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Bonds and the Budget

Bonds are promises to pay interest at a fixed rate for a long period of time. Whether a bond is a good deal depends upon the ratio of the interest paid to the inflation rate. If prices are going up faster than the interest rate, the bondholder will have less purchasing power at the end than when she bought the bond. Prospective bondholders, therefore, demand a higher interest rate for their money if they expect high inflation. Conversely, the bond sellers (debtors) are more willing to offer those rates if they believe inflation will give them more dollars with which to pay off. In essence a 4 percent interest rate at 2 percent inflation is the same term of trade as 14 percent interest at 12 percent inflation: a real return ("real interest rate") of 2 percent per year.

On February 18, the Labor Department announced that in January wholesale prices had risen at an annual rate of 19.2 percent. Interest rates, The Economist reported, zoomed upward throughout the industrialized world "in hot pursuit of the inflation rate." High interest rates


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were bad for anyone who wanted to issue a new bond; they were terrible for anyone who owned an old bond.

A bond is an asset; its value depends on the income it provides. People want to be able to trade assets as well as hold them in their portfolios. The portfolio value of a bond is how much it can be sold for, which depends not on the original price but on its yield.

Take a $1,000 bond that yields $80 per year (8 percent). If 8 percent is a good return, the bond will sell for its original value (par). If new bonds or other comparable instruments yield 10 percent, however, it would be silly to pay $1,000 for the old bond. Someone who expected a 10 percent return would pay only $800 to get the $80 per year return. Inflation has the same effect on values.

As interest rates go up, therefore, the prices of old bonds and the value of portfolios of old bonds go down. In theory, bonds, promising a steady return over a long time, represent the ideal safe investment. If interest rates are volatile, however—especially if they and inflation head up—the last place to be is locked into a thirty-year contract for a devaluing asset. The bond market—not stocks—was the major source of capital investment. Conditions in 1980 threatened that "the notion of bonds as a safe harbor for prudent money managers … could become as archaic as gold at $35 an ounce."[20] Capital investment could dry up. Worse, losses on their bond portfolios could badly damage banks and other financial institutions, leading to a general contraction of credit.

The bond market collapse was noticed by only a small portion of Americans. But those who noticed mattered. Economic policymakers viewed it as evidence that Carter's budget was a disaster. Economists differed in the details of their explanation, but all agreed that, if investors had trusted Carter's policy to reduce inflation, then they would not have insisted on higher interest rates. And when economists used investors' behavior to show that the policy was insufficient, investors, hearing that the president's policy would not work, panicked further.

In October 1979 the new chairman of the Federal Reserve Board, Paul Volcker, announced that the board had adopted monetarist principles for a war against inflation. The Fed would tighten monetary policy and allow bank interest rates to rise accordingly. To attract buyers, longterm bond rates rose in tandem with the rates paid by banks. If market participants had believed that the tight money policy would reduce inflation, they might have tempered their predictions about inflation, therefore countering the short-term effects of higher interest rates. But that was not to be.

On January 29 interest rates on long-term Treasury bonds reached 11 percent, higher even than during the Civil War.[21] On February 5 professional bond traders, "faced with a prolonged buyers' strike,"


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dumped a new thirty-year Treasury issue (maturing in 2009) on the market rather than waiting for buyers at face value (par). In response, the 2009 Treasury fell another 2.5 percent, and other bonds followed. The next day brought a flood of sell orders as bondholders tried to dispose of their devaluing portfolios. By Tuesday, February 19, the 2009 Treasuries had lost 20 percent of their value since the year's beginning. Issues from major companies like IBM were doing no better.[22]

A Wall Street Journal article on February 21 estimated portfolio losses since October at $400 billion. On that same day any hope of recovery was stifled when investment banking guru Henry Kaufman gave a speech to the American Banking Association in which, predicting continued high inflation, he called for declaring a national emergency. The markets were so jittery that Kaufman's speech immediately set them on their ear.[23]

