"Consequences" of the Deficit
In spite of the recovery, therefore, bad things were still going on in the economy. Where there are bad things, there must be blame, and blame means worry about the deficits. In the case of interest rates, blame could have meant worry about the Federal Reserve, the other half of the double whammy that supposedly kept rates high. Yet the consensus of business and political elites in defense of Volcker was so overwhelming that criticism of the Fed was muted.
The power of elite consensus became evident when the administration had to decide whether to reappoint Volcker as the Board's chairman. Although Milton Friedman urged Reagan to replace Volcker, Time asked
the right question: "Does he really have a choice?" The answer was, probably not.[40] To replace Volcker was extremely risky; it may be hard to win the confidence of "the markets," but it seems fairly easy to lose it. Previous presidents had not dared to take similar risks; thus, both Kennedy and Johnson had reluctantly reappointed Chairman William McChesney Martin.
Feldstein, Stockman, Howard Baker, and Paul Laxalt urged Volcker's retention. As the risks of dumping Volcker grew clear, Treasury Secretary Regan switched to supporting him. No one else had Volcker's credentials for dealing with the other crisis in the Fed's purview, debt in the third world.[41] Ultimately, the chairman was deemed indispensable; on June 18 Reagan announced Volcker's reappointment.[42]
The White House had a schizophrenic position on the evils of the deficit. It was hard to maintain that deficits were both so terrible that spending should be cut drastically but not so bad that taxes should be raised. If asked about tax hikes, Martin Feldstein would say, well, yes, if necessary, while Donald Regan kept claiming that, after all, deficits did not affect much of anything. In one speech Regan declared that "I will offer a prize to anyone who can show me the connection between high rates of interest and high deficits." Yet, Time commented, "he seemed to enter his own contest" when the Treasury secretary told another audience that "I do guarantee we will make visible progress in removing the specter which arose from the January budget: record deficits as far as the eye could see."[43]
Regan, while calling spending cuts "the only meaningful solution to the deficit problem," declared also that his staff had found "no empirical evidence that correlates deficits and interest rates." Yet he did add that "deficits constrict capital formation":[44] if not through interest rates, how?[45]
The secretary of the Treasury and the president downplayed the deficit when they thought tax hikes were more likely than spending cuts. CEA Chairman Feldstein continually condemned the deficits: "The president isn't well-served," he declared, "unless he gets honest advice from his advisers."[46] No one could argue with that sentiment; the issue was whether advice should be public or private. As he continued to speak out, relations between Feldstein and Regan and White House staff steadily deteriorated.
Feldstein was not about to divert Reagan from his moral economy. But the chairman's statements added force to the continuing demand by the media and mainstream economists that deficits be reduced. Now the evil consequences were an "unbalanced" recovery, an overvalued dollar, high real interest rates, a massive trade deficit, and, ultimately, excessive risk to the international financial system. A new conventional
wisdom said that these consequences, rather than the predicted inflation and stagnation, resulted from the willingness of foreigners to finance American consumption. As one leading Keynesian put it, the deficit hadn't stifled recovery "because we failed to anticipate the case with which the United States could borrow overseas. That foreign borrowing has played a key role in providing the financing for investment that we have been unwilling to provide for ourselves."[47]
Net foreign investment in the United States increased dramatically as the United States recovered while other major economies stagnated. If we think of the dollar not only as a medium of exchange but also as a repository of value, even as an investment, people around the world, comparing their situation to ours, evidently wanted to hold American currency and to use it in the United States.
As the value of the dollar rose, increasing 79 percent from 1980 to early 1985, so did the relative prices of American goods.[48] Businesses that produced in America but sold abroad found that they could not reduce costs sufficiently to make up for the rapidly rising value of the dollar. American exports suffered, but American imports increased; industries vulnerable to foreign competition in the U.S. market were damaged. This price competition caused by the strong dollar, however, helped keep inflation down, thus encouraging the economy to grow. Bad news for some is good news for others.
