The New Empire of Debt: The Rise and Fall of an Epic Financial Bubble (32 page)

Politicians had no trouble giving the economy the boost that Keynes had suggested. But when it came to saving money to have something to give a boost with, the time never seemed quite right.The moment for underspending never seemed to come. Like fat men at a wedding feast, policymakers told themselves they would eat less after the party was over, to make up for their gluttony now. But in public finance, there is never a good time for fasting.

When the Reagan team arrived in Washington, the nation had been living with Keynesian deficits for many years. Savers and lenders had grown wary. Consumer price inflation hit 13.5 percent in 1980. Lenders feared it would go higher still. They demanded protection. In 1980, 30-year mortgages could be had at 15 percent interest. By the following year, the mortgage rate rose to a peak of 18.9 percent.

But then, Paul Volcker’s anti-inflation policies at the Fed began to pay off. Investors did not yet know it, but the bond market had found its bottom. For the next two and a half decades, bonds would go up. Bond yields—a measure of what people must pay to borrow—went down. Thus, were the two cornerstones of the Reagan era in place—lower taxes and lower real cost of credit. Neither was an improvement to America’s system of imperial finance. Both were merely corrections to previous meddling.Taxes had been raised so that the government would have money to spend on its imperial programs: bread and circuses at home; wars at the periphery. High bond yields (a high cost of credit) were the result of Keynesian policies. Neither problem was caused by neglect. Instead, both were the inevitable debris of previous improvements, previous innovations in the field of economics, and previous generations of self-aggrandizing empire builders posing as do-gooders.

After Reagan’s tax cuts, U.S. gross domestic product (GDP) grew at an average rate of 3.2 percent per year throughout the eight years of Reagan’s two terms. This was a bit more than the 2.8 percent average gain in the eight years before and substantially more than the 2.1 percent of the eight years following. Still the growth was slower than it had been in the 1960s, after Kennedy’s 30 percent tax cut of 1964 produced 5 percent annual GDP rates. Meanwhile, real median household income rose from $37,868 in 1981 to $42,049 in 1989. This, too, was much better than the rate of growth before or after the Reagan years. But much of it—maybe all of it—came not from real increases in wages, but simply from more people working longer hours, as we illustrated in our previous book.

Real wage increases require three things: First, the society must save money so that it has the capital to invest. Second, it must invest the savings in profitable businesses. Third, these capital investments must result in increased productivity.

Alas, none of these things happened. Instead, these three critical things began trending in the wrong direction. National savings—including public savings—fell from 7.7 percent in the 1970s to only 3 percent by 1990. Business investment fell from 18.6 percent of GDP in the 1970s to 17.4 percent in the 1980s. And productivity? In the 25 years after World War II, output per employee had risen at an average rate of 2.8 percent per year. During the 1980s, this rate fell to less than 1 percent.

There was a bump in productivity after 1995, but this was largely a feature of the Labor Department’s new way of calculating it. With falling savings, falling business investment, and (consequently) falling productivity, you could not expect the economy to do very well. It didn’t.

While the supply side of supply-side economics was a total flop, the demand side was a stunning success. The Reagan team at least figured out how to pay for an empire: Borrow.

As a percentage of GDP, federal government receipts fell from 20.2 in 1981 to 18.6 in 1992. But spending rose from 22.9 percent in 1981 to 23.5 percent in 1992. Naturally, debts rose.

By the end of 1992, the federal debt was more than $4 trillion. When Reagan took over, it was less than $1 trillion.

No fraud is so lovable as the illusion of getting something for nothing. But something-for-nothing was just what the new conservatives now promised voters—just like the Democrats. The difference was that the Democrats pledged to steal the money from the rich (Republicans). The Republicans promised to create it in a free economy, like Jesus multiplying the loaves and fishes at Beth Saida.“Voodoo economics,” was how George Bush described it.

When supply-side economics first appeared in the American press, real economists were perplexed. They had never heard of it. There were no university departments specializing in it. There were no peer-reviewed papers. There were no scholarly books describing it. There were scarcely any economists claiming to be supply-siders. It was, apparently, a school of thought without a school. Some wondered if it also lacked a thought.

Traditional economists—mostly empire builders and world improvers, but of the Keynesian variety—had gotten themselves stuck on a teeter-totter. On one end sat inflation. On the other was employment.They could press down on one end, but the other would rise up and hit them on the chin. There seemed to be no way out. No free lunch. It seemed that they would have to pay for every something with something else. If they wanted to reduce inflation, it would cost them jobs. If they wanted to increase employment, consumer prices would rise.

Milton Friedman, among others, warned that Keynesianism was just folderol. As soon as people realized what the government was doing, the jig would be up. They would merely raise prices in anticipation of inflation, without increasing production.
Stagflation
—rising prices in a sluggish economy—would result. Other economists pointed out that any attempt to manipulate the business cycle would fail for the same reason. Once the policy were known, people would adjust their behavior to it, nullifying its effectiveness. They would not mistake inflation for greater demand:They would not increase production; they would not hire more workers; they would not spend more money. The only thing the policymakers could possibly do that would have an effect would be something people did not expect. And that could only be a policy of random manipulations—which would cause further confusion and who-knew-what results. Keynesians, even new Keynesians, never had any real answer to this problem. But that didn’t stop them.They decided to ignore it. Meddlers and empire builders can’t be bothered with theoretical problems; they are too busy creating a better world!

Stagflation came in the 1970s, just as Milton Friedman had said it would. It was not the better world the Keynesian economists had hoped to create. But it was the world they got. (Like everyone else, world improvers don’t get exactly what they expect; they get what they deserve.) Stagflation posed a problem with no easy solution. Prices were rising, but employment was flat. Policymakers wanted to increase employment, but they were loath to add more inflation. They could try to lower inflation, but that would hurt employment even more.

