Executive Summary: The White House assumes that changes in its basic economic program have to be made by April 1, more or less, in order to show results in time for the November elections. The deficit-inspired hysteria in Congress, hyped by widening talk of "Depression," invites fiscal solutions that would only deepen the recession and heighten deficits. Republicans won't suffer in November as long as they resist Democratic advice and stick with Reagan. A Volcker policy shift away from monetarism, lower interest rates, could still bring major GOP gains. The Reagan-Volcker meeting of Feb. 15 may have planted the seeds for policy change, a gamble on interest-rate, exchange-rate targeting following the Bank of England's move away from monetarism.
Prospects for Policy Change
This coming April 1 is said to be a political deadline at the White House. There is an assumption that economic policies have to be in place by that date, more or less, to have a positive impact on the November congressional elections. The assumption is doubtful, in the sense that the electorate can and often does respond to a policy change at the 11th hour, positively or negatively, depending on its evaluation of the change. Political markets can discount as efficiently as financial markets via "rational expectations" Still, if policymakers impose deadlines on themselves activity intensifies as the deadlines approach, and the activity around the President's economic program has already intensified to the point of hysteria. Civilized discourse has become the exception rather than the rule on Capitol Hill and there is a general impression of politicians running in circles and shouting that the sky is falling. On February 28, both the Sunday Washington Post and New York Times helped matters along with hand-wringing "think" pieces about the coming Global Depression. Of course, the supply-siders are to blame.
A week earlier, White House chief-of-staff James Baker III inadvertently contributed to the madness when he told a Face the Nation reporter that he would consider it a victory of sorts if the GOP lost no more than 38 seats in the House this November, because that is the average number lost in the midterm elections by the party in control of the White House. Baker's demeanor was so defensive, so defeatist, that it seemed the White House was conceding deep losses. Congressional Republicans seemed to take this as a sign of the President's weakness and there were immediately new attacks on his economic program by the Senate GOP leadership and by some in the House. Senate Finance Chairman Bob Dole and Senate Budget Chairman Pete Domenici are almost frenzied in their focus on the projected federal deficits as the cause of the recession instead of the result. At the end of March, when the debt ceiling must be lifted, Dole and Domenici now threaten to block the legislation unless their tax increases are appended as riders (really threatening to shut down the government in a repeat of last fall's adventure). Senate Majority Leader Howard Baker Jr. began signing up colleagues behind a 10 percent income-tax surcharge proposal, which seemed to invite a 20-point plunge of the DJI on February 22 (after the market opened up 7 points). House Minority Leader Bob Michel, panicky over the thought that he might fail to get any budget through, joined the taxers out of sheer frustration and said he would support a postponement of next year's income-tax cut.
In all this fiscal frothing, though, there is much less than meets the eye. When the President in January made his basic decision to oppose a change in his tax program, the White House knew it had to brace itself for several weeks of pandemonium on Capitol Hill. But the administration strategists assumed that Congress would be forced to climb the same "decision tree" that the administration budgeteers had climbed, and for all the shrieking and shouting would come out at the same place. There will be moments of high drama along the way to periodic confrontation points (maybe there will be another "shutdown" of the government). But because there is no consensus for an alternative, the President does hold "the whip hand," as one of his senior aides puts it.
It is not even clear that the Republicans are in grave danger of serious losses this fall, even with the deficits, the unemployment, the recession. Bill Anderson of the Independent Petroleum Association of America, one of the best political handicappers in Washington, says that if everything stays the way it is at the moment the GOP will break even on House seats in November.
"The Democrats have no program, they have no money, and they have no candidate recruitment program to speak of," he says. "They can't criticize Reagan, because he's still tremendously popular. And where the unemployment lines are the longest, the Republicans don't have seats now and didn't have much chance of picking up seats anyway. If interest rates came down some, the Republicans could still swamp the Democrats in November. The big thing is that Reagan has the only program. The reason there's so much distress on the Hill is that Democrats and Republicans look at each other and see a mirror image, and they're horrified."
What could have disrupted this political assessment would have been a victory in January by Stockman, Dole, Domenici et al, to aim the GOP artillery at the federal deficit and away from economic growth. Paul Craig Roberts was exactly correct in his Wall Street Journal essay of March 3 that "Democrats and Keynesians who know better are egging on the policy of simultaneously reducing both credit and cash flow, because they see in the brewing depression the destruction of their Republican and supply-side rivals."
