1970 Keynesianism ruled, and we faced a decade of stagflation. But
we're all supply-siders now, thanks in part to
dinners at Michael I, and even George Bush has embraced voodoo economics.
The policy that came to be known as "Reaganomics" started more than
two years before the election of Ronald Reagan. At least for me,
the new era dawned on April 20, 1978. On that morning, a Wall
Street Journal article on the House Ways and Means Committee's
doubts about the Carter Administration tax proposals included the
A major cause for worry on the part of liberals and the Administration
is a proposal by Representative William Steiger (R., Wis.) to reduce
the tax on capital gains. Representative Steiger claims to be close
to the 19 votes he needs to win approval for his amendment from
the 37-member committee
Representative Steiger's amendment would roll back the maximum rate
on capital gains for both individuals and corporations
to 25 per cent, the top rate in effect prior to the Tax Reform Act
While Representative Steiger argues that this tax cut would stimulate
enough business activity and tax revenue to pay for itself, committee
sources estimate the net annual revenue loss to the Treasury at
between $ 2 billion and $ 3 billion.
Electrified by this news, I started my working day with a call to
Jude Wanniski, who happened to be in Washington. Read this, I suggested,
and, naturally, drop everything and go talk to Steiger. This, I
said, may be what we've been looking for, the reason for the sudden
surge in the stock market. For by then, these issues had been explored
for innumerable hours at the Michael I restaurant and the Lehrman
Institute by Jude, the already notable Canadian economist Robert
Mundell, former OMB Chief Economist Arthur Laffer, and a few others.
Jude returned from Washington and produced a seminal editorial,
"Stupendous Steiger" (April 26, 1978), asserting that the quiet,
young, slightly built congressman from Wisconsin had "shaken the
earth," that his amendment was "not one tax provision among many,
but the cutting edge of an important intellectual and financial
breakthrough." As he wrote, I got a call from Warren Phillips, chairman
of Dow Jones & Co., publisher of the Journal. He said he had run
into Jude while walking through the editorial-page office, that
Jude had virtually grabbed him by the lapels and excitedly exclaimed
that the market had bottomed, the market had bottomed. What's going
on, Warren asked? Jude's a little overexcited, I explained, but
Whatever the wear and tear on Warren's lapels, Jude was right, more
or less. The Dow Jones average had been falling steadily since a
few weeks before the Carter presidential victory, hitting a low
of 742 on February 28, and hovering just above that figure into
April. It turned up as Representative Steiger gathered his votes,
climbing over 900 as the tax bill moved toward passage. The 1978
lows withstood two later tests as inflation was wrung out of the
system, and the real stock-market boom started in 1983, with the
first net tax cuts of the Reagan era.
At this remove, it's hard even to recall the pre-Reagan economic
landscape. Do you remember the gasoline lines? How about Jimmy Carter's
$ 50 rebate? Or his voluntary wage and price controls? Or even before
that, Jerry Ford's WIN buttons, Whip Inflation Now? For the mid
1970s witnessed a crisis of not only economic policy but also economic
thought. The prevailing Keynesian orthodoxy had nothing to say about
stagnation. It had pretty much distilled itself down to the Phillips
curve: To cure inflation, a little more unemployment; to cure unemployment,
a little more inflation. For high and accelerating inflation accompanied
by high and accelerating unemployment, it had no explanation and
For every policy target you need a policy tool, Bob Mundell instructed
the diners at Michael I on Trinity Place in downtown Manhattan.
To combat stagnation plus inflation, you needed two levers: tight
money to curb inflation, and tax cuts to promote growth.
In a Keynesian world, of course, tight money would merely offset
tax cuts; one would contract aggregate demand while the other expanded
it. The key was that supply-side tax cuts provided stimulus not
by expanding aggregate demand "putting money into people's
pockets"but by stimulating supply, by increasing incentives to work
and invest. Producing deficits by more spending would not work,
and neither would tax "rebates" or other non-marginal tax cuts.
The cuts had to be directed at the taxes that did the most to curb
incentives, that is, at the highest marginal rates. Indeed, where
marginal rates are the highest, as Art Laffer sketched on his famous
napkin, a tax cut might actually produce more revenues.
