Viewpoint: The Recovery They Love to Hate


You'd think everyone would have been happy about the economic expansion experienced this past year. But if anything has been more surprising than the recovery's strength and apparent endurance, it has been the associated attitudes of the news media and the economic analysts whose views they report. Never has a healthy economic expansion been accompanied by such constant expressions of trepidation and anguish! Nightly we have been told that "economists" fear that rising interest rates resulting from excessively rapid growth will choke off the recovery.

Now consider the logic here: Rapid growth makes interest rates rise; higher interest rates reduce growth; so we should have slower growth to prevent the higher interest rates that reduce growth! It is perhaps significant that this bizarre argument is always attributed to unnamed economic analysts. I, too, would be reluctant to have my name attached to such reasoning.

Even the basic assumption of the argument can be shown to be false. Economic growth does indeed lead to higher interest rates as businesses seek loans to expand operations. But interest rates that rise because of increased credit demand attributable to economic growth must necessarily be associated with increased (not decreased) credit extended—and hence must increase, not reduce, economic growth.

This is demonstrably what has happened. Interest rates on financial instruments began rising in May 1983 and continued through July of this year. The prime rate (the rate charged by banks to their largest customers) began rising in August 1983. But business loans, rather than falling, started increasing rapidly in October 1983.

By the fall of 1984, evidence of slower growth was emerging (greeted with euphoria in the media). But this was not because the expansion made interest rates rise. The amount of credit extended would decline (resulting in a recession) only if interest rates increased because of a reduction in the supply of credit. That is usually a consequence of action by the government, via the Federal Reserve, to severely reduce the rate of growth of the money stock.

Some of the confusion and misinterpretation of the current expansion may be a legitimate result of its unusual character. All previous post-Korean war recoveries have been demand-side expansions. In each case the Federal Reserve had caused the prior recession by reducing money-stock growth (to fight inflation). But then, under pressure to cure the resulting unemployment, the Fed responded with rapid expansion of the money stock, increasing the demand for goods, services, and labor—and inducing another round of inflation.

Of course, none of this was ever necessary. Any one of those recessions would have ended without the Fed undertaking rapid monetary growth. If the rate of growth of the money stock was kept low and steady, the inflation rate would sooner or later fall below it.

This would take a little longer than it does for the Fed to "inflate" the economy out of a recession. If it had been done once, however, and inflation had thus been controlled, the whole series of subsequent contractions and expansions would have been avoided (with the exception of the OPEC-induced recession of 1974).

One of the things that is different about the current expansion is that we may have done exactly what could have been done earlier. During the recent contraction, the Fed kept monetary growth low for so long, in the face of massive pressure to reverse course, that people became convinced that for once it really meant to control inflation. Inflation and the rate of expected future inflation (and hence interest rates leading up to the expansion itself) all fell.

The second thing that is different about this recovery is that it is a supply-side, not a demand-side, expansion. Alterations in the growth of the money stock can only cause temporary fluctuations in the growth rates of output and employment around their trends. To increase the trends themselves it is necessary to increase the incentives people have to work, save, and invest in productive equipment. And the best way to do that is to lower tax rates on the income earned from such activities.

Liberals who opposed supply-side from the outset have tried to portray the expansion as being led by consumer spending, rather than supply-side factors. But in fact savings are up, and consumption spending as a proportion of disposable income is down.

Investment spending also tells a supply-side tale. Personal consumer spending rose at a 4.6 percent annual rate in the first quarter of 1984 and at a 6.9 percent rate in the second. But at the same time capital spending by business was soaring at a 20 percent annual rate. Meanwhile, productivity is up, and the rate of new-business formation and job creation in the last year have been the highest in decades.

The most surprising aspects of this expansion, such as the unexpectedly high growth rates of GNP (10.1 percent per annum in the first quarter, 7.5 in the second) and the persistently low inflation rates, are best explained by its supply-shift character. And that also explains why the reporting of all this good news has, in the liberal media, been characterized by palpable fear and loathing. For the supply-side vision accords individuals a lot more economic freedom than liberals are wont to concede.

James Rolph Edwards teaches economics at Hillsdale College.