A Monetary/Fiscal Stalemate Jude Wanniski February 3, 1981

Executive Summary: Donald Regan's swift conversion to the supply-side on fiscal policy points to almost certain success of a Reagan tax reform package and a continuation of the bull-market trend. The Keynesians, however, pose a dilemma. Their leading polemicist, Yale's James Tobin, posits a "Keynesian Train" immobilized as expansionary fiscal policy is offset by constrictive monetary policy. Thus the debate shifts to Volcker and the Federal Reserve, where austerity-minded, high-interest rate objectives threaten to offset the impulse to real growth. But monetarists and supply-siders are in temporary conjunction on the need to change monetary procedures toward lower inflation and interest rate policies. President Reagan reveals his gold bias, unofficially opening debate that may lead to a quicker return to a gold standard than conventional wisdom now can imagine. A major bull market in bonds may be on the horizon.

A Monetary/Fiscal Stalemate

When President-elect Reagan in late November revealed his intention to name Merrill Lynch's Donald Regan to the Treasury post in his Cabinet, the competing economic schools were mystified. Unlike William Simon and Walter Wriston, who have long been identified with Milton Friedman's brand of monetarism and who were thought to be in line for the Treasury job, Regan had no ideological identity. Indeed, as the New Right activists observed angrily, he seemed to have no defined political bent, contributing to Democrats and Republicans, liberals and conservatives, without pattern. Supply-siders were unhappy not to land Treasury for their candidate, New York businessman/intellectual Lewis E. Lehrman, but were generally pleased that Simon and Wriston were denied in favor of a relative neutral, especially on the issue of dollar/gold convertibility.

As Treasury Secretary-designate, Regan was disappointing in his public appearances, seeming very conventional. This led to the view that he would be a burden to supply-siders. In the last month, though, Regan dazzled the supply-siders by populating the top ranks at Treasury with leaders of the school: Norman Ture as Undersecretary for Tax Policy; Paul Craig Roberts as Assistant Secretary for Economic Policy; and Steven Entin as deputy to Roberts. Regan's private explanation was that he had reviewed Ronald Reagan's campaign speeches, determined that Reagan was a committed supply-sider on tax policy, and that it would serve the President to have his views reflected by Treasury. To the critical position of Undersecretary for Monetary Affairs, Regan appointed Beryl Sprinkel, a devoted Friedmanite from Chicago's Harris Trust, with the express idea of "balancing" Ture with Sprinkel.

The net result of having the new Treasury Secretary spend several weeks in this mix, as well as conferring with the OMB team of supply-siders assembled by David Stockman, has been a delightfully swift conversion by Regan to the supply-side. In his first appearance before Congress as Secretary, on January 27, he cheered supply-siders (and the stock market) by climbing out on a limb with Stockman on the critical issue of timing. The debate, rooted in differences of economic theory, has divided those who insist spending cuts must accompany tax cuts dollar-for-dollar, and those who argue for separate tracks for spending cuts and tax cuts. Stockman has argued for separate tracks, on the grounds that the high tax rates contribute significantly to Federal deficits and should be attacked regardless of success in directly cutting outlays. On January 27, Regan told the Senate Appropriations Committee that the Reagan administration's plans to cut taxes "can't wait until budget outlays are reduced." He said tax reductions are necessary to spur economic growth that will help increase government revenue and reduce Federal borrowing. This represents a fundamental embrace of the Laffer Curve rationale and means that Regan, without question, will be an ally rather than a burden to the "radical" tax cutters.

In fact, it is now highly probable that Regan will supplant Stockman as the chief supply-side spokesman in the Cabinet, if only because of the superior firepower he has in Ture, Roberts and Entin, and also because his age and stature in the financial community can match those of the Old Guard, like Arthur Burns, who stand in opposition. Regan told the Senate Committee: "The economic rules of thumb of the postwar period have been proved wrong by the overwhelming empirical evidence of the last three decades."

