During the third quarter the U.S. economy grew at seven times the underlying inflation rate. Growth was 4.2 percent while inflation, measured by the gross domestic product deflator, was 0.6 percent. That is the lowest rate of underlying inflation since the second quarter of 1963, when the GDP deflator was at zero percent.

Growth and Inflation

The economy last grew at seven times the inflation rate during the first quarter of 1964, when growth, pushed upward by a surge in consumption and investment demand, soared to an unsustainable rate of 10.4 percent. At that time the underlying inflation rate was 1.5 percent and yielded a 7.1 percent ratio of growth to underlying inflation.

While the mid-1960s and the mid-1990s each had a strongly favorable growth-to-inflation ratio, the underlying fundamentals are much better today than thirty years ago, as we describe below. In particular, there is a significant difference between the engines of demand growth then and now--rapidly rising government spending in the later 1960s versus strong private investment in the 1990s.

The first-quarter 1964 yield on five-year Treasury notes was 4 percent, far below the 7.9 percent year-over-year nominal GDP growth rate toward which five-year yields typically gravitate. Today, the reverse is true, with five-year notes yielding 5.7 percent, almost a full percentage point above the nominal GDP growth rate of 4.8 percent. Paradoxically, during the 1960s five-year yields were low relative to the benchmark GDP growth rate. That configuration signaled an expected return to the low inflation rate of 2 percent or less characteristic of the previous twenty years. Today five-year yields are high relative to the GDP benchmark; this situation indicates some expectation of a return to higher inflation.

Over the five years following 1964, thanks to the guns-and-butter strains of the Great Society and the Vietnam War, inflation crept up to a 5 percent rate and virtually eliminated the real yield over the life of a five-year bond purchased in 1964. Today in 1995, almost half a decade into a disinflationary supply-side recovery, the yield on five-year notes is nearly a full percentage point above its historical benchmark.

The U.S. economy in the mid-1990s is closer to the resilient pre-Great Society condition enjoyed during the 1950s and early 1960s than at any other time since 1965.

The high ratio of growth to inflation late in this remarkable economic expansion, which began nearly five years ago in the spring of 1991, is an important reminder. The U.S. economy in the mid-1990s is closer to the resilient pre-Great Society condition enjoyed during the 1950s and early 1960s than at any other time since 1965.

This positive transformation has not gone entirely unnoticed in the stock and bond markets, where rallies have been extended dramatically since early this year. The stock market is up by more than 30 percent, and bond yields are down, from 8.0 percent to 6.2 percent. Currency markets have yet to observe the dramatic underlying improvement in the U.S. economy, with the dollar only having recovered from an overshoot to the downside against the yen after starting the year at about 100 yen per dollar. The dollar has actually fallen 10.0 percent against the deutsche mark, from 1.55 deutsche marks per dollar early this year to 1.40 deutsche marks per dollar during recent weeks.

The excellent basic health of the U.S. economy may be missed in the current flap over the budget and amid a possible slowdown of demand growth in the fourth quarter. But when the dust settles after the budget debate, the path of real federal spending growth will have been tilted slightly lower as long as the final budget deal approaches the outlines of the current congressional proposals. Meanwhile, investment growth will likely continue to add to U.S. productive capacity. There may be a pause of one or two quarters while an imbalance between supply and demand growth is remedied by one or two quarters of slower investment growth. Further disinflation with outright deflation in some areas is likely to continue.

The U.S. Potential for Growth

The upside potential of the U.S. economy during the 1990s is considerably greater than in the mid-1960s, when growth driven by investment was giving way to growth driven by rapidly rising government expenditure. During the 1960s, financial markets were slow to distinguish between supply-side or investment-driven growth and demand-side growth driven by rapid increases in government outlays. In the mid-1960s, amid the boom in government spending, the stock market was pushed up by 85 percent from its trough of 535 on June 26, 1962, to its peak of 995 on February 9, 1966. After the February 1966 peak, the stock market plummeted by 25 percent to 744 by October 1966. Over the balance of the decade, the market managed to struggle back to its peak late in 1968, only to finish the 1960s at about 800, well below its peak of 995 in February 1966.

The problems that plagued corporate earnings and initiated the rising inflation of the late 1960s and early 1970s can be seen from the composition of demand growth after the mid-1960s. During the eight quarters beginning in the spring of 1965 and ending in the spring of 1967, a pattern emerged: growth in government spending, not investment, was driving the economy. During those eight quarters, government spending, measured in real terms, on average contributed 2.35 percentage points to GDP growth while investment contributed just 0.4 percent.

