Memo To: Supply-Siders Everywhere
From: Jude Wanniski
Re: Deficits and Surpluses
There are several myths about the federal budget deficits and the national debt that are becoming more and more entrenched in the conventional wisdom. As time has elapsed over the last two decades, the dominance of the “demand-siders” in the economics profession and in the news media has brought this about. I’m talking about Republicans as well as Democrats, conservatives as well as liberals. Yes, the Democratic litany has been that the deficits were the direct result of the Reagan tax cuts and the “rosy scenarios” about how they would bring instant surpluses through the effects of the Laffer Curve. The Republicans, though, have countered with the argument that it was the spendthrift Democratic Congress which increased spending on social programs faster than revenues grew. Republicans do acknowledge that the Reagan defense buildup also added to deficit, but this spending was needed to win the Cold War. Very little of this has anything to do with the rise and fall of the deficits and appearance of surpluses. Let us do what we can to straighten this out or the politicians of both parties will continue to operate on these misreads.
The most important fact is that in real terms, the national debt is now roughly where it was when Richard Nixon took office in 1969. We have to use real terms from 1969 because monetary inflation really began in this period, after President Lyndon Johnson closed down the London gold pool in 1967, an event accompanied by a gradual rise in long-term interest rates. Once we accept the idea that we are back where we started, we can understand that the government did not make any serious fiscal errors during the points in between. By this I mean that Congress spent the amount of money that it had to spend during the constant process of adjustment to the swings in the value of the unit of account, the U.S. dollar.
The spending went up as dramatically as it did under Reagan because prices were catching up with the gold inflation that occurred under Nixon, Ford and Carter. When prices rose by a factor of ten, the cost of welfare entitlement programs and the costs of maintaining (not to mention beefing up) the military had to follow. There had to be a dramatic increase in the deficit or the tax increases necessary to offset the higher spending levels would have sent the economy into a deep Depression. Michael Boskin, a conservative Keynesian who was chief economic advisor to President George Bush, noted at the time that if the national debt is $3 trillion and the inflation rate is 5%, the debt is falling in real terms by $150 billion ($3 trillion x .05%). Unless the government runs a $150 billion deficit, he said, that much real aggregate demand is being withdrawn from the economy, thus inviting a recession.
The inflation impulses ended when the Reagan Fed wrestled down the price of gold. This was fairly easy to do when the RR tax cuts were boosting the demand for liquidity. That’s because when the economy is expanding, it needs more currency and bank reserves -- the combination of which is termed “liquidity,” because neither pay interest to the government, as do “illiquid” government bonds which do pay interest. If the economy wants liquidity and the Fed does not supply it by replacing bonds held by the banks with new money, the existing money has to do “more work,” which means each dollar becomes more valuable -- first relative to gold, then in terms of everything else priced in dollars. (That’s deflation.) When RR took office, gold was at $620 or so. The Reagan tax cuts, passed in the early summer of 1981 (only after the assassination attempt on him), immediately created a demand for fresh money, but Fed Chairman Paul Volcker was being harassed by the monetarists to keep money “tight.” By starving the economy of liquidity, Volcker induced the gold price to fall to $300, producing a horrendous deflationary recession that did not end until he was forced to pump $3 billion of liquidity into the banking system to prevent nationwide bankruptcies. Gold jumped over $400 in a few months, and as the fresh liquidity coursed through the economy, it teamed up with the Reagan tax cuts to produce a boom in the stock and bond markets, and then in the real economy as recession ended. Gold finally stabilized at the $350 level by 1985 under the influence of Reagan’s Fed appointees, chiefly Wayne Angell and Manuel Johnson in 1985, then Alan Greenspan in 1987.
If gold had stabilized at $250 instead of $350, the budget deficits might not have increased so dramatically because there would not have been as much inflation catch-up. The costs of the entitlement programs would have slowed much sooner. I say might because after the Carter administration induced so much gold inflation in its four years, the adjustment costs of deflating back to $250 would have been very high. Better to allow some inflation catch-up to $350, supply-siders argued at the time, even though it would mean temporarily higher budget deficits.
From this perspective, we can see that neither Reagan nor the Democratic Congresses of the Reagan years can be “blamed” for the budget deficits. The monetary inflation created by President Nixon’s decision to float the dollar -- a decision backed by ALL the demand-side economists in the nation -- was the sole cause. The end of the inflation is largely the reason why the deficits ended and the surpluses appeared. The credit President Bill Clinton deserves in this process is his willingness to retain Greenspan as Fed chairman during the past eight years. However, the 1993 tax increase, if anything, has slowed the process of moving from deficit to surplus.