Theory and Policy; Mundell to Reagan
This semester's emphasis is on the political side of the political economy, which affords me the special opportunity this week to discuss Robert Mundell's Nobel Laureate in economics and how his theories elected a President and changed the world. In the week since his prize was announced, there have been a great many stories about Bob and the influence of his work, some close to being accurate, most missing by a mile. Because I was essentially the transmitter of his academic ideas into the rough-and-tumble political arena, I'm in the best position to discuss the nexus and how it happened. This lecture doesn't exactly fit into this semester's sequence, but in a large sense, it is a perfect example of how a politician -- trying to get elected President of the United States -- has an advantage over his competitors if he has a Mundell at his elbow at just the right time. I've said that Ronald Reagan would not have been elected President without Mundell's influence. People scratch their heads wondering how that could be so, especially since Mundell and Reagan never met. So let me tell you how it happened.
In 1970, as the political columnist of the National Observer, the now defunct Dow Jones newsweekly, I felt disadvantaged in covering the big economic issues, because I never studied economics in school and did not know offhand the law of supply and demand. Early that year, I was forced to learn a little, the hot issue in Washington being the economic assumptions underpinning President Richard Nixon's proposed budget for fiscal 1971, which would begin in October 1970. The controversy raged over the administration assumption that GNP in fiscal 1971 would hit $1.065 trillion. The number was higher than that of any private economist and became the subject of ridicule when it became known that it was the product of the 30-year-old chief economist of the Office of Management and Budget, Arthur B. Laffer. The news media were soon filled with heavy analytical pieces about the method Laffer had used to hit that number. As I recall, the lowest guess by any of the noted private economists being surveyed was by Alan Greenspan, president of Townsend Greenspan & Co., a Wall Street consulting company. His guess was $1.024 trillion.
It seems odd now that such a controversy should have erupted over a projection, but the number really was about whether Richard Nixon would get re-elected or not. Fiscal 1971, after all, stretched all the way to the end of September 1971, the beginning of the next presidential election year. If the economy would grow as fast as all that, it was assumed Nixon easily would be swept back into office. As a non-economist, all I could gather was that Laffer was saying if the money supply grew at such-and-such a rate, it would translate into a GNP of $1.065 trillion. It seemed as if all the Fed had to do would be to print money at a faster rate, and the economy would grow faster and Nixon would be re-elected. The ridicule came primary from the Democrats, who said this was "Arthur Laffer's Money Machine," which would miraculously turn greenbacks into a cornucopia of goods and services.
It seemed odd to me then, but what did I know? So I called OMB and asked to speak to Laffer. I told him I knew nothing about economics, but wanted to learn as fast I could, so I could understand the controversy. Instead of hanging up, he said I was the first reporter to call and ask for a lesson, that all the others thought they knew about it all beforehand. He invited me to lunch and we went to a now defunct Eddie Leonard's Sandwich Shop a block from the White House. Laffer informed me cordially that he really did not predict $1.065, but that he had drawn up a table showing that if the measured money supply grew at any of a dozen different rates, the rates of GDP could more or less be known within narrow ranges. His boss, OMB Director George Shultz, wanting to get Nixon re-elected, picked out $1.065 as a good, high number that suggested a fast-growing economy, and it was factored into the overall economic program for fiscal 1971. It would then be up to the Federal Reserve, then chaired by Nixon's buddy, Arthur F. Burns, to print money at the rate demanded by $1.065. While gnawing on his sandwich, the roly-poly Laffer cheerfully informed me that it was not easy to get the money supply to grow that fast, but he was a good soldier, and would explain to all the relevant committees of Congress that the correlations were correct.
In the months that followed, I could not discuss the economy with any of the Nixon political people without hearing grumblings that Fed Chairman Burns was not increasing the money supply as fast as was needed. Meanwhile, the international currency-exchange markets were in constant turmoil. There seemed to be a crisis a week over the deutschemark, which was trying to become stronger than the dollar, which was not supposed to happen under the 1944 Bretton Woods Agreement. In those months from February to August, I talked to Laffer several times, never really understanding what he was talking about, but now and then getting a quote I could use in my column to make it sound like I was in the know.
