The Reagan Presidency II Jude Wanniski June 18, 2004

Memo To: Historians
From: Jude Wanniski
Re: Correcting Paul Krugman

Because I was so personally involved in the revival of the classical economic theory that underpinned the success of the Reagan presidency, I’d like to set the record straight on what really happened in those eight years. The statistics are all available, but the analysis is tricky because of all the cross-currents involved. What I’d like to do today is push against Paul Krugman’s June 11 column in the New York Times inasmuch as Krugman’s piece is the most distorted I’ve seen. Krugman does not distort on purpose, but he does so because his perspective is so different. I'll answer within the text of his column:

An Economic Legend
By Paul Krugman

In the movie "The Man Who Shot Liberty Valance," a reporter defends prettifying history: "This is the West, sir. When the legend becomes fact, print the legend." That principle has informed many of this week's Reagan retrospectives. But let's not be bullied into accepting the right-wing legend about Reaganomics.

Here's a sample version of the legend: according to a recent article in The Washington Times, Ronald Reagan "crushed inflation along with left-wing Keynesian economics and launched the longest economic expansion in U.S. history." Actually, the 1982-90 economic expansion ranks third, after 1991-2001 and 1961-69 but even that comparison overstates the degree of real economic success.

WANNISKI: Reagan’s most lasting achievement was his revival of classical, supply-side economic theory of the kind he was taught in college. Keynesian economics continues to thrive, among conservative Republicans as well as liberal Democrats. But for the first time since classical theory was discredited in the Great Depression, Keynesians and their demand-side monetarist cousins now have to compete in the political marketplace with the supply-side analytical framework. Never again will classical theory be consigned to the dustbin of history.

Supply-siders count the Reagan expansion from 1982 to 2001 not merely to 1990. The brief downturn between 1990 and 1991 was caused by a brief revival of demand-side economics when President Bush broke his 1988 pledge, “read my lips, no new taxes.”

KRUGMAN: The secret of the long climb after 1982 was the economic plunge that preceded it. By the end of 1982 the U.S. economy was deeply depressed, with the worst unemployment rate since the Great Depression. So there was plenty of room to grow before the economy returned to anything like full employment.

WANNISKI: The plunge that preceded the Reagan expansion is the reason Reagan defeated Carter. The Keynesians who advised the Carter administration counseled an ever-weakening dollar to make exports cheaper. When Paul Volcker, a conservative Keynesian and a Democrat was named to head the Fed in the late spring of 1979, the Democratic monetarists who controlled the staffs of the House & Senate Banking Committees urged a Fed switch in its operating mechanism, targeting the monetary aggregates instead of interest rates. The plan was to push the economy into expansion with aggressive monetary policy and Volcker complied by stating in October 1979 that because the economy would grow faster in the year ahead, more liquidity would be needed to accommodate the expansion. At the same time a system of capital controls was instituted, which reduced the demand for liquidity. The net effect was a flooding of the banking system with liquidity that it did not need or want. The price of gold soared from $240 when Volcker took office to $850 per ounce on Feb.1, 1980. It tailed off a bit when the Fed adjusted the flow, but was still about $650 oz when Reagan was elected in November 1980.

The “plunge” to which Krugman refers was the result of the monetary deflation that brought the gold price down to $300 by March 1982. This was not Volcker’s doing, but the side-effects of the Reagan tax cuts of 1981, which were properly aimed at expanding the sluggish economy. This kind of expansion really did lead to an increase in demand for liquidity. When the Fed clung to its monetarist targets instead of supplying that liquidity, dollars became scarce relative to gold and the gold price rapidly ran down to $300. Throughout 1981 I warned my clients and in the public prints this was the problem. In November 1981 Robert Mundell warned that the Reagan administration should intervene and stabilize the gold price between $400 and $425 to prevent the deflation he could see coming.