The report that Senator Domenici was conferring with Harvard's John Kenneth Galbraith, who the senator said was alarmed at the size of the deficit projections, recalled President Ford's economic "summit" meeting of 1974, when Galbraith advised Ford to raise taxes via an income-tax surcharge of the kind Senator Baker proposed recently. A surcharge of this type is the worst kind of tax, to a supply-sider, because it amounts to a progressive tax on top of a progressive tax and has a double disincentive effect. As President Ford swallowed the advice (Alan Greenspan was his chief economic adviser), the Dow Jones Industrials sank to their low point of the decade in anticipation of the deep recession that followed, and the GOP lost 40-plus seats in the November 1974 elections. A year later, uncharacteristically, Galbraith wrote an essay in the New York Times saying he had been wrong in his advice to Ford, by gosh.
This is not to suggest there is an explicit conspiracy to feed bum advice to Presidents and Senators. But that's just the way things work out as economists and politicians strain to differentiate their products in the zero-sum political marketplace. In 1978, Milton Friedman, who had proclaimed for decades that he would support any and all tax cuts in order to starve public spending, came out against the Kemp-Roth bill, which was narrowly defeated on the House floor, because it was designed by his supply-side rivals. Yet now, his spokesman in The Wall Street Journal, Lindley Clark, Jr., credits Professor Friedman with the intellectual godfathering of the Reagan tax program. On February 16, he wrote that "Milton Friedman, sort of an intellectual uncle to the administration, assured us that the only way we could ever shrink Federal government was to reduce its tax revenues. ..."
Paul Craig Roberts, who considers himself the intellectual godfather of the supply-siders (so does Treasury Undersecretary Norman Jure), must also differentiate his product in order to stake his claim. In the February 22 Fortune, Roberts writes that "None of the supply-siders in the administration were 'Lafferites,' promising higher revenues from lower tax rates." But later in the article he makes a purely Lafferian observation: "Assuming that the cost of recession will be of average severity, with real growth resuming in the late spring of this year, tax receipts will be lower by some $35 billion in fiscal 1982 than they would have been if economic growth had continued as expected." Roberts also continues to position himself carefully on the right side of Milton Friedman, echoing the monetarist criticisms of Fed Chairman Paul Volcker. He worries that the President's apparent embrace of Volcker on February 15 will keep attention focused on fiscal policy, however, which is hardly a monetarist concern.
From the standpoint of the political market, and perhaps the financial markets too, the Reagan-Volcker meeting may prove to be extremely important. The President and Chairman met without a third party, so the details have not leaked. But the net result of the session so far seems to be that the White House will stop casting aspersions on Volcker and Volcker will support the President's fiscal program, including opposition to those who would defer the third year of the personal tax cuts.
On the political side, the meeting is worrisome. In closing down his criticism of the Fed, the President has dealt away a card that the GOP could have been playing in the congressional campaigns. And in return Volcker acquiesces to a fiscal policy that he can't really change anyway. There seems to be no percentage. Indeed, soon after Reagan's embrace of Volcker, Yale's James Tobin, who has more influence on Democratic Party economic policy than any other economist, came out swinging against Volcker and the Fed.
"Tobin Says Fed Imperils Recovery," ran the headline in the back pages of the Feb. 25 Times.
"Monetary policy brought the high interest rates," Professor Tobin said. "Those rates crowded out investment and all kinds of interest-sensitive demand for goods and services. This collapse produced the recession, and the recession ballooned the deficit for this fiscal year.
"The only sense in which this year's fiscal policy, including the first two installments of tax reduction, is responsible for today's interest rates is that by keeping the economy from being even weaker, it prevents interest rates from going a bit lower.
"In short, it is not that monetary policy is colliding with fiscal policy -- it is colliding with the economy. Monetary policy would block full recovery whether the demand fuel for recovery were government spending for defense, private spending of tax cuts or entitlements, or spontaneously buoyant private investment or consumption."
Yes, it's all very clear. The Fed caused the high interest rates which caused the recession which caused the deficits. And now what do we do Professor Tobin?
"Professor Tobin said the Fed could relax its monetary stance without rekindling inflation if its action were coupled with measures to reduce Federal deficits.
"He proposed eliminating a 10 percent cut in tax rates scheduled for July 1983, reducing defense spending plans by $10 billion a year, imposing $10 billion in "windfall profits'1 taxes from a decontrol of natural gas prices and raising another $10 billion by closing tax loopholes."