In the Mundell-Laffer world, the tight-money half of the prescription
was also quite specific. Money-supply numbers told you little. For
one thing, Mundell kept repeating, the only closed economy is the
world economy. The national money supply means little when the demand
for the dollar is global; a debate raged, and still smolders, over
whether money creation takes place in the Eurodollar market. More
broadly, monetary aggregates are useful guides only if the demand
for money is stable or predictable, as monetarist theory assumes.
This stability ended, as Mundell predicted it would, when President
Nixon in 1971 tore the dollar from its golden anchor and allowed
it to float in value against other currencies and commodities.
So to incorporate both the supply and the demand for money you need
a measure priced by the marketplace: an index of sensitive commodity
prices, for example, or simply the price of gold. And to adapt to
the one-world economy, you need one world money, so that price signals
can be accurately reflected and transmitted. A world unitary currency
can be simulated by a system of fixed exchange rates. When the dollar
and pound and peso and franc and D-mark and yen have definite values
in relation to each other and to gold, global finance and commerce
are based on one set of prices, unhampered by the confusion of constantly
By now, when we dismiss gasoline lines as quaint history, it's hard
even to remember how foreign these intrinsically simple ideas seemed
in a Keynesian-trained world. In 1976, Herbert Stein coined the
phrase "supply-side fiscalists" as a pejorative; as I remember,
the phrase first appeared in print in the Wall Street Journal.
Jude, audaciously ignoring the intended negative connotation, quickly
appropriated Stein's label, dropping the clumsy and misleading "fiscalists."
Supply-side economics it was.
We only slowly came to understand that similar debates were going
on in other cloisters. In Washington Norman Ture and Paul Craig
Roberts developed the tax-incentive side of the model. They, like
Jude, captured the attention of Representative Jack Kemp. Craig
joined the congressional staff, where he worked with Kemp and others,
and tilted with the Congressional Budget Office. He captured the
congressional battles in his article "The Breakdown of the Keynesian
Model" in The Public Interest of Summer 1978. As the Journal
Op-Ed page provided a daily bulletin board for such ideas, other
volunteers appeared. But to me, supply-side economics remained essentially
the policy mix we had debated in those dinners and seminars in New
On the monetary side of the model, a sliding dollar forced President
Carter to appoint Paul Voicker chairman of the Federal Reserve in
July 1979, and to give him his head on policy in October. The attempt
to use monetary aggregates led to some policy confusions, with an
initial burst of inflation. But when the gold price rocketed to
a peak of $ 850 in February 1980, Volcker began tightening in earnest.
On the tax side, the Steiger Amendment quickly proved a success.
Collections on long-term capital gains jumped to a record $ 10.6
billion in 1979, from $ 8.5 billion in 1978 (they maintained that
level through the 1982 recession, and jumped to $ 16.5 billion in
1983, $ 20.1 billion in 1984, and $ 23.7 billion in 1985). The supply-side
idea began to run rampant, with or without the Reagan campaign.
In the waning days of 1980, the Senate passed a Kemp-Roth lookalike,
and the House directed its conferees to accept it. In the wee hours
of the morning, the conferees rejected it; "too big a deal," declared
Chairman Russell Long.
So it fell to the Reagan Administration to enact supplyside tax
cuts. When Mr. Reagan took office, marginal rates for the federal
income tax reached 70 per cent on "unearned" income (which is to
say, returns on savings and investment). As he left office, the
highest rate in the tax code was 33 per cent in certain notches,
dropping to 28 per cent at the highest level.
With these tax rates in place, the nation remains in the longest
sustained peacetime economic recovery ever recorded. The double-digit
inflation of the 1970s is only a memory. The economy's problem is
not unemployment but a labor shortage. The "misery index" devised
by the late Arthur Okun unemployment plus inflation
shows a spectacular success, having fallen from nearly 20 per cent
in 1980 to under 10 per cent in 1988. Perhaps the best way to encapsulate
economic policy in the decade of the 1980s is to say that we have
succeeded in checking an impending worldwide inflation without causing
the world depression many would have predicted a spectacular
success by any historical standard.
For all this success, the ending of the Reagan Presidency was marked
by a wide unease. Especially after the October 19 stock-market crash
of 1987, the conventional wisdom is that six years of prosperity
is only transitory, that some kind of economic disaster lies around
The first answer to this is Burke's "Men have no right to put the
well-being of the present generation wholly out of the question.
Perhaps the only moral trust with any certainty in our hands is
the care of our own time." If some calamity does lie ahead, it is
as likely to be the result not of old mistakes but of fresh ones.
