Viewpoint: Less Is Really More
Economic forecasting has become quite easy lately—it just requires a solid background in the alphabet. Last year there was speculation that we were in an L-shaped recession, or perhaps a U-shaped one. Then it turned out to be V-shaped, until economists decided it was W-shaped. I have just completed an elaborate technical analysis that demonstrates conclusively that all of those descriptions were wrong. What we have been in is a Q-shaped recession. That's where you go 'round and 'round in circles until you fall off the edge.
Real after-tax income, per person, and industrial production have gone essentially nowhere for two years. Real GNP in the fourth quarter was less than one percent higher than at the start of 1979. The economy is fragile, overleveraged, volatile yet stagnant. We're suffering from the Anglo-American disease: taxing success to subsidize failure and guaranteeing loans to firms that don't supply what people want while abusing antitrust to break up those that do.
Since Christmas, I have been working with Dave Stockman at the Office of Management and Budget on the overall economic strategy and forecast. The essentials were already set by January 7, when we prepared a briefing book for the president. John Rutledge was brought in later to add a bit more courage to the forecast than we could squeeze out of Alan Greenspan.
The only significant changes have been to postpone the question of indexing the personal tax and to drop the idea of cutting the 70 percent rate to 50 percent right away. Media speculation about major internal disputes between Stockman and Donald Regan, about crazy forecasts of 7 percent real growth, and about the dominance of the "old guard" Nixon-Ford economists were and are entirely wrong.
The 1982-86 growth rate of 4.4 percent forecasted by the administration would be the second-most-anemic postwar recovery—particularly since it follows almost three years of stagnation. Yet Business Week finds the forecast "wildly optimistic" and "amazing," while also reporting (quite incorrectly) that it was "drastically scaled back."
The Administration's basic strategy is to use monetary policy to slow the growth of spending (nominal GNP), while using tax, budget, and regulatory policy to lower the barriers to expanding production (real GNP). With fewer dollars spent and more goodies produced, inflation necessarily comes down. The forecast shows the deflator slowing from 9.9 percent this year to 5.4 percent in 1985.
With good reasons to expect less inflation ahead, there will be less rushing to borrow in order to hedge, speculate, and buy before prices go up. There will also be more reason to save. Together, that means falling interest rates. Bond yields are forecast at 10.7 percent in the final quarter of 1981, 8 percent at the end of 1984.
Lower expected inflation strengthens the dollar, holds down prices of commodities priced in dollars (including OPEC oil), holds down wage demands, and otherwise constrains costs. People shift from tangible assets, like gold and diamonds, to financial assets—facilitating the financing of business investment.
Now, this vision of the future conflicts with both of the leading schools of political philosophy—cynicism and skepticism. It is also judged impossible by one of the two leading schools of economics, and there are only two—the right wing and the wrong.
Keynesian theory says we have to alternate between using unemployment to fix inflation and using inflation to fix unemployment. It doesn't work. We get more of both.
Supply-side economics, by contrast, says we can only get more and better goodies when people supply more and better effort and capital and use them more efficiently. If people don't get to keep much of any added earnings, because of rising marginal tax rates, they won't try hard to earn more by producing more. And if real output and income per person is not rising, neither is that thing we call "the economy." People are important, and people with high earning potential are particularly important. Some economists have somehow left people out of their models.
Let's run through some of the reasons behind the Reagan package.
First, federal spending. It has doubled since 1975. It was growing by 7 percent a year when President Carter took office; it has been growing by more than 18 percent over the past year. All private wages and salaries now add up to only twice as much as the government salaries and transfer payments they must support. We clearly have more government than we can afford, whether we pay for it by taxing, borrowing, or printing money.
And it is naive to suggest that much of the $433 billion in nondefense spending (aside from interest) goes to the poor. If it did, they'd be rich! That's enough to provide the equivalent of $70,000 per family of four, tax-free, to the poorest 25 million people in America.
Even programs that appear to help the poor largely involve raising the demand for and price of the subsidized items—Medicaid pushes up medical salaries, food stamps bid up food prices, housing subsidies help construction, and so on.
Of nearly $50 billion in proposed budget savings in 1982, only $5.2 billion is trimmed from programs that are ostensibly for those with low incomes. Even then, the cuts do not affect anyone who approaches a meaningful definition of poor.
Then there are taxes. Federal taxes alone were 18.3 percent of GNP in 1976, 21.1 percent this year, and would soar further to 24 percent by 1986 under the previous administration's budget. That would be a $290 billion increase in just the share of our income going to taxes. The Reagan tax cuts merely bring the tax share down to 19.3 percent in a few years—the same average burden as in 1978, but lower at the margin. The percentage of taxpayers in brackets above 30 percent has at least doubled since 1976.
And the budget? Instead of using a balanced budget to help fight inflation, the last administration used inflation to balance the budget. That's a curious reversal of ends and means, and it doesn't work.
It may be helpful to recall the technical definition of a deficit: a deficit is what you have when you have less than you had when you had nothing. Some argue that massive deficits will necessarily prevent interest rates or inflation from declining. They cannot explain what happened in 1976, or in Germany and Japan.
The budget deficit was 4.5 percent of GNP in 1976, absorbing almost 22 percent of gross savings. It was 2.9 percent of GNP last year, 12.7 percent of gross savings. Those proportions will be much smaller this year and beyond—about 2 percent of GNP this year, for example.
Treasury borrowing does displace private borrowing, but there will be less need to borrow—and hence more savings available—with the tax cuts. Financing the deficits may push real interest rates up a bit, but nominal rates will surely fall if the Fed stops monetizing so much debt. There is no visible link between the size of deficits and how much the Fed buys, which is why falling deficits under Carter were accompanied by an unprecedented three years of 8 percent money growth. From the second quarter of '75 to the same quarter of '79, the deficit fell from an annual rate of $99 billion to an insignificant $8 billion; inflation went from 6.8 percent to 12 percent. The only place we need credit controls is on the Fed's portfolio.
We'll never balance the budget if we don't cut tax rates. Without growth, payrolls and profits are too weak to generate much tax revenue. And federal spending ends up much higher on unemployment benefits, food stamps, trade adjustment assistance, public works schemes, bailouts for depressed industries and distressed cities, debt service, and so on.
The risk is that the president's bold new experiment will be whittled down by inches. A French fable tells us you can't boil a frog by tossing him in boiling water, because he'll jump out. You have to put him in cool water and turn the heat up slowly. A lot of timid people are trying to boil Dave Stockman that way, but they underestimate how far he can jump.
Alan Reynolds is vice-president of research at a major US bank.