U.S. Economy

to reach agreement about the need for the government to change spending

or taxes. Part of the problem is this: In order to increase or decrease

the overall level of government spending or taxes, specific expenditures

or taxes have to be increased or decreased, meaning that specific

programs and voters are directly affected. Choosing which programs and

voters to help or hurt often becomes a highly controversial political

issue.

Because discretionary fiscal policies affect the government’s annual

deficit or surplus, as well as the national debt, they can often be

controversial and politically sensitive. For these reasons, at the close

of the 20th century, which experienced years with normal levels of

unemployment and inflation, there was more reliance on monetary policies,

rather than on discretionary fiscal policies to try to stabilize the

national economy. There have been, however, some famous episodes of

changing federal spending and tax policies to reduce unemployment and

fight inflation in the U.S. economy during the past 40 years. In the

early 1980s, the administration of U.S. president Ronald Reagan cut

taxes. Other notable tax cuts occurred during the administrations of U.S.

presidents John Kennedy and Lyndon Johnson in 1963 and 1964.

Limitations of Government Programs

Government economic programs are not always successful in correcting

market failures. Just as markets fail to produce the right amount of

certain kinds of goods and services, the government will often spend too

much on some programs and too little on others for a number of reasons.

One is simply that the government is expected to deal with some of the

most difficult problems facing the economy, taking over where markets

fail because consumers or producers are not providing clear signals about

what they want. This lack of clear signals also makes it difficult for

the government to determine a policy that will correct the problem.

Political influences, rather than purely economic factors, often play a

major role in inefficient government policies. Elected officials

generally try to respond to the wishes of the voting public when making

decisions that affect the economy. However, many citizens choose not to

vote at all, so it is not clear how good the political signals are that

elected officials have to work with. In addition, most voters are not

well informed on complicated matters of economic policy.

For example, the federal government’s budget director David Stockman and

other officials in the administration of President Reagan proposed cuts

in income tax rates. Congress adopted the cuts in 1981 and 1984 as a way

to reduce unemployment and make the economy grow so much that tax

revenues would actually end up rising, not falling. Most economists and

many politicians did not believe that would happen, but the tax cuts were

politically popular.

In fact, the tax cuts resulted in very large budget deficits because the

government did not collect enough taxes to cover its expenditures. The

government had to borrow money, and the national debt grew very rapidly

for many years. As the government borrowed large sums of money, the

increased demand caused interest rates to rise. The higher interest rates

made it more expensive for U.S. firms to invest in capital goods, and

increased the demand for dollars on foreign exchange markets as

foreigners bought U.S. bonds paying higher interest rates. That caused

the value of the dollar to rise, compared with other nations’ currencies,

and as a result U.S. exports became more expensive for foreigners to buy.

When that happened in the mid-1980s, most U.S. companies that exported

goods and services faced very difficult times.

In addition, whenever resources are allocated through the political

process, the problem of special interest groups looms large. Many

policies, such as tariffs or quotas on imported goods, create very large

benefits for a small group of people and firms, while the costs are

spread out across a large number of people. That gives those who receive

the benefits strong reasons to lobby for the policy, while those who each

pay a small part of the cost are unlikely to oppose it actively. This

situation can occur even if the overall costs of the program greatly

exceed its overall benefits.

For instance, the United States limits sugar imports. The resulting

higher U.S. price for sugar greatly benefits farmers who grow sugarcane

and sugar beets in the United States. U.S. corn farmers also benefit

because the higher price for sugar increases demand for corn-based

sweeteners that substitute for sugar. Companies in the United States that

refine sugar and corn sweeteners also benefit. But candy and beverage

companies that use sweeteners pay higher prices, which they pass on to

millions of consumers who buy their products. However, these higher

prices are spread across so many consumers that the increased cost for

any one is very small. It therefore does not pay a consumer to spend much

time, money, or effort to oppose the import barriers.

