In The Shadows of the Twin Towers

By Stephen Koepp

"Reagan's economic policy is an off-the-wall approach. We're running an incredible experiment with these ((budget and trade)) deficits."

-- The late economist Otto Eckstein, February 1982

"It is a scandal. I don't know what they're on, down in Washington. It's wacko time."

-- Chrysler Chairman Lee Iacocca, February 1984

The warnings did not match the violence and volume of last week's stock- market statement, but they have been sounding for years. Innumerable economists, business leaders and politicians from both the Democratic and Republican parties have issued alarms about the growth of America's budget and trade deficits. And yet the problems grew and grew. Now dubbed the twin towers, a reference to Manhattan's World Trade Center and the long shadows it casts across Wall Street, the hulking deficits are threatening to sink the U.S. economy. In just a twinkling, between 1981 and 1986, the U.S. has metamorphosed from the world's largest creditor to the biggest borrower, carrying a net debt to foreigners that is expected to hit $1 trillion by 1992.

There is plenty of blame to go around, as the deficits are the product of a unique American decade of budget deadlock, unfettered spending and unprecedented borrowing. President Reagan, for his part, fought bitterly against tax increases and cuts in the defense budget when both seemed called for. The Democrats, for their part, were slow to compromise on social spending and, like the Republicans, cherished their pork-barrel projects. Corporate America, which had grown content with its domestic marketplace, aggravated the trade deficit by its lack of motivation to sell products abroad. Consumers added to the trouble by developing a ravenous taste for imported goods and credit-card spending. All told, the roaring '80s have been a time of refusal to confront limitations. Declares Investment Banker Felix Rohatyn: "In an act of the ultimate financial cowardice, we have attempted to pass on to our children the cost of this behavior by borrowing from tomorrow."

How did it happen? Fiscal restraint was already slipping when President Reagan took office. The fiscal-1980 budget gap was $73.8 billion, compared with a deficit of just $2.8 billion ten years earlier. Yet the real ballooning of the deficit to dangerous levels ($220.7 billion by fiscal 1986) was triggered during the early Reagan years, when the Administration tried to cut taxes and boost defense spending at the same time. According to Reagan's true believers, the deficits were supposed to shrink as a result of the tax cut. By stimulating the economy's so-called supply side, the cuts were expected to encourage work and investment so that Government revenues would actually rise rather than fall. Thus was born Reaganomics.

This proposed budget magic drew widespread skepticism, including George Bush's "voodoo economics" charge during the 1980 presidential primaries. Yet by 1981 Congress was eager to find a way to pump up the sagging economy. When Reagan sent Congress his tax-cut proposal, the lawmakers squabbled over the details but eventually gave the President virtually everything he wanted. In the end, the Economic Recovery Tax Act slashed personal-income tax rates 23% over three years. Reaganomics was supposed to produce a budget surplus of $500 million by 1984, but one of the Administration's master strategists, Budget Director David Stockman, knew better. "None of us really understands what's going on with all these numbers," he confessed in a December 1981 magazine article that rocked the White House. "People are getting from A to B, and it's not clear how they are getting there."

The tax cuts were accompanied by a substantial increase in federal spending, despite Reagan's campaign promises about reining in the Government. During the Administration's first term, total federal spending jumped 26%, to $852 billion in fiscal 1984. The biggest item was defense, reflecting the President's view that the military had suffered a decade of neglect in the 1970s. Reagan's buildup cost $1.2 trillion over the fiscal years 1981-'86, which boosted military spending 41% after adjustment for inflation. Among the new hardware: the B-1B bomber (cost: $280 billion) and the MX missile system ($20.7 billion for the first 50). The Strategic Defense Initiative, or Star Wars, research and development was allotted $9.3 billion for the first five years.