The upside potential of the U.S. economy during the 1990s is considerably greater than in the mid-1960s, when growth driven by investment was giving way to growth driven by rapidly rising government expenditure.

The imbalance generated by this growth pattern--less investment meaning that capacity was not increasing while government outlays were simultaneously accelerating--created a latent inflation rate in the 4.0 to 6.0 percent range during the late 1960s. Further inflation pressure persisted during the early 1970s until oil and other energy prices eventually exploded in 1973 and signaled the new phenomenon of stagflation, with output growth falling as inflation increased.

The 1990s, in particular the past two years, have seen an inversion of the stagflation that emerged in the late 1960s and early 1970s.

Stagflation is basically the product of demanddriven growth accompanied by inadequate increases in productive capacity so that the economy reaches a point where higher inflation rates are accompanied by lower growth. The underlying explanation for this condition is an exogenous collapse in productive capacity. Accelerating increases in the prices of raw materials reduce aggregate supply at each price level while demand growth continues to put increasing pressure on shrinking productive capacity.

The 1990s, in particular the past two years, have seen an inversion of the stagflation that emerged in the late 1960s and early 1970s. The fundamental reason for this situation is the reversal of the mixture between the capacity-generating growth attributable to investment and the growth attributable to increases in government spending. During the eight quarters following the fourth quarter of 1993, investment growth contributed an average of 2.1 percentage points of the annual growth rate of GDP. At the same time government spending contributed nothing.

As a result of the unusually high level of investment growth during this expansion, the capacity to produce has grown rapidly as the relative size of the government sector has shrunk. Thus, as the recovery has continued, no inflation pressures have emerged. Quite the contrary: since the powerful increase in investment has caused the economy's productive capacity to grow more rapidly than demand, we are actually seeing disinflation and in some cases deflation almost five years into a recovery.

Business-cycle analysts, schooled in the usual patterns of demand-led recoveries, have missed much of the potential for economic performance and financial markets that emerges in a supply-side recovery such as the one being experienced by the United States. The continued solid increases in productive capacity, together with disinflationary pressures, have maintained earnings growth and have therefore enabled the stock market to continue to rise later in the cycle than usual.

Positive Economic Indicators

The behavior of the bond market is perhaps an even bigger surprise. Normally, four to five years into a business expansion as capacity is used up, inflation begins to accelerate, and long-term rates begin to rise more rapidly than short-term rates. Over the past year, however, the inflation rate has continued to decelerate while long-term rates have come down by almost two full percentage points and short-term rates have come down by only one-quarter of one percentage point.

Based on the latest monthly data, the producer price index shows decelerating inflation of finished, intermediate, and crude goods. The core inflation rate measured by the producer price index fell to a 1.1 percent annual rate over the past three months, down from a 2.4 percent inflation rate over the past twelve months. A similar deflation pattern has emerged at the intermediate and crude goods level.

The inflation rate of the consumer price index, which measures price increases of both goods and services, has decelerated more moderately, from a 2.7 percent rate of increase over the past twelve months to a 2.0 annual rate of increase over the past three months ending in October. The slower deceleration of the CPI reflects the fact that more than half of the CPI inflation index measures the prices of services instead of goods. The annualized rate of inflation of goods over the past six months is 1.2 percent against a 3.2 percent inflation rate in the services sector. Prices for services are less subject to international competition than prices for goods and tend to come down more slowly.

Bonds may play an unusual role for market strategists in this unique disinflationary economic recovery. Normally, as earnings growth slows, stock market managers look for defensive investments to preserve the rapid gains enjoyed by equities. Typically, late in a cycle, portfolio managers turn to defensive stocks such as suppliers of food and household products; earnings in these areas are less subject to cyclical variation. In this expansion, however, where disinflation continues late in the cycle, the ideal defensive instrument may be a long-term U.S. government bond. Disinflation coupled with the falling earnings potential for cyclical companies may produce a portfolio shift from cyclical stocks into U.S. bonds; such a move would push the yields on such bonds down to 5.5 percent in fairly short order.

Praise for the Dollar

The foreign exchange markets have as yet failed to credit the dollar fully for the disinflation and growth potential implicit in the U.S. supply-side recovery. Both sustained growth and falling inflation tend to strengthen a currency. The unusually high ratio of growth to underlying inflation in the U.S. economy, which has not been seen since the mid-1960s, when exchange rates were fixed, will probably lead to a much stronger dollar over the coming year.