There was no particularly good reason, under any economic theory, either to blame Carter's budget or even to panic. The bond market decline had begun before Carter announced his budget. A few voices did call for calm. Beryl Sprinkel of Harris Bank in Chicago, a leading monetarist, pointed out that Paul Volcker had only begun the Federal Reserve's monetarist fight against inflation in October, so the lack of immediate results was to be expected.[24] February 19 and February 25, Volcker said the same in testimony to Congress, arguing that markets were overreacting to entirely predictable economic news, that is, the January wholesale price increase.[25]

By February 25 panic was replacing policy. The chairman of the Federal Reserve joined the chorus. "We have reached the point in this inflationary situation," Volcker declared, "where I believe decisive action is necessary."[26] The markets made no sense, but that did not reduce the need to calm them. He recommended the nation's all-purpose remedy, balancing the budget. On the same day, Jimmy Carter told a group of out-of-town newspaper editors that the inflation/energy problem had "reached a crisis stage."[27] His and Volcker's comments, of course, contributed to the fear. The balanced budget panic of 1980 had begun.

The great organs of the media fanned the flames of panic. On February 24, 1980, the Washington Post editorialized: "The latest inflation figures will set off another wild search for a quick solution." Joining in that search, the paper contended that "if President Carter wants to move fast on inflation, he has only one lever that will make much difference. He will have to start cutting his budget, rapidly and severely—not only next year's budget, but the current one."[28] The New York Times On February 28 added that "nobody any longer knows for sure" how to slow the inflation but that budget balance had to be part of the solution.[29]

For the next few months the key word would be "expectations." By


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expecting inflation, consumers and producers and borrowers and lenders might indeed make it come true; something had to be done to change those expectations. Newsweek reported,

However it is achieved, a balanced budget would have almost magical significance. "The budget has raised inflationary expectations more than anything," says Leif Olsen of Citibank, "so cutting Federal spending is exactly what we need to restore confidence and cut those higher expectations."[30]

Balancing the budget supposedly would make everybody expect better times; I balance, Descartes might have said, therefore I am prosperous.

Politicians were scared. The administration felt the pressure. Newsweek reported that "the mood in the White House … seemed to verge on something close to panic…. 'Grown men, thoughtful men are scared,' said a top White House aide. 'It's time to be scared.'"[31] "When you have bank executives come in and say, 'We're getting close to bank lines,' people get frightened," reported Representative Richard Gephardt, a leader of the moderate Democrats. "If ever there was a time in recent history to balance the budget, this is it."[32]

Within the Keynesian logic, budget balance in that situation made little sense. Arthur Okun commented that $16 billion in cuts—enough, ostensibly, to balance the budget—"will reduce inflation by 0.3 percentage points and lower the gross national product by 1.3 percent … a minuscule effect on inflation and a significant, if not drastic, effect on employment."[33] The CBO issued a similar dampening prognosis.[34]

Policy makers, however, along with most commentators, had moved beyond reliance on input-output models of the economy. They had entered a land of speculation about the moods of economic actors in which the symbolic virtues of budget cutting exceeded any effects on demand. "The problem is psychological," one administration official declared. "That's where you really have to get results."[35]

The administration moved toward a policy of (a) balancing the FY81 budget so as to change inflationary expectations, and (b) finding more ways to ensure the recession that would have a real effect on inflation. On February 28 OMB ordered agencies to prepare cuts in their FY81 submissions. As a sign of resolve, the administration canceled plans for a $300-million farm policy initiative.[36] On the Hill cut lists were being devised by everybody, from liberals David Obey and William Brodhead to conservatives David Stockman and Phil Gramm.

