Originally published October 29, 1984
NOW, about that deficit: Ronald Reagan was quite correct, during the first Presidential debate, in insisting that there is no connection between the deficit and the interest rate. If he had been more precise, he would have said that there is no invariant connection between the two. Walter Mondale, too, was quite correct in insisting that the deficit presents a threat to the economy, to the nation and to the peace of the world, although again there is no invariant connection.
There are, in fact, few (if any) invariant connections in economics, but it would be lèse majesté to expect Mr. Reagan or Mr. Mondale to understand that, especially since most economists don’t either. There are few (if any) invariant connections in economics, because every economics question has to do with money. As I said in this space last time (” ‘Trust Funds,”’ NL, October 15), without money you have physiology and engineering and so on (all necessary parts of our life), but you don’t have economics (also a part of life, like it or not). And as I said here two and a half years ago (“Let’s Put Indexing on the Index,” NL, April 5, 1982), there is no invariant connection between any good or service and money. The mere fact of inflation is enough to settle that question, even if there were not sound metaphysical considerations (which you may not take so seriously as I do) on the same side.
So we seem to have a dilemma. Reagan and Mondale are both right, and they’re both wrong. At the root of the dilemma is money – well known to be at the bottom of much else. At the root of money is the banking system, and in the United States the Federal Reserve Board is at the root of the banking system. Since neither Reagan nor Mondale dared or cared to mention the Federal Reserve Board, there was an air of irrelevance to their debate.
Before digging to the root of the matter, let’s consider the causes for and the effects of the exponential surge in the deficit. The principal causes are not in dispute: a tremendous increase in military spending, the vast and varied tax cuts of 1981 and the high interest rates. Of these, the military spending had a positive effect on the business recovery, the tax cuts were neutral and the interest rates were negative.
The economic virtue of military spending is that there is no end to it. In a famous example of his irony, Keynes writes: “Ancient Egypt was doubly fortunate … in that it possessed two activities, namely, pyramid building as well as the search for precious metals, the fruits of which, since they could not serve the needs of man by being consumed, did not stale with abundance. The Middle Ages built cathedrals and sang dirges. Two pyramids, two masses for the dead, are twice as good as one, but not so two railways from London to York.”
Military hardware likewise does not “serve the needs of many by being consumed,” so it can be added to forever. And like pyramid building it increases aggregate demand. Demand is what stimulates business activity. Businesses produce things if they foresee a demand for them. Any expenditure is stimulative, yet government expenditure, being both large and highly visible, is especially stimulative. As Keynes suggests, building housing would be as stimulative as building pyramids or armaments. Or as John Ruskin (a better economist than you may have realized) exclaims, “What an absurd idea it seems, put fairly in words, that the wealth of the capitalists of civilized nations should ever come to support literature instead of war!” It would, in short, not be difficult to conjure up better uses for our money, and hence better ways of stimulating the economy; nonetheless, the military build-up-foolishness, highmindedness, viciousness, waste, and all – has in fact been the motive power behind the recent business recovery.
The tax cuts were, as I say, essentially neutral. If you wisely keep a file of THE NEW LEADER, you will find the reasons set forth in the issue of March 8, 1982 (“Why Deficits Matter”). For those who can’t lay their hands on back issues, I’ll summarize the reasons briefly. The tax cuts were, you will remember, intended to stimulate the supply side, on the theory that saving is the cause of investment. The theory is fallacious. Not even Representative Jack Kemp (R.- N. Y.) can imagine that the industrial half of President Eisenhower’s Military – Industrial Complex would build a factory to produce cruise missiles before the military half placed an order.
The supply-side theory turned out to be fallacious in still another way. In accordance with its logic, the 1981 personal income tax favored the rich, and the corporate tax favored the prosperous, the hope being that those who didn’t need the money would save it. This hope was disappointed, and for a simple reason. Since the Federal budget was already in deficit, the tax cuts necessarily increased that deficit. The increased deficit had to be funded; that is, bonds to cover it had to be sold. To whom were they sold? To those who had money to pay for them, of course, and they were, in general, the people who had benefited from the tax cuts. The upshot was that the rich and prosperous were given money to buy government bonds. In effect, they were given the bonds. The maneuver accomplished as extraordinary a transfer of wealth – albeit to the wealthy – as America has seen.
