Principles of Economics in Context, Second Edition – Sample Chapter for Early Release
5
DRAFT
during the 1930s, but World War II had an even greater impact. Because consumer
goods were rationed, savings accumulated, and people used them to purchase U.S.
war bonds (a form of debt), which helped finance U.S. participation in World War II.
After the war, the national debt totaled an unprecedented 122 percent of GDP.
2.2 “SUPPLY-SIDE” ECONOMICS
After World War II, the debt generally declined as a percentage of GDP until 1980.
The national debt was just over $900 billion in 1981, but rose by nearly $2 trillion during
the next eight years. In other words, over those eight years the country incurred twice
as much debt as it had in its first 200 years! How did this happen?
Ronald Reagan’s 1980 presidential campaign leaned heavily on the principles of
“supply-side” economics, which promised that offering more benefits and incentives to
the individuals and groups that held the most wealth and productive capital would
stimulate rapid investment growth and job creation. According to this principle, tax cuts
would pay for themselves through greater revenues from an expanded economy. This
is consistent with the oft-heard but controversial concept of “trickle-down” economics,
which is the idea that benefits enjoyed by the well-off eventually percolate (i.e., trickle
down) to everyone else.
The major policy experiment with supply-side economics was the Economic
Recovery Act (ERA, 1981), which cut income and corporate tax rates, substantially
reducing government revenues. At the same time, military spending increased in the
1980s. Consequently, the annual budget deficit, which had been 2.7 percent of GDP
in 1980, grew to an annual average of about 4 percent during the Reagan presidency
(see Chapter 25, Figure 25.5). A portion of the debt increase was due to cyclical
factors, specifically an unusually deep recession in 1981–1982. Most of it, however,
resulted from the failure of supply-side economics to produce the revenue growth that
was needed to make up for the tax cut.
2.3 1989 TO THE PRESENT
In absolute terms, the national debt continued to grow after Reagan left office, despite
the fact that by then public awareness of the government’s fiscal problems had grown.
In an attempt to address persistent deficits, President George H.W. Bush raised tax
rates slightly and signed a bill in 1990 requiring that all spending increases be matched
by either decreases in spending in other areas or tax increases, in a system known as
PAYGO (“pay as you go”). Despite the introduction of that system, another recession
(1990–1991) and the first Iraq war kept deficits in the range of 4 percent of GDP
annually. It also did not help matters that sizable sums had to be used to bail out many
savings and loan banks that collapsed due to losses from risky and ill-conceived real
estate investments (a precursor of the real estate bubble of the twenty-first century).
In 1992 the national debt was $4 trillion.
Bush’s PAYGO policy was continued under the administration of Bill Clinton.
Congress again raised income tax rates, and the end of the Cold War allowed the
federal government to lower military expenditures (relative to GDP, although not in
absolute terms), a side benefit often referred to as a “peace dividend.” At the same
time, the economy emerged from recession and began a period of sustained growth.
The resulting movement from the trough to the peak of the business cycle from 1992
to 2000 generated surpluses in the overall federal budget from 1998 to 2001, a feat
that had not been achieved since 1969. This period of budget surpluses, however,