Politics & Policy

Debt, Lies, and Inflation

EDITOR’S NOTE: The August 31, 1992, issue of National Review, set out to set the record straight about the Reagan administration’s economic record. We reprint the content of the issue here.

The pro-entrepreneurial policies supported by Ronald Reagan and supply-side economics pose a massive threat to interests of the rent-seeking Democratic and Republican establishments, as well as to the ideological commitments of left-leaning media and academic pundits. It is not surprising, then, that the American public has been subjected to an unprecedented disinformation campaign against “Reaganomics.” The campaign was carefully crafted to appeal to conservatives who have long been convinced that public debt is a certain road to national collapse. President Reagan was shown to have increased the public debt even more than the despised Jimmy Carter. President Reagan’s policies had left Americans uniquely burdened with red ink, and the country was collapsing beneath the “Twin Towers of Debt.” Only another tax increase could save us.

The twin towers of debt were budget and trade deficits, and the implication was that only Americans were burdened with these ills. As the result of them, we had been rendered economically uncompetitive, hopelessly in debt to foreigners, and at their mercy. The day the Japanese stopped buying our Treasury bonds, interest rates would skyrocket, and our economy would plunge over the precipice. Moreover, federal irresponsibility had encouraged corporate and household debt to explode as well. Wherever one looked, the U.S. was smothered in debt.

This story has been repeated relentlessly for a decade despite its lack of any factual basis. Throughout the dis-information campaign, the Organization for Economic Cooperation and Development (OECD) twice a year published internationally comparable statistics on public, corporate, and household debt that reveal nothing unique about U.S. debt levels. If we have too much debt, so do our competitors in the Group of Seven industrialized countries. If we are dependent on our G-7 partners to finance our debts, who is financing theirs?

As the information in the table below(?) shows, U.S. public debt as a share of gross domestic product is below the G-7 average. U.S. corporate debt as a share of GDP is the lowest of the G-7 countries. And U.S. household debt as a share of GDP, while above average, is lower than Japanese and British household debt.

The OECD’s measure of public debt, which includes federal, state, and local, reveals nothing unusual about the growth or level of U.S. public debt. During the 1980s, only Germany and France have had public-debt ratios consistently lower than the United States’, and the difference is not large. The UK has had a lower ratio only since 1990, and Japan’s ratio has been lower only since 1986. Italy and Canada have substantially higher ratios. The U.S. ratio has almost doubled since 1980, but Canada’s has increased fourfold. All the public-debt ratios have increased except the Japanese and British, which fell during the second half of the decade–proof governments can bring debt, under control. Moreover, the British ratio fell following the massive Thatcher tax-rate reduction–proof that tax-rate reduction does not cause debt to rise.

U.S. non-financial corporations may be over-leveraged and burdened with junk bonds, but their aggregate gross debt ratio is by far the lowest in the Group of Seven.

The gross household debt ratios suggest that if the American consumer is overburdened, so are the British, Japanese, and Canadians. It is Germany and Italy, with extremely low ratios, that are the anomalies.

Overall, there appears to be a rough balance of sorts. Countries with relatively high public-debt ratios tend not to have high corporate and household debt ratios also, and vice versa. But whatever we make of the figures, one thing is clear: The United States is not uniquely burdened with debt.

The Twin Towers of Debt argument was constructed by economists such as Martin Feldstein, who apparently lack the ability to read balance-of-payments statistics. According to their totally spurious argument, large budget deficits from the loss of tax revenues brought high interest rates. Lured by high interest rates, foreign money poured into the U.S. pushing up the dollar and causing the trade deficit. Thus, the two pillars of debt were both due to cutting tax rates. Between 1982 and 1983, when the U.S. became a net importer of capital, many academic economists joined Feldstein in putting out the story of foreign money pouring into America to finance over-consumption caused by the Reagan tax-rate reduction. Reaganomics was portrayed as an extreme form of Keynesianism that was causing America to disinvest and deindustrialize.

In fact, the official balance-of-payments statistics show no evidence of the foreign money that allegedly was financing excessive U.S. consumption. As the table below (?) shows, between 1982 and 1983 foreign-capital inflow into the U.S. actually fell by $9 billion. The change in the capital amount of the balance of payments resulted from a $71-billion fall in U.S. capital outflows. During 1982-84 there was no significant change in the inflow of foreign capital into the United States. However, U.S. capital outflows dropped from $121 billion to $22 billion – a decline of 80 per cent – throwing the U.S. capital account into a $100-billion surplus. It was this collapse in U.S. capital outflow that created the large trade deficit, which by definition is a mirror image of the capital surplus.

Why did American investors suddenly cease exporting their capital and instead retain it at home where it supposedly was subject to reckless policies of inflationary debt accumulation? After all, such a dangerous program as Reagan’s was alleged to be should have resulted in capital flight. Why then the sudden preference of American capital for the U.S. as compared, for example, to West Germany, a country with an economic policy that everyone considered sound?

