Executive Summary: The demand-side establishmentarians are congratulating themselves for transforming President Reagan into a "realist" on "horrifying" outyear budget deficits. But it's clear that the President's standby tax is as mythical as the "structural deficits" it is supposed to counter. While former Treasury Secretaries and Nobel Prize economists offer sage advice on whether money should be going into or taken out of consumer pockets, Reagan has bought time for the recovery to take place unimpeded by perverse fiscal "remedies." Stockman/Feldstein arguments about slow growth as a rationale for tax hikes are joined by Penner worries of rapid recovery, an encouraging sign. Volcker's fiscal views are still tortured, but he's playing it down the middle between inflationists and deflationists. Our optimism persists.
Mythical Deficits: A Mythical Tax
At the January 27 meeting of the Joint Economic Committee of Congress, Senator Edward Kennedy had Fed Chairman Paul Volcker in the docket, accusing him of keeping interest rates high when, according to various illustrious economists, he should be easing up. Said Kennedy: "Now what is it that you know so much better than these Nobel laureates, skilled economists...?"
"I think we can find Nobel laureates on both sides of that issue" said Volcker.
Indeed we can. In the January 31 issue of U.S. News & World Report we are advised on "How to Get the Country Moving Again" by six Nobel Prize economists. At the same time, President Reagan is being counseled by a cluster of distinguished former public officials, including five former Treasury Secretaries and the ubiquitous Peter G. Peterson, who was President Nixon's Secretary of Commerce, plus legions of industrialists and financiers. We find amazing bipartisan uniformity on the question of whether something should be done about the "horrifying" budget deficits that David Stockman tells us we will have later in the decade, with or without economic growth. But Volcker is right. On the question of whether we should have easier money or tighter money, the greybeards of the Establishment are all over the lot. There are easy-money Nobel Prizers and tight-money Nobel Prizers, strong-dollar Treasury Secretaries and captains of industry and soft-dollar advocates in their ranks.
From a supply-side standpoint, they are all wrong. Every last Nobel Prizer, Treasury Secretary and pillar of the Establishment. Nothing should be done about David Stockman's "outyear" budget deficits because they are simply figments of his diabolical mind. And nothing should be done on the monetary advice of these greybeards, whichever "side of the issue" they are on. That is to say, money shouldn't be "easy" or "tight," but fixed in value, and the dollar shouldn't be "hard" or "soft," but also fixed in value.
Another way of putting it is this: If the economic advice of any or all of these eminent personae became policy now and in the future as it has been in the past, the economy would suffer just as surely as it did in the past. They are all demand-siders and the demand model of the way the world works is a false one. The inescapable fact that their logical arguments can all be traced back to the same starting assumption—that the economy revolves around the consumer, not the producer—explains why they can all have such high IQs and blue blood and outstanding credentials and still be so systematically wrong in their counsel. This post-World War II crowd of American leaders was taught in school that the "flow of funds" through the consumer's pocket determines the unemployment rate and the rate of inflation. And they can't escape their training, especially when the most distinguished journalists of the print and electronic media—who were similarly trained in the demand model-broadcast their common cleverness.
The reason we remain optimistic about the future of the domestic and world economy, and the persistence of the bull market we are enjoying, is based on the belief that the demand model is going under. Agreed, the demand-siders seem amazingly energetic, but so is the drowning man who is about to go under for the last time. And it now takes an awesome amount of energy and effort for the Establishmentarians to keep the demand-side ground from slipping away from under them.
Look at all the trouble they went to in trying to persuade President Reagan that he had to raise taxes again this year, and see how little they came away with. On the front page of the Sunday New York Times of January 30, we learn that "Aides' Tenacity Led to Reagan Tax Shift" in a story by Steven R. Weisman. Weisman, who is one of Stockman's mascots in the Washington press corps, gleefully counts the process by which the President came to be overwhelmed by the pro-tax arguments of most everyone near and dear to him.
According to Weisman: "For months, President Reagan told his aides the same thing: he was not going to raise taxes to reduce the Federal deficit. Yet his aides persisted, virtually unanimously, in thinking that new taxes would eventually be necessary." George Shultz, the Secretary of State, was key figure in arguing that "the Federal deficit could prolong the recession" and of getting Reagan to agree to "a standby tax if the deficit did not fall fast enough."