As a result of this surprisingly assertive support from Donald Regan, there is now little reason to worry about the tax package the President will unveil in the week of February 16. The plan will include, says Regan, the 30 percent cut in individual tax rates over three years and accelerated depreciation writeoffs. The effective date issue has not yet been decided, though, which means that if the cut is not made retroactive to January 1, it will take longer to phase in the 30 percent cut. A July 1 effective date would mean a 5 percent cut in calendar 1981, which would require a 15 percent cut in calendar 1983 to complete the 30 percent within three years. Regan does publicly dismiss the prospect that the distinction between earned and unearned income be eliminated for tax purposes. The maximum tax on investment income is now 70 percent, on wages and salaries 50 percent. There is, though, broad support within the administration for ending the distinction, an act that would have a powerful effect on economic activity, productivity and the stock market. There is still a fairly high chance that it will be included in the President's plan because of the recognition that if the change isn't made now, it would be several years before the time might be ripe again. (The Ford administration almost proposed the measure in early 1975, but because Nelson Rockefeller was vice president, the White House was wary of Democratic criticism of a "rich man's tax bill."

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These developments suggest we have less need to fear the "Thatcherization" of Ronald Reagan than we might have had even several weeks ago. He is not going to try to wring inflation out of the economy through fiscal austerity. Nevertheless, the situation in the financial markets for both equity and debt suggests irresolution. The stock market and the bond market move in a narrow range, as if pulling in the opposite direction. We might picture a tug of war, with supply-siders having "Won" on fiscal policy and the Keynesians still "winning" on monetary policy. Unlike the United Kingdom, the U.S. economy continues to show vitality, straining in the direction of real expansion, but in both places interest rates and inflation remain high, crippling especially the housing and auto industries.

The Keynesians have the same picture. On January 20, in a letter to the editor of The Wall Street Journal Professor James Tobin of Yale took issue with the Journal's idea that tax cuts and tight money would do the trick. Tobin, the nation's leading Keynesian polemicist, posed the following question:

If a west-bound locomotive is harnessed to one end of an Amtrak train in New Haven and an east-bound engine to the other end, will the train go simultaneously to New York and Boston? If a Volcker monetary locomotive pulls the economy one way while a Kemp-Stockman fiscal engine pulls it the other, will the train reach both destinations, disinflation and expansion?....

The dominant mechanisms relating fiscal and monetary levers to price and output goals are the same; both policies work via the pressure of demand on productive resources. The policy mix does matter, to be sure, but for other objectives, e.g. the dollar exchange rate, capital formation.

It's best to be realistic about stagflation. It can't be solved by assigning disinflation to the Fed while tax cuts and defense spending "get the economy moving again." The train may creep in one direction or the other, but the main result will be high interest rates, nominal and real.

Tobin's argument — his string of assertions — immediately was echoed by other Keynesian economists and their followers in the Democratic Party. Walter Heller, who was chairman of President Kennedy's Council of Economic Advisers, told the Senate Appropriations Committee that "A tug of war between huge personal tax cuts and ever-tighter money would be unremitting bad news for the economy/' because it would raise interest rates and inflation. "I think you have to proceed on a very modest basis when you're operating" at a high rate of inflation. Rep. James R. Jones of Oklahoma, the new Democratic chairman of the House Budget Committee, also comes out four-square for modesty. According to Tom Wicker of The New York Times, January 27: "The budget chairman, Mr. Jones, believes that....Kemp-Roth 'brings shudders' to the credit markets, would reinforce 'inflationary psychology' and in any case is more nearly a 'Keynesian consumption stimulus' than a 'supply-side' production incentive. His gravest fear is that Kemp-Roth would further drive up interest rates because the credit markets and the Federal Reserve would take it as a signal that the new Administration was no more serious about fighting inflation than the old one was."

What we are seeing is a massing of Keynesian ideology against implementation of the supply-side prescriptions, with liberal Keynesians like Tobin and Heller joining forces with Arthur Burns, Herbert Stein, and Paul Volcker, dubbed the "commercial Keynesians." In the face of the supply-side idea, which would put the Keynesians out of business, even Harvard's John Kenneth Galbraith announced in The New York Times of January 4, 1981 that he has observed in the mirror, while shaving, that he has become a "conservative."

