In a truly pathetic display worthy of King Canute, the majority leader of the Senate, Howard Baker, and the minority leader of the House, Robert Michel, threatened Wall Street in September with credit controls, an excess-profits tax on interest receipts, and even wage-price controls if interest rates did not come down pronto. This statist manifesto from a supposedly free-market administration was not repudiated by President Reagan or any member of the executive branch.
The threat was not only despotic; it was also idiotic, because it strongly implied that a handful of Wall Streeters had for some reason conspired to keep interest rates high and thereby thwart the noble goals of the administration. What nonsense to postulate that a small group of people can control a $4-trillion bond market and a $1-trillion equity market!
The executive branch has been almost as guilty of Canute-ism. Since May, Secretary of the Treasury Donald Regan, while not threatening controls, has been hectoring the bond market for not having sufficient faith in the future. Perhaps the former head of Merrill Lynch has been taken in by his own hokum about being "bullish on America" and can't understand why no one is listening.
But it is not only the Republicans who are nonplussed at the failure of their confident prediction that interest rates would plummet as soon as the Reagan budget and tax programs won their dramatic victories in Congress. For it is possible that the Friedmanite monetarists, who have been essentially calling the economic shots for the Reagan administration, will go down the tubes even earlier than the Reagan program as a whole. Monetarist dogma holds that once inflation moderates (as it has, slightly, this year), interest rates will fall sharply to keep "real" interest rates (inflation rates corrected for inflation) constant. So why hasn't this happened?
For the last decade it has been clear to economists and politicians that one important element of our chronic and worsening inflation is "inflationary expectations"—the fact that people now know deep in their bones that inflation will continue, so that they tend to spend faster and save less while prices are relatively lower. This response makes the inflation problem worse.
Successive administrations have each tried in their own way to reverse inflationary expectations but without doing anything substantial to correct the true root cause of inflation: the government's continuing creation of new money. The Johnson and Carter administrations, for example, tried "jawboning." That didn't work. The Nixon administration tried to make its anti-inflationary will credible to the public by imposing wage-price controls. That turned out to be a disaster. The Reagan administration has tried what amounts to phony but dramatic budget and tax cuts to attempt the same sort of joshing the public and the market out of their belief in continued inflation.
Actually, there was a method to the Nixon madness that was very similar to the Reagan viewpoint: to allow a breathing space for Friedmanite monetarist magic to do its work and to reduce the monetary expansion at the root of inflation. The problem is that the monetarists, even though they focus on the money supply, do not want to stop counterfeiting by the Federal Reserve: they don't want to end monetary inflation. In order to avoid severe recessions or any sort of dislocation, they only wish very, very gradually to reduce the rate of Fed counterfeiting (money growth), so as to gradually turn inflation around with no one the worse off.
But gradualism won't work. It's too late for all that.
The only thing that could make Reagan's anti-inflationary will credible to a shell-shocked, wisely cynical market is, as F.A. Hayek has been pointing out, to forget gradualism and slam on the monetary brakes. Only a vivid and dramatic move will work—for example, a law prohibiting the Federal Reserve from buying any more assets ever again. This would ensure a zero counterfeiting rate in the future. Or a return to a genuine, not phony, gold standard, where the dollar is once again redeemable in gold coin. Or abolishing the Federal Reserve. Or, better, a combination of all three. Pussyfooting and fine tuning are like shuffling deck chairs on the Titanic.
The monetarist predictions were wrong because inflationary expectations are subjective and cannot be encased in mechanistic statistical formulas. The "real" interest rate is high because people expect the Fed to loosen up and therefore for inflation to accelerate once again. And they are right.
What sort of a "tight money" policy is it, for example, that increases M2 (the best available statistic on the money supply) by an annual rate of 10 percent and by as much as 12 percent in the month of August? This is loose money, not tight. It signals the market that the Reagan administration and the Fed are still not truly serious about cutting down, much less stopping, the counterfeiting that is at the root of the whole inflation problem.
It is also no use for the monetarists to wail that the high and rising deficit estimates for next year have nothing to do with inflation. If the huge deficit is not "monetized" (paid for by creating new money) it is indeed not inflationary. But it raises interest rates and diverts savings from productive investment. Only a huge drop in inflationary expectations could then lower interest rates, but how could this occur when absolutely no one trusts the Fed not to monetize part of the enormous deficits looming ahead?
We need truly drastic cuts (cut-cuts, not just cuts in the rate of growth) in government spending, and we need to stop Fed counterfeiting in its tracks. Nothing else is going to work.
Murray Rothbard is a professor of economics at Brooklyn Polytechnic Institute of New York and the author of numerous articles and books on economics, history, and the libertarian movement.
This article originally appeared in print under the headline "Viewpoint: Reagan and King Canute".