For sugar growers and refiners, of course, the higher price of sugar and

the greater quantity of sugar they can produce and sell makes the import

barriers something they value greatly. It is clearly in their interest to

hire lobbyists and write letters to elected officials supporting these

programs. When these officials hear from the people who benefit from the

policies, but not from those who bear the costs, they may well decide to

vote for the import restrictions. This can happen despite the fact that

many studies indicate the total costs to consumers and the U.S. economy

for these programs are much higher than the benefits received by sugar

producers.

Special interest groups and issues are facts of life in the political

arena. One striking way to see that is to drive around the U.S. national

capital, Washington D.C., or a state capital and notice the number of

lobbying groups that have large offices near the capitol building. Or

simply look at the list of trade and professional associations in the

yellow pages for those cities. These lobbying groups are important and

useful to the political process in many ways. They provide information on

issues and legislation affecting their interests. But these special

interest groups also favor legislation that often benefits their members

at the expense of the overall public welfare.

E The Scope of Government in the U.S. Economy

The size of the government sector in the U.S. economy increased

dramatically during the 20th century. Federal revenues totaled less than

5 percent of total GDP in the early 1930s. In 1995 they made up 22

percent. State, county, and local government revenues represent an

additional 15 percent of GDP.

Although overall government revenues and spending are somewhat lower in

the United States than they are in many other industrialized market

economies, it is still important to consider why the size of government

has increased so rapidly during the 20th century. The general answer is

that the citizens of the United States have elected representatives who

have voted to increase government spending on a variety of programs and

to approve the taxes required to pay for these programs.

Actually, government spending has increased since the 1930s for a number

of specific reasons. First, the different branches of government began to

provide services that improved the economic security of individuals and

families. These services include Social Security and Medicare for the

elderly, as well as health care, food stamps, and subsidized housing

programs for low-income families. In addition, new technology increased

the cost of some government services; for example, sophisticated new

weapons boosted the cost of national defense. As the economy grew, so did

demand for the government to provide more and better transportation

services, such as super highways and modern airports. As the population

increased and became more prosperous, demand grew for government-financed

universities, museums, parks, and arts programs. In other words, as

incomes rose in the United States, people became more willing to be taxed

to support more of the kinds of programs that government agencies

provide.

Social changes have also contributed to the growing role of government.

As the structure of U.S. families changed, the government has

increasingly taken over services that were once provided mainly by

families. For instance, in past times, families provided housing and

health care for their elderly. Today, extended families with several

generations living together are rare, partly because workers move more

often than they did in the past to take new jobs. Also the elderly live

longer today than they once did, and often require much more

sophisticated and expensive forms of medical care. Furthermore, once the

government began to provide more services, people began to look to the

government for more support, forming special interest groups to push

their demands.

Some people and groups in the United States favor further expansion of

government programs, while others favor sharp reductions in the current

size and scope of government. Reliance on a market system implies a

limited role for government and identifies fairly specific kinds of

things for the government to do in the economy. Private households and

businesses are expected to make most economic decisions. It is also true

that if taxes and other government revenues take too large a share of

personal income, incentives to work, save, and invest are diminished,

which hurts the overall performance of the economy. But these general

principles do not establish precise guidelines on how large or small a

role the government should play in a market economy. Judging the

effectiveness of any current or proposed government program requires a

careful analysis of the additional benefits and costs of the program. And

ultimately, of course, the size of government is something that U.S.

citizens decide through democratic elections.

IX IMPACT OF THE WORLD ECONOMY Today, virtually every country

in the world is affected by what happens in other countries. Some of

these effects are a result of political events, such as the overthrow of

one government in favor of another. But a great deal of the

interdependence among the nations is economic in nature, based on the

production and trading of goods and services.

One of the most rapidly growing and changing sectors of the U.S. economy

involves trade with other nations. In recent decades, the level of goods

and services imported from other countries by U.S. consumers, businesses,

and government agencies has increased dramatically. But so, too, has the

level of U.S. goods and services sold as exports to consumers,

businesses, and government agencies in other nations. This international

trade and the policies that encourage or restrict the growth of imports

and exports have wide-ranging effects on the U.S. economy.