The answer is so obvious that the only mystery is how economists and financial writers missed it. The 1981 business-tax cut and the reductions in personal-income-tax rates in 1982 and 1983 raised the after-tax earnings on real investment in the U.S. relative to the rest of the world. Instead of exporting capital, the U.S. retained it and financed its own deficit.

The spectacle of almost every economist misinterpreting the source of the capital surplus is extraordinary. Economists looked at the net figure, ignored its composition, and, seeing what they wanted to see, erroneously concluded that the net inflow was foreign money financing American over-consumption.

After convincing themselves and many others on the basis of this fundamental error that the U.S. was dangerously dependent on foreign capital, economists began warning of the consequences. The inflow of foreign money to finance our consumption, they declared, was keeping the dollar high, thus wrecking the competitiveness of U.S. industry. Furthermore, our addiction to foreign capital meant that the U.S. would have to maintain high interest rates in order to continue to attract the money, thus undermining U.S. investment and deindustrializing America. If U.S. interest rates or the dollar were to fall, foreign capital would flee, depriving us of financing for the “twin deficits.”

This doomsday scenario was picked up by journalists and kept international markets unnerved. U.S. economic policy came under ever-stronger criticism from our allies. America’s “twin deficits” became the scapegoat for every country’s problems.

Then, in the autumn of 1985, Secretary of the Treasury James A. Baker III engineered the political fall of the dollar, which plunged, along with U.S. interest rates, in 1986 and 1987. Remarkably, foreign capital inflows to the U.S. promptly doubled.

There’s More . . .

The Twin Towers of Debt argument was also contradicted by the behavior of interest rates. As the budget deficit rose, interest rates fell. The high interest rates that retirees fondly recall preceded the large deficits. An inverted yield curve, with short-term rates above long-term rates, characterized the economy in 1979, 1980 and 1981. The inverted yield curve is a sign that high interest rates are caused by stringent monetary policy. The federal-fund rate, an overnight rate set by the Fed, was higher than the interest rate on long-term triple-A corporate bonds from October 1978 to May 1980, from October 1980 to October 1981, and from March 1982 to June 1982. The federal-funds rate exceeded the corporate-bond rate by 5.57 percentage points in April 1980 and by 5.69 percentage points in December 1980. In January 1981, when Mr. Reagan was inaugurated as President, the gap peaked at 6.27 percentage points. Overall, interest rates peaked in 1981, with the budget deficit unchanged from its previous year’s level. Reagan’s budget deficit peaked in 1986 at three times the size of the 1981 deficit, with the federal-funds rate only one-third as high as it was in 1981. By the summer of 1992, Bush’s budget deficit was twice the size of Reagan’s and interest rates (long and short) had fallen to the lowest levels since the 1960s. None of the predicted financing problems of the debt have materialized.

But what about the debt? Isn’t it historically high, and, unlike the past when we “owed it to ourselves,” don’t foreigners hold a dangerously high percentage? The answer to both questions is “no.” The accumulated public debt today as a share of GNP is less than half what it was in 1946. We financed World War II by borrowing, and at the close of the war the public debt was 127 per cent of GNP. This huge debt overhang did not prevent the postwar expansion of the U.S. economy. Taxes were not raised to pay off the debt, and government spending was not cut. Government spending has grown consistently during the postwar period, as has the public debt. But the economy grow, too, and we grew out from under the debt.

During the 1980s, the ratio of public debt to GNP rose slightly, back to where it had been under John Kennedy. Under George Bush the ratio has risen further, due in part to his resumption of tax-and-spend policies and to a weak economy, but primarily to the negative impact the 1986 Tax Reform Act has had on real-estate values and insured financial deposits. Unless the bailout of insured deposits becomes an ongoing activity of the government, the deficit should decline again, both absolutely and as a share of GNP, as it did in the latter part of Reagan’s second term.

As for foreign holdings of U.S. debt, the official U.S. statistics show they peaked in 1978 as a percentage of the total. The recycling of petrodollars had a bigger impact on foreign holdings of U.S. debt than the budget and trade deficits of the 1980s.

But what about investment? Isn’t it true that investment measures show the U.S. to be in decline? The illusion of the U.S. as a disinvesting nation was created by incompetent economists measuring investment in net nominal terms, without adjusting for inflation and for shifts in the composition of investment. During the 1980s, prices of capital goods in the U.S. rose only about half as fast as the overall U.S. inflation rate. Unless an inflation-adjusted measure of investment is used, the decline in the relative price of capital goods can be misinterpreted as a fall in investment’s share of GDP.