Also according to Weisman:
By all accounts, Mr. Reagan accepted with great reluctance at least two other ingredients in the budget for the fiscal year 1984: a set of pessimistic projections on the economy, and a decision to trim, if only slightly, the planned growth in military spending.
In the view of many nonparticipants in the budget process so far, in Congress, in the public and even in the Administration, the path to these key decisions was hampered by Presidential aloofness and general disarray.
One would think that this would be cause for celebration at the Times, which had devoted itself promoting Stockman's deficit blatherings during the previous six weeks. Jonathan Fuerbringer of the Times Washington bureau actually announced the arrival of "structural deficits" on the Times front page with a certainty usually reserved for sunrise, sunset and Halley's Comet. But the Times isn't happy with the "key decision" of a President in "general disarray." In its lead editorial of Sunday the 30th of January, the Times complained:
The President declares the Federal deficit to be "a clear and present danger to the basic health of our Republic." There's a clearer, more present danger: That he will use political subterfuge, continue to steer economic policy in the wrong direction. Public Enemy No. 1 is not the deficit; it is the recession...
The "freeze," more slush than ice, would apply to Congressional appropriations, not cash spending. It would allow a 5 percent increase in overall appropriations to offset inflation, masking sharp rises and sharp cuts. The sharp rises are all in military procurement. The sharp cuts are all in domestic spending. In short, it's the old Reagan priorities packaged in a new slogan.
The contingency tax is hardly more than a slogan. It would include a temporary rise in personal and corporate taxes and a tax on domestic and imported oil. These taxes, proposed for a vote in 1983, would be effective in 1986 if, in 1985, it appears the deficit is not coming down fast enough—and only if the economy is growing. What a nice trick: Laying off taxes onto a future Congress and possibly a future President. The present Congress is unlikely to be interested in such tricks.
Of course it won't. And no wonder the stock market took a dive on January 26 when it got firm word the President would push his standby tax. No wonder it soared when it saw, close up, that the tax could not take effect unless six impossible things happened before breakfast. Stockman's mythical "structural deficits" will be met by Reagan's mythical "contingency tax."
The Times is irked because Reagan, despite his state of general disarray, has managed to wriggle off the hook. He's met all the concerns of the "realists," yet he's done nothing to actually "restrain the recovery." And if the Times and its followers remain unhappy with the pace of the recovery that is now underway, and urge Reagan into a more aggressive stance against Public Enemy No. 1, the recession, he can always propose further tax cuts.
The President was being playful with his frustrated adversaries when he suggested elimination of the corporate income tax and/or elimination of the capital-gains tax. Reagan doesn't have a Nobel Prize in economics, but he knows that elimination of these two low-revenue, high disincentive tax rates would blow the recession to bits. But because the idea would somehow be politically disadvantageous, identifying Reagan with "the rich," his aides rushed forward to hush him up. Not a word of encouragement came from the Times or any of the Nobel Prizers or Pete Peterson. How could they possibly embrace a supply-side remedy? If only the President had one Cabinet officer, senior staff aide or close friend in Congress who would support him in advancing such initiatives, he might be able to survive the arguments of the other experts around him. But he really is alone. Our vague hopes that his chief of staff, Jim Baker, was pulling with the President instead of against him on these issues now seem misplaced.
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Just how would the experts "get the country moving again"? The U.S. News & World Report interviews with the six demand-side Nobel Prizers is illuminating. Each of them represents views of a distinct political faction.
Milton Friedman leads off by saying the government should get money supply growth down to 5 or 6 percent this year and knock a point off every year thereafter until monetary growth is 2 percent, where it should be kept. This will "gradually eliminate the rest of the inflation in the system and permit a healthy recovery." Friedman also urges that the government attack "the big budget deficits on the spending side." And he would put money back into the people's pockets "with an honest-to-God, real flat-rate tax" that will reduce the cost of paying accountants, etc.
Friedman doesn't tell us what measure of money should be wrestled down into his new strait-jacket. But by any measure, his monetary proposal would certainly not get the country moving again, except if he means we would again be in the deflationary tailspin that led us into the current deep recession. Friedman lately has been joining one of his students, Alien Meltzer of Carnegie Mellon, in arguing for Fed control of the monetary base. Had the Fed been targeting the monetary base in the first six months of 1982, when it was expanding at a 10 percent rate at the same time commodity prices were in a nosedive, we could not have avoided international financial panic and collapse.
