On August 16, 1982, Business Week made an ass of itself. For a year the American economy had been in a recession of surprising depth and duration. At midyear 1982 there had been confident predictions by economists of recovery in the second half. They were wrong. By August, many people had begun to fear that the economy would never get out of the recession, and this fear was elevated to the status of a dismal scientific truth by the following syllogism:
1. High interest rates cause recession.
2. High budget deficits cause high interest rates.
3. Therefore, the recession will not end until high budget deficits are reduced. QED
Business Week devoted the cover and most of the issue of August 16 to the propagation of this scientific truth, and concluded portentously:
. . . . never in history[!] has it been more imperative that Congress not pursue business as usual. Failing to deal with the deficit will preordain that the U.S. will never get back on the road to prosperity.
On the very next day, August 17, there occurred one of the biggest bond market rallies on record, and three months later, even though the budget deficit had worsened dramatically, there began one of the strongest economic recoveries in American history!
Nowadays, Business Week is a much less reliable source of economic nonsense and nostrums because it has hired Professor Paul Craig Roberts to write a regular column called “Economic Watch.” Roberts, who holds the William Simon Chair at Georgetown’s Center for Strategic and International Studies, was among the original “supply-siders” who gathered around Congressman Jack Kemp in the mid-seventies and helped to draft the Kemp-Roth tax cut bill. The supply-siders have no more formidable advocate in their ranks.
But what is Roberts doing at Georgetown and Business Week instead of serving in the administration of America’s “first supply-side president”? Well, it turns out that he was in that administration, as Assistant Secretary of the Treasury for Economic Policy, but to hear him tell it, supply-siders were about as welcome in the Reagan administration as witch doctors are at the Mayo Clinic. The President, who had campaigned in 1980 as a supply-sider, surrounded himself in office with economic physicians like James Baker/ David Stockman, and Martin Feldstein, who looked upon the prescription of tax cuts for a sick economy as “voodoo economics.”
All of this is told about in Roberts’s book, The Supply-Side Revolution, published this year by Harvard University Press. It is clear that the author regards the supply-side revolution as a revolution betrayed.
According to Roberts, supply-side economics originated not in the academy but on Capitol Hill. By 1980, it had become the dominant approach to the economic problems of the day among a nonpartisan coalition of congressmen. Only the opposition of President Carter prevented the supply-side agenda being voted into law in October of 1978. President Reagan, in this view, inherited a program which had already won the decisive legislative battles well before he came to office in 1981.
No sooner had the tax cuts passed in 1981, than certain White House officials, among them David Stockman, director of the OMB, and James Baker, chief of staff, began the effort to persuade Reagan to reverse them. On September 24, 1981, just a month after signing the tax cut bill, President Reagan went on national television to argue for a $22-billion tax increase. This was the first small step of a retreat that was to end in 1982 only when America’s first supply-side president signed into law the greatest peacetime tax increase in American history.
It is a misnomer, then, to call supply-side economics “Reaganomics.” On the contrary, as regards fiscal policy the Reagan administration is a nest of counterrevolutionaries, in the opinion of Paul Craig Roberts. The story of Roberts’s book is the struggle between the supply-side revolutionaries, centered in the Treasury Department, and the fiscal reactionaries, centered in the White House.
It would be a mistake, however, to give the impression that this was a genuine debate over the economic merits of fiscal policy. The theme of Roberts’s book is that narrow economic analysis was constantly dominated by political considerations, especially personal ambition. I will return to the main theme of the book shortly, but let me first discuss fiscal policy on narrow economic grounds.
Supply-side economics is not synonymous with tax cuts. It refers to a certain kind of tax cut, namely, a reduction in the marginal tax rate. The marginal tax rate for a taxpayer is the percentage of tax he would pay on any additional income. Supply-siders believe that the higher the marginal tax rate, the less incentive there is to work, save, invest, and take risks. They blame the economic difficulties of the past fifteen years primarily on excessive marginal rates of taxation.
