Reagan's Real Revolution, Part Two
by Bill Bonner
Ronald Reagan may have called himself a conservative. But his real revolution lay in redefining conservatism as an activist, world-improving creed. First, the neo-cons took over foreign policy. Soon, Americans were stirring up trouble everywhere from Latin America to Afghanistan. Then, they took over domestic policy. In a few cases, the ghastly remnants of previous improvers – such as 70% top marginal rates – were knocked over. In other cases, new edifices were built up. The sharp tax cuts of 1981 were not followed by sharp spending cuts. Instead, spending went up. And not just on defense. Reagan had pledged to abolish the Department of Education. Instead, he increased its budget by 50%.
There were four key elements to Reaganomics. Restrict the money supply in order to slow inflation (admirably carried out by Paul Volcker at the Fed). Cut taxes (a 25% across-the-board tax cut was enacted in 1981). Balance the budget by controlling domestic spending. (A complete failure…deficits grew larger than ever.) And reduce government regulation. (Ditto.)
As you can see, the first two objectives were, more or less, achieved. They produced, more or less, what Milton Friedman had expected. But neither was an activist measure. Both merely undid some of the worst damage done by previous office-holders. Lyndon Johnson, Richard Nixon, and Jimmy Carter had made a mess of the economy. Ronald Reagan and Paul Volcker helped clean it up. But without action on the other two objections, the clean-up lacked the necessary suds and elbow grease. The dirt and clutter were mostly left alone, while new trash was heaped on.
The big cut in taxes gave people more money to spend. Since government spending was not cut, the result was more net spending in the economy. This was equivalent to an increase in the money supply – or an increase in demand. Consumers began a buying spree, while government borrowed the money to fund the deficit. Looked at from a macro-economic perspective, Americans had no more money to spend after Reagan took office than they had when he was in California. But they thought they had more. They had more money in their pockets. More money to spend.
Few people asked, “Where did it come from?” If they had thought about it, they would have realized that, collectively, they were merely going further into debt in order to increase their current standards of living. If they had reflected on it deeply, they would have realized that they were running up bills that future generations would have to pay…they were spending money that their children and grandchildren hadn’t earned yet. For what was a national debt, but an inter-generational obligation, a burden placed on infants by their parents and grandparents?
Hardly anyone thought about it then…or since.
“Supply-side economics” was meant to be different from “Keynesian” economics, in that it celebrated the power of the free market to create wealth. If only the restrictions imposed on the economy by previous generations of world improvers could be removed, they said, the economy would boom and people would get rich.
Thus, it came to be that taxes were cut and the economy boomed. Just as Keynes said it would. What the supply-siders had done was nothing more than administer a Keynesian boost. John Maynard Keynes, a British economist of the early 20th century, had given world improvers a tool. He showed that recessions could be offset by government spending. When private spenders pulled back, he noted, government could take up the slack – by running deficits – thus, helping to pull the entire economy out of recession. He also recommended that governments run surpluses in good times so they’d have money to spend in bad ones. This was the part the politicians never particularly liked, and the part of his plan they never could quite follow. It was all very well to increase the money supply and consumer demand – who complained when people had more money to spend?
But decreasing the money supply meant taking purchasing power out of the economy. Human nature being what it is, the moment for under-spending never seemed to come. Like fat men at a wedding feast, policy makers told themselves they would eat less after the party was over, to make up for it. But in public finance, there is never a good time for fasting.
With no surpluses to draw upon, government had to turn to debt. But government is a unique and wondrous borrower. It, and only it, has the power to control the terms of the trade, and never fails to turn them to its own advantage. Most important, it controls the quantity (and indirectly, the price) of the currency in which its borrowings are measured. It can borrow in a currency of one value…and pay back in the same currency, but at a cheaper rate. How surprising is it the price of the dollar fell, in both Republican as well as Democratic administrations? “We are all Keynesians now, ” said Richard Nixon in the early ’70s.
After Reagan’s tax cuts U.S. GDP grew at an average rate of 3.2% per year – throughout the eight years of Reagan’s two terms. This was a bit more than the 2.8% average gain in the eight years before and substantially more than the 2.1% of the eight years following. Still the growth was slower than it had been in the 1960s, after Kennedy’s 30% tax cut of 1964 produced 5% annual GDP rates. Meanwhile, real median household income rose from $37,868 in 1981 to $42,049 in 1989. This, too, was much better than what had happened before or after the Reagan years. But much of it – maybe all of it – came not from real increases in wages, but simply from the fact that more people worked longer hours.
