 Reagan's
Real Revolution, Part Two
Bill Bonner
The
Daily Reckoning
March 15, 2005
The Daily Reckoning PRESENTS:
On the
outside, the U.S economy looks just fine and dandy, thanks to
the "world improvers"...but if you dig a little deeper
and open your eyes a little wider, you'll see something quite
different. Read on . .
.
Ronald Reagan
may have called himself a conservative. But his real revolution
lay in redefining conservatism as an activist, world-improving
creed. First, the neo-cons took over foreign policy. Soon, Americans
were stirring up trouble everywhere from Latin America to Afghanistan.
Then, they took over domestic policy. In a few cases, the ghastly
remnants of previous improvers - such as 70% top marginal rates
- were knocked over. In other cases, new edifices were built
up. The sharp tax cuts of 1981 were not followed by sharp spending
cuts. Instead, spending went up. And not just on defense. Reagan
had pledged to abolish the Department of Education. Instead,
he increased its budget by 50%.
There were
four key elements to Reaganomics. Restrict the money supply in
order to slow inflation (admirably carried out by Paul Volcker
at the Fed). Cut taxes (a 25% across-the-board tax cut was enacted
in 1981). Balance the budget by controlling domestic spending.
(A complete failure...deficits grew larger than ever.) And reduce
government regulation. (Ditto.)
As you can
see, the first two objectives were, more or less, achieved. They
produced, more or less, what Milton Friedman had expected. But
neither was an activist measure. Both merely undid some of the
worst damage done by previous office-holders. Lyndon Johnson,
Richard Nixon, and Jimmy Carter had made a mess of the economy.
Ronald Reagan and Paul Volcker helped clean it up. But without
action on the other two objections, the clean-up lacked the necessary
suds and elbow grease. The dirt and clutter were mostly left
alone, while new trash was heaped on.
The big cut
in taxes gave people more money to spend. Since government spending
was not cut, the result was more net spending in the economy.
This was equivalent to an increase in the money supply - or an
increase in demand. Consumers began a buying spree, while government
borrowed the money to fund the deficit. Looked at from a macro-economic
perspective, Americans had no more money to spend after Reagan
took office than they had when he was in California. But they
thought they had more. They had more money in their pockets.
More money to spend.
Few people
asked, "Where did it come from?" If they had thought
about it, they would have realized that, collectively, they were
merely going further into debt in order to increase their current
standards of living. If they had reflected on it deeply, they
would have realized that they were running up bills that future
generations would have to pay...they were spending money that
their children and grandchildren hadn't earned yet. For what
was a national debt, but an inter-generational obligation, a
burden placed on infants by their parents and grandparents?
Hardly anyone
thought about it then...or since.
"Supply-side
economics" was meant to be different from "Keynesian"
economics, in that it celebrated the power of the free market
to create wealth. If only the restrictions imposed on the economy
by previous generations of world improvers could be removed,
they said, the economy would boom and people would get rich.
Thus, it came
to be that taxes were cut and the economy boomed. Just as Keynes
said it would. What the supply-siders had done was nothing more
than administer a Keynesian boost. John Maynard Keynes, a British
economist of the early 20th century, had given world improvers
a tool. He showed that recessions could be offset by government
spending. When private spenders pulled back, he noted, government
could take up the slack - by running deficits - thus, helping
to pull the entire economy out of recession. He also recommended
that governments run surpluses in good times so they'd have money
to spend in bad ones. This was the part the politicians never
particularly liked, and the part of his plan they never could
quite follow. It was all very well to increase the money supply
and consumer demand - who complained when people had more money
to spend?
But decreasing
the money supply meant taking purchasing power out of the economy.
Human nature being what it is, the moment for under-spending
never seemed to come. Like fat men at a wedding feast, policy
makers told themselves they would eat less after the party was
over, to make up for it. But in public finance, there is never
a good time for fasting.
With no surpluses
to draw upon, government had to turn to debt. But government
is a unique and wondrous borrower. It, and only it, has the power
to control the terms of the trade, and never fails to turn them
to its own advantage. Most important, it controls the quantity
(and indirectly, the price) of the currency in which its borrowings
are measured. It can borrow in a currency of one value...and
pay back in the same currency, but at a cheaper rate. How surprising
is it the price of the dollar fell, in both Republican as well
as Democratic administrations? "We are all Keynesians now,
" said Richard Nixon in the early '70s.
