplo ees, and about David 80 percent by firms with 100 or fewer employees. 77 Studi e s show that small businesses are also more innovative than large corporations and contribute the bulk of the nation's output. According to Capital Publishing, "Small business accounts for 55 percent of all private employment, 48 percent of the nation's bu s iness output, 43 percent of the G and more than 50 percent of all industrial inventions and innovations."ls The Reagan economic program aims, in large part, to stimulate entre preneurial activity. The cuts in capital gains tax, personal income tax rates, a nd inheritance taxes have altered the incentives for risk taking and personal savings for small business. As a survey by The National Federation of Independent Business discovered, almost 70 percent of new firms use personal savings as their major source o f capital.19 record for new business incorporations. Nearly 600,000 new busi Saving is especially vital Despite the recession's severity, 1981 marked an all-time l6 l7 l8 l9 Stanley E. Pratt et al How to Raise Venture Capital (New York: Scribner 1982 p. 1 97.

David Birch Who Creates Jobs The Public Interest, No. 65 Fall 1981).

The Venture Capital Industry--A Brief Overview (Wellesley Hills, Massachu setts: Capital Publishing Corporation, 1982 p. 64.

Jonathan A. Scott, Assistant 'Professor of Finance, Sout hern Methodist University, statement before the Subcommittee on Tax, Access to Equity Capital and Business Opportunity of the House Small Business Committee Washington, D.C May 20, 1982 10 NEW BUS 1 N ESS COR PORATION S IN THOUSANDS 57s 550 525 500 47s 45 0 425 400 37s 350 325 300 27Si NOTE NUMBER IN PARENTHESES IN 01 UTES YEAR -TO- YEAR CHANGE IN PERCENT 1982 ESTIMATE BASED ON flRST 8 MONTHS 274.267 250 I I I I I I I I I I I I I I 1969 fQ 71 72 73 74 75 76 77 78 79 00 81 02 SOURCELDUNN AND BRADSTREET, MnNT U I V NEW 11 nesses applied, for corporate status, twice the number of ten years ago. New business incorporations have held up surprisingly well in 1982.. During the first eight months, Dun and Bradstreet reports that the pace of new activity is only 5 perc ent off last year's record.20 During recessions, according to Birch, new business incorporations swell, as unemployed workers seek new opportunities in entrepreneurship.

The gloom felt by many over the state of the economy overlooks the emergence of this huge, new generation of job-creating firms.

Observers also tend to ignore the important change taking place in the structure of industry. It is true that the manufacturing sector has receded sharply over the last decade and the current business recession i s no doubt hastening that decline. But today only 13 percent of the workforce is employed in manufacturing.

Sixty percent either produce or process information. The overwhelm ing number of new jobs have come from the vibrant service sector.

The manufacturinu sector, which has actuallv lost iobs, becran its decline long before Reagan took office.

But what about business failures? Business bankruptcies indeed, swelled to their highest level since the Great Depression.

The failure rate according to Dun and Bradstreet,'exceeded 80 per 10,000 the highest rate since 1933.22 These figures, however do not portend disaster. Many businesses, it is true, have failed because high interest rates have squeezed profits and a I I uecirniny economy nas snrunK =err marKe T ;s. nuz mucn WL me current high failure rate simply reflects the recent bumper crop of new businesses.. Record numbers of new business starts create record numbers of business failures. small and vounu firms always have high failure rates. Studies show th a t one-third of fail within two years.23 all new businesses fail within one year, and about 50 percent Business. failures, not surprisingly, are greater' in growing areas like Houston than in declining regions 5.6 million businesses in the U.S MITfs Birch d iscovered that The more dynamic the local economy (e.g., Houston) the greater proportion of firms that fail. Our most successful areas are In his study of O David E. Gumpert, "Business Start-ups Are at a Near-Record High," The Wall Street Journal, Septemb er 27, 19

82. See also The State of Small Business A Report of the President, U.S. Small Business Administration, Washington D.C., March 1982.

Tom Richman, "Peering into Tomorrow Inc. Magazine, October 1982, pp 45-48.

Edward I. Altman, Professor of Finan ce, Chairman MBA Program, New York University, before the Subcommittee on General Oversight of the Committee on Small Business, U.S. House of Representatives, June 23, 1982 Business Failures, Business Turnover Rates, and Bankruptcies ,I1 Economic Memo U.S . Small Business Administration, Economic Research Division, August 21 22 23 13, 1Y82 12 those with the highest rates of innovation and failure, not the Business failure, often read as a sign of economic decline at this time is a necessary side effect of i nnovation and economic growth 4. Best Year for Venture Capital The booming venture' capital industry is another indication that the economy is experiencing healthy structural change.

