Two
Democrats in a Budget Trap
In 1980 the Democratic party lost control of the American government. The Democrats' defeat was most evident in the election. Incumbent Jimmy Carter got only 41 percent of the vote, with 51 percent going to Republican Ronald Reagan and 7 percent to independent John Anderson. In the House of Representatives, the Democratic majority was slashed by thirty-three seats, a change that, considering conservative southerners, made the Democratic majority fade away. Most dramatically, Democrats lost twelve Senate seats; their once solid majority now had melted to a forty-six to fifty-three minority. For the first time since 1954, Republicans would rule a house of Congress. For the first time in more than twenty years, a Republican president could more than dream of having legislative majorities to enact his program.
The election, however, only formalized the Democrats' loss of control. There is more to governing than simply holding office. In 1980 the Democrats could not govern because they could not agree on how to use the offices they held. Bitter divisions were revealed in Senator Edward M. Kennedy's (D-Mass.) challenge for the presidential nomination. But the nomination battle was only one phase of the strife within the governing coalition in Washington. Assailed from the left of his party in the campaign, Carter was, attacked from the right in Congress. In either arena, conflict centered on the budget and the economy.
Internal conflict was hardly new to the Democratic party. As in any coalition, Democrats managed conflict by bargaining on some issues and, where agreement was impossible, ignoring others. Unfortunately for them, the Democrats could not finesse their 1980 disagreements over budget policy.
The Budgeting Dilemma
Budget resolutions (setting internal congressional targets for total spending and revenue) and appropriations could be delayed but eventually would have to be passed. When resolutions were considered, Democrats had to face the great divisive issues of defense spending and inflation. On defense, a large faction of Democrats, led by Senators Hollings of South Carolina and Nunn of Georgia, was enough alarmed by America's military position to join Republicans in fighting President Carter for a larger military buildup. And many Democrats, along with most Republicans, felt that inflation posed so great a threat that some action—probably budget balancing—was imperative.
Two contradictory pressures—higher defense spending and stopping inflation—originated in attitudes toward events beyond Capitol Hill. The Soviet Union's invasion of Afghanistan, the administration's reaction to a Soviet combat brigade in Cuba, and the taking of American hostages in Iran all helped generate a sense of American military weakness. Voters in their districts and commentators in the media informed politicians that people felt insecure about national defense.
Congress clamored for a big defense buildup. Speaker O'Neill declared:
I think the mood out there is that we have to be prepared for conventional skirmishes, and the American people feel for the first time that we do not have that capability. I'm talking about the safety of the country, and you put that ahead of energy, inflation, balancing the budget and everything else.[1]
If Carter bowed to this pressure, yet wanted to balance the budget, he would have to raise taxes further or turn on the Democrats' own constituencies by taking from social programs to give to defense; if the president held down the defense buildup, he would come under fire for risking the nation's security.
But if the public felt insecure about defense, it reached near panic at the prospect of inflation. The polls were showing inflation as the major political issue, while financial markets gyrated wildly and the media clamored for action.
Consumer prices already had increased by 13 percent in 1979, and the trend was toward even faster increases. The inflation reduced individuals' real average gross weekly earnings by about 4 percent in 1979.[2] Consequently, the public's pain threatened to become the president's trouble. In mid-October 1979 a Gallup poll showed that only one-third of the respondents approved of Carter's job performance (with half
disapproving) and that two-thirds listed inflation as the nation's most important problem.[3] Conventional wisdom said that one way to reduce inflation was to reduce the federal budget deficit.
Whether the deficit increased inflation or not, inflation did increase the deficit. Social security and the other pension programs were slated for large increases in fiscal 1981, mandated by law to compensate their beneficiaries for the 1979–1980 inflation. Costs of medical programs could be predicted to rise as the price of health care soared, along with fuel costs for the military and food costs for school lunches; in many such ways inflation would increase the cost of providing in FY81 the same services provided in FY80. Price increases were accompanied by (somewhat smaller) wage hikes, thereby increasing collections from income and other payroll taxes. The burden on many taxpayers increased as their nominal wages crept up into higher tax brackets but their real wages (what they could buy) remained steady or declined because prices rose more quickly. This automatic tax hike angered voters. Yet even higher tax payments from "bracket creep" could not make up for the automatic increases in entitlement funding and the desired jump in military spending.