It was on August 15, a Sunday, that I heard on the radio news that Nixon had made a major announcement from Camp David. He was imposing wage and price controls. He was imposing a tariff surtax on imports to discourage them. He was cutting various nuisance taxes. He was devaluing the dollar by 13% or so against the Japanese yen. And he was closing the gold window, whatever that was. The next day the stock market boomed and it seemed the crisis in the international currency markets had come to a happy end. Because among all the reporters at the National Observer I had seemed to be in the know on economic stuff, I was assigned to write the big story for the following weekend's Observer. I immediately called Laffer and he invited me to lunch that day, the 16th, a sunny Monday. This time I took him to a fancy French restaurant, where he told me the most important thing Nixon had done was to close the gold window. He said he had been opposed to the idea while on the gold committee to which he had been assigned in drawing up the package. (Paul Volcker, the Treasury Secretary of Monetary Affairs was another. Ken Dam, a White House lawyer who went on to become provost of the University of Chicago law school, was the third.) My recollection was that neither Volcker nor Dam wanted to close the gold window, but they had been overruled at Camp David by the "Gray Beards" and Treasury Secretary John Connally.
My appetite now whetted, I followed the story as it moved along in the next four months, at one point telling Laffer I needed to talk to the best economists available and wanted him to give me a list of ten. It was in that exercise that he told me the best economist in the world was Bob Mundell, then teaching at the University of Ottawa. In the next several weeks, I ran around interviewing most of the men on the list, but could not swing the expenses for a Canada trip to interview an economist none of the Observer editors had ever heard of. I don't remember why Laffer told me he was the best and I don't remember asking. It's been a long time.
It was in January 1972 that I got a call from Bob Bartley of The Wall Street Journal, who told me he had just been named editor of the editorial page. We had become friendly in covering national security issues and he invited me to join him in New York to be an editorial writer, with primary responsibilities in writing about politics. It was in the next two years that I began to learn some more economics, at long distance. Laffer had returned to the University of Chicago, a source of ridicule as his GNP forecast was wildly off in the first reports that came out, with Greenspan's low number on target. Still, Art was cheerfully waving off criticisms and talking to me long distance almost every other day, about the state of the economy and the politics of the moment. His explanations of what was going on in the economy always were radically different from what I could read in the financial press, including our own, and I eventually began to pass his views on to Bartley and the other fellows on the editorial page -- including Art's inflation forecasts, which were always far above the consensus forecasts. These were always related to the price of gold, which quadrupled by 1973, to $140 from $35 when Nixon closed the gold window. Bartley began letting me write economic editorials relating to monetary policy, which caused grief to the Friedman monetarists who had been advising the editorial page for many years. Laffer also began talking to me about taxes and how they figured into economic policy. It was in a telephone call that he first hit me with the idea that there are always two tax rates that will produce the same level of revenues.
Because of Laffer's occasional visits to New York and the success of his private forecasts, which I kept reminding the others on the staff were highly accurate, we were not taken in by the fourfold increase in the price of oil in 1973. The rest of the economic universe thought the Arabs could do this because the world was running out of oil. Laffer pointed out that Mundell, who I still had not met, had predicted that in January 1972 the price would soon rise dramatically and be followed by price increases in all other commodities -- this, because of the rise in the gold price.
In May 1974, Laffer and a monetarist, David Meiselman, hosted a conference on inflation at the American Enterprise Institute. I came down from New York to listen to the discussions of the eminent economists in attendance. Mundell was there, as eager to meet me as I was to meet him, because the editorials I was writing were the only pieces in the world reflecting his views. In a break in the conference, he invited me to his room at the Georgetown Inn and for two or three hours he answered questions that Laffer could not answer in a way I could fully understand. I remember leaving the session on a cloud, excited as I had never been before, seeing clearly the whole world economy spread out before me and knowing I was only one of three men in the world who saw it so. Mixed with my excitement was the clarity of Mundell's vision that the U.S. economy was headed toward a serious recession, which not one other economist at the AEI event could see. Mundell said there had to be a $10 billion tax cut immediately or the unemployment rate would go over 8% in January.
Rushing back with the news to New York, I fully expected to write an editorial urging a big tax cut as soon as I explained the picture to Bob Bartley. I'll never forget him throwing up his hands and saying I thought all I had to buy into was monetary policy and now you tell me I have to get behind a tax cut! The problem was that William F. Kirby, president of Dow Jones & Co., who had never written for the editorial page, had come down from the top floor that day with a signed op-ed announcing that we had to have a tax increase in order to fight inflation!! I was checkmated. To get Mundell his tax cut, I would have to work behind the scenes. Alas, amidst all this, Nixon resigned over Watergate and Gerald R. Ford became President. He called an "economic summit" at the end of August and followed the advice of all the big-time Nobel prizewinners and other stars of the profession, liberal and conservative, asking Congress for a tax increase to reduce pressure on prices.