Venture capital firms specialize in funding the fast growing high tech businesses that are on the cutting edge of the economy.

They are injecting much needed risk capital in an otherwise anemic economy. Venture, as recorded by Venture Economics, a respected research fir m, rose to a record of 1.4 billion in 1981, from less than one-third that amount five years earlier 1982 is expected to set another record. Private venture capital partnerships raised 65 percent more funds in the first half of 1982 than in the first half of 1981-more than $700 million compared with $867 million in all of 1981 and $661. million in 1980 The venture capital industry began to improve in 1978 after the capital gains tax was reduced from 49'to a 28 percent maximum.

In June 1982, the industry had estimated committed funds of 6.6 billion more than twice the level of only five years ago and an increase of 4 billion since 19

77. Critical to the indus try's rapid expansion was the additional cut in capital gains taxes from 28 to 20 percent enacted as part of the 1981 Reagan tax package Some venture backed firms, tiny only a few years ago, are now giants, employing thousands of workers. Brent Rider, Chairman of NASBIC, the National Association of Small Business Investment Companies, explains that ther e is a close connection between the venture capital industry and the lead sellers of the economy Almost every new business in high tech fields during the past 20 years, I' says Rider I "including Teledyne I Apple Computer, Atari Intel, American Microsystem s , and Data General-received backing from one or more venture companies.Il26 capital to job creation venture capital Ifgenerated more than 10 times the employment growth of all small business, 11 times the growth in sales and assets, and six times the incr ease in federal tax payments.I A recent study by NASBIC reveals the importance of venture According to the study, firms backed by 24 Birch, op. cit 25 26 The State of Small Business, op. cit p. 146.

Brent T. Rider, Statement before the. Subcommittee on Int ernational Trade Finance, and Security Economics, of the Joint Economic Committee, September 30. 1982. 27 Wiilis Witter Venture Capital Seen Solution," The Washington Times October 1, 1982. 13 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 VENTUR E CAPITAL INDUSTRY FUNDING DISBURSEMENTS MILLIONS I ANNUAL ESTIMATED DISWRSEMENTS BY ORGANIZED VENTURE CAPITAL IN OUSTRY 100-1 25 PARTNERSH I PSI 1.~00 r r I I NEW PRIVATE CAPITAL COMMITTED TO ORGANIZED VENTURE CAPITAL FIRMS (100-12S PARTNERSHIPS I I I I E NOTED THAT IN ADDITION TO THE NEW CAPITAL COMMITTED, THERE SA RECYCLING OF FUNDS THROUGH LIQUIDATION OF I INVESI'MENTS AND 8 62 I ACQUISITIONS 45-37 pH I I 1 I I I I 1 I I 1 I I I I SOURCE DEVELOPED BY GAO FROM DATA PROVIDED est. Est.

I969 70 71 f2 73 74 75 76 77 78 79 80 81 02 BY VENTURE ECONOMICS. 14 The stimulus to venture capital and risk taking provided by the Administration's 1981 tax measure has changed the economic landscape fundamentally. Stanley Pratt calls the reemergence of entrepreneurship "t h e most remarkable social development of the late 1970s He writes: l'Colleges today are bursting with young entrepreneurship driven by the apparent availability of funds and they are creating more opportunities than ever before, as each successful funding s timulates other attempts 5. The New Incentive to Save One of the most important consequences of the 1981 tax reduction and the moderation in inflation has been the increase in the savings rate, Once again, Americans are investing in their nation's economi c future boost its savings rate A larger pool of savings, he argued helps fuel increased capital spending in plant and equipment-the mainspring .of improving standards of living. And, as noted earlier, personal savings also play a crucial role in financing new business ventures Reagan long ago stressed the need for the United States to Japan's high savings rate is widely credited with fueling that country's prosperity. Japan saves 19.4 percent of its disposable income, compared to America's 6 to 7 percent l evel.

Japan has created powerful incentives for savings by its tax structure and its tight lid on inflation. Japan does not tax capital gains accruing to individuals; the U.S taxes capital gains at rates up to 20 percent. Japan's corporate income personal income, and dividends are also taxed at substantially lower rates than they are in the United States. Overall, Japan took 24.1 percent of its GNP in taxes in 1978, compared to the U.S. government's share at all levels of 30.2'percent of GNP.29 Just as imp ortant, Japan has kept inflation below 4 to 5 percent for most of its recelit history. Japan's low 3 percent inflation this year, creates an attractive climate for savings.

Though the Japanese deficit is far larger than the American as a proportion of GNP, it is far less harmful to its economy.

The Japanese government can dip into the ample Japanese savings pool to finance the proportionally larger deficit. In Japan, at least, budget deficits do not automatically translate into high interest rates and infl ation A high rate of savings can offset the government's borrowing needs.