Yet the supply-side tax cuts, designed to stimulate the output of goods by giving workers and businesses greater rewards, failed to produce an offsetting revenue bonanza. While sky-high interest rates and the 1981-'82 recession might be partly to blame, supply-side critics say the idea was faulty from the start. In any case, the budget deficit exploded as Government receipts shrank. The flow of red ink nearly tripled in two years, hitting $207.8 billion in fiscal 1983. It would have been even higher if Congress had not adopted a $98 billion tax increase in 1982, which Reagan grudgingly signed. Moreover, the deficit kept mounting despite the Administration's imaginative revenue- boosting plans, which ranged from the sale of Government land to the increase of user fees for airports, waterways and even Coast Guard services.

Whistle blowers within the Administration were consistently squelched. When Martin Feldstein, the President's chief economic adviser in 1982-84, warned of the deficit dangers in the Administration's annual economic report, then Treasury Secretary Donald Regan told reporters they could "throw away" the document. Meanwhile, supply-siders like Economist Paul Craig Roberts, who was an Assistant Treasury Secretary during 1981 and 1982, kept minimizing the problem. Said he in 1984: "Deficits are on the way out." Later the Administration's budgeteers grew so wary of mentioning the prospect of new taxes that they started calling it the T word.

The Administration and Congress found some items to cut, though perhaps only expedient ones. Federal spending on nonmilitary research and development, after adjustment for inflation, has declined 25% from 1979 to 1986 while aid to schools has fallen 14%, notes former Commerce Secretary Peter Peterson. Many economists have railed against these cuts because they have borrowed from America's future competitiveness and well-being. Wrote Peterson in an essay in the October Atlantic: "Unfortunately, since the future has no lobby . . . the Administration and Congress have found this the perfect place to demonstrate their budget-cutting zeal publicly even while allowing all other types of spending to keep rising."

The budget has become increasingly hard to trim as the outstanding federal debt ($2.37 trillion) has mounted, since interest payments on old borrowings are crowding out other items. Net interest outlays increased from 9% of the budget in fiscal 1980 to 14% in 1986, or $136 billion. Such uncontrollable expenditures, along with the Administration's determination to spare large categories like defense and Social Security, have forced budget cutters "to work in an impossibly small corner covering only 30% of the spending total," observes TIME Correspondent Lawrence Malkin in his recent book, The National Debt. A frustrated Pete Domenici, chairman of the Senate Budget Committee during 1981, told Reagan, "You can't get $100 billion in savings out of this little bitty piece that's left. You got money in there for feeding babies, for building roads, for cancer research, for the national parks, the FBI. We'll help you squeeze 'em, but we can't bleed 'em."

Perhaps the most insidious growth in the budget has come in payments to middle- and upper-class citizens, a type of handout that typically carries no test of need. Social Security payments have increased 17% between 1981 and 1986, to $198.8 billion, even after adjustment for inflation. Many entitlements rise automatically because they are indexed to inflation.

Farm supports, meanwhile, rose more than 500%, to $25.8 billion in 1986. Notes Journalist Alfred Malabre Jr. in his book Beyond Our Means: "In 1984, less than 20% of all direct Governmental aid to agriculture went to farmers ! who were financially distressed. In other words, for every $1 going to needy farmers, some $4 was winding up with prosperous ones."

The alarming surge of the budget deficits through the $200 billion mark seems finally to be forcing some budget progress. The Administration agreed in 1985 to a freeze in the defense buildup, and that has held increases in military outlays below the level of inflation. During the same year, Congress passed the Gramm-Rudman deficit-reduction bill, designed to impose automatic spending reductions if the Administration and legislators failed to meet targets for cutbacks. But the Supreme Court found a crucial part of the law unconstitutional. By the time a revised version was passed in September, Congress had reduced the size of automatic cuts for fiscal 1988 from $37 billion to $23 billion and pushed back the deadline for a balanced budget from 1991 to 1993.

It is that trend toward postponing the tough budget-cutting decisions that has been spooking the financial markets. Said Federal Reserve Chairman Alan Greenspan during his Senate confirmation hearings in July: "Should the . . . evidence suggest that the deficit is getting out of control again, then we are going to find ourselves in a very serious financial bind."