I could not actually write an editorial countering Bill Kirby, but Bartley allowed me to write an interview with Mundell, "It's Time to Cut Taxes," which appeared on December 11, 1974. It was this piece which we ran last week as our "Memo on the Margin," upon learning that Mundell had won the Nobel Prize. A careful reading shows that every fundamental element of the supply-side agenda can be seen in that one article. I did not simply interview him and write the piece, but composed it with him, word by word, to make sure it was exactly what he had in mind.
Only one week earlier, Laffer and I had met with Dick Cheney, the deputy White House Chief-of- Staff, to make the case for a Ford tax cut instead of his promised tax increase. Cheney's boss, Donald Rumsfeld, had not been chief-of-staff at the time Ford swallowed the advice on a tax increase to fight inflation, so he was open to switching to a tax cut, especially after the GOP lost four dozen seats in the November off-year elections. I had explained to him that the voters were not blaming congressional GOPers for Nixon or Ford's pardon of him, but for Ford's promise of a tax increase. The Dow Jones Industrial Average was in the 500s, its lowest point in decades. When Cheney could not grasp the concept of two tax rates producing the same revenue, one at a higher level of production, Laffer grabbed a cocktail napkin and drew his famous curve... which I named for him in 1977 when I wrote "The Laffer Curve" as Chapter Six of my book, The Way the World Works.
At roughly the same time, November 1974, Irving Kristol, a friend of Bartley's who was editor of the Public Interest Quarterly, invited me to lunch in midtown Manhattan at what was then the Italian Pavilion. I didn't know what he had in mind, but soon found he wanted me to write a long essay for his periodical about the incompetence of the press corps when it came to writing about economics. I said the problem was not incompetence of the press corps, but of the economics profession. I told him I knew of only two economists who knew their stuff and that they had a completely different view of how things worked. He had never heard of Mundell or Laffer, but on the spot commissioned me to write 10,000 words for $2500 -- a huge sum in those days. He needed the manuscript in six weeks for the spring edition and I worked like hell to produce "The Mundell-Laffer Hypothesis: A New View of the World Economy." It was in this long piece that I wrote the first formal description of the supply-side concept of the Laffer Curve. It appeared only as a footnote, #4, which Mundell wrote word for word, how a lower tax rate could finance itself if it had been too high to begin with. Later, the attacks and ridicule from the professional economists and political opponents focused on Laffer's simple picture, but the Mundell argument had to be ignored because it was unassailable.
In late January 1975, the Ford administration revealed its "tax cut," which was actually a $50 rebate to every taxpayer, a horrible blunder by the William Simon Treasury department because it had no supply-side marginal incentive effects. It was pure Keynesian demand management, giving the taxpayers cash in a way that could not be self-financing. For one such blunder after another, Ford lost his chance to be re-elected on his own right. Ronald Reagan almost took the GOP nomination from Ford at the Kansas City convention of 1976. Reagan's research director, Jeff Bell, had read the Mundell-Laffer Hypothesis and he saw in it a winning issue for his boss. Bell, though, had to fight the Old Guard politicos around Reagan, who would not buy the idea of a self-financing tax cut. Bell came up with a $90 billion tax cut that would be financed with $90 billion in spending cuts, a zero-sum approach that was doomed from the start, made worse when Bell let slip a proposed list of the spending cuts. Ford's camp attacked the cuts as harsh and cruel and the outcry forced Reagan to drop the plan altogether, thereby losing his lead in the New Hampshire poll, and in the end losing the nomination fight by a handful of votes.
The years 1975-76 were also important in the forging of a coherent supply-side "Model." In my daily telephone calls to Laffer in Chicago and Mundell now at Columbia University, it became clear the two economists had disagreements that I feared would show up in a political campaign to advance the "Model." Whenever Laffer got to New York, we would get together for dinner, either at Michael 1 restaurant a few blocks south of the WSJournal offices, or at the Waldorf Astoria, where Laffer stayed. Bartley, who usually attended the Michael 1 dinners, wrote about them in his 1983 book about the supply-side revolution, The Seven Fat Years. At each of the dinners, usually hosted by a Laffer supporter on Wall Street, Charlie Parker, I'd come with a question or two to be resolved, and the debate between the two economists would lead to long and heated discussions. Laffer's position invariably was the more conservative, leaning toward small government and the interests of the creditor class, Mundell's the more liberal, leaning toward bigger government and the debtor class.
