Economists and Budgets

In politics, though not in logic, there are three relevant schools of economists: Keynesians; an alliance of supply-siders and monetarists; and neo-classicists.

The Keynesian Orthodoxy

However painful the conditions, classical economics claimed that government could do nothing to correct the problem of unemployment; instead, market conditions eventually would right themselves. Unemployment, for example, could lower wages to a point where hiring people would be more attractive. Looking at the 25 percent unemployment of the 1930s, Keynes pointed out that when times got rough enough no one would hire people because there would be no customers. Businesses needed to perceive a demand for their products. Without demand, even cheap labor would not be hired.

Keynes argued that the government could create demand, either by itself purchasing new goods and services (direct spending) or by increasing the money in people's pockets through a tax cut. Either way, a government deficit would result. But, by "priming the pump," government might get the economic well to again yield some water.

If a deficit would heat up the economy, a surplus, by reducing consumption (as the government took in money without spending it), would cool the economy down. Reduced demand would mean reduced inflation; in essence, a trade-off between limiting unemployment and limiting inflation could be managed through the government deficit.

Experience in the 1970s challenged Keynesian theory in two ways: First, over the decade, inflation and unemployment both rose; and inflation rose far more quickly than the level of employment seemed to warrant. Second, the United States faced a growing productivity crisis. Growth of GNP was slow—compared to both American experience in the previous two decades and the rate of growth in other industrialized nations, such as Japan.

The Supply-Side Challenge

The supply-siders, as their name suggests, argued that by emphasizing demand Keynesians had neglected the factors that encourage investment.

They claimed that productivity had slowed because government policies reduced the incentive to produce. Regulation had business owners filling out forms rather than doing business. High, progressive income taxes reduced the reward for working harder or investing more.

One version of this tendency, represented by the editors of the Wall Street Journal, emphasized reduction of what they deemed unproductive public spending:

Income transfers conducted through the federal budget are seriously eroding savings and capital formation…. In other words, it is money transferred from people who are working to people who are not, lowering the incentives of both for productive labor .^[17]

The Journal's editors believed that the welfare state had broken the link between work and reward. This side of the analysis was congenial to oldline Republicans who disapproved of nearly all government activity except maintaining public order and security. Another side, exemplified by Representative Jack Kemp, was willing to maintain most existing governmental activities (an important difference) while emphasizing the positive effects of tax cuts. Economist Arthur Laffer claimed that high taxes so discouraged economic activity that a large cut, by increasing incentives to work and invest, would generate much economic growth. In a reasonably short time, therefore, even the government would be better off because the smaller tax cut would come from a much larger economic pie. This was the (in)famous "Laffer Curve."

The supply-side analysis essentially ignored the demand problem that preoccupied Keynesians. Also it paid little attention to interest rates, which surely, if to an unknown degree, influenced rates of investment and economic growth. Yet, in spite of these analytic weaknesses, supply-side proponents had two practical advantages: in proposing tax cuts they were suggesting something that politicians like to do; they also were proposing to manipulate an instrument of policy—tax rates—that, unlike interest rates or personal consumption, the government could directly control.

Laffer used the Keynesians' tax cut during the Kennedy administration as an example of how lower taxes could increase economic growth. Keynesians, however, had argued that tax cuts stimulate demand and thus, potentially, inflation. With inflation already high, supply-siders needed a counterargument. They found it by allying with the monetarists, who held that monetary, not fiscal, policy affected prices.

Money and Monetarism

To monetarists, inflation came from too much money chasing too few goods. Prices rose when the banking system, meaning the Federal Reserve in its various ways of influencing banks, created money faster than

the rest of the economy produced goods. If the Federal Reserve contracted the money supply, then prices would go down because there would be less money for goods. This deflation, monetarists believed (and Keynesians agreed), would slow down economic activity because it would make more sense to hold dollars, which would buy more goods later, than to invest or spend them, receiving fewer dollars later given price declines. Monetarists such as Nobel laureate Milton Friedman argued that, if the Federal Reserve maintained a steady, moderate rate of growth of the money supply, the economy would avoid both depression and inflation.

Perhaps this is true, but the Fed's actions also influenced interest rates, because the price of something depends on its supply. Rates depend as well on the demand for money, which brings us to the Federal Reserve's role in managing the federal debt.

Government bonds, "T-bills," and so on are the safest of all investments because the government can get money in ways that private industry cannot match and because, if the government went under, everything else would collapse with it anyway. The government will pay whatever interest is necessary to sell its bonds. If the government increases its sale of bonds (deficit) during an economic downturn, these sales will soak up idle cash and put it to (relatively) productive use. But if idle money is scarce, then the deficit must divert cash from other kinds of investments (crowd them out) and, in the competition for investment money, can drive interest rates upward. Keynesians and neoclassicists claim that less investment, lower profits from investment, and eventually lower economic growth result.