But if this transfer had any effect on the Gross National Product, it was merely a distortion of priorities. The disadvantaged were somewhat less able to buy food and housing, and the fall-off was balanced by a surge in the sale of Cadillacs and Lincolns. Aggregate demand, and hence aggregate production, were not substantially affected one way or the other. (Do you wonder why I’m disrespectful of the GNP?)
The third factor in the deficit, the high interest rates, was of course a drag on the business recovery. Mind-boggling though the fact is, this was intended to be a drag. The idiocy of the intention is not, however, what interests me at the moment. It is the effectiveness of the intention that gets to the root of the matter, for the policies of the Federal Reserve Board are thus demonstrated to be not irrelevant.
Empirically, Reagan was perfectly right. In 1980 the deficit was much lower than today’s, but the interest rate was much higher. How, then, can one claim that the deficit is the cause of high interest rates? But Mondale was perfectly right, too. The present deficit is indeed the cause of the present high interest rates, and these in turn contribute to continuing high unemployment, the strength of the dollar, the decline in exports, and the increasing trade gap.
The reason why the deficit is the cause of high interest rates is very simple: The Federal Reserve Board says it is. On this subject Board Chairman Paul A. Volcker is a cracked record, going around and around, saying the same thing endlessly.
To be sure, it is not literally what the Federal Reserve Board says that is of consequence. Persuasive though he is, Volcker does not run the rates up or down simply by jawboning. His speeches have an impact on the rates only to the extent that they are taken as hints of what the Board will do. It is what the Board does that matters. For the Board controls the rates, partly by setting the rediscount rate, partly by determining margin requirements, and mainly by controlling the money supply. Money earns interest in rough proportion to its scarcity, and for a third of a century now the Federal Reserve has been making money scarcer and scarcer. It has been doing this under the misapprehension that it was thereby containing inflation. It obviously wasn’t. The record is clear here, but that is another story.
WHETHER THE deficit causes the high interest rates directly by scaring Wall Street or indirectly by scaring the Federal Reserve Board, there is no doubt that the high rates increase the deficit. The bonds that were sold to finance the 1981 tax cuts and are now sold to finance the deficit offer a fantastic return -12 to 14 per cent or more. I have some that will pay me 14 per cent yearly until November 15, 2011. I should live so long.
The interest payable on the Federal debt is an incubus of daunting weight that will smother the economy for generations to come. Even now, as Senator Daniel P. Moynihan (D.-N.Y.) has shown, the annual interest payments are approximately equal to the annual deficit, and the compounding of that interest will more than offset any savings that might be made elsewhere in the budget. The compounding, moreover, is not of the ordinary sort. Thirty-year bonds that were sold in 1954, paying an average rate of 2.4 per cent, must be paid off today with money raised by selling bonds paying more than five times the old rate. Look at this another way: If the old rates were still in force, the deficit would be less than one fifth of what it is.
Continuing the observation, we see that the world according to Volcker is upside down. He says it would be fine to have low interest rates, if only the deficit could be reduced to manageable size. But the deficit would have been manageable if the Federal Reserve Board had kept interest rates low. The interest rates have no life of their own, any more than the deficit has. Even on Volcker’s theory, it would appear that high interest rates swelled the deficit, and not the other way around.
As things are, the only way to reduce the deficit-the Federal Reserve Board’s price for lowering the interest rates is to raise taxes. That is what Mondale promised to do. But Reagan (good Keynesian malgré lui) said raising taxes threatens to send the economy into a new depression, because increased taxes mean a reduction in aggregate demand, and a reduction in demand is followed by a depression as surely as an increase in demand is followed by a boom.
This dilemma could have been avoided if the tax cuts had gone to those who would spend them. It could have been avoided if the Treasury and the Federal Reserve Board had cooperated in holding down the interest rates, as they did during World War II. As it happened, both fiscal and monetary policies were fatefully misdirected. If the President does not look good in the history books, the reason may be that he did not have the wit – and we did not give him the power – to beat some sense into the Federal Reserve Board.
The New Leader