Yet the unease provokes comment on three areas: the 1982 recession,
the problem of the deficit, and the remaining agenda of exchange
rates. Passage of the first Reagan tax cuts in 1981 was promptly
followed by the 1982 recession, with a dip in government revenues
and soaring deficits. In the debate over this bill, the Laffer curve
came to be understood not merely as a truism that at some point
raising marginal rates will reduce revenues, but as an assertion
that any tax cut will always pay for itself immediately. Tax-cut
opponents promoted this interpretation to ridicule the whole idea,
and advocates promoted it to build support for a tax cut that politically
had to deliver some benefit to lower-income people with lower marginal
rates. As the recession took hold, opponents crowed that the Laffer
curve and supplyside economics were forever refuted.
In fact, as the tax cuts passed, the consensus economic forecast
was for a mild upturn, and only supply-siders were worried about
1982. In the inevitable congressional compromise, concern over the
deficit resulted in a tax cut staggered over three years. And already
enacted Social Security increases and bracket creep offset the first
two tranches of rate reduction. The impending cuts actually created
incentives to postpone income out of 1982. Moreover, with Volcker
at the Fed, the tight-money side of the Mundell prescription was
already firmly in place. This ground inflation out of the economy
more rapidly than most thought possible, but there would be no net
tax cut to offset tight money until 1983.
None of this, of course, prevented conventional wisdom from blaming
the 1982 recession on deficits, tax cuts, and supply-siders. Especially
so with the defection of OMB Director David Stockman, who announced
$ 200-billion deficits as far as the eye could see. But if deficits
and anticipation of deficits caused the 1982 recession, what caused
the 1983 recovery?
As 1983 opened, the first headline in the editorial columns of the
Wall Street Journal was "At Last, a Tax Cut." By then the
conventional wisdom held that deficits doomed the economy to sluggish
growth at best, but supply-siders were talking boom. Alan Reynolds
of Jude Wanniski's Polyconomics hit the growth number on the head6.5
per cent growth for the fourth quarter of 1983 over the fourth quarter
This was the start of the recovery we still enjoyed as Ronald Reagan
left office. Properly read, the record suggests that Mundell's two-pronged
prescription worked. Inflation was conquered far more quickly than
the conventional wisdom believed possible. And once tax cuts were
actually applied, growth resumed and, helped by further marginal-rate
reduction in 1986, continued for an unprecedented time. Taking any
relative historical view, and recalling the actual economic conditions
of 1978, this was a considerable achievement indeed.
Now, a few remarks on the deficit, the twin deficits, Mr. Reagan's
"riverboat gamble," and his "$ 200 billion in hot checks." To begin
with, the deficit is a problem of spending, not of tax cuts. During
the Reagan prosperity, government revenues grew smartly, along with
the rest of the economy. As a percentage of GNP, tax revenues are
about where they've been for decades, but spending has grown even
In part, President Reagan's tolerance of deficits was a political
calculation to fight the size-of-government issue on the tax side
rather than the spending side. Republicans have of course preached
the smaller-government gospel for years. But holding out the carrot
of lower taxes only after spending cuts had been introduced left
Republicans with the worst of both worlds; indeed, it left them
repeatedly urging higher taxes to validate Democratic spending increases.
Mr. Reagan cut this Gordian knot by putting tax cuts first and letting
spenders worry about deficits.
On the evidence so far, the success of this strategy has been, if
by no means complete, greater than usually understood. Under pressure
of the deficit, spending as a percentage of GNP peaked in 1983 and
showed a gradually declining trend for the remainder of the Reagan
Presidency. There is, of course, reason to wonder what will happen
in the Bush Administration, especially as we have watched drought-relief
and catastrophic-illness bills roll through Congress with even the
Reagan Administration's blessing. But the post-1983 trend does suggest
that there is nothing at all wrong with the mathematics of President
Bush's "flexible freeze." Moderate budget restraint will close the
deficit; the only question is whether our current institutions allow
it to be implemented politically.
For another thing, everyone talks about the federal deficit being
the instrument of Keynesian fine tuning. But in measuring, say,
supply and demand in the credit markets, much of the federal deficit
is offset by the surplus in state- and local-government pension
funds. Other nations measure not a federal deficit but a public-sector
borrowing requirement, including all levels of government. When
appropriate adjustments are made, as they regularly are by the OECD,
the current U.S. deficit is not out of line with that of other industrial
nations. The official federal deficit fell from 6.3 per cent of
GNP in FY1983 to 3.2 per cent in FY1988, with no effect on the decibel
level of the concern about it.
