What Really Happened in 1981

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COMMENT What Really Happened in 1981

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PAUL CRAIG ROBERTS

aving written a number of articles over the past twenty years showing that the “Reagan deficits” were the consequence of an unanticipated collapse in Hthe rate of inflation (Roberts 1984, 1986, 1988, 1989a, 1989b, 1989c, 1989d, 1990, 1991, 1992; Roberts and others 1986), I was pleased to find Timothy J. Muris adding his voice to the discussion of this issue in “Ronald Reagan and the Rise of Large Deficits: What Really Happened in 1981” (Independent Review 4 [2000]: 365–76). Muris is correct that there was neither a rosy forecast nor a “Laffer curve” assumption that the tax cuts proposed at the outset of the Reagan administration would be self-financing. These facts are so obvious from official government doc- uments and my own writings that it says a great deal about the carelessness or preju- dice of the economics establishment that journalists such as Sidney Blumenthal and economists such as Benjamin Friedman (1988) could so successfully spread the views that Muris refutes. Considering the extraordinary misinformation that still prevails, however, it is worthwhile to strengthen Muris’s argument and to fill some gaps. Congressman David Stockman was not the architect of Reaganomics. The archi- tects were supply-side economists, most of whom were trained at the University of Chicago or by Chicago-trained professors. Supply-siders said that “stagflation” (simul- taneous recession and inflation) and the “Phillips curve” (an inverse relation of the inflation rate and the unemployment rate) were products of a demand-management

Paul Craig Roberts is the chairman of the Institute for Political Economy, research fellow at the Inde- pendent Institute, and a senior research fellow at the Hoover Institution, Stanford University. In 1981–82 he was Assistant Secretary of the Treasury for Economic Policy.

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policy mix that used monetary policy to stimulate employment and high tax rates to restrain inflation. Supply-siders said that the easy money pumped up demand, while the high tax rates restrained real output. The result was inflation. The supply-side cure was to use monetary policy in order to control inflation and to reduce marginal tax rates in order to stimulate the growth of real output. This altered policy mix, we claimed, would permit real output to grow while the rate of inflation fell. The challenges confronting the new macroeconomic policy and any forecast based on it were the commitments of economists to the theory of the Phillips curve, the idea of “core inflation,” and the Keynesian interpretation of fiscal policy as a means of shifting only aggregate demand. At the time the administration was preparing its budget forecast, widely used forecasting models had a core rate of inflation of 10 percent. That rate was seen as a floor even with restrictive monetary and fiscal policies (in the Keynesian sense). The administration’s marginal-tax-rate reductions were widely interpreted as a Keynesian fiscal stimulus. We heard endlessly that a forecast that combined tax cuts with falling inflation was not credible. It was especially not credible originating as it did at a time of double-digit inflation after years of rising inflation expectations. Nevertheless, we pushed through a forecast that combined both declining inflation and real-output growth equivalent to what had been achieved between 1976 and 1980. Most mem- bers of the economics profession considered that forecast to be an implausible com- bination, and they stuck with the Phillips curve. Federal Reserve Chairman Paul Vol- cker also considered the forecast implausible, as did his economic consultants. In July 1981, David Stockman and Richard Darman might have been wandering around in a parking lot sharing deficit musings, as Muris reports, but the real action was taking place elsewhere. At a July 1981 meeting of the board of governors of the Federal Reserve System with its economic consultants (at which I was present as the administration’s representative), Alan Greenspan (among others) advised that a restrictive monetary policy would be overwhelmed by the tax cuts and therefore inflation would explode. Monetary policy, he said, was the junior partner, a “weak sister,” and could “do nothing other than a weak rear-guard action.” Over the preceding months, the Treasury had explained to the Fed on numer- ous occasions our view that a change in policy mix would free the economy from worsening Phillips-curve trade-offs. We had emphasized that the Fed must gradually tighten but stay within the target ranges. Our biggest mistake was to overestimate the Fed’s capacity for independent judgment. Instead, the Fed was guided by conventional wisdom, panicked, and slammed on the brakes. The tax-rate reductions had been delayed, and the economy hit the skids. The unexpected rate of disinflation not only reduced the tax base but also built in higher levels of real spending than the administration had intended.

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Political partisans and economists defending their intellectual commitment to demand-management theories have done much to obscure both the policy goals and the achievements of the Reagan administration. But the two decades that have passed since 1981 have given us the results that supply-side economists predicted: two record back-to-back economic expansions—if not one expansion briefly interrupted by war and policy uncertainties—while inflation fell and then remained low. The changed policy mix worked. It was not implausible, impossible, or “voodoo” economics after all.

References

Friedman, Benjamin. 1988. Day of Reckoning: The Consequences of American Economic Policy under Reagan and After. New York: Random House. Roberts, Paul Craig. 1984. The Supply-Side Revolution. Cambridge, Mass.: Harvard University Press. ———. 1986. How the Fed Crowded Out Reagan’s Economic Policy. Cato Journal 5 (winter): 777–85. ———. 1988. Supply-Side Economics—Theory and Results. The Public Interest 93 (fall): 16–36. ———. 1989a. Supply-Side Economics, Theory and Results: An Assessment of the American Expe- rience in the 1980s. Washington, D.C.: Institute for Political Economy. ———. 1989b. Supply-Side Economics, the American Experience. In Reaganomics and After, 23–62. London: Institute of Economic Affairs. ———. 1989c. Supply-Side Economics. Rivista di Politica Economica 79 (1989): 3–54. ———. 1989d. Supply-Side Theory and Experience. Zeitschrift fur Wirtschaftspolitik 38: 5–42. ———. 1990. Supply-Side Economics and the Future. In Readings in Introductory Macroeco- nomics, edited by Peter D. McClelland, 171–72. New York: McGraw-Hill. ———. 1991. What Everyone “Knows” about Reaganomics. In Readings in Introductory Macroeconomics, edited by Peter D. McClelland, 154–59. New York: McGraw-Hill. ———. 1992. My Experience with Government Forecasting. Cato Journal 12 (spring–summer): 125–28. Roberts, Paul Craig, and others. 1986. The Relative Impact of Taxation and Interest Rates on the Cost of Capital. In Technology and Economic Policy, edited by Dale Jorgenson, 281–316. Cambridge, Mass.: Ballinger.

VOLUME V, NUMBER 2, FALL 2000