The Federal Reserve can intervene in this process by buying bonds from its member banks. When it buys a bond, it credits the seller's reserve account. Banks are allowed to lend an amount several times their reserves; therefore, expansion of reserves allows a proportionate expansion of lending. Some of that lending will come back into the banks as demand deposits (checking accounts), to be lent out again as the cycle repeats. Thus, when the Fed buys bonds, it increases demand deposits and bank reserves, the major bases of the money supply. It also increases bank lending, so interest rates should go down. Conversely, when the Fed sells bonds (debiting banks' reserve accounts), it contracts the money supply, thus driving interest rates higher.

The purchase of bonds is how the Federal Reserve "prints money" to pay for the government's expenses. The Fed's decision to purchase depends upon whether it is more concerned with steadying the money supply (then it will not buy bonds) or keeping interest rates low (then it will buy them).

If monetarists were right, the Federal Reserve could stop inflation by

reducing the money supply. But the resultant higher interest rates might send the economy into a recession. Keynesians were nervous about using such potent measures. Because supply-siders believed interest rates mattered less and tax rates more to business interests, the supply-siders were more optimistic that a tax cut could be combined with monetary restraint to increase production and reduce inflation. To Keynesians the combination of tight money and large tax cuts guaranteed only high interest rates that would bring the economy down in a resounding crash.

The Neoclassicists

The swing vote among economists was held by the neoclassicists, who shared the Keynesians' basic model of the economy but had the supply-siders' trust in markets and dislike of wage-setting unions. Representing a large segment of established academic economists, neoclassicists commanded the paraphernalia of authority (econometric models, chaired professorships at universities) needed to impress the nonexpert. These neoclassicists included some of the nation's most eminent mainstream economists, such as Paul McCracken, Herbert Stein, and Alan Greenspan, all former CEA chairmen. Their pronouncements would determine whether the supply-siders would seem irresponsible or respectable.

Neoclassicists shared the Keynesian concern with interest rates and the supply-sider dislike of taxes. Their ideal was low taxes and low spending, with occasional pump-priming if economic growth severely declined. The difference between Keynesians and neoclassicists was really a choice between inflation and unemployment, really a choice of whom to favor. Keynesians emphasized demand and employment, which favored employees. The neoclassical concern with steady prices served holders of wealth, the value of whose investments would be eroded by inflation.

Both mainstream schools, however, emphasized the need for investment to create growth. Members of each school worried because savings, and thus investment, were lower in the United States than in other industrial nations. They agreed that high interest rates and inflation created uncertainty that dampened the "Animal Spirits" (Keynes's term) of the entrepreneur. Both schools emphasized corporate investments rather than individual incentives, viewing capital investment more as the product of corporate choices than as the individual desire to make money. Unlike the supply-siders, therefore, neoclassicists (and Keynesians) preferred corporate tax cuts—particularly adjustments in the depreciation schedules for capital investment—to reduced personal levies.

Economists and the Economy

The reaction to Carte's January 1980 budget reflected these converging and diverging perspectives. To supply-siders, whose voice was

the Wall Street Journal, a budget nearly balanced by tax hikes was totally unacceptable. Newsweek and Time differed because the more Keynesian Newsweek, caring more about unemployment, was impressed by the degree of restraint in the budget.

Yet there was also agreement, centering on the shared concern for business investment as the source of productivity. Keynesian Arthur Okun of the Brookings Institution called Carter's plan "a directionless, muddle-through budget of an election year." "I wish to hell," he added, "that there was some concrete policy you were buying with all that extra money, liked a reduction in corporate depreciation rates to stimulate investment."^[18] His colleague Joseph Pechman, similarly worried, felt that a tax cut was needed to stimulate investment; to allow for this, he wanted a spending cut.^[19] Keynesians had begun to worry more about investment than consumption. The administration's economists were also working to restrain workers' consumption through recession. Democratic economists were deserting Democratic constituencies.

Ultimately, all economists emphasized the confidence of business interests. Keynesians wanted to manipulate demand in order to encourage entrepreneurs. Supply-siders wanted lower taxes. Neoclassicists wanted higher profits from lower wage increases and interest rates. All believed that if, for whatever reason, business lost confidence in the future, that future would be dismal. The crucial barometer of business confidence was the behavior of the financial markets. In February 1980, one major market, the market for bonds, collapsed; that collapse in turn killed Carter's budget.