I'd tried to interest several Republican senators in the "Model," starting with Bob Dole, who I knew and admired as a fighter, then Nevada's Paul Laxalt, a close friend of Reagan's, then Howard Baker of Tennessee and Bob Packwood of Oregon. Each devoted time to hearing me out, but did not have the time to really learn the "Model" so they could champion it within the GOP and in the Congress. Both Bartley and Irving Kristol had urged me to meet Jack Kemp, the former quarterback of the Buffalo Bills, who was a third-term congressman from Buffalo. Kemp had read the Mundell interview in December 1974 and its tax-cutting idea had excited him as one he could run with. His blue-collar district had an unemployment rate close to 20% at one point. In early 1976, by chance I met Kemp, and he quickly committed himself to learning the Model.
Again by chance, Kemp, who grew up in California, had been the QB for the San Diego Chargers early in his pro career. Long before we met, Jack worked in Sacramento as a summer intern for the California Governor, Ronald Reagan. The connection was important as a bridge between those of us who had devised and refined the Model, and a man with the potential of becoming President. Kemp, with Sen. Bill Roth of Delaware, had introduced tax-cut legislation that became known as the Kemp-Roth bill, which I more or less outlined, but which was fleshed out by Jack's staff economists, first Paul Craig Roberts, then Bruce Bartlett, with help from the late Norman Ture, an economist who had helped design the Kennedy tax legislation of 1962, which finally passed in 1964. With the fervor of an evangelist, Kemp made speeches around the country and on the House floor. He finally sold his plan to the Republican Party, which officially endorsed the idea in September 1977, on the very day I finished writing my The Way the World Works.
It was Jeff Bell, Reagan's research director, who insisted I had to write a book to explain the new way of looking at the world. In late 1976, he moved to New Jersey, where he had been born, and decided to use the supply-side ideas to run for the U.S. Senate. With only $8,000 in life savings and no political base, in 1978 he challenged five-term GOP Senator Clifford Case and shocked the political universe by beating him in the June Republican primary. Bell, who converted from the Lutheran Church to the Catholic Church in the middle of the campaign, decided to run against his Democratic opponent, Bill Bradley, with a combination of tax cuts and social conservatism -- constitutional amendments to ban abortion and mandate school prayer. He lost narrowly to Bradley, but John Sears, Reagan's campaign manager and a friend of Bell's, ordered a post-election poll. He found that the New Jersey electorate favored Bell's views on taxes by 75% to Bradley's 25%, but Bradley over Bell on the social issues by a wide margin.
He took these findings to Reagan and argued that in 1980, Reagan should embrace the supply-siders and run not on a zero-sum plan, but on the dynamic model implied by the Laffer Curve. It was not a hard sell, especially after Sears invited Kemp and his wife Joanne to California for a long meeting and dinner with Ron and Nancy. We had been hoping Kemp would run for President, not quite trusting Reagan, but he informed us that Reagan was 90% with us on all the issues and that was close enough. It turned out that was the correct move. Reagan, who had earned his degree in economics in 1932, from Eureka College, Ill., was completely in tune with classical, supply-side ideas. That was all that was taught in the college curriculum, before the Keynesian Revolution that began in 1936. It helped that the young Reagan in his Hollywood years made enough money to find himself in the 91% tax bracket and thought about the discouraging effects of confiscatory taxation.
Eureka College did not teach Reagan about the impact monetary inflation would have on progressive taxes, because the United States never had an inflation in combination with progressive taxes until the late 1930s. The devaluation of the dollar against gold in 1934 produced a mild monetary inflation that was masked by the tariff-and-tax related Depression. It was Mundell who first saw the early moves away from a gold dollar and warned it would bring an inflation. It also was Mundell and Laffer who were the first to see the connection to the progressive tax structure, and how "bracket creep" would steadily raise real rates of taxation to levels that would smother economic efficiency and drive down real wages and standards of living. It was this combination of economic theory and political drive that produced the Reagan Presidency. A case can now be made that Reagan was the most important President of the century, certainly of the last half of the century, with FDR number one in the first half. A case also can be made the Mundell will be seen as the most important economist of the 20th century, at least of the last half, with John Maynard Keynes number one in the first half. As I try to make clear here, neither Reagan nor Mundell would have been worth much in historic terms if they did not have each other.