WHEN President Reagan first assumed office in 1981, he made a set of momentous decisions: Slash taxes, boost defense spending, assume that the enlarged deficits will force Congress to reduce spending. ``It was probably the biggest fiscal mistake in the history of the United States,'' says William H. Branson, a professor of economics and international affairs at Princeton University. ``It led us into the soup.''
And, according to Professor Branson, the US is still wallowing in that soup.
What happened was that anticipation of the massive deficit by the financial community started sending interest rates up. This attracted foreign money into the country and boosted the dollar. By the first quarter of 1985, the dollar was more than 50 percent above its 1980 level on the foreign-exchange markets. By mid-1985, the current-account deficit of the international balance of payments was $120 billion at an annual rate, helping finance an annual budget deficit of $200 billion.
On top of all that, Congress did not cut civilian spending enough to reduce the deficit -- ``a political misjudgment'' by President Reagan, Dr. Branson figures. Federal spending has been rising at an 8.4 percent compounded annual rate for the past two years -- hardly austerity.
As a result of the superdollar, American manufacturing output was decimated. Some 10 percent of jobs disappeared.
With James P. Love, also of Princeton, Branson has calculated that this upgrading of the dollar cost 1.8 million jobs in the manufacturing sector. With the dollar so strong, American manufacturers could not beat the prices offered by their competitors in Western Europe, Japan, or the newly industrialized countries (NICs), such as South Korea and Taiwan. Many American manufacturers set up plants in the NICs.
Since March 1985, the dollar has plunged dramatically. But it is still 20 percent above its 1980 level.
Treasury Secretary James Baker III spoke again last week of a need for a further decline in the dollar to remedy the trade imbalances. That dollar promptly did so.
Even with a decline of the dollar, some lost manufacturing will not return to the US, says Branson. It is gone permanently.
Money has already been sunk in the overseas plants. Wage levels in those plants may be relatively low and the technology comparatively modern. So it will not pay to set up competitive plants in the US.
So far the plunge in the dollar since the winter of 1985 has not had as dramatic an effect on American trade as many expected. Most economists, taking account of what they call the ``J-curve,'' predicted a rise in imports in nominal dollars because of their increasing cost when the dollar is cheaper on foreign exchange markets.
Import prices, however, have risen far less than the change in exchange rates indicated. Indeed, import volume in physical terms has actually increased, notes Paul R. Krugman, a professor of economics at Massachusetts Institute of Technology.
The administration is counting on the drop in the dollar to stimulate exports and thereby pep up domestic output in coming months. If that doesn't happen, growth could continue stagnant.
When the Department of Commerce last week reviewed its gross national product figures for the April-through-June quarter, the results showed total real output rising at an unchanged, slow 0.6 percent annual rate.
Branson and Dr. Krugman were here for the annual meeting of the National Association of Business Economists. A survey of its members found that on average they predict real output growth to be almost 3 percent next year, compared with an estimate of 2.5 percent for 1986. They also forecast somewhat more inflation next year than in 1986, slightly higher interest rates, stable unemployment, a lower dollar on foreign-exchange markets, increased spending by business on plant and equipment, higher corporate profits, slightly lower auto sales, and fewer housing starts.
That indicates that the recovery, already 45 months old, should continue along a modest growth path -- less than the 4 percent rate forecast by the Reagan administration.
The ``consensus'' forecast among groups of economists has not been too bad in the past, or, to put it less kindly, certainly no worse than the forecasts of many individual economists.
One individual forecast was offered by Alan Greenspan, chairman of the Council of Economic Advisers under President Ford and now back at his own economic consulting firm in New York. He sees an economy chugging along at a tame pace.
One danger in this scenario, he warns, is that the administration will try to stimulate output with looser fiscal or monetary policy. The result could be a repeat in the early 1990s of the ``devastation of the 1970s,'' with double-digit inflation and a boom-bust cycle.
Some economists worry that considerably higher inflation could return -- though maybe not at a double-digit rate -- well before the 1990s.
``There is concern,'' says Wayne D. Gantt, an economist with Trust Company of Georgia.
Mr. Gantt likes to describe Paul Volcker, chairman of the Federal Reserve Board, as ``the great Wallenda'' of central banking, trying to balance on the high wire of monetary policy, not leaning on the side of too much monetary stimulation and inflation or on the other side of too little and recession.
For some six months the Fed has been pumping newly created reserves into the nation's banks at an average rate of more than 20 percent. The money supply, fuel for the economy, has shot up nearly as fast.
So far, consumers and businesses have not set this fuel on fire. But Gantt worries that this could happen. Looking at increases in prices of imports and services, he sees a ``faint glow.''