Real wage increases require three things: first, the society must save money…so it has the capital to invest. Second, it must invest the savings in productive businesses. Third, these capital investments must result in increased productivity.
Alas, none of these things happened.
Everyone loves a good fraud. And no fraud is so loveable as the illusion of getting something for nothing. That is what the supply siders seemed to promise. Government could spend more…and cut taxes at the same time. For a while, it even seemed to work. America boomed. And the boom continues even today.
But real booms need real money. Typically, a person saves money when he is wary and spends it when he is flush. The spending is real. The money is real. The boost in sales is real. The profits are real.
But a boom built on phony money is itself phony. Every step of the way takes him in the wrong direction. The demand is an illusion. The spending is a mistake. The money itself is suspect. And the resulting business profits are not merely temporary, they are nothing more than next year’s sales disguised as this year’s earnings.
A man who borrows money to begin his spending spree contributes nothing to the economy. Every dollar he spends must someday be withdrawn. It must be paid back. Imagine that he borrows $1 million. In a small town, even that sum might be enough to set off a boom. He buys a new car. He goes out to the restaurant. He gives money to church and charities. He takes a holiday. He orders a new suit. He builds a new wing on his house. Soon, his money is out of his pocket. But it is not gone. It has found a new home in pockets all over town. And now the butcher, the baker, the builder, the travel agent, and many others are all planning little additions to their own standards of living.
But imagine the disappointment when, the following year, the man who spent so freely no longer comes around. He is not seen at the tailor, or at the travel agent, or at the restaurant, or the car dealer. He is not even seen so frequently at his old haunts. It seems to all of them that something has happened. Not only does he not spend as freely as he did the year before, he barely spends at all. For now he must cut his regular spending by enough to pay back the $1 million – plus interest. In other words, net spending in the town will actually go down, over a multi-year period, by the amount of interest he pays (assuming that the loan came from outside the community).
(We will invite readers, later, to consider the current U.S. situation – when loans from overseas surpass $600 billion per year!)
After many years of Keynesian deficits, by 1981, savers and lenders had grown wary. Consumer price inflation hit 13.5% in 1980. Lenders feared it would go higher still. They demanded protection. In 1980, 30 year mortgages could be had at 15% interest. By the following year, the mortgage rate rose to a peak of 18.9%.
But by then, Paul Volcker’s anti-inflation policies at the Fed began to pay off. Investors did not yet know it, but the bond market had found its bottom. For the next two decades, bonds would go up. Bond yields – a measure of what people must pay to borrow – went down. Thus, the two cornerstones of the Reagan boom were in place – lower taxes and lower cost of credit. Neither, we repeat ourselves, was an improvement to the world financial system; both were merely corrections to previous meddling. Taxes had been raised so that the government would have more money to spend on its marvy programs. High bond yields (a high cost of credit) were the result of Keynesian policies. Neither problem was caused by neglect, in other words.
We have already explained how the Reagan tax cuts were a bit of legerdemain. Without offsetting cuts to federal spending, they increased spending…and misled the economy about aggregate demand. The lower cost of credit, on the other hand, was clearly a plus. Falling interest rates made it cheaper to borrow; people borrowed. But they had not forgotten the lesson of the ’70s. Instinctively, they expected prices to go up – which would lower the cost of their loans still further. Rising prices would also undermine the value of their savings. They did the reasonable thing: they borrowed. They did not save.
The savings rate fell during the ’80s from 8% to 6.5%. In the ’90s it continued to fall – to 4.9%. In the 2000s, it fell even lower. How were Americans going to finance their government deficits? Where would they get the money to build new factories…and develop new technologies?
How could a modern economy compete without savings?
No one asked the questions. Stocks were rising. Incomes were going up. It was ‘morning in America.’ The questions would have to wait until evening.
Now, America is minting new voters all over the mid-east. Reagan’s campaign against the “Evil Empire” has become Bush’s war against the “Axis of Evil.” Reagan’s tax cuts…have been followed by Bush’s tax cuts. Ronald Reagan’s deficits have been upstaged by those George Bush. And the Reagan boom has evolved into the Bush boom.
But interest rates were high in ’81…and coming down. Stocks were low…and going up. It is nearly a quarter of a century later than when Ronald Reagan took office. We don’t know what will happen, but surely the sun must be sinking and the questions must be rising…
Readers expecting an apology will have to wait.