Finally, the deficit is measured on a cash basis, rather than on
the basis of generally accepted accounting principles. Under GAAP
accrual accounting, you would measure all future obligations undertaken,
not merely those for which bonds have been issued, As it happens,
Arthur Andersen & Co. has periodically undertaken to put the government's
accounts on a GAAP basis. Its studies show a total deficit roughly
twice that measured by the conventional measure, principally because
the latter does not include the unfunded liabilities of the Social
Security system. While the conventional deficit grew in the Reagan
years, however, unfunded Social Security liabilities declined, and
more of the spending was on long-lived assets such as aircraft carriers,
The Andersen studies show that while the federal deficit grew to
5.2 per cent of GNP in 1984 from 2.9 per cent in 1980, over the
same years the GAAP deficit fell to 9.3 per centof GNP from 12.5
per cent. Under Reaganomics, the burden we are leaving to our grandchildren
has not been mushrooming; it's been shrinking.
The federal deficit's "twin," the trade deficit, is of even less
consequence. In a one-world economy, the trade deficit is merely
an artifact of history a reflection of where politics has
drawn lines on a map. If comparable statistics were collected, Manhattan
Island would be terrified by an astronomical trade deficit. For
that matter, the trade deficit is also an artifact of economic fashion:
a reflection of where economists currently choose to draw lines
in a great circle of transactions. Once everything goods,
services, bonds, and so on is included, the accounts must
balance; for every buyer there has to be a seller.
This is scarcely to say there are no big problems in international
economics, but they are rather the opposite of what the conventional
wisdom believes. In its focus on the merchandise trade deficit,
the conventional wisdom believes the tail wags the dog. In fact,
a year's worth of world trade amounts to only about two weeks' worth
of world capital movement.
The trade deficit first arose when the Reagan tax cuts stimulated
the U.S. economy, making it the only growth opportunity in the world.
This resulted in a tremendous net capital inflow; at the same time
U.S. banks stopped exporting capital through Third World loans.
With the capital accounts showing a huge surplus, a merchandise
trade deficit was necessary to balance the equation. As inflation
was brought to a sharp halt in the early 1980s, indeed, the U.S.
trade deficit was probably the only thing standing between the world
and a second Great Depression.
Still, of course, all cannot be well economically while interest
rates remain at historically unprecedented levels even while inflation
declines. Nor can all be well when the world's strongest economy
imports capital instead of exporting it to developing nations where
opportunities ought to be greater. The original prescription worked
out at Michael I has an answer to these puzzles, for part of the
agenda remains unfinished. In particular, the nations of the world
are still trying to run one economy with a gamut of different moneys.
The seemingly arbitrary movement of exchange rates wipes out investments,
closes and opens factories, and destroys and creates jobs throughout
the world. No wonder interest rates are high; no wonder many people
feel economically insecure; no wonder different nations toy with
the poisonous nostrum of protectionism.
On the exchange-rate issue, the Reagan Administration reflected
the conflicts among conservative economists who otherwise agree.
Martin Feldstein, for example, advocated/ predicted a lower dollar
to balance the trade accounts. Milton Friedman, a powerful voice
in any crowd, strongly believes in the positive virtues of floating
exchange rates. On early indications, the Bush Administration will
be no more inclined to a reform of the exchange-rate mechanism.
Yet the power of events does seem to be pushing the world, both
practically and intellectually, toward the kind of international
monetary reform that Bob Mundell, Art Laffer, and Jude Wanniski
talked about in the mid 1970s.
The international meetings of finance ministers and central bankers
do, after all, represent a movement away from floating rates, In
the Plaza agreement in September 1985, Treasury Secretary Baker
acknowledged U.S. global responsibility for dollar policy, ending
the long period of "benign neglect" of the dollar's international
value. The G5 nations agreed that the dollar was too strong, In
the Louvre accord in February 1987, the expanded G-7 nations agreed
its depreciation had gone too far, disrupting the world economy.
And at the 1987 World Bank-IMF annual meeting, Treasury Secretary
Baker, now Mr. Bush's Secretary of State, talked of an international
economic policy based on "the relationship among our currencies
and a basket of commodities, including gold."