As the nation with the world’s largest economy, the United States plays a

key role on the international political and economic stages. The United

States is also the largest trading nation in the world, exporting and

importing more goods and services than any other country.. Some people

worry that extensive levels of international trade may have hurt the U.S.

economy, and U.S. workers in particular. But while some firms and workers

have been hurt by international competition, in general economists view

international trade like any other kind of voluntary trade: Both parties

can gain, and usually do. International trade increases the total level

of production and consumption in the world, lowers the costs of

production and prices that consumers pay, and increases standards of

living. How does that happen?

All over the world, people specialize in producing particular goods and

services, then trade with others to get all of the other goods and

services they can afford to buy and consume. It is far more efficient for

some people to be lawyers and other people doctors, butchers, bakers, and

teachers than it is for each person to try to make or do all of the

things he or she consumes.

In earlier centuries, the majority of trade took place between

individuals living in the same town or city. Later, as transportation and

communications networks improved, individuals began to trade more

frequently with people in other places. The industrial revolution that

began in the 18th century greatly increased the volume of goods that

could be shipped to other cities and regions, and eventually to other

nations. As people became more prosperous, they also traveled more to

other countries and began to demand the new products they encountered

during their travels.

The basic motivation and benefits of international trade are actually no

different from those that lead to trade within a nation. But

international trade differs from trade within a nation in two major ways.

First, international trade involves at least two national currencies,

which must usually be exchanged before goods and services can be imported

or exported. Second, nations sometimes impose barriers on international

trade that they do not impose on trade that occurs entirely inside their

own country.

A U.S. Imports and Exports

U.S. exports are goods and services made in the United States that are

sold to people or businesses in other countries. Goods and services from

other countries that U.S. citizens or firms purchase are imports for the

United States. Like almost all of the other nations of the world, the

United States has seen a rapid increase in both its imports and exports

over the last several decades. In 1959 the combined value of U.S. imports

and exports amounted to less than 9 percent of the country’s gross

domestic product (GDP); by 1997 that figure had risen to 25 percent.

Clearly, the international trade sector has grown much more rapidly than

the overall economy.

Most of this trade occurs between industrialized, developed nations and

involves similar kinds of products as both imports and exports. While it

is true that the U.S. imports some things that are only found or grown in

other parts of the world, most trade involves products that could be made

in the United States or any other industrialized market economies. In

fact, some products that are now imported, such as clothing and textiles,

were once manufactured extensively in the United States. However,

economists note that just because things were or could be made in a

country does not mean that they should be made there.

Just as individuals can increase their standard of living by specializing

in the production of the things they do best, nations also specialize in

the products they can make most efficiently. The kinds of goods and

services that the United States can produce most competitively for export

are determined by its resources. The United States has a great deal of

fertile land, is the most technologically advanced nation in the world,

and has a highly educated and skilled labor force. That explains why U.S.

companies produce and export many agricultural products as well as

sophisticated machines, such as commercial jets and medical diagnostic

equipment.

Many other nations have lower labor costs than the United States, which

allows them to export goods that require a lot of labor, such as shoes,

clothing, and textiles. But even in trading with other industrialized

countries—whose workers are similarly well educated, trained, and highly

paid—the United States finds it advantageous to export some high-tech

products or professional services and to import others. For example, the

United States both imports and exports commercial airplanes, automobiles,

and various kinds of computer products. These trading patterns arise

because within these categories of goods, production is further

specialized into particular kinds of airplanes, automobiles, and computer

products. For example, automobile manufacturers in one nation may focus

production primarily on trucks and utility vehicles, while the automobile

industries in other countries may focus on sport cars or compact

vehicles.