The U.S. trade deficit rose from a normal level (1977–1982) of around $30 billion to $60 billion in 1983, doubled again in 1984, and continued to grow. To paint the picture in broad brush strokes, the debt crisis reduced American lending abroad, while weak European recoveries and high American real interest rates attracted capital to the United States from the developed nations. These roughly equal trends caused American net foreign investment—the difference between American investments overseas and foreign investments in the United States—to change from roughly zero to a negative 3 percent of GNP. This was a dramatic reversal of the twentieth-century trend in which the United States had been a creditor rather than a debtor nation. By 1985 the change in investments meant that foreigners, for the first time since World War I, earned more from investments in America than American citizens earned from investments abroad.
The direct distributional stakes in the budget battles were quite clear: to the extent that tax reductions increased interest rates, tax policy had the same effects on corporations as tax and budget policy had on individuals. It reinforced the existing trend of the economy, which benefited those who already had money (to lend or invest) and hurt those who were already in trouble (and had to borrow). Thus, Democrats had fought for a different kind of tax cut and spending priorities. The indirect
distributional effects of policy were also sensed by the participants; this would become a major theme of liberal critiques of Reaganism.[49] By their analysis, the consequences of the big deficit strikingly resemble the old Jeffersonian/Jacksonian critique that had been a pillar of the balanced budget norm; federal debt favored those who began with greater resources. We must emphasize, however, that Democratic economists in 1980 and some politicians, including the president and other budgeters, accepted the idea that bad news for bondholders ultimately, through lower investment and productivity, would mean bad news for wage earners. When Senator Byrd protested tight money, he was shot down by other Democrats as well as Republicans. Inflation fighting came first.
As the economy recovered, without inflation, attention would turn to the problem that remained: some industries and jobs were not recovering. Senators and representatives from the industrial heartland could not accept the idea that their industries should die. Too much of the "creative destruction" that, according to Joseph Schumpeter, made capitalism great,[50] was being fed, many feared, not by real efficiency differences but by high interest rates and high exchange value of the dollar. Economists from Alan Greenspan to Otto Eckstein blamed the budget deficit for the trade deficit and thus for the losers in the economy.[51] "If Congress fails to take the necessary steps" to reduce the deficit, Martin Feldstein concluded, "real interest rates will remain high, the dollar will continue to be overvalued and a large segment of American industry will suffer the consequences of declining competitiveness."[52] In 1987 and 1988, of course, as the dollar lost more than half its value, the deficit would also be blamed.
Many suffering industries took it out on their unionized employees. Greyhound Bus drivers lost a bitter strike against management demands for compensation reductions; unionized packinghouse workers faced 25 percent wage cuts; Eastern Airlines employees had to agree to large wage reductions and altered work rules in return for shares of stock. Having won concessions in the most recent bargaining, U.S. Steel demanded more. "We are going to get beat up worse and worse," commented William Wimpisinger, president of the International Association of Machinists.[53] To the extent the deficits could be blamed for the manufacturing industries' and debtors' difficulties, the Democrats' interest-based acceptance of deficits was diluted. Union leaders still preferred to reduce the deficit with tax increases, but Democratic politicians became even less likely than in 1980 to say deficits were not a problem. Furthermore, as the economy recovered, the deficit became the easiest target for Democratic attacks.
Conservative Republicans, who believed in worrying about the future,
believed the economists who predicted bad times ahead. High real interest rates linked the antideficit ideology of conservative Republicans to their constituency interests; for example, in the farm belt, heavy farm indebtedness reinforced the antideficit positions of Senators Dole of Kansas and Grassley of Iowa.
In spite of the recovery, therefore, neither Democrats nor mainstream Republicans nor the economic gurus would surrender the idea that deficits were terrible. Ultimately, neither did Ronald Reagan. He still wanted it both ways: deficits were terrible but not so bad that they should be solved by tax hikes or defense cuts. That was his moral economy; therefore, he consistently condemned deficits in general, even as he defended his own. Thus, no one, save a few isolated supply-siders, willingly defended the deficits in economic terms. CBO summed up the situation in its 1984 Economic Outlook: "In regard to fiscal policy, it is almost universally agreed that action must be taken to reduce future deficits significantly." "But," they added, "it is not clear how or when the problem will be resolved."[54]
We discuss the shifting and contrary anti-deficit arguments at such length because, while public discourse so often claimed national interest in avoiding the evident evils of deficits, most assertions about how the economy works, including assertions about the deficit, proved inaccurate. It is neither that deficits are inherently good nor that Reaganomics (in its various forms) made them good. The manner in which the evils of the deficit kept being redefined should alert the reader to the consideration that deficit reduction was as much a solution in search of a problem as a response to difficulties.