The dilemma for Democrats was to reconcile the seemingly irreconcilable: cutting deficits caused by inflation in order to reduce inflation, while increasing defense spending and diminishing the tax burden. Something had to give; in 1981 the Reagan administration risked higher deficits to build the military up and keep taxes down. But in 1980 Jimmy Carter went the other way.
By all reports, Carter, who introduced the "zero base budgeting" reform system in Georgia, truly believed in the fiscal responsibility and control that a balanced budget represents.[4] This belief, moreover, was reinforced in the political-economic arena. His Republican challengers naturally were denouncing deficits, but so were Democrats: California Governor Edmund G. (Jerry) Brown, Jr., supported a constitutional amendment calling for a balanced budget; even Senator Edward Kennedy condemned deficits, announcing in late January that he favored "the steps that have been taken by the Congress to insure that we're going to achieve a balanced budget next year."[5] Most Americans agreed that a balanced budget was desirable; in March 1980, for example, a Gallup Poll reported respondents supporting by more than four to one a constitutional amendment requiring balanced budgets.[6]
In addition to the lasting symbolic power of a balanced budget in American political history—as a sign that things were right and government could govern—support for balanced budgets had two contemporary sources. One was a deep, widely held suspicion that the federal government wastes money—fifty-two cents on every dollar, according to
the median respondent in a November 1979 Gallup Poll.[7] In the public mind, an unbalanced budget stands for and allows wastefulness. The second source was a widespread belief that government deficits fuel inflation. Although the link is neither direct nor predictable, and is possibly even mistaken when overwhelmed by other factors, most economists believe that deficits work more to increase than to decrease prices. The March 1980 Gallup Poll showed that the public, by more than a four to one margin, agreed that deficits were more likely to raise prices. In January 1980, government waste probably had not changed, but inflation was increasing dramatically. Politicians, therefore, seized on deficit reduction as something they could do about inflation.
The Politics of Recession
The difficulty with using the budget to attack inflation was that a recession might well result, bringing unemployment, lower profits, and bankruptcies. Recessions are not popular; neither, under normal circumstances, are presidents who go out of their way to start them.
Carter faced unique difficulties because he was a Democrat. Recessionary policies would attack his party's basic constituencies: labor and beneficiaries of social programs. In October, James Fallows reflected on Carter's plight:
Ford and Nixon were Republicans, and therefore had some theoretical excuse for tolerating unemployment while fighting inflation. For a Democrat to do that is like an American fighter plane joining a kamikaze squad: no one can figure out what's in it for him.[8]
Because Democratic politicians were particularly opposed to unemployment, and because Republican politicians were particularly opposed to Democratic administrations, Carter could count on no one to support a recessionary budget. Beyond such short-term tactical difficulties, to pursue unemployment explicitly flew in the face of the mission and history of the Democratic party. Democrats had become the majority party because, in the Great Depression, they had worked to reduce unemployment and its miseries. Democrats built the modern welfare state so that fluctuations in the economy, the boom-and-bust business cycle, would not leave millions destitute. As the party of full employment, Democrats liked to portray Republicans as the party of unemployment. Even in January 1980, when the Carter administration's inability to control inflation caused Americans to feel that Republicans would be better at running the economy, the Republican party's own polls reported that Americans (by nearly two to one) still believed that Democrats were better at reducing unemployment, helping young people buy homes, and
providing financial security for the elderly.[9] If they began to create unemployment, what were Democrats good for? If the public wanted to cut social programs, why not just hire some Republicans to do the job?
Caught in a double bind, the administration, like Goldilocks, wanted a recession that was "just right": one that would both reduce demand (one source of price pressure) and be seen to reduce demand (thereby reducing expectations of inflation, a major source, some thought, of the spiral), yet not hurt anyone very much. Ideally the recession would be long enough to convince the public but short enough to seemingly end by election day. By January 1980 it may well have been too late to accomplish any of those goals.