Supply-side economics has had to make its way through a gridlock of economic thinking. Urging Democrats in one direction were the Keynesian economists, who believe that higher government spending and budget deficits provide stimulus for economic growth. Urging Republicans in a different direction were economists who believed in fiscal responsibility and a balanced budget. The best part of Roberts’s book is his destruction of both the Keynesians and the proponents of the view that a balanced budget should be the first priority of fiscal policy.
Keynesianism has dominated the study of economics for half a century, but it has become increasingly discredited in the past decade. In their desperate efforts to repel the supply-side advance, the Keynesians were driven to make some strange arguments against tax cuts, which exposed them to the charge of hypocrisy. And in fact the hypocrisy of the Keynesians has been extraordinary and inexplicable if Keynesianism is viewed narrowly, as an economic theory. The truth is, of course, that Keynesianism has a political mission, namely, the justification of massive government spending, to which the economic theory has proven to be subordinate. Be that as it may, the contradictions of Keynesianism are undeniable.
1. If anyone has forgotten the fervent assertions by Keynesians that large deficits would prevent healthy economic growth by raising interest rates, he has only to listen to any speech these days by Walter Mondale. In 1981, during the debate over Reaganomics, there were many predictions of raging inflation and high interest rates if the tax cuts should pass.
But in early 1977, at the beginning of the Carter-Mondale administration, the Keynesians had been singing a different tune. Notwithstanding a strong recovery, another Minnesota Keynesian named Walter (Heller) testified before Congress that a budget deficit of $70 billion (3.7% of GNP) was minor and did not raise “even a remote specter” of inflation. (In 1977, Walter Heller was not looking for inflation and high interest rates, but we got a murderous dose of both; in 1981, he was looking for inflation and higher interest rates, but we got neither. In truth, both interest rates and inflation have more to do with monetary than with fiscal policy. High money growth in the late seventies caused higher inflation and higher nominal interest rates; lower money growth in 1981-1982 caused lower inflation and interest rates.)
2. Against the supply-side contention that tax cuts would cause people to work more, the Keynesians made the argument that tax cuts, even though they made leisure more expensive in terms of foregone earnings, might actually cause people to work less. (The corollary, of course, is that you get people to work harder by taxing them more!) If tax cuts allow people to make the same income with less work, they might take their tax cuts in the form of greater leisure. But here we see the fallacy of composition. What is true of one worker cannot be true of all workers. If everyone worked less, then total income would fall, and therefore so would individual income.
Moreover, if it is true that tax cuts might result in more leisure rather than more work, then fifty years of Keynesian analysis is refuted. Keynesians had always argued that tax cuts would increase aggregate demand and stimulate the production of goods and services. But if tax cuts cause people to work less, then output falls, and the greater demand for reduced goods results simply in higher inflation.
3. Sometimes the Keynesians wanted to argue that the tax cuts would not cause a higher savings rate, as supply-siders claimed, and other times they wanted to argue that they would but that higher savings retard growth. In arguing thus, the Keynesians achieved the remarkable feat of making contradictory arguments, both of which were false! The truth is that the Kennedy tax cuts did cause a higher savings rate, which proved to be perfectly compatible with strong economic growth.
The Budget Balancers
Notwithstanding the hypocrisy of the Keynesians on deficit spending, there were many opponents of the tax cuts who had always opposed deficit spending. Such opponents tended to be Republicans, who had fought deficit spending for fifty years and more, whether under F.D.R. or Eisenhower, Nixon or Carter.
Within the administration of the first supply-side president, no one worked more assiduously than David Stockman to reverse the President’s 1981 tax cut, in the name of a balanced budget. Whatever his motives, he was faithful to ancient Republican tradition. But Roberts shows that that tradition is an inadequate guide to policy.
