The Budget Debate: 1932 Again?
Jude Wanniski and David Goldman
January 15, 1993


With the death of demand management, macroeconomic thinking tends to revert back to pre-Keynesian prejudices about budget deficits. In the last U.S. presidential election before the Keynesian revolution, remember, Herbert Hoover and Franklin Roosevelt offered competing plans to balance the Federal budget. Some Clinton advisors have proposed a combination of tax increases and spending cuts totaling $200 billion by the end of Clinton's first (and, in this scenario, last) term, the Los Angeles Times reported January 14. As Sylvia Nasar reported in the January 14 New York Times, Keynesian "benign neglect" toward the deficit is discredited. The trendiest Democratic economists now call for Hooverian budget austerity, using a technique called "generational accounting" to translate present trends in the deficit into future tax rates. The University of Pennsylvania's Alan Auerbach, a favorite of past New York Times attacks on a capital gains tax cut, helped invent the notion. Auerbach and his collaborators say that the next generation will pay an average tax rate of 71% if Federal debt keeps accumulating at present rates.

The post-Keynesian "neo-classical synthesis" concocted at MIT's economics department appears to have returned full circle to the "classical" position which Keynes ridiculed. Auerbach's idea of accounting for the effect of future deficits goes in the right direction, but straight-line projections of present trends are a very poor way to go about it. Economic policy can't do much to change deficits in the short-run, nor should it try. The most important criterion for present policy is the way it affects expectations about future income. The market gauges the impact of present government debt against the expected future income available to pay the real cost of debt service in the future. What counts is not the ratio of net Federal debt to Gross Domestic Product, but the ratio of expected debt to expected future national income. The "neo-classical" argument claims that government deficits soak up private savings, an argument which is so simplistic as to bear little relation to reality.

Two factors must be kept in view. The first is inflation, which benefits debtors (e.g., the Treasury) at the expense of creditors. Even 3% annual inflation wipes out $100 billion of national debt in real terms. The second, which is of far greater magnitude, is the volume of capital gains or losses in financial markets. By definition, a capital gain or loss is equivalent to a revised estimate of future income streams. During the 1980s, private assets increased by an average of $2 trillion per year, largely due to improved expectations about the economy's future prospects. At the DJIA low in 1978, the U.S. economy was selling at liquidation value; after the Reagan tax cuts and the Fed's shift towards disinflation, all private assets reflected buoyant growth expectations. Most of the $2 trillion annual increase in private assets reflected capital gains, i.e., the discounted present value of higher expected income streams. Because the IRS would take over 20% of those future income streams, this increment in private assets translated into an expected increment of future tax revenues with a present value of several hundred billion dollars per year. For this reason, bond investors were unperturbed by the budget deficits of the Reagan years.

Policies which raise expectations about future income, i.e. generate capital gains, increase the demand for government securities, for two related reasons. First, higher expected private earnings translate into higher government revenues; this is why higher stock prices consistently favor lower bond yields, contrary to the conventional account. Financial market commentators are befuddled by the bond market's consistent failure to follow the "Phillips Curve" trade-off between inflation and growth. As we have shown, bond yields change with expected inflation and the inflation risk premium, best measured by gold market signals. Once we isolate the inflation factor in our model, it is transparent that bond yields fall with rising growth expectations.

Second, portfolio diversification also causes higher growth expectations to increase demand for government debt. The largest capital gains are obtained in the riskiest investments, e.g., low-cap stocks as opposed to high-cap stocks. Higher valuation of the riskiest assets thus shifts the average composition of portfolios towards risk. As some of the winners "insure" their positions by "cashing in" some portion of their winnings, they will diversify towards more secure assets, such as Treasury securities. Suppose you own $1,000 of Treasury bills and $1,000 of Microsoft. Your balance between "risky" and "secure" assets is 50:50. A policy change then raises growth expectations, and Microsoft doubles. The ratio of risky to secure assets is now 100:50. Even if you wish to shift your portfolio to higher risk, say to 60:40, you will have to buy more Treasury bills.

For the same reasons, policies which lower growth expectations must reduce demand for government securities. (DG)

CLINTON'S CAMPAIGN PROMISES: There is much hullaballoo about Bill Clinton systematically retreating from all his campaign promises prior to the Inauguration. The fact is, Clinton was elected despite his campaign promises, the electorate being forced to disgorge George Bush from the White House and unable to handle Ross Perot's idiosyncrasies. There are no promises he made that he can't break or bend that will cause him the kind of punishment the voters gave Bush for breaking his tax pledge. Campaign promises have to be weighed in light of the election returns, and Clinton's 43% was a go-slow signal. The most serious promise made and now bent was to reverse the Bush policy on the Haitian boat people. At the time President Bush enunciated the policy, I felt this alone meant the bankruptcy of his administration since Haiti, our neighbor, is the poorest spot in his hemisphere largely because of the economic advice the American government and its agents in the International Monetary Fund have foisted on Haiti over the years! Clinton is correct to bend his promise now, as it makes no sense to accept refugees when, with a little effort, the Haitian economy can be pointed in the right direction. I've urged Clinton's people for several months to think of sending a private task force to Port au Prince to advise the government on how to get the economy functioning. Just keep the academic economists and government bureaucrats out. There is precedent. In 1981, immediately after the inauguration of Ronald Reagan, David Rockefeller led a delegation to Jamaica to advise that sorry spot on economic policy. Of course, the advice delivered led to riots soon thereafter, which suggests that David Rockefeller should not be asked to lead a group to Haiti. An entrepreneurial capitalist with an understanding of finance would quickly find three dozen easy things to do to turn the boat people around. (JW)

MICKEY KANTOR, who is Governor Clinton's nominee to be US Special Trade Representative, is under heavy fire from the Establishment because he does not have experience in trade. No less a personage than David Rockefeller -- yes, David himself -- roused himself from his rocking chair to fly to Little Rock to protest the Kantor appointment. Of course, this suggests Kantor is just the right man for the job, as he is not automatically programmed to negotiate the interests of the Big Banks and the Business Roundtable. (JW)