The Keynesian Train that Tobin employs as a metaphor is an effective one, but it is just as appropriate when examining the economy from a classical perspective. Indeed, in the Tobin-Heller world, in which the economy is driven by the consumer's pocket, it is only possible to move the train in one direction or the other. The government either puts money in the consumer's pocket through fiscal policy and what the Keynesians call an "accommodative" monetary policy — which yields expansion plus inflation. Or, the government withdraws money from the consumer's pocket via fiscal and monetary policy, conquering inflation via austerity. In this Keynesian world, "where both policies work via the pressure of demand on productive resources," as Tobin says in his letter, if fiscal policy is putting money into the consumer's pocket and monetary policy is taking it out, nothing has been accomplished. Notice, though, that for both Tobin and Heller there is a net effect of higher interest rates and inflation, but they do not tell us why there should be this net effect if equal and opposing forces are canceling each other out inside the consumer's pocket.

In the supply-side model, where the producer is at the center of economic activity, the "Classical Train" can proceed in the direction of economic growth without inflation....Or, economic contraction with inflation....Or, if fiscal policy pulls the train in one direction and monetary policy in the other, we can have irresolution. In other words, if the producer is encouraged to produce more because the government will permit him to keep more of his incremental production (a tax rate cut), but at the same time the government devalues the currency in which the producer trades and stores his production, the incentive effects can net to zero.

The idea that Paul Volcker and the Fed is now following a "tight money" policy is one that occurs naturally to Keynesians like Tobin and Heller, who equate "tight money" and high interest rates. Paul Volcker himself seems to believe he is being restrictive, courageously attempting to halt inflation single-handedly while the politicians attempt to do him in by cutting taxes, which he insists can only be done dollar-for-dollar with spending cuts.

To the supply-siders, though, "tight money" is not equated with high interest rates or some "M" measure of money supply. Money is "tight" when the supply of money matches the demand for money at a real, fixed price. The price of money is not the interest rate, which is the price of credit. The price of money is its purchasing power in real goods and services. What does one have to give up in goods and/or services in order to acquire a dollar? Thus, the classical, supply-side advocacy is a return to a gold standard, with the dollar/gold ratio (or price of gold in dollars) serving as a proxy for all goods and services. When the monetary authority matches the supply of money with the demand for money at a fixed dollar/gold ratio, and producers in the marketplace understand that this will be the monetary policy over time, the inflation rate will net to zero over time, and interest rates will not have an "inflation component."

How is monetary policy now conducted? First, Volcker and his fellow governors at the Fed surmise an inflation rate in the coming year, based on their own expectations. Then, they surmise what real growth will occur in the economy. Say they surmise 10 percent inflation and 3 percent growth. This means the money supply will have to increase by 13 percent to support the expected level of economic activity. To bite the bullet and fight inflation, the Fed would decide to increase the money supply by only, say, 12 percent. To be really tough, they would target, say, 10 percent. With less/money in supply than the exchange economy needs for transaction purposes, there is less real growth but also less inflation. If the Fed can stick to this plan long enough, inflationary expectations by business and labor will be broken, or so goes the thinking.

After these simple pictures run through Mr. Volcker's head, the policy must be implemented somehow. Elaborate instructions are given the Fed's computer, which trigger interventions via the open-market desk in New York, via the discount rate, reserve requirements and foreign exchange. The idea of matching money supply to money demand at a stable money price never comes up. Instead, money and credit are pumped into the system at a rate imagined to be "tight" only because it is thought to be exerting downward pressure on the surmised rate of inflation. As the First Chicago World Report describes the operation:

The Fed does not present any targets for the growth of bank reserves or the monetary base, adjusted for different reserve requirements. Targets are set for several measures of money, but the variety of goals allows a variety of interpretations when the targets are met for some measures and not for others. Moreover, the Fed has only limited short-term control over the changing forms of money, but has very precise control over bank reserves and currency, which constitute one side of the Fed's own balance sheet. Monetary goals are always presented as subject to change without notice, as though monetary policy could and should be fine tuned to the latest news. No specific goals are offered beyond one year and even the extremely gradual 1981 goal of slowing money "on the order of 1 percentage point" would nonetheless be "reconsidered as conditions warranted."

