Fixing the US Economy

The U.S. has served as the primary engine of global economic growth for decades, but its recent failures now depress global growth.  The Obama administration and Congress have been doing all the wrong things – but not all is lost.  The forces of economic sanity seem to be making a comeback, and there is hope.

In the nine quarter of a century periods since the American Republic was founded in 1789, the one with highest economic growth and job creation was the period from 1983 trough 2007.  And particularly remarkable — there were only four quarters (out of 100) of negative economic growth in that entire interval.  That period of time was characterized by a reduction in government spending from 23.5 percent of GDP to 20.0 percent (the low point was 18.4 percent in 2000), and a reduction in marginal tax rates.  Despite the reduction in tax rates, tax revenues both in absolute terms and as a percentage of GDP grew in the 1983-2007 period – because of the improved work and investment incentives.  As a result, the deficit fell from 6 percent of GDP in 1983 to only 1.2 percent in 2007.

For many years (until 1983), the Federal Reserve (Fed) implicitly followed the “Taylor Rule” to guide monetary policy, which gave the U.S. both a falling and relatively stable rate of inflation.  (The Taylor Rule is a formula that provides central bankers with information as to whether they are creating too much or too little money.)

During that golden quarter century, both the Presidency and Congress switched parties a couple of times.  Thus, it should be politically possible to go back to the policies that gave us the golden quarter.  Most people understand that if the government is growing faster than the economy (as it has been for the last two years) ultimately disaster will occur, but if the economy and the private sector grow faster than the government, as they did from 1983-2007, almost everyone can be far better off.

First, the growth in federal spending needs to be frozen.  This is not impossible.  The first President Bush in 1988 ran on a platform of a “flexible freeze” in spending and “no new taxes” and won by a large margin. After the election of the Republican Congress in 1994, during the Clinton administration, the growth in federal spending dropped sharply as a percentage of GDP.  The election of Senator Brown and the “tea party” movement are indications that the American people understand more than their leaders that spending growth must be stopped.

Actually, curtailing the growth in spending is easier than it might seem.  Discretionary spending could be frozen in inflation adjusted dollars at 2007 levels, if it were done as a flexible freeze (where some departments and functions would be allowed to grow in real terms if others were reduced).  The so-called mandatory entitlement programs, particularly Medicare and Medicaid, are the big problems because the political class has yet to explain that not everyone can have all the free health care he or she wants.  Health care must be rationed by price, by queuing (as is done in Canada and the U.K.) or by which condition is treated (as is done in most countries).  There are no other choices.  Independent policy organizations, such as the Cato Institute and NCPA (National Center for Policy Analysis), have developed economically sound and politically practical proposals for dealing with these problems, which can be found on their respective web sites.

As noted, the golden quarter was characterized by a long-term trend toward lower tax rates (again some counterproductive retrenchments). Many tax rates, particularly on capital, such as the capital gains tax and corporate income tax, are well above their revenue and welfare-maximizing rates and should be reduced, not increased.  Congress and the administration need to also reverse course on trade, and stop and remove their protectionist acts.

Finally, America needs a return to a predicable and sound monetary policy – by reinstituting the Taylor Rule.