The Administration's economic strategy has centered on reducing the two principal barriers to savings: high inflation 28 Pratt, op. cit p. 14 29 "Federal Tax Policy Memo Washington, D.C Tax Foundation, May, 8 1981 15 and high tax rates. Both factors have lowered the return on each dollar saved taxes, tax deferred savings plans, and slower money growth has begun to reward savers. After personal savings reached a low of 5.4 percent in January of 1981, it climbed to nearly 7 percent in October 1982--the highest rate since 1976.30 The rates typically fluctuate widely. November's rate dropped to 5.8 percent, but the trend is unmistakably upward. This improvement is occurring even before t h e final 10 percent tax rate reduction planned for .I next July. With disposable personal income now over $2.2 trillion every percentage point increase in the savings rate adds about 22 billion to the pool of savings about 2 percentage points higher than t hat of the last five years If this level continues, the stock of savings will be about 44 billion higher next year.

This savings expansion is manifest in various ways. Money market funds have surged a stunning 300 percent in the last 21 months, largely in response to financial deregulation. In just the first nine months of 1982, the funds grew at an annualized rate of 25 percent to a total of $180 billion.31 plans, which allow tax delayed accumulation of savings for retire ment, attracted more than 15 bill i on in new money between February and November 1982 The Administration's package of lower marginal The savings rate is now IRAs and Keogh FUNDS FOR IRA AND KEOGHS in billions Mutual Commercial Savings Savings Credit Banks Banks Banks Unions Total February 6, 1982 $10.074 $4.885 14.456 353 $29.768 November 1982 $17.3 $6.2 20. S 943 44.94 Estimated from October figures of no ceiling accounts and March figures of ceiling accounts Estimated from July figures.

Source: Federal Reserve Board The upsurge really beg an in early 1982 when the right to participate in these plans was extended to more than 116 million Americans. By November, millions of Americans had invested an estimated $40 billion in IRA and Keogh accounts at banks, savings and loan associations, cred it unions, mutual savings banks investment companies, and other. financial institutions. This pool of funds is more than 50 percent larger than ten months 30 31 Ibid.

Business Conditions Digest, op. cit 16 17 earlier and is expected to swell substantially more. If the trend continues, more than $25 billion in new money will flow to these retirement accounts as the April 15th tax deadline approaches.

These funds are providing Americans with not only a high return investment toward a more secure retirement, but also the capital for new investment and entrepreneurship that will give the economy a much needed boost.

This spectacular performance refutes t he contention that savings does not respond to tax incentives. Indeed, the evidence clearly suggests that the keystone of the supply-side philosophy that savings and investment have been repressed by the tax struc ture is s'ubstantially correct. The Ameri c an public saved less than the Japanese or Germans not because we were less thrifty or virtuous, but because the U.S. tax and,business climate was more hostile to savings than in these more prosperous countries. The U.S. public has responded to lower tax r a tes exactly as supply siders promised by red-ucing consuniption expenditures and stashing more into savings accounts 6. Interest Rates The success in taming inflation is also paying off in a dramatic reduction in interest rates. Over the past year, rates h ave dropped substantially relaxing their choking grip on busi nessmen, investors, and consumers and setting the stage for economic recovery. The prime interest rate, for example, fell from 20 1/2 percent in August 1981 to the December 1982 figure of 11 1/ 2 a 40 percent improvement since Reagan assumed office.

Corporate bond rates also have decreased from-16.97 percent in September 1981 to around 12.5 percent at the end of 1982..32 As a result, the heavy interest burden on businesses will be substan tially lightened.

Small and marginal firms. without' access to the long-term debt markets were particularly vulnerable and many were squeezed into bankruptcy as interest rates soared. The average nonfinancial corporation in 1981 paid 40 cents in interest charges for every dollar of income, up sharply from 20 cents for every dollar of income in 1978.33 .Businessess that have held on, however, are taking advantage of the improved interest rates to refinance their short-term debt. Larger businesses that can float t h eir own bonds are rushing to, beef up balance sheets by refinancing their high-cost, short-term debt with the now lower-cost, long term debt As a result, corporate America looks stronger today than even six months ago. Balance sheets are blacker, cash flo ws are healthier, and income reports are brighter Lower interest rates are a boon to the government as well.

Treasury continually must refinance over one trillion dollars of 32 Ibid 33 Altman, op. tit. 18 m 8 rl 0 3 3 3 v laaar I n a W a loo+ I W Izo> I 1 9 national debt as well as pay for burgeoning future deficits. The Treasury bill rate has dropped from a high of 16.3 percent in May to around 8 percent at the end of 1982, sharply cutting the Treasury's cost of servicing the debt. Every one percent drop in the T-bill rate, reports the Congressional Budget Office, will cut the budget deficit over the next 3 years by over $15 billion..