Greater specialization allows producers to take full advantage of

economies of scale. Manufacturers can build large factories geared toward

production of specialized inventories, rather than spending extra

resources on factory equipment needed to produce a wide variety of goods.

Also, by selling more of their products to a greater number of consumers

in global markets, manufacturers can produce enough to make

specialization profitable.

The United States enjoyed a special advantage in the availability of

factories, machinery, and other capital goods after World War II ended in

1945. During the following decade or two, many of the other industrial

nations were recovering from the devastation of the war. But that

situation has largely disappeared, and the quality of the U.S. labor

force and the level of technological innovation in U.S. industry have

become more important in determining trade patterns and other

characteristics of the U.S. economy. A skilled labor force and the

ability of businesses to develop or adapt new technologies are the key to

high standards of living in modern global economies, particularly in

highly industrialized nations. Workers with low levels of education and

training will find it increasingly difficult to earn high wages and

salaries in any part of the world, including the United States.

B Barriers to Trade Despite the mutual advantages of global

trade, governments often adopt policies that reduce or eliminate

international trade in some markets. Historically, the most important

trade barriers have been tariffs (taxes on imports) and quotas (limits on

the number of products that can be imported into a country). In recent

decades, however, many countries have used product safety standards or

legal standards controlling the production or distribution of goods and

services to make it difficult for foreign businesses to sell in their

markets. For example, Russia recently used health standards to limit

imports of frozen chicken from the United States, and the United States

has frequently charged Japan with using legal restrictions and allowing

exclusive trade agreements among Japanese companies. These exclusive

agreements make it very difficult for U.S. banks and other firms to

operate or sell products in Japan.

While there are special reasons for limiting imports or exports of

certain kinds of products—such as products that are vital to a nation’s

national defense—economists generally view trade barriers as hurting both

importing and exporting nations. Although the trade barriers protect

workers and firms in industries competing with foreign firms, the costs

of this protection to consumers and other businesses are typically much

higher than the benefits to the protected workers and firms. And in the

long run it usually becomes prohibitively expensive to continue this kind

of protection. Instead it often makes more sense to end the trade barrier

and help workers in industries that are hurt by the increased imports to

relocate or retrain for jobs with firms that are competitive. In the

United States, trade adjustment assistance payments were provided to

steelworkers and autoworkers in the late 1970s, instead of imposing trade

barriers on imported cars. Since then, these direct cash payments have

been largely phased out in favor of retraining programs.

During recessions, when national unemployment rates are high or rising,

workers and firms facing competition from foreign companies usually want

the government to adopt trade barriers to protect their industries. But

again, historical experience with such policies shows that they do not

work. Perhaps the most famous example of these policies occurred during

the Great Depression of the 1930s. The United States raised its tariffs

and other trade barriers in legislation such as the Smoot-Hawley Act of

1930. Other nations imposed similar kinds of trade barriers, and the

overall result was to make the Great Depression even worse by reducing

world trade.

C World Trade Organization (WTO) and Its Predecessors

As World War II drew to a close, leaders in the United States and other

Western nations began working to promote freer trade for the post-war

world. They set up the International Monetary Fund (IMF) in 1944 to

stabilize exchange rates across member nations. The Marshall Plan,

developed by U.S. general and economist George Marshall, promoted free

trade. It gave U.S. aid to European nations rebuilding after the war,

provided those nations reduced tariffs and other trade barriers.

In 1947 the United States and many of its allies signed the General

Agreement on Tariffs and Trade (GATT), which was especially successful in

reducing tariffs over the next five decades. In 1995 the member nations

of the GATT founded the World Trade Organization (WTO), which set even

greater obligations on member countries to follow the rules established

under GATT. It also established procedures and organizations to deal with

disputes among member nations about the trading policies adopted by

individual nations.

In 1992 the United States also signed the North American Free Trade

Agreement (NAFTA) with its closest neighbors and major trading partners,

Canada and Mexico. The provisions of this agreement took effect in 1994.

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