Superficially, at least, the Friedman position appeals to the creditor class, who think they somehow benefit by deflation, high real interest rates and a general decline in commodity prices. The position is still upheld inside the Reagan Administration by Beryl Sprinkel at Treasury, Larry Kudlow at OMB, and Bill Poole at the Council of Economic Advisers. But Martin Feldstein, for all his faults as chairman of the Council, is no monetarist, and is said to be playing an active role in blocking a revival of deflationary monetarism. In any case, Congress wouldn't permit another '81-'82 type squeeze.
The second Nobel Prizer to be heard from is MIT's Paul Samuelson. Teddy Kennedy and the traditional liberals reflect his views, or perhaps he reflects theirs. He would put more money into people's pockets by increasing "the money supply until we are definitely in a healthy recovery with an annual growth rate of at least 4 percent after adjustment for inflation." Samuelson says we shouldn't be paranoid about deficits, but because $300 billion projections are "sensible extrapolations of all we know about fiscal policy," the President should "recommend additional taxes that will take place in 1984, 1985, 1986."
The notion of having the Fed target a 4 percent growth rate "after adjustment for inflation" suggests the possibility of an economy growing nominally at 604 percent a year with an inflation rate of 600 percent. But Samuelson assures us that it's "nonsense" to suggest this will lead to "banana-republic hyperinflation." He also tells us we're an "undertaxing nation," which suggests he's been reading George Will's columns in Newsweek. Fiscal policy should take money out of people's pockets and the Fed should put it back in. Samuelson's economic primer, an influence on policymakers since the 1940's, has been instrumental in elevating the concept of an unemployment/inflation tradeoff, the so-called "Phillips Curve." His remarks in USN&WR still insist that a little bit of inflation is good for the system, an idea that Paul Volcker had the good sense to reject in his Joint Economic Committee appearance on January 27.
George Stigler of the University of Chicago represents the laissez faire segment of the political spectrum. He tells us in USN&WR that "there's nothing that monetary or fiscal policy or anything else can do to raise total employment in the United States in the near future." Stigler, who is not a serious student of the national economy and does not advise politicians, reflects a conventional, "conservative" viewpoint. We should "eliminate large swings in the money supply." And, "a substantial recovery will reduce the deficits substantially by raising tax revenues and lowering spending. But we'd still have a residual deficit that should be wiped out—the sooner the better, in my opinion." Professor Stigler reads the newspapers.
Lawrence Klein of the University of Pennsylvania is a state capitalist who favors national industrial plans and the like. But on monetary and fiscal questions, he thinks "A lot of the trouble that we're in now is due to monetary and fiscal policy operating at cross purposes," with tax cuts and spending policies putting money into people's pockets and the Fed taking it out. Klein suggests the exact opposite. No kidding.
Kenneth Arrow of Stanford, like Stigler, doesn't hang around policymakers. But he likes the idea of monetary ease and a "higher level of taxation." Still, he thinks "marginal income-tax rates are too high" and to avoid their adverse effects, "all forms of savings, including investments," should be exempt from taxation. People should be allowed to keep financial assets in their pockets as long as they don't spend it. Arrow's tastes reflect the views of the capital-formation crowd and can be found among Pete Peterson's coalition. Peterson wants to raise taxes on "consumption," which is the old commercial Keynesian idea. (Don't tax a businessman for selling a widget to his customer. Tax the customer for buying a widget from the businessman. That way you get more "capital formation.")
Last but not least in the USN&WR gallery of Nobel Prizers is James Tobin of Yale, who is the neo-Keynesian architect of the policy mix so popular among "moderate" Democrats: monetary ease and fiscal tightness. The Fed should ease, and because there is so much idle labor and industrial capacity, the increase in spending will be absorbed "by expanding production and employment rather than by major tax increases." Thus, in the near term, "the President is quite right in wanting to let the 10 percent tax cut scheduled for July 1 stand." We don't need to take it out of their pockets quite yet. Worry about deficits later in the decade when unemployment is down to 6 or 7 percent. But "recovery can't occur without a further relaxation of monetary policy," says Tobin. If the Fed can't put more money into people's pockets, nobody can.
Tobin's inflationist arguments are also represented in the quintet of former Treasury Secretaries. Michael Blumenthal is still talking about devaluing the dollar as the key to it all. But his buddy in the Bipartisan Budget Appeal, William Simon, would love another round of deflation. It all depends whether you line up with debtors or creditors. Tobin is easily the most influential of the academic Keynesians because he's willing to argue that monetary ease isn't very inflationary in a recession, enabling policymakers to concentrate monetary and fiscal instruments on the recession. But Tobin "recoveries" are illusory. Consumer demand picks up as people realize the government is devaluing the paper currency, not because the government has provided a healthier monetary and fiscal environment for capital and labor.
