Budget Summitry Jude Wanniski May 17, 1990

The early maneuvering by White House and Democratic leaders at the budget summit continues to suggest, to me, the futility of the process. The Bush team is of two minds: Budget Director Richard Darman represents the "Let's Make a Deal" faction, lest the administration be forced into a massive $100 billion sequestration that will be very painful; Chief of Staff John Sununu represents the hardliners who argue the White House should be prepared to walk away from the summit and sequester.

The common problem with both factions is that they both think the budget deficit is so serious a problem that major spending cuts are required. But the deficit is not the problem they think it is. Of the players in the White House, only Michael Boskin understands that the deficit is an inflationary illusion. That is, inflation is reducing the real burden of the $3 trillion national debt by $150 billion per year. This means $150 billion has to be added back onto the government's burden, or the people will have the burden of paying off that amount of debt out of existing income. Adding that amount in through monetary ease isn't a solution, because easy money is the cause of the inflation to begin with.

Another way of putting it is this: If we were now to balance the budget amidst a 5% inflation rate, we would be achieving the equivalent of a $150 billion budget surplus, paying down the national debt by that amount. "We're not Keynesians around here," one of Boskin's staff economists told me Tuesday in Washington, "but that's an awful big hit for the economy to take." In his news conference yesterday, the President also hinted that hitting the targets by these amounts might do more harm to the economy than good. Economists advising the Democrats know what's going on here. House Budget Chairman Leon Panetta says that "You may not be able to save that much without harming the economy in some way."

In the Keynesian model, this would be called fiscal drag. In a supply model, think of the collapse of economic incentives involved. In the extreme, as in Argentina, where this kind of policymaking has been followed, imagine that we would decide to pay off most of the $3 trillion national debt through monetary policy, the equivalent of 8 billion ounces of gold. A hyperinflation of 1000% for a year would shrink this to 8 million ounces, the equivalent of $3 billion today. The nation's creditors would have lost almost all their wealth, insofar as they were holding government or private bonds. With the government's credit shattered, it could be expected to raise taxes to finance the costs of general government, which we might also expect would soar in this example. The country's most productive citizens, who have had their wealth confiscated in the hyperinflation, would not be able to take an increase in taxes.

The scale we're talking about in the United States is of course much smaller, but the pain of running an inflation-adjusted $100 billion surplus through sequestered spending cuts would trigger a recession, and severe losses for the GOP this November. Indeed, it has long been my belief that the voters will not trust the Congress to the Republican Party until the GOP understands this phenomenon. Instead, we still have the legacy of the Old Guard, which sees the budget confrontation as an opportunity to forcibly shrink the size of the government. The electorate, I'm sure, does not want the size of the government shrunk, except in a relative sense, through economic growth.

Martin Anderson, who served as an economic advisor to President Reagan, put it well in an excellent op-ed essay in Wednesday's New York Times:

How bad is the Federal deficit? The deficit, as a percentage of the gross national product, has fallen steadily since 1985 (when it was 5.4 percent) to an estimated 2.2 percent for 1990. Even with the latest "the sky is falling" estimates, the deficit would still be only 2.6 percent of GNP in 1990 and 1.5 percent in 1991. We have had deficits in this range many times before... The same is true of Federal debt. As a percentage of GNP it has been falling in recent years and now stands at about 40 percent. That is lower than at any time from 1945 to 1965. It was not a serious problem then, and it is not a serious problem now.

The reason for the budget summit is that the participants believe the deficit is in fact a serious political problem. My current optimism is based on the belief that the summitry will fail, as it becomes clear that the Democrats have no intention of agreeing to serious spending cuts on either social programs or pork barrel defense, and at the same time swallowing new consumption taxes and a cut in the capital gains tax.

Darman was in a much stronger position last October, when a modest sequestration was directly linked to the capital gains bill that had passed the House and was being blocked by Senate liberals. As the spending cuts bit, at least the President could have argued the pain was tied to the stubbornness of the Democratic liberals in blocking capgains on procedural grounds. Now, with that linkage broken, the Democrats seem quite prepared to let the White House stew in its own juice. A $100 billion sequestration would send hordes of blue-collar and black Americans who have been enjoying the GOP prosperity back into the arms of the New Dealers.

At Tuesday's summit session, we saw the Democratic leadership inviting the President to address the nation on the budget issue, to present his detailed plan. They know the Darman strategy has run aground, and the President is trapped by the budget bogeyman that Darman has used to force a summit. The President can not list the spending cuts and tax increases he desires in order to meet the Gramm-Rudman targets without looking like Herbert Hoover. If he refuses, as so far he has, the path leads toward sequestration and bigtime Hooverville.

The alternative strategy that could be deployed as soon as Darman's string runs out would involve the President accepting the Democratic invitation to address the nation. He would then be able to make the case that the deficit has swollen because the Democrats blocked his capgains proposal last October, that he invites them to immediately bring the House-passed bill to a Senate vote, and that because of the delay he asks Congress to defer the Gramm-Rudman targets for a year in order to avoid the severe spending cuts that would most afflict the poor and the elderly. If you wish to know what the Democratic response would be, you need only contemplate what such a speech would do to the prospects of Republicans in the congressional campaigns. The GOP would have both sides of the bread and butter issues, taxes and spending.

At a Washington conference Tuesday, I engaged in a mini-debate with Ohio's Senator Howard Metzenbaum, who had made a little speech on the terrible costs of the S&L crisis and how President Bush continues to add to the costs by pushing out William Seidman, who Metzenbaum admires. The Senator also allowed as to how the insurance industry might have to start marking to market its poor-performing assets, to protect the people.

I asked him if he had considered that by blocking President Bush's capital gains proposal last October, the Senate liberals had caused the value of all capital assets to be lower today than they would otherwise be — bonds, mortgages, commercial real estate, etc. And I asked if he realized that had the capgains proposal passed, the portfolios of the S&Ls and the insurance companies could be marked to market above water instead of below water, and the taxpayers would be saved many tens of billions of dollars.

Metzenbaum clearly was flustered. He'd obviously never encountered the argument, and so jumped around nervously declaiming against a capital gains cut as a boon to the rich, and that he would do everything he could to prevent its enactment. When he ended his long harangue, I said: "Then you reject my argument that if you had not blocked the cut in October, the taxpayers would now be saving tens of billions of dollars in the S&L bailout?" Now really flustered, he blurted that the positive effects would only be temporary, and that I really didn't know what I was talking about. Suddenly composing himself, he apologized to me two or three times, saying he did not intend to "insult" me. I said it was quite all right. "I'm a supply-sider, Senator. I'm used to insults."

It will not take much for the President to get the entire Democratic Party tangled up in just this fashion. I think it's only a matter of time.