Yes, it's all very clear. The deficits cause the high interest rates by causing the Fed to tighten to fight inflation, thus causing recession which causes deficits, a process that can be halted by raising taxes in order to permit the Fed to ease.
Taken together, Tobin's prescriptions don't seem to fit the diagnosis, but at least they further confuse the politics surrounding the President's economic program. Tobin can't be accused of "scape-goating" by laying the recession and deficits at Volcker's door, and Reagan partisans will surely find his remarks useful in defending the tax program rather than, as Tobin suggests, dismantling it.
We begin to sense, though, that Reagan is not really interested in scapegoating or defensive maneuvers, and that his meeting with Volcker may have involved a political gamble on Reagan's part. Far better than an excuse on why his program isn't working is, after all, a program that is working. To accomplish that, at least in our model, requires the abandonment of monetarism as a framework for policymaking at the Fed. Oddly enough, Volcker has always agreed that the monetarists and their money targets are an impediment to progress. On February 9, coincidentally the day the bond market rally began, Volcker wrote me a note that commented on the "unfortunate debate on the mechanics of monetary policy" that has "obscured the real issue about whether the demand instability of a particular arbitrarily defined money measure should matter so much."
This indeed is the "real issue," the M1 paper cross that has crucified the economy since October 1979 and in a less direct way all the way back to the early 1970s. In the supply-side model, a real economic expansion from the current depressed levels would increase significantly the demand for M1 and the supply would increase through private creation and shifts from less liquid M forms. For M1 to increase because of real demand is a positive development, yet according to the monetarist formulations it must be suppressed by the Fed's interventions.
The Bank of England last August shifted away from its M target and began targeting the European exchange rates, leaving a quantity rule for a price rule. The idea of linking floating currencies together through central bank exchange rate targets - the "snake"--is really unsatisfactory without a reference point, which is what the gold standard does for the system. Imagine a convoy crossing the Atlantic without compass or stars. Yes they stay together but they may travel in circles without ever knowing it.
In this sense, the abandonment of M1 targets to a price rule around gold is the least risky solution but also the least likely. There is now far more open discussion about the failure of monetarism as a policy guide. But the likely path out of the woods seems to be the same one that brought us into the woods, which means a retracing of steps past the October 1979 guidepost and a re-targeting of interest rates, also with co-ordination of European exchange rates. And there are rumors leaking out of the Fed that something of this sort is afoot. In his February 24 Polyconomics paper, "Policy Shocks: The Impact on Interest Rates" Alan Reynolds concluded that such a shift in targets might help to initiate a significant decline in interest rates, and in the current environment of gloom and doom even a minor decline would be celebrated. There is, admittedly, less optimism among other supply-siders who believe the transition must be to gold.
In any case, the first step of any monetary policy change will have to be away from monetarism and its "arbitrarily defined money measures." Volcker's difficulties with the supply-siders has not been his allegiance to monetarism, which he in fact scorns, but his practice of it while directing blame for high interest rates at the deficits, in turn caused by the high interest rates.
It is nice to imagine the President's Feb. 15 meeting with Volcker turning on the real issue, with Volcker ridiculing the whole notion of chasing the M's from pillar to post, and having the President agree with him. Just as Margaret Thatcher must have decided after the July 1981 riots in London that the Friedmanites were too expensive to keep around, so we have been waiting for Ronald Reagan to come to the same conclusion.
The Friedmanites still seem to be in command in and around the White House. David Stockman's budget message was a monetarist tract. Murray Weidenbaum's economic report was a monetarist tract. And Treasury Secretary Donald Regan seems to be checking his M's with Beryl Sprinkel every day. The only visible sign of distress came from Jerry Jordan, the Friedman disciple on the Council of Economic Advisers, who told Jane Bryant Quinn in the March 1 Newsweek: "What hurts us most is the public perception that monetarism necessarily means higher interest rates, which isn't the case." Except that Jordan can not tell us about a greenback period anytime in the history of mankind that was not accompanied by high interest rates. He did promise lower interest rates in the future with "a little help from lower deficits, lower government spending and better money policies at the Federal Reserve."
Our rule of thumb here, though, has been that we would not see a secular decline in interest rates until we first saw the decline of monetarism. "Sprinkel down, bonds up." The bond market's current surge is said to be based on the economy's weakness, and certainly there has been no confirmation by the stock market of a breakout. But there seems to be a whiff of policy change in the air, and it could be the change we've been waiting for. Surely we'll know more by April 1, a political deadline of sorts as well as April Fool's Day.