Consumers, too, benefit from interest rate reductions.

Everything consumers buy on credit, from cars to houses to house ho ld appliances, becomes subs.tantially cheaper when interest rates decline. Mortgage rates, for one, have dropped from a high of 18 1/2 percent in September 1981 to around 13 percent in December 19

82. This reduces average homebuyer's mortgage costs by sev eral thousand dollars L CONCLUSION The Administration's success in containing inflation and cutting tax rates has begun to pay rich economic dividends that soon could propel the economy to long-term growth..and prosperity.

One of the most promising trends .is the recent surge of new capital. Personal savings, which provides most small businesses with initial seed capital, is at a five-year high. Venture capital, the source of new risk capital for high-growth and technologically advanced companies, is expec ted to.reach a record this year. The stock market, a major source of capital for medium-and-larger-sized businesses, is at a ten-year high.

Initial public stock offerings are at a surprisingly healthy level 'for a recessionary period. Other hints -of a str onger economy are interest rates dom by one-third and the inflation rate cut in half since Ronald Reagan took office. The U.S dollar soared against major European and Japanese currencies signaling the confidence abroad in the U.S. economy. The G.N.P too, h as had positive, if timid, increases over the second and third quarters of 1982 These successes lead to a number of important implications a) The supply siders are essentially correct-- marginal tax cuts stimulate savings rather than excess demand. Contra ry to much critical speculation, as the tax rates were cut 15 percent over the last two years, inflation fell by half.

Firm monetary policy is essential to reducing inflation c) Reducing inflation is the key to economic health--to savings, low interest rat es, and an expansion in employment d) Reductions in unemployment always lag behind economic recovery. There is no long-term trade-off, however, between inflation and unemployment e) Cutting inflation is rarely painless. Weaning an economy from an inflatio n ary binge is like drying out an alcoholic. The 20 withdrawal symptoms can be severe, but they are the unavoidable price of recovery f) Deficits are not a major factor in causing high interest rates or inflation. Today's projected budget deficits are more f orecast, yet interest rates have been cut by more than one-third and inflation by half enhanced by the shift of household wealth out of tangible assets such as housing into financial assets such as stocks and bonds. than eight times higher than in.the Adm i nistration's March 1981 g) The chances for an inflation free recovery have been These signal important directions for the new Congress 1. The third year of the tax rate reduction scheduled for July 1983, together with the indexation of tax brackets for in f lation, is essential to preserving and strengthening the incentives for saving and capital formation. Congress should accelerate both indexing and the.10 percent rate cut to January 1983 2. Economic recovery must not be sabotaged by further tax hikes No m a tter which euphemism is used Itrevenue enhance ments, Illoophole closings Ifcompliance measures I) or "user fees any measure that generates additional revenue to the government reduces available capital for business investment 3. The Federal Reserve Board must regain control of the money supply. The current acceleration in money growth, if continued, will rekindle inflation, possibly throwing the economy back into recession and sabotaging the'entire Reagan economic program. Congress should consider monetar y reforms to ensure that the'Fed pursues a policy of low and stable money growth 4. Congress should reduce taxes further on savings, dividends and capital create jobs through greater capital investment rather than through make-work sjobsll bills A good start to index capital gains for inflation and eliminate penalties for early withdrawal of money from IRA and Keogh accounts. These actions would move the tax system to a consumption based tax that encourages savings and investment 5. The Pr e sident should support additional marginal income tax rate reductions, perhaps to a top rate of 20 percent. This would bring much of the underground economy to the (taxable surface, expand the tax base, unleash new savings and investment activity, and make deductions, exemptions, and most loopholes much less worthwhile 6. There is need for further budget cuts and reforms to reduce the expanding public sector, which consumed a record 24 percent of the nation's GNP in 19

82. Reduced government spending would free additional. resources for business investment,. entrepre neurship, and ultimately more jobs 21 7. Congress must formulate a long-term solution for social The security's underlying financial and structural problems Social security's unfunded liabiliti e s, now larger than the national debt and growing, hang like a dark cloud over the economy prospect of huge new social security taxes to finance the deficit demoralizes the younger generation and threatens to undermine economic growth by coopting new capit al sources.

This agenda builds on the Administration's first year strate gy. In the second year, the legislative debates were monopolized by the economic philosophy that prosperity is induced by taxing more and spending more past 50 years and it never will . At the beginning of its third and perhaps its most important legislative year, the Reagan Administration should return to the bold colors of its first year's program. It is clear from the changes taking place in the American economy that Reaganomics is working. In 1983, the program must be defended and expanded This philosophy has not worked in the I Thomas M. Humbert Walker Fellow in Economics

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