The unusually high ratio of growth to underlying inflation in the U.S. economy will probably lead to a much stronger dollar over the coming year.

Foreign exchange markets have tended to penalize the dollar because of the high U.S. current account deficit. Markets are overlooking the difference between a country with a high current account deficit generated by external borrowing to fund consumption and high government spending and one with a high current deficit generated by external borrowing to fund investment. The United States fulfilled the former criterion during the period of dollar weakness in the late 1970s. Now, in 1995, the United States arguably has the industrial world's most efficient productive capacity and will have a stronger currency as it gains global market share.

False Budget Alarms?

The extremely favorable basic conditions for U.S. financial instruments, especially for the dollar, have been temporarily obscured by the acrimonious battle between the Republican Congress and the Clinton White House over the deficit-reduction package being put forward by Congress. It is no accident that American stock and bond markets barely skipped a beat in their upward march in mid-November, when the budget battle heated up. American investors could see through all the blather coming out of Washington and therefore continued to look at fundamentals.

Foreign investors, however, were understandably more alarmed since they are less able to understand the American budget ritual. For their benefit and the benefit of others attempting to navigate their way as investors or decision makers through the current U.S. budget battle, I offer a few suggestions. First, it will be painful to watch the budget battle. The political stakes are far higher than the economic stakes, and it is politics that matters in Washington. Second, by the end of the year the budget deficit debate will be settled, and the president will sign a budget that accomplishes nearly all the objectives in the current budget bills proposed by the Republican Congress. Watch for some face-saving, last-minute compromise that slightly dilutes the budget bill but leaves intact its major thrust, a slowdown in the growth of government spending.

Regrettably this year a third caveat must be added to guide normal people through the budget process: ignore White House spokesmen and especially Treasury Secretary Rubin when he attempts to impugn the full faith and credit of the U.S. government by talking about a possible default. There is no risk of default. The real risk for financial markets is the president's significantly watering down efforts to eliminate the budget deficit by such irresponsible tactics.

By the end of the year the budget deficit debate will be settled, and the president will sign a budget that accomplishes nearly all the objectives in the current budget bills proposed by the Republican Congress.

A little more focus on the default issue is appropriate in view of the important implications for the full faith and credit of the U.S. government. After raising dark hints about a possible default, Treasury Secretary Rubin publicly admitted on November 9 and November 15 that a relabeling of interest-bearing assets in the government employees' trust fund as non-interest-bearing assets enables the Treasury to continue to finance its activities and thereby to make timely interest payments on outstanding debt.

On November 15, when the Treasury undertook its first write-down of marketable securities in the government employees' trust fund, Secretary Rubin indicated that the federal government could finance itself through the end of the year but suggested that the possibility of default might reemerge at that time. This assessment is incorrect and dangerous.

If the budget battle continues through the end of the year, the Treasury need only relabel as non-interest-bearing another $60 billion of nonmarketable securities in the government employees' trust fund, and it can issue yet another $60 billion of marketable securities to carry on its activity and service its debts. In fact, the total of securities available for this purpose is nearly $400 billion; since the federal budget deficit is probably running at about $150 billion a year, the government could finance itself in this way for at least two years if necessary.

Eventually the trust fund strategy will be ended--it is hoped before the move provokes a court challenge by a potential or actual beneficiary of a federal pension plan. Even an injunction to stop "borrowing" from the trust funds could be managed. The Treasury secretary and ultimately the president would invoke the authority necessary to avoid default. They ought to have clarified these options by now; the failure to do so has created some weakness in the dollar and hesitation in the U.S. bond market, while bond markets in other industrial countries with far less favorable fundamentals have continued to rally strongly.

While the intensely political U.S. budget battle this year will unsettle financial markets for the next month or so, the process of depressing the dollar and the prices of U.S. government securities below levels merited by fundamentals will create some real value for investors willing to look beyond the budget battle. As markets tire of the budget farce, we shall see strong rallies of U.S. bonds, stocks, and the dollar. If the dollar can rally against the mark and the yen in the face of a likely cut in short-term interest rates by the Federal Reserve in response to slowing demand growth in the U.S. economy, we shall have a strong sign that the dollar's long slide is over.

John H. Makin is a resident scholar at the American Enterprise Institute.