Along came the supply-siders. They had no real solution. But at least they had a way to hide the problem.What both the public and the politicians wanted, they noted, was employment without price increases. They wanted a booming economy and no inflation.Voters wanted money from government ; they also wanted to lower taxes.

The trouble with traditional conservative economists was that they were always pointing out the true cost of things.“There’s no such thing as a free lunch,” was practically tattooed on their foreheads. Conservative economists typically argued against government debt, against deficits, and against more spending, against activism in all its forms; they knew there would be a price to be paid for it, eventually.This attitude made conservative economists deeply unpopular. They were, after all, party poopers. Who would want such a killjoy around? None could ever be elected to high office.The essence of politics was promising things that couldn’t be delivered honestly. If a man could get no more from an election than what he actually earned, why would he bother to vote at all?

The supply-siders’ proposal seemed to offer something for everyone—at no cost to anyone. Taxes could be cut, said Arthur Laffer; lower taxes would create such a boom that output would go up—eliminating inflation. Government revenues would go up, too—even at lower tax rates.The budget would be balanced. Most importantly, it offered a way to get conservatives elected—by turning them into big spenders.

REAL BOOMS VERSUS THE PHONY VARIETY

Real booms need real money. Typically, people save money when they are wary and spend it when they are flush. The spending is real. The money is real.The boost in sales is real.The profits are real.

But a boom that people build on phony money is itself phony. Every step of the way takes them in the wrong direction. The demand is an illusion. The spending is a mistake. The money is suspect. And the resulting business profits are not merely temporary, they are nothing more than next year’s sales disguised as this year’s earnings.

A man who borrows money to begin his spending spree contributes nothing to the economy. Every dollar he spends must someday be withdrawn. It must be paid back. Imagine that he borrows $1 million. In a small town, that sum might be enough to set off a boom. He buys a new car. He goes out to the restaurant. He gives money to church and charities. He takes a holiday. He orders a new suit. He builds a new wing on his house. Soon, the money is out of his pocket. But it is not gone. It has found a new home in pockets all over town. And now the butcher, the baker, the builder, the travel agent, and many others are all planning little additions to their own standards of living.

But imagine the disappointment when, the following year, the man who spent so freely no longer comes around. He is not seen at the tailor, or at the travel agent, or at the restaurant, or the car dealer. He is not even seen so frequently at his old haunts. Not only does he not spend as freely as he did the year before, he barely spends at all. For now he must cut his regular spending by enough to pay back the $1 million plus interest. Net spending in the town will actually go down, over a multi-year period, by the amount of interest he pays (assuming that the loan came from outside the community).

(We invite readers to consider the current U.S. situation—when loans from overseas surpass $1 trillion per year.)

The supply-siders’ key insight was that government is essentially a parasite. It lives off its host like a leech. And like any bloodsucker, it has to be careful not to suck too much. Otherwise, it will weaken its host and maybe even kill it. Or, if it sucks too little, it fails to fully exploit the opportunity and invites competition.

The supply-siders’ concept was hardly a formula for maximizing individual freedom. On the contrary, it was a formula for financing an empire by increasing government revenues. Arthur Laffer’s curve merely illustrates a rational bloodsucker’s optimization strategy; he will get the most at a level that is neither too high nor too low. A government that imposes tax rates that are too high weakens the economy and ends up with less resources than it might otherwise have. This was a problem with communism—it asked too much of its citizens. The poor schleps were drained dry. Democratic regimes in the West took a lower percentage of their citizens’ output. But their hosts thrived, giving the government more money to spend. The government of the Soviet Union took less from each citizen than the United States did, but it took a much higher percentage of each citizen’s output.This was why the West won the Cold War; it had fixed its tax rates lower.

But Reagan’s tax cuts were an empty gesture. Without offsetting cuts to federal spending, deficits increased. What really matters to an economy is not the nominal tax rates, but the percentage of the economy’s resources taken away by the government. Actual tax rates in the Soviet Union were zero. The communists claimed the right to 100 percent of production, a portion of which was turned over to citizens for personal use. The government’s percentage of production, or what might be called its
real tax rate,
while difficult to measure, was very high. That, combined with even more government meddling than in the United States, doomed the Soviet experiment.

Reagan cut nominal tax rates, but government consumed more and more resources. The leech grew. Lower tax rates gave citizens the impression that they had more money to spend. Individually, they did. Collectively, they did not. The program was merely a monumental legerdemain. For every tax-cut dollar that a citizen spent, the federal government had to borrow as much as $1.18 (with interest).

Still, citizens thought they had more to spend. They spent it. It was this extra spending—this Keynesian boost of money borrowed by the federal government to replace the forgone tax revenues—that picked up the economy.

And now, pardon us if we go over to this dead horse and lay on the whip again. Reducing taxes is a conservative, anti-activist, anti-world-improving, anti-political, anti-empire gesture. Taxes are imposed by people who pretend that the world will be a better place if your money is taken from you and redirected to others’ pockets. Cutting taxes is a way of removing the improvement residues of the past. It is a way of tipping society away from the political means of doing things back toward civilized, consensual, economic life. The lower the taxes—and here, we speak of real tax rates (the amount of resources consumed by the government)—the more modest the world-improvers’ ambitions. Lowering tax rates was the right idea. But lowering only nominal tax rates, while simultaneously increasing the government’s resources, was a sham.

Since the tax cut was a sham, so was the resulting boom. It was inspired by consumer demand that didn’t exist. But the financial world is a complicated, confusing affair with many promiscuous liaisons. Events are engendered by other events.They are
path dependent,
as economists say. One event fathers another. Life was good in the Reagan years.The supply-siders patted each other on the back. “We did it,” they congratulated each other. Someone should have asked for a paternity test.