The object of monetary policy should not be to put money into or take money out of the consumer's pocket, but to provide producers — and consumers — with a unit of account that does not change in value, thus permitting goods and services to be traded over long periods of time. But this is not the object of monetary policy under Paul Volcker's Fed, and as a result of trying to hit multiple targets by chasing elusive forms of money, it provides a gyrating standard. And the more it intervenes to attempt to hit its targets, the more the gyrations, the less the unit of account is worth to the exchange economy. It is as if the Bureau of Weights and Measures, in attempting to maintain the yardstick as a standard of measure, erred in the morning and came up with 35 inches, then shot for 37 in the afternoon so the average would come to 36.

Until the Fed changes the way it thinks about monetary policy, which means re-programming its computer, it will continue to cause inflation — which can be defined as a decline in the monetary standard — and interest rates will remain high. The beneficial effects of tax reforms can be swamped in the process. Even if the Fed maintained its varied money-supply targets, but found ways to intervene less to achieve them, there would be some help. As it is, the more sophisticated the Fed becomes in its manipulations, the more disturbance it creates.

The traditional Friedmanite monetarists, like Beryl Sprinkel, Allan Meltzer, Karl Brunner, have in the last year become less sanguine about the ability of the Fed to hit money supply targets, even with the best of intentions. More often, we hear monetariests suggest that the Fed concentrate on "controlling its own portfolio," which is to say the liabilities of the bank itself.

In an open letter to Volcker in the January 30 Wall Street Journal Milton Friedman himself announced this important shift in his own thinking. Instead of urging the Fed to control some "M" quantity of money, as he has for many years, Friedman proposes an "alternative procedure", controlling the monetary base directly. "The base consists of the Fed's own liabilities, on which it has accurate day-to-day figures," says Friedman. He acknowledges that this change of procedure would not in itself enable the Reagan Administration to achieve its goals of reduced inflation and healthier economic growth. "But failure of the Fed to improve its performance could frustrate achievement of those goals," writes Friedman.

Such a procedural change long has been the position of the supply-siders, who of course argue that bank liabilities be managed around a price rule, a specific dollar/gold ratio. The monetarists continue to believe the bank liabilities should be managed around a quantity rule, a percentage increase of some fixed amount annually. Nevertheless, there now seems a happy conjunction over the mechanism to be employed, which suggests a solid front of monetarists and supply-siders within the Reagan administration as critics of Fed policy under Volcker.

The first meeting of President Reagan and Volcker on January 23 did not seem to reflect any schism of this sort. The only remarks made public, though, were notable in revealing the President's bias to gold. Reagan reportedly mentioned having read a forecast that gold would nose-dive to $250 an ounce, and that this would be good for the easing of inflation. Volcker was reported to say that he would "love to see that." Where Reagan has privately expressed a sense of correlation between the price of gold and dollar inflation, it was extremely important that he would do so as President and permit his remark to be broadcast. The report almost certainly will fan the spark of life in gold as a monetary standard into serious discussion, alerting foreign central bankers to adjust their thinking. It should also be observed that in the Reagan high command and Cabinet, there are no individuals ideologically opposed to gold. The chairman of the Council of Economic Advisers, Murray Weidenbaum, is neutral and open-minded on the subject, which was sufficient for supply-siders to cheer his appointment.

The hard fact is that Reagan is a personal supporter of the idea of a gold-based currency. While he has demonstrated he is not the kind of leader who thinks he can superimpose his tastes on an unwilling electorate, Reagan has a willingness to move an idea along, with a smooth persistence that permits the opposition to adjust and come around.

In the Washington Post of January 18, Lewis Lehrman suggested that by January 1982, "the President should announce his intention to restore a stable dollar to the world by creating a gold-based currency. Second, the President should call for an international monetary conference, to be held in January 1983, to reform the world monetary system, to uphold an open trading system, to contain the rising tide of protectionism."

It will take definite signals from Reagan to move events on this fast a track. But given what we know of his preferences, the reality of inflation, and the players involved, it is likely that such signals will be given, and that we will soon see serious — as opposed to peripheral — debate around the question of dollar convertibility. The sooner it happens, the sooner we can experience a precipitous decline in interest rates and a concomitant bull market in bonds. It will take such a shift in ideas to break the monetary/fiscal stalemate.