These papers are all on the record, including a letter I got from President Reagan in October 1981 in response to a note I sent him warning of consequences of deflation. He answered simply that he was getting “divided counsel” and that “Milton F” was assured him that by holding to his course, there would soon be a sharp decline in interest rates. Keynesians actually also warned that monetary policy was offsetting the fiscal effects of the tax cuts, but it was not until Mexico could not pay interest on its massive debts to American banks in August 1982 that the “plunge”turned into “expansion.” That is because Volcker had to monetize $3 billion in Mexican peso bonds so Mexico could pay the U.S. banks. To do this, he had to tell the Reagan Treasury department that he had to set aside the monetarist money targets. That was effectively the end of monetarism.

KRUGMAN: The depressed economy in 1982 also explains "Morning in America," the economic boom of 1983 and 1984. You see, rapid growth is normal when an economy is bouncing back from a deep slump. (Last year, Argentina's economy grew more than 8 percent.)

WANNISKI: This is all technically true. In many ways the economy has never completely adjusted to that disastrous experiment with monetarism, but Krugman was barely out of college at the time and watch events in Washington unfold from his neo-Keynesian perspective. His recollections today are reflective of his impressions back then.

KRUGMAN: And the economic expansion under President Reagan did not validate his economic doctrine. His supply-side advisers didn't promise a one-time growth spurt as the economy emerged from recession; they promised, but failed to deliver, a sustained acceleration in economic growth.

WANNISKI: Krugman is right in that a number of economists associated with “Reaganomics” promised more than was delivered given the persistent struggles with the other economic schools, which did not roll over and play dead. After Reagan’s election, supply-siders could not get a single person into a Cabinet or sub-Cabinet level position with responsibilities in monetary policy. Paul Craig Roberts was at Treasury immersed in the tax-cutting battles and Larry Kudlow was chief economist to David Stockman at OMB, immersed in budget cutting. All the monetary posts were occupied by followers of Milton Friedman, whose ideas led to the 1981-82 plunge.

KRUGMAN: Inflation did come down sharply on Mr. Reagan's watch: it was running at 12 percent when he took office, but was only 4.5 percent when he left. But this victory came at a heavy price. For much of the Reagan era, the economy suffered from very high unemployment. Despite the rapid growth of 1983 and 1984, over the whole of the Reagan administration the unemployment rate averaged a very uncomfortable 7.5 percent.

WANNISKI: This is also true, but the errors made were because of divergences from Reagan’s own instincts and from those the supply-siders were espousing. The first two years of the eight were at double-digit unemployment because of the monetarist deflation. The last 15 months slowed because of the Crash of 1987, which history will show was caused by the collapse of the Louvre Accord of February 1987, which attempted to keep currency exchange rates aligned. Historians should look into the papers of Treasury Secretary James Baker III, which should show I met with him in his office, six days before the Crash, delivering a message from Robert Mundell that a crisis loomed which could only be stopped by defending the dollar, even if it meant selling gold from Fort Knox. On the Friday before the Monday Crash on Wall Street, Fortune magazine appeared with an interview of Alan Greenspan, the new Fed chairman, in which he opined that the dollar was overvalued. If not for this blunder, the economy in the last months of the Reagan administration would have seen much stronger employment numbers.

KRUGMAN: In other words, it all played out just as "left-wing Keynesian economics" predicted.

WANNISKI: Left-wing Keynesians such as Robert Solow of MIT actually predicted that the 1981 tax cuts would not do much good for the economy because they were too small in terms of “aggregate demand” relative to the size of the economy. Solow called the supply-side ideas of Robert Mundell, whose PhD was acquired at MIT, “snake oil.” In the boom than began in 1983, the Keynesian cry was that the Reagan tax cuts were actually “Keynesian,” trying to claim theoretical credit for policies they had earlier derided.

KRUGMAN: In the late 1970's most economists believed that eliminating the high inflation then prevailing in the United States would require inflicting a lot of pain: the economy would have to go through an extended period of high unemployment and depressed output. Once the inflation had been wrung out of the system, the unemployment rate could go back down. And that's exactly what happened. In fact, it's instructive to put a graph showing the actual track of unemployment and inflation during the 1980's next to a figure from a 1978-vintage textbook showing a hypothetical disinflation scenario; the two look almost identical.