As the budget swelled, a new problem was rising. America was consuming far more than it was producing. The deficit between U.S. imports and exports, $36.3 billion in 1980, jumped to $123.3 billion in 1984. The trade gap can be viewed at least partly as an outgrowth of Washington's budget deficits. Reason: the Federal Reserve felt compelled to keep interest rates high (average 1983 prime rate: 10.8%) during the early 1980s not only to attack inflation but also to attract foreign money to finance America's growing budget gap. That strategy worked well, making dollar-denominated securities so popular that the currency rose steadily in value. At first the mighty dollar seemed like a bonus, enabling U.S. consumers to travel cheaply overseas and buy foreign imports at bargain prices.

The strong dollar, however, had devastating consequences for American industry because it made U.S. exports more expensive and thus tougher to sell competitively abroad. Complained Edward Jefferson in early 1985, when he was chairman of Du Pont: "Since 1980 the rise in the value of the dollar has put a 50% surcharge on all U.S. goods sold abroad and a 50% subsidy on all imports." Caterpillar, the longtime world leader in sales of heavy construction equipment, posted losses of $953 million from 1982 through 1984, mostly because of a drop in overseas sales. An estimated 3 million U.S. manufacturing jobs disappeared as imported goods poured into the U.S. Finally corporate America's anguish grew so great that the finance ministers and central bankers of the five major industrial democracies met in September 1985 at Manhattan's Plaza Hotel to reach their now famous agreement to push down the dollar's value.

Yet the 40% decline in the currency since then has been slow to produce an impact. During 1986 the deficit hit $156 billion, and it is growing this year at a rate that could produce a gap of $171 billion. Most economists expected that an improvement in the trade balance would take more than a year, since the initial result of a weaker dollar is to make imported merchandise cost more and thus increase the country's bill for foreign merchandise. After two years, though, the volume of imports should have fallen enough to reduce the trade gap substantially. While exports have shown some modest gains during 1987, "it is clear we have not made a dent in the problem," contends Mark Anderson, an international economist for the AFL-CIO.

Some unexpected forces have interfered. One is that many foreign companies, determined to hold their U.S. market share, have postponed boosting their U.S. prices to compensate for the rise of their currencies against the dollar, even if it meant cutting into their profit margins. "The average foreign producer is probably selling at a loss right now," says Stephen Roach, a senior economist at the Morgan Stanley investment firm. Another factor is a reluctance among many U.S. businesses, which feel content with America as their main marketplace, to take advantage of the falling dollar to expand their sales abroad. Says Vladimir Pucik, assistant professor of international business at the University of Michigan: "What many American companies are doing is concentrating on defending their own territory. That's not enough."

Yet foreign markets have been less than welcoming. As the global marketing battle takes hold, some countries are reacting with protectionism. Moreover, economic expansion around the world is so sluggish at the moment that few countries besides the U.S. are showing much demand for imports. Observes David Hale, chief economist for Kemper Financial Services: "The U.S. has been playing the role of global borrower and spender of last resort because of a sharp slowdown in the growth rates of other countries."

The flabbiness of corporate America has been another major contributor to the trade deficit. Domestic manufacturers were ill-equipped to deal with the onslaught of eager foreign competitors. But now many U.S. companies have boosted their competitiveness by slimming down their costs and speeding up their reaction times. Among Detroit automakers, for instance, the "arrogance is diminishing. There is a sense of vulnerability," observes Maryann Keller, an auto-industry analyst.

Yet American companies cannot hope to conquer the trade deficit as long as its twin, the budget deficit, remains so huge. The stimulus of Washington's deficit spending, especially on a steadily expanding economy, makes the U.S. far too hungry for imported merchandise. This connection between the twin deficits has been almost universally recognized for years, and yet the Administration and Congress are still spending well beyond the country's means. That is the perilous formula that came to grief last week.