What, finally, of the 1987 "crash"? The Wanniski explanation of
the 1929 crash and Great Depresssion in The Way the World Works
is the epitome of his original and controversial observations, and
deserves an updating in the light of the events of October 1987.
The '29 crash came, he argues, when political maneuvering in Washington
made it apparent that the impending tariff would not after all be
confined to agriculture. The Depression, in turn, was caused by
the Smoot-Hawley tariff, the trade war that followed, and the Hoover
tax increases wrongheadedly designed to calm Wall Street.
Skeptics argue that even if you persuade yourself that Jude has
identified the politically crucial moment in the tariff debate,
it seems a small event and a large crash. While Smoot-Hawley may
have played a key role in the Great Depression, they see the 1929
crash as the bursting of a speculative bubble.
Perhaps. But with the "rational expectations" work on the stock
market, we now understand much more acutely that markets anticipate
events; a crash some months before the enactment of an economically
catastrophic law is precisely what we would expect. And Jude's evidence
consists not of one isolated incident but of a long string of coincidences.
Indeed "bubble" is scarcely an apt metaphor for the 1929-1930 stock
fluctuations. Bubbles collapse, and the Dow Jones Industrials fell
from 298 on October 28 to 230 on October 29 of 1929. But bubbles
do not reinflate, as the Dow did to 294 the next April, after a
November low of 198. Jude's comments on the 1929-1930 crash, at
the very least, prove that what needs to be explained is not October
1929, but the drop from 294 (or 244 when Hoover announced he would
sign the tariff), to 41 a few months before the election of Franklin
Roosevelt in 1932.
In October 1987, the market crashed 500 points in one day. From
the August high of 2,722 it fell to the October 19 low of 1,738,
a total of 36 per cent. By comparison, from the 1929 high of 381
in September to the November low was a fall of 48 per cent. The
1987 collapse was more concentrated, probably because computers
and global communications make speculation more efficient. But the
real economy, at least to this writing, has rolled along unimpeded.
This bubble, if that is what it was, was certainly not punctured
in a vacuum. The collapse came the week the Ways and Means Committee
suddenly concocted a bill to stop the takeovers that had boosted
the stock market. The arbitrage community collapsed overnight, with
a decline in takeover stocks preceding the general debacle on the
Even more to the point, at least to anyone at Michael I, the collapse
came in the context of a breakdown of the international monetary
order. In mid October, the Louvre agreement was foundering as Treasury
Secretary Baker and the Germans fought over whether the dollar should
be defended by printing fewer dollars or more marks, whether the
exchange rate should be defended by contracting or expanding world
The crash on Monday followed Sunday's televised warning by Secretary
Baker that "we will not sit back in this country and watch surplus
countries jack up their interest rates and squeeze growth world
wide on the expectation that the United States somehow will follow
by raising its interest rates." On the same day, the New York Times
carried a story asserting Treasury's willingness to see the dollar
fall in its dispute with the Bundesbank. I'm convinced that the
market-makers' eyes were glued to Secretary Baker's Sunday appearance;
I know mine were.
A sense of crisis, I also know, dominated the financial markets
through the rest of 1987. But the mood bottomed out with the advent
of the new year. And as it happened, in the first week of January
the world's central banks intervened massively in support of the
dollar. The Louvre agreement was back in business. During 1988,
the banks demonstrated an ability to control the dollar-mark rate,
and to a lesser extent the dollar-yen rate. Stocks rose through
the year, and the sense of crisis ebbed as the world economy prospered.
Why was the bursting of the 1929 "bubble" followed by a Great Depression,
while the bursting of the 1987 "bubble" has, at least so far, had
no impact on the real economy. Dumb luck, perhaps? Or perhaps it
is because markets don't ordain but warn. And perhaps because in
1929, the crash panicked policy-makers into compounding their errors,
while in 1987 policy-makers somehow got the message and corrected
their errors. In trying to work both events into a coherent and
useful model, so far as I can see, this mode of thought offers the
only explanation on the table.
The new president is not a supply-side firebrand. Rather, he is
a man who once described these policies as "voodoo economics." But
George Bush no longer talks that way; instead, it's "read my lips."
And this victory is made more delicious by irony. In the tugging
and pushing over the last tax cuts, Bill Steiger's capital-gains
rate got shoved up to 28 per cent from the 20 per cent low it reached
during the manic phase of Reagan supply-side thinking. George Bush
wants to chop it back down; the President who coined the phrase
"voodoo economics" says that will produce more revenue.