WANNISKI: Once again Krugman is absolutely correct in that ALL Keynesian economists I knew at the time -- including Alan Greenspan, a conservative Keynesian – insisted the inflation could only be broken with great pain and recession. Supply-siders like Mundell (but not Arthur Laffer) understood that if the gold price could be brought down gradually, the positive effects of the tax cuts would ameliorate the adjustment problems associated with deflation. Laffer, by the way, departed from Mundell on the monetary issue, believing the deflation was good for the economy.

KRUGMAN: Ronald Reagan didn't decide to inflict that pain. The architect of America's great disinflation was Paul Volcker, the Fed chairman. In fact, Mr. Volcker began the process in 1979, when he adopted the tight monetary policy that caused that record unemployment rate. He was also mainly responsible for the recovery that followed: it was his decision to loosen up on the money supply in the summer of 1982 that set the stage for the rebound a few months later.

WANNISKI: History will show that Volcker’s biggest contribution to monetary policy during his tenure from 1979 to 1987 was the enormous inflation at the beginning, when he did the bidding of the Democratic monetarists in the Carter administration. He did not adopt a tight monetary policy, but looked on as an innocent bystander as the Reagan tax cuts caused an increase in demand for money that he could not supply without telling the monetarists to go to blazes. Volcker’s finest hour was in dealing with the Mexico crisis of August 1982, when he did tell the monetarists to go to blazes.

KRUGMAN: There was, in short, nothing magical about the Reagan economy. The United States did, eventually, experience an economic miracle but not until Bill Clinton's second term. Only then did the economy achieve a combination of rapid growth, low unemployment and quiescent inflation that confounded the conventional economic wisdom. (I'm aware, by the way, that this plain statement of fact will generate an avalanche of angry mail. Irrational Clinton hatred remains a powerful force in American life.)

WANNISKI: From my vantage point, which you historians will be able to read on an almost daily basis as I follow the Clinton years, the prosperity without inflation really was the result of the Reagan policies bearing fruit after his tenure ended. Some supply-siders predicted terrible things with the Clinton tax increase of 1993, but my contemporaneous client letter shows great relief that it did not raise the capital gains tax and thus would have much less damaging effect than would have been the case otherwise. It is important that you always remember, in reading my client letters, that I am betting my whole company on my analysis, as my clients are institutional investors managing, in total, some $6 trillion. Krugman can be wrong and the only people who suffer are Democratic candidates for public office who lose.

KRUGMAN: It's a measure of how desperate the faithful are to believe in the Reagan legend that one often reads conservative commentators claiming that the Clinton-era miracle was the result of Mr. Reagan's policies, and indeed vindicated them. Think about it: Mr. Reagan passed his big tax cut right at the beginning of his presidency, and mainly raised taxes thereafter. So we're supposed to believe that a tax cut passed in 1981 was somehow responsible for an economic miracle that didn't materialize until around 1997. Apply the same timing to the good things that happened on Mr. Reagan's watch, and you'll discover that Lyndon Johnson deserves the credit for "Morning in America."

WANNISKI: Reagan did raise taxes a number of times, including an increase in the federal gasoline tax in 1982, which I supported. His biggest regret was raising taxes in 1982 against the open opposition of the supply-siders. It was White House chief of staff Jim Baker who led the way, having lost confidence that the phased-in tax cuts of 1981 were having any positive effects on the economy. He need only have waited a few months as the Fed broke loose from the monetarists in August and the stock market took off like a rocket, anticipating the boom that would soon be evident.

KRUGMAN: So here's my plea: let's honor Mr. Reagan for his real achievements, not dishonor him and mislead the nation with false claims about his economic record.

WANNISKI: Once again, I am not attacking Krugman here, only correcting him. It will be up to economic historians to sort all this out, but they should have these corrections to think about in the sorting process. JW