New budget proposals would help only if they had a chance to pass. The administration therefore tried something unprecedented: the budget would be remade in negotiations with its party leaders in the House and the Senate. For forty-six hours, beginning March 6, administration


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and congressional Democratic leaders negotiated.[37] The meetings were chaired by Senate Majority Leader Robert Byrd, who explained that "this is an effort to develop unity, so we can all walk the plank together."[38]

There was a theme: it was a nasty job, but someone had to do it. Bargaining was painful because the negotiators included supporters of almost every threatened program.[39] Representative Brademas of Indiana protested education cuts; Jim Wright of Texas protected public works; Tom Foley of Washington fought for food stamps; and Senate Finance Chairman Russell Long resisted intrusions on the cherished jurisdiction of his Finance Committee.

The Democrats' internal negotiations foreshadowed later "big powwows"—the 1982 "Gang of 17," the 1984 negotiations, the 1987 summit. In theory, if the leaders all agreed, they could carry Congress with them. In practice, neither side wanted the blame for cutting cost-of-living adjustments (COLAs) to social security. Members of Congress thought a tax on imported oil might be fine, but they wanted Carter to impose it administratively so they wouldn't have to vote.[40] They were able to find many but not quite enough areas of agreement. Meanwhile, bad news piled up: CBO raised its FY80 deficit projection by $17 billion;[41] wholesale and retail prices went up 1.5 percent in February; Chase Manhattan raised its prime rate to a record 18.25 percent on March 13.[42]

On March 13 the negotiations ended with a rough sense of how cuts might be made and revenues raised, but no detailed package emerged. That left room for House, Senate, and president to fight over details. To respond to the panic, Carter felt he had to announce a new policy quickly. On March 14 Carter promised a balanced budget through roughly equal spending cuts and revenue increases. Though he specified only a few reductions from his January plan, including elimination of the states' portion of General Revenue Sharing (GRS), he promised to submit a total of $13 billion in cuts by the end of the month. To raise revenues, Carter proposed withholding taxes on dividend and interest income (a measure that was to have a long and controversial career over the following years) and an oil import fee (which was to have a very short, noncontroversial life).

Most important for the politics of the next few months—and nearly ignored—was a decision that did not reduce the ostensible deficit at all: Carter chose not to increase defense spending. Almost all analysts had been expecting defense spending to rise far above the January totals. The January budget included underestimated fuel costs and no reaction to the Soviet move into Afghanistan.[43] Now Carter decided that budget restraint required denying further increases for defense.[44] He stood with House liberals against the tide of defense spending demands.[45]

By his statement and subsequent actions, Carter hoped that the federal


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government would demonstrate "discipline," thereby calming the markets. Meanwhile, the Federal Reserve Board was called upon to force a recession. The Fed was asked to do its part by restraining credit. Chairman Volcker wanted to restrain business lending anyway. Aside from the generally tight money, the March 14 package added a "voluntary" program to restrain growth in loans by large banks, enforced by a hefty raise in the discount rate for any bank that borrowed from the Fed (used the discount window) too often.

Chairman Volcker was far less interested in directly limiting consumer credit. Carter, however, was interested. If consumer borrowing prevented recession, restrictions on that borrowing could bring on the slump. Volcker did not like controls in principle; he believed borrowing was already beginning to slow. Imposing controls became part of an implicit deal between the chairman and the president; in Charles Schultze's words, "Just as Carter was doing unpleasant things for himself … [alienating] the liberal constituencies, so he too, Volcker, would have to do some things he wasn't quite anxious to do."[46]

The controls focused on credit cards. Essentially, they worked by raising the costs for banks if they expanded total lending on those cards. Unenthusiastic about the idea, Fed officials allowed a lot of loopholes, expecting lenders and borrowers to find them.[47]

For mysterious reasons—the best source emphasizes the publicity attached to Carter's attacks on credit card debt and the imposition of controls, to which we might add the existing nervousness—the controls worked far better than intended. Consumer borrowing not only stopped growing but turned negative. The economy, which had already begun to falter, fell off the cliff.


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Two Democrats in a Budget Trap
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