Carter's Goldilocks budget predicted an unemployment rate of 7.5 percent for 1980, inflation of 10.4 percent, and a FY81 deficit of $15.8 billion. Defense spending was up by choice; entitlements were up by inertia; and the remaining domestic budget was held constant or slightly decreased. The deficit would go down, in spite of higher unemployment, because taxes would go up. Inflationary effects on wages and legislation passed or in progress (e.g., the projected adoption of the windfall profits tax on oil companies and a January 1981 scheduled increase in the social security payroll tax) would increase revenues by 14.5 percent over the FY80 level, compared to a 9 percent spending increase.
Essentially, Carter was pushing the economy toward recession with higher taxes. His budget message promised to limit the pain of the unemployed. The deficit, he said, was only one cause of inflation. But the basic message remained that "by continuing a clear and consistent policy of restraint, the 1981 budget ensures that the federal budget will not be an inflationary force in the economy."[10] Another term for restraint was unemployment.
The president and his advisers had decided that to limit inflation—and to be seen as steadfast in this—was more important politically than to avoid tax increases. They believed that the public was willing to pay a high price to stop the inflationary spiral.[11] Yet accepting unemployment levels of more than 7 percent without countermeasures was extraordinary, especially for a Democratic administration. The administration could not have accepted such a grim prospect if its economic theory had offered any alternative.
The Economics of Recession
The administration's theory emphasized the impact of oil shocks on "core inflation." In mid-1979, the Organization of Petroleum Exporting Countries (OPEC) doubled oil prices. Oil was more expensive, so the nation would have either less oil or less of something else. In real terms (product
per person), paying more for oil meant less personal income. As prices affected by oil rose, workers would try for proportionate pay increases in their wage bargaining. If workers succeeded, businesses that gave raises would immediately raise prices, hoping thereby to recapture profits. Then workers in other industries would react to these new prices by demanding higher wages from their employers. Wages and prices would chase each other at increasing speed, both spiraling upward, as employer and employee groups strove to stick the other with the cost of OPEC's oil. At worst, the spiral takes on its own life, as workers and managers expect it to continue, separate from its original cause.
This self-perpetuating spiral is called the core inflation rate. Administration economists believed that core inflation was up to 8 percent in 1979, and heading much higher, and their solution was to keep wages from chasing prices; the only reliable way to do this was through unemployment, which would pressure workers to accept smaller wage increases or lose their jobs to those already unemployed. Thus, as John Berry of the Washington Post reported the policy, "slower economic growth and higher unemployment [were] the key to both the short-run and the long-run attack on rising prices."[12] Chairman of the Council of Economic Advisers Charles Schultze said that "the Administration's greatest fear involves a further increase in inflation if workers try to recover some of the purchasing power lost last year to inflation and, particularly, to higher oil prices."[13]
While Carter's dilemma recalled Goldilocks, reactions to the budget reminded us of the classic Japanese story of Rashomon, in which the same event is reported entirely differently by various participants and witnesses. The National Journal titled its story, "A Campaign Budget for an Election Year," mentioning all the bows to defense, domestic programs, and anti-inflation pressures while somehow ignoring the electoral problems presented by tax increases. But The Economist proclaimed:
The deficit is an infinitesimal part of a $3 trillion GNP and is dwarfed by the foreign tax imposed on the American economy by OPEC's increased oil prices. President Carter has presented a non-electioneering budget in an election year. Such courage deserves to succeed.[14]
Time described the galloping inflation and concluded that "the injection into the economy of new cold war defense spending, without any concomitant reduction in social expenditures, could be like hitting the gas pedal in a car already careening out of control down a hill."[15] Newsweek's writers saw the exact opposite. "At bottom," they concluded, "the Carter budget obviously reflects the lessons learned in the late 1960s when Lyndon Johnson's pursuit of a guns-and-butter policy started the nation on a road to a disastrous inflation."[16]
These different judgments reflected the clashing perspectives about the economy that observers applied to Carter's set of choices. Each columnist wrote as if the analysis was self-evident but each analysis, of course, was not. The agreements and disagreements among competing schools of economists would, however, influence budget politics until the present time. We pause to describe the competing schools.
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.
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
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,"
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
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
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
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.