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The Markets Say No

When the tax cut passed, the coming deep recession was not obvious, though the economy had begun to slow and private economists were nowhere near as optimistic as the administration.[2] The recession was coming in large part because the Federal Reserve had finally taken a choke hold on the economy. An upward blip in the money supply in April supposedly spooked the markets, so the Fed decided to make sure it did not happen again. In early May the central bank raised the discount rate one point to 14 percent with a four point penalty for frequent, large borrowers, allowed the federal funds rate to rise above 20 percent, and began an unprecedented monetary squeeze. M1-B shrank in May and June, not regaining its April level until November.[3] It took a while for what the Fed was doing to be noticed or believed. By the end of June, however, Jerry Jordan of the CEA, commented that the Board was being very strict; Edward Yardeni of E. F. Hutton said that the Fed might


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push the economy over a cliff; Lacy Hunt of Fidelity Bank predicted that unemployment would rise above 8 percent.[4]

Inflation was still slowing, but so far that seemed mainly a result of good luck on commodity prices. Governors of the Federal Reserve Board were worried that inflation might accelerate again, and so were bondholders. "I assume markets are so skeptical now," Mellon Bank's Norman Robertson suggested, "that no amount of talk will change people's anticipations. The markets will have to see actual results."[5] By mid-July CEA member William Niskanen was declaring that "I think we should acknowledge that we are puzzled…. People don't change their expectations of long-term inflation very fast."[6] Trying to soothe European worries about American interest rates, Treasury Secretary Donald Regan was explaining that "you cannot get inflation under control without having high interest rates…. It's a result of supply and demand for money."[7] Interest rates were not coming down, and the arguments they would were daily growing less credible.

Federal Reserve officials expected interest rates to ease "only if we get real softness in the economy." They believed as well that inflation could be controlled only if the economy were weak enough to hold down wages in basic industries like steel, trucking, and automobiles.[8] In July, although money supply growth was running below target and the economy was at a virtual standstill, the Fed lowered the announced targets for 1981. On July 21 members of the House Banking Committee blasted Volcker. Representative Henry Gonzales (D-Tex.) accused the Board of "legalized usury." "Can the country," Norman Shumway (R-Calif.) asked, "stand the cure for this [inflation] problem?" The chairman of the Federal Reserve replied that "turning back the inflationary tide, as we can see, is not a simple, painless process, free from risks and strains of its own. All I would claim is that the risks of not carrying through on the effort to restore price stability would be much greater."[9] The politicians were being judged on many criteria, including employment; Volcker was being judged only on one—inflation.

Instead of a boom, passage of Reagan's economic package preceded the worst economic slump since the Great Depression. From Stockman's Dunkirk memo to Reagan's comments upon the passage of the tax bill, the administration had dreamt that expectations, raised by enacting its program, would cause an investment boom, while tight money would assure price stability. By mid-July that position was becoming very difficult to maintain. Perhaps they hadn't meant that tight. Investors had not been inspired to optimism by the Reagan package, or, if they had, they had not been inspired to pay or charge less for their money. In the June 5 meeting, Reagan's advisers decided not to acknowledge in the midyear review that a rosy scenario was losing credibility. Yet they had to


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forecast the deficit for their own use, not just to sell their tax program; by late July only the supply-side coterie at Treasury was willing to defend the old forecast.

Stockman, Weidenbaum, OMB chief economist Larry Kudlow, and monetarist Jerry Jordan of the CEA believed that the unlikely assumptions about money velocity should be corrected. The tax and spending packages also produced larger tax cuts and smaller spending cuts, particularly for FY85 on, than had been planned. The administration's Senate allies were expressing strong doubts about the old forecast. Finally, as one policy maker puts it, "The closer you get to the actual, the more realistic you have to be…. You move the optimism into the out-years." In late July the economic troika put together a new, more realistic forecast. Even assuming 5 percent real growth of GNP from late 1981 on—a very fine economy indeed—the new forecast, as worked up into budget projections by OMB, implied a deficit of $83 billion in FY83, heading over $100 billion in later years.[10]

On August 3, Weidenbaum briefed his colleagues and the president on the new economic forecast; Stockman followed with a long briefing on the budget bad news. "The president," a participant recalled, "looked stunned." Donald Regan, who had accepted the new economic projections, raised some doubts about the deficit numbers but confirmed the main point: the deficit was likely to be worse than previous projections admitted.

No formal decision came out of the meeting, yet there seems to have been a general, undiscussed conclusion that the administration should respond. Reagan commented that the news would make Tip O'Neill look like he had been right all along; when Stockman suggested (rhetorically) that they abandon the target of a balanced budget in FY84, the president responded, "No, we can't give up on the balanced budget. Deficit spending is how we got into this mess." He added that precise balance in FY84 wasn't necessary, but they should come close and show they had made the effort.[11]

What response was possible? Stockman broached the subject of scaling down the defense buildup; Reagan would have none of it. He emphasized that in the campaign he had said national security was more important than the deficit; he believed it, and the people cheered. Stockman brought up the avenue of tax increases; Don Regan, happy to fight the deficit but with spending cuts, opposed the budget director. Stockman discussed "draconian" cuts in social programs; the president suggested savings from "waste" from federal personnel. He said the federal bureaucracy was "layered in fat."

No doubt Reagan believed it. He had said it before, believing 10 percent of the budget could be cut by eliminating waste, and he would


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say it again. At the end of 1981 he told Senate Republican leaders as much as $40 billion could be saved from general government overhead.[12] Unfortunately for Stockman and other budgeters, no matter how much waste there may be in the government, people could not agree on what it was. Certainly $40 billion couldn't be taken out of overhead; total payroll for all the civilian agencies wasn't much more than that. Reagan wanted deficit reduction that hurt only "free-loading" bureaucrats, but Stockman had to take checks and benefits away from citizens.

Stockman's difficulty, as he left the inconclusive meeting on August 3, was that, as Newsweek reported, "The easy cuts have all been made." By definition, everything the boll weevils or gypsy moths had forced out of his earlier package was difficult, never mind the cuts that never made it to public view.


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