The Reagan Deficits Jude Wanniski March 1, 2001

Memo To: Sen. John Kerry [D MA]
From: Jude Wanniski
Re: Where They Came From

When I saw you jumping up and down about the Reagan Deficits on the Sunday talk shows last weekend, it was absolutely clear you were not posturing. You really, truly believe the Reagan tax cuts of 1981 were the cause of the enormous deficits that emerged in the years that followed. That’s really not how the deficits occurred, Senator, and for you to believe that means you would have to believe the voters of the United States were stupid for electing Ronald Reagan in 1980 and re-electing him by a landslide in 1984, with Massachusetts joining the celebration for the Gipper.

Actually, I was more or less responsible for introducing the idea that there had to be serious cuts in the income-tax rates because of the monetary inflation that began in the Nixon years. I’d become persuaded of this by Arthur Laffer and his mentor, Robert Mundell, and sold the idea to Jack Kemp. If the deficits were the responsibility of any President, they belong to Richard Nixon, who followed the advise of those economists who told him to go off the gold standard in August of 1971. Robert Mundell, the Canadian economist who won the Nobel Prize in economics in 1999, made the prediction in January 1972 that there soon would be a dramatic increase in all prices, starting with oil. The inflation got worse and worse as the Keynesian and monetarist economists advising Nixon, then Gerry Ford, then Jimmy Carter, insisted on pushing the same levers. The gold price of $35 in 1971 when the process began was $850 on February 1, 1980, and still over $600 when Reagan was elected. This was a tidal wave of inflation that fed on itself as it produced the “bracket creep” in the progressive tax system. If it had not been halted by the Reagan tax cuts, the inflation would have pushed the entire work force into the highest tax brackets. It is not possible to imagine the destruction that would have followed.

Republicans over the years have blamed the Democratic Congress for spending us into the giant deficits that you term the “Reagan Deficits,” but that is not a fair charge either. The inflation itself meant the government had to buy goods and services at extraordinarily high nominal prices in order to meet commitments to military and social spending. Yes, there was a military build-up in the Reagan years, but even there the associated costs were swollen by the inflation, tracing back to August 1971 when we floated the dollar. In addition, the cost of financing the debt soared with the highest interest rates in U.S. history. When Reagan was elected, supply-siders urged a return to gold IF ONLY TO PRODUCE GOLD-STANDARD INTEREST RATES OF 4% OR 5%, which would have saved $50 billion a year or more as the national debt was refinanced. The monetarists in the Reagan administration killed that idea, but there was no support for it among Democrats, so the short-sightedness can be blamed on the political establishment in general, not on any political party.

You were not on the scene at the time, Senator, but if you check you will find that the fiscal 1981 budget submitted by President Carter in January of 1980 contained budget surpluses as far as the eye could see. The problem with the torrent of revenues the Carter budgeteers had projected is that they actually were based on the idea that the work force would be inflated into higher brackets and thus would pay higher taxes!! With hindsight, you should realize yourself how deeply flawed that idea was. The market economy was being brought to its knees by high rates of inflation and high tax rates, and the Carter budget saw the results with rose-colored glasses. There is a myth spawned by the Democratic economists that the “Reagan Deficits” emerged because the Gipper’s first budget was supposedly based on a Rosy Scenario that showed mushrooming tax revenues gushing into Treasury via Laffer Curve effects. Actually, there was no “dynamic analysis” in that budget, and in fact the static analysis showed there would be a very small revenue loss because in 1981 there would only be a teeny tax cut. The second and third installments would not show up until fiscal 1983 and 1984.

Indeed, the static revenue losses from the Reagan tax cuts were so small that the Keynesians, including a number of Nobel Prize winners who live in Massachusetts, argued that their effects on aggregate demand would be so small that they could not grow the economy!!! There was a deep recession that began in 1981 and did not relent until late 1982, but that was entirely related to the monetary deflation of that period. The Reagan tax cuts invited increased economic activity which would require more liquidity from the Federal Reserve. When the Volcker Fed did not supply it, as it was still grappling with the inflation surge of 1979-80, the price of gold tumbled as a sure signal of monetary deflation. At the time, in early 1981, Professor James Tobin of Yale wrote a letter to the WSJournal arguing that the Reagan policy would not work, because monetary policy would be pulling against fiscal policy. As he put it, the policy mix was like a train in New Haven, with a locomotive on one end headed to Boston, with another on the other end headed to New York. But again, it is clear from that Nobel Prize winner that the deficits that emerged out of that recession were not related to the tax cuts, which were trying to grow the economy, against the deflationary policy at the Fed. See what I mean?

There is a lot to be learned in studying that early period of the Reagan years, but when you do, you learn that the only way you can say the deficits were caused by the lower tax rates is by assuming the higher rates would have produced more revenues as the economy expanded, which it began doing in August 1982 when the Fed ended the deflation. Both locomotives were then pulling in the same direction. The way you can tell the income-tax cuts were actually having their supply-side effects is by realizing that INTEREST RATES ON GOVERNMENT BONDS WERE FALLING EVEN AS THE DEFICITS WERE GROWING. This had been the prediction of Robert Mundell, who had made the explicit argument that as long as the tax rate that you are cutting causes the economy to grow fast enough to pay interest on the bonds used to finance the tax cut, you are coming out ahead of the game.

As you confront the current economic problems of our country, Senator, think of tax cutting in those terms, as investments that will produce bigger economies and greater revenues, as long as they are the right kinds of tax cuts. If I were you, I would have a word with Sen. Bob Torricelli, your Democratic colleague from New Jersey. He would advise changing the shape of the Bush tax cut plan to include a cut in the capital gains tax, which would have powerful supply-side effects. Of course, you will also have to persuade Alan Greenspan to stop running the Fed’s locomotive in the opposite direction.