After Reagan's
tax cuts U.S. GDP grew at an average rate of 3.2% per year -
throughout the eight years of Reagan's two terms. This was a
bit more than the 2.8% average gain in the eight years before
and substantially more than the 2.1% of the eight years following.
Still the growth was slower than it had been in the 1960s, after
Kennedy's 30% tax cut of 1964 produced 5% 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 what had happened before
or after the Reagan years. But much of it - maybe all of it -
came not from real increases in wages, but simply from the fact
that more people worked longer hours.
Real wage increases
require three things: first, the society must save money...so
it has the capital to invest. Second, it must invest the savings
in productive businesses. Third, these capital investments must
result in increased productivity.
Alas, none
of these things happened.
Everyone loves
a good fraud. And no fraud is so loveable as the illusion of
getting something for nothing. That is what the supply siders
seemed to promise. Government could spend more...and cut taxes
at the same time. For a while, it even seemed to work. America
boomed. And the boom continues even today.
But real booms
need real money. Typically, a person saves money when he is wary
and spends it when he is flush. The spending is real. The money
is real. The boost in sales is real. The profits are real.
But a boom
built on phony money is itself phony. Every step of the way takes
him in the wrong direction. The demand is an illusion. The spending
is a mistake. The money itself 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, even 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, his 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. It seems to all of them that something has happened.
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. In other
words, 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 will invite
readers, later, to consider the current U.S. situation - when
loans from overseas surpass $600 billion per year!)
After many
years of Keynesian deficits, by 1981, savers and lenders had
grown wary. Consumer price inflation hit 13.5% in 1980. Lenders
feared it would go higher still. They demanded protection. In
1980, 30 year mortgages could be had at 15% interest. By the
following year, the mortgage rate rose to a peak of 18.9%.
But by 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 decades, bonds would go up. Bond
yields - a measure of what people must pay to borrow - went down.
Thus, the two cornerstones of the Reagan boom were in place -
lower taxes and lower cost of credit. Neither, we repeat ourselves,
was an improvement to the world financial system; both were merely
corrections to previous meddling. Taxes had been raised so that
the government would have more money to spend on its marvy programs.
High bond yields (a high cost of credit) were the result of Keynesian
policies. Neither problem was caused by neglect, in other words.
We have already
explained how the Reagan tax cuts were a bit of legerdemain.
Without offsetting cuts to federal spending, they increased spending...and
misled the economy about aggregate demand. The lower cost of
credit, on the other hand, was clearly a plus. Falling interest
rates made it cheaper to borrow; people borrowed. But they had
not forgotten the lesson of the '70s. Instinctively, they expected
prices to go up - which would lower the cost of their loans still
further. Rising prices would also undermine the value of their
savings. They did the reasonable thing: they borrowed. They did
not save.
The savings
rate fell during the '80s from 8% to 6.5%. In the '90s it continued
to fall - to 4.9%. In the 2000s, it fell even lower. How were
Americans going to finance their government deficits? Where would
they get the money to build new factories...and develop new technologies?
How could a
modern economy compete without savings?
No one asked
the questions. Stocks were rising. Incomes were going up. It
was 'morning in America.' The questions would have to wait until
evening.
Now, America
is minting new voters all over the mid-east. Reagan's campaign
against the "Evil Empire" has become Bush's war against
the "Axis of Evil." Reagan's tax cuts...have been followed
by Bush's tax cuts. Ronald Reagan's deficits have been upstaged
by those George Bush. And the Reagan boom has evolved into the
Bush boom.
But interest
rates were high in '81...and coming down. Stocks were low...and
going up. It is nearly a quarter of a century later than when
Ronald Reagan took office. We don't know what will happen, but
surely the sun must be sinking and the questions must be rising...
Readers expecting
an apology will have to wait.
Regards,
Bill Bonner
 The
Daily Reckoning
Editor's Note:
Bill Bonner is the founder and editor of The Daily Reckoning.
He is also the author, with Addison Wiggin, of The Wall Street
Journal best seller Financial
Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley &
Sons).
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