It cannot be shown that government deficits cause significantly higher interest rates. Not only is there no statistical correlation between high deficits and high interest rates, deficits and interest rates move in opposite directions. Roberts clearly explains why this is so. At the peak of the economic cycle, deficits tend to be lowest, because most people are working, business is profitable, and therefore large revenues are flowing into the Treasury. At the same time, interest rates are high because consumption and investment are booming. Now watch what happens when the economy turns down. As businesses lose profits or go bankrupt, the Treasury’s tax receipts decline. As unemployment mounts, income tax receipts fall but unemployment and welfare expenditures increase. The budget, in short, becomes badly unbalanced. Meanwhile, interest rates tend to fall, notwithstanding the deficit, because private demand for credit is diminished by the recession.
The latest business cycle provides once again empirical confirmation of this scenario. Between the tax reduction in the summer of 1981 and the tax increase of 1982 (which was said to be justified by the fear of budget deficits), the United States went through a severe recession. Both the actual federal deficit and the administration projections of future deficits worsened dramatically, and yet during the same period there were extraordinary declines in interest rates. From August to August, the federal funds rate fell from 19% to 11%; commercial paper from 17% to 11%; Treasury bills from 15% to 10%; the prime rate from 20% to 15%.
In his capacity as budget director, David Stockman attempted to blame one economic ill after another on the budget deficit, and for this he receives from Roberts a decisive and well-deserved rebuke:
[Stockman] began with the argument that deficits cause inflation. Then, when the inflation rate collapsed in spite of growing deficits, he argued that deficits cause high interest rates. When interest rates collapsed, he argued that deficits prevent economic recovery. Whatever was there . . . he hooked his argument to it.
Politics and Economics
The theme of The Supply-Side Revolution is that economic policy is not made in an antiseptic scientific laboratory. It is contaminated by political and personal considerations. In particular, the current debate within the Republican Party has less to do, according to Roberts, with the merits of economic policy, or even what the leading players believe are the merits, than with the 1988 campaign for the Republican nomination, which is shaping up in the minds of many observers as a Kemp-Bush battle.
This is not to suggest that Roberts ignores the influence of less grand motives in the policy process. He asserts, for example, that David Stockman placed a balanced budget at the top of the economic agenda only because Stockman, as director of OMB, could not otherwise hope to be one of the stars on the Reagan team. Low personal ambition, as well as high personal ambition, thereby distorted, and nearly destroyed, the original Reagan economic strategy. Roberts goes so far in portraying Washington as a hive of interest group infighting and unprincipled personal ambition (which it is of course), that he becomes almost Hobbesian in his view of politics: every man’s hand seems to be raised against every other’s. There is in the political process little evidence of public spiritedness or the common good. At the same time, the book ends on a jarringly optimistic note. Roberts seems sanguine about the possibility that supply-side economics will ultimately prevail.
But there is no contradiction here, since old Tom Hobbes was himself a great optimist. He knew that every man’s hand was raised against every other’s, but he knew also that there was an invisible hand at work, more powerful than all these taken together. Like Roberts, Hobbes knew that there is “an abundance of evidence of the positive effects of good incentives.” In Hobbes we see the great principles of modern politics, greed and fear: the invisible hand of the market and the very visible hand of the sovereign.
Does Roberts really accept this formal solution to the problem of how good policy arises from well-nigh universal corruption? Probably not. Otherwise, like Hobbes, he would write with a merry twinkle in his eye. But Roberts seems genuinely appalled by the lack of integrity and public-spiritedness he witnessed in Washington. He seems to think it matters whether men are good or bad, and in the main he seems to think that they are bad. In this, however, he goes too far.
The real story of the supply-side revolution is not that it was betrayed but that it occurred at all. A handful of economists put forth a program which, despite the ignorance and self-interest that always accompany political debate, caught the imagination of the public and was, however imperfectly, enacted into law. Had President Reagan been more resolute, the supply-side revolution might well have been more far-reaching; at the very least it would never have been betrayed.
If it is wrong to expect too much out of politics, it is also wrong to expect too little. Men of character and intelligence may not abound, but they do exist, and they sometimes get their way. Or so we must believe, if political happiness is to be in any measure attainable. The only alternative is to believe that America is a whorehouse, which one day will be filled with happy hookers.