Paul Volcker leans against the Tobin view of monetary ease, which is why Senator Kennedy tries to take him to task. But Volcker can't seem to imagine a world in which there is no inflation and full employment either. He's trapped on the bend of the Phillips Curve, which purports to demonstrate the automatic tradeoff between inflation and unemployment, a modern artifact of the consumer-driven model. Economic growth is inflationary. This comes across clearly in his tortured austerity speech of January 20 before the American Council for Capital Formation, which surely helped nudge the stock market into a brief tailspin: "It is tempting to suggest that the budget problem is a statistical artifact related to 'pessimistic' economic forecasts and can be eliminated by stronger economic growth than is expected by most forecasters. But that is wishful thinking, under any reasonable forecast and without further policy adjustment, the deficits will remain historically huge unless we make the unacceptable assumption that we will also revert to an historically high inflation rate."
Volcker thereby accepts the idea of a "structural deficit," as concocted by David Stockman's OMB shop. To Volcker, this means that two-thirds of the $200 billion federal deficit for 1983 is "cyclical," and can be eliminated by economic growth. But the rest is "structural," which is "the imbalance that would remain even if the economy were operating at a fairly high level."
Because each percentage point of unemployment counts for $40 billion of the deficit, Volcker is really accepting the idea that "full employment" is now 8 percent; to get to 6 percent unemployment, which would theoretically eliminate the entire $200 deficit, would require a renewal of wage inflation. In this model, you see, economic growth can't cure deficits, but inflation can.
The argument is complex enough to sound smart, and one has to think it through to realize it is baloney. A truly ridiculous line of reasoning now comes from Rudy Penner, who was chief economist at OMB back in President Ford's day and is now angling for Alice Rivlin's job at the Congressional Budget Office. Penner, a commercial Keynesian, warns in the January 31 Washington Post that the economy is going to grow much faster than the Administration thinks and therefore taxes have to be raised in a hurry! "With growth more vigorous than expected, the need to reduce the deficit becomes even more urgent." As in the Tobin line of reasoning, you see, deficits are okay as long as the economy is in recession. But when it's not, deficits are bad. Where Stockman and Feldstein want to raise taxes because the recovery will be slow, Penner wants to raise taxes because it will be vigorous. And get this: "Even if the unemployment rate magically fell to 5 percent, we would still have a deficit above $50 billion by 1985... In other words, we cannot grow ourselves out of this problem." Wait a minute, Rudy: Six unemployment points times $40 billion equals $240 billion.
Volcker actually has a variation on this theme in his January 20 speech, where he allows that the current budget deficits are acceptable because they are "supporting incomes." But they will become inappropriate in future "prospering years," so that such prosperity can not "be sustained for long." But he doesn't draw the logical, albeit paradoxical conclusion, that if prosperity wanes because of the deficits, the deficits will be needed again to support income. Does our Fed chairman, who some say is the most powerful man in the world, really believe that (1) deficits are good until they cause inflation and (2) inflation cures deficits? But such is life in the consumer's pocket.
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Where does this leave us? It can be very easy to turn sour if we simply add up all the nonsense and palaver being spouted by the nation's wise men and opinion leaders. But if we concentrate on what's really happening in the economy and to the shaping of policy, it's hard to not be optimistic. The sunniest economic indicator on the political front may be Rudy Penner's "warning" of economic boom. President Reagan's mythical standby tax is already being dismissed as a waste of effort on Capitol Hill. To imagine that Reagan will be talked into a formal tax hike, on imported oil or an end to indexation, was possible only if it could have been achieved quickly, before the recovery was evident. But Reagan wriggled off the hook and it will take many months before it can be baited again. By then, the recovery that Penner worries about will be all too evident, and it will be impossible to talk Reagan into worrying about the dire effects of 5 percent unemployment. Nor are we going to worry about monetary policy anytime soon. Volcker's too close to the end of his tenure to do any serious inflating or deflating. As long as he can point to Nobel Prizers on both sides of that issue, he can sit it out in the middle, and for the time being that's not a bad place to be. Sooner or later, though, we expect he'll react to the upward drift of the price of gold and its inflationary expectations. But when?