Is the deficit itself, then, no problem? We would not go that far. There may have been adverse distributional effects. How much of the mid-1980s increase in inequality stemmed from fiscal and monetary policy, how much from other politics (not raising the minimum wage), and how much from the underlying transformation of the world economy, we wouldn't hazard to guess. Furthermore, it is hard to disagree with Herbert Stein that, over the long term, "an economy with a budget deficit equal to, say, 4 percent of GNP will probably have less private investment than with a budget deficit equal to 2 percent of GNP, and, if other things are equal, it will probably have less growth of productivity…. Over a long period [this effect] would almost certainly be significant."[55] Almost certainly so.[56] But the relationship between investment and productivity growth is very difficult to judge; the 1970s slump in productivity growth, for instance, was not associated with a drop in investment. Whether the short-term costs of deficit reduction were worth the long-term gains depended on how the economics turned out—unknowable—and how
one valued the activities eliminated by deficit reduction—a question the economists never asked.
Large deficits, unless the interest payments are effectively reduced or denied to creditors by the future effects of inflation, do finance current government consumption at the expense of future government spending. That is, future citizens, instead of buying services with their taxes, will be paying a larger and larger proportion just for interest payments. Deficits, therefore, can plausibly be seen as people today engaging services that will be paid for by their children and grandchildren. This fairly consensual analysis of long-term effects explains why conservative Republicans of a more social, that is, hierarchical/paternalistic, bent particularly dislike growing deficits.
Democrats could legitimately fear that interest payments down the line would displace social spending. In 1981 Democrats fought the third-year tax cut precisely because they could see how it would pressure their programs. While Reagan would not have put it in those words—that interest payments would constrain substantive spending—he certainly believed that the tax cut would; he and his opponents thus actually agreed. All sides could agree that increasing interest costs is bad for any organization. So do we. Republicans would avoid burdening grandchildren by cutting spending now; Democrats wanted to protect spending later by financing current spending. Of course, the two parties and their various factions disagreed on which spending was worth preserving.
As a matter of prudence, we believe, any organization should limit its indebtedness. The absolute amount is less important than the burden of its service; thus, we would pay most attention to measures of our ability to pay, interest as a share of GNP; or ability to spend, the interest share of the federal budget. Sometimes going into greater debt makes sense, depending on your return for the money. Reagan would say we bought much greater national security by borrowing for his military buildup. Perhaps, but limiting deficits to a point where the interest share of spending is stable or shrinking is certainly a worthy, even a major, goal. Is balance then the major concern of policy making? We cannot see it; certainly it cannot be justified in economic terms.
We have criticized many economic arguments about the deficit. Perhaps the most telling indicator of their difficulty is that no side could say what the deficit should be. The administration had no coherent fiscal policy rationale, for it did not want such a rationale in place of its moral vision. As for the Democrats, if they had an argument, they never articulated it. Our colleague, James Savage, has described how Democratic politicians, faced with the difficulty of maintaining Keynesian principles while worrying about deficits, resorted to waffling, trying to have it both
ways.[57] Because of the difference between long-term and short-term effects, some waffling was actually appropriate. But the Democrats were never able to marshal an argument about the appropriate level and time of deficit. Their deficit-reduction figures always seemed selected more for comparison to the Republicans' than for any economic rationale. Thus, as Savage argues, Walter Mondale promised to reduce Reagan's deficit as much as two-thirds by 1989. But why two-thirds? Why not a half, or all? If President Reagan came off better, it was because his preferences for a different moral economy needed no economic arguments, only faith and prosperity.