Measuring investment net of depreciation or replacement of the capital used in production has the same result. On the surface net investment seems to be a more reliable measure than gross investment. However, net investment fails to make any adjustment for the shift in the composition of investment from longer-lived assets, such as buildings, to shorter-lived assets, such as equipment, that generate more rapid depreciation. Net investment has been falling as a share of U.S. GNP for the past 25 years as a result of a rise in the depreciation rate corresponding to an increase in equipment’s share of investment. By misinterpreting a change in asset mix as a decline in investment, economists painted a false picture of disinvestment. As the table below(?) shows, real gross investment’s share of GNP in the 1980s was unprecedented in the postwar era.

Prompted by criticisms from economists that U.S. Government statistics were failing to detect a weakening in the nation’s industrial base, the Commerce Department undertook a two-and-a-half year study of American manufacturing. The study, released in 1991, shows that the 1980s were years of an almost unbelievable revival by U.S. industry.

In a front-page story that must have been galling for that paper’s editorial writers, the New York Times reported on February 5, 1991, that the rate of growth in U.S. manufacturing productivity had tripled during the 1980s and now was on a par with Japan’s and Europe’s and that manufacturing’s share of GNP had rebounded to the “level of output achieved in the 1960 when American factories hummed at a feverish clip.” Far from losing its competitiveness, the report revealed, the U.S. had experienced an unprecedented export boom.

Turing Japanese

On the rare occasion when they are confronted with facts, the purveyors of disinformation retreat to lesser theses. Foreigners, they say, can afford more debt than Americans because they save more. The high Japanese saving rate is invoked as proof of the failure of Reagan’s tax cuts. If only we had not cut taxes, we would not have the deficits and, therefore, would be saving more.

But the high Japanese saving rate, used to deflate American economic success in the 1980s, is apparently another fable. In the spring 1989 issue of the Quarterly Review of the Federal Reserve Bank of Minneapolis, University of Pennsylvania Professor Fumio Hayashi points out that most of the “apparent savings-rate gap between Japan and the U.S. is a statistical illusion attributable to differences in the way the two countries compile their national income accounts.”

The Japanese value depreciation at historical cost rather than at the higher replacement-cost figure that Americans use. As a result, Japanese accounting understates the value of assets used in production and makes Japanese investment look higher than it is. Another source of the saving-gap illusion is the U.S. practice of counting all government expenditures–including money spent on roads, schools, and warships–as consumption, whereas Japan counts such spending as investment. Once the accounting systems are put on an equal footing, Hayashi finds, the notoriously wide difference in the savings rate disappears.

Economists who look carefully at the subject have found that the gloomy view of the U.S. as a community of spendthrifts is without foundation. For example, Robert E. Lipsey of Queens College and Irving B. Kravis of the University of Pennsylvania studied savings and investment rates in industrialized countries and found that America’s bad reputation is based on careless comparisons and narrow measures of investment. This is consonant with other distortions, for example the myth that Reaganomics was based on the belief in self-financing tax cuts and that the deficits prove its failure. In fact, all the official public documents setting out the Reagan program show that the tax reductions at the heart of the 1981-85 budget plan are based on the traditional Treasury static-revenue estimate that every dollar of tax cut would lose a dollar of revenue.

President Reagan’s economic program was set forth in an inch-thick document, “A Program for Economic Recovery,” made available to the public and submitted to Congress on February 18, 1981. Tables in the document make it unmistakably clear that the Administration expected the forth-coming tax cut to reduce revenues substantially below the amounts that would be collected in the absence of such a cut. Without the tax cut, revenues were projected to rise from $609 billion in 1981 to $1,159.8 billion in 1986. With the tax cut, they were projected to rise from $600.2 billion in 1981 to $942 billion in 1986. The total six-year revenue cost of the tax cut was thus estimated at $718.2 billion.

As the tax-rate reduction was expected to slow the growth of revenues, receipts as a percentage of GNP were expected to fall from 21.1 per cent in 1981 to 19.6 percent in 1986. Accordingly, the document spelled out the necessity of slowing the growth of spending in order to avoid rising deficits. The Administration planned to hold the annual growth of spending to 6 per cent during 1981-84 and to 9 per cent during 1984-86. On this basis, the Reagan budget projected a rise in spending (including the defense buildup) from $654.7 billion in 1981 to $912.1 billion in 1986.

A summary fact sheet showing the expected revenue losses and planned spending reductions was put out for wire transmission. Months of testimony and debate followed, during the course of which the massive revenue losses were in the forefront. After the Economic Recovery Tax Act of 1981 was passed, the Treasury Department issued to the media a comprehensive report on the legislation, including a three-page table detailing the revenue loss for each of its provisions. (Between introduction and final passage of the bill, the estimated total six-year revenue cost has grown slightly, from $718.2 to $726.6 billion.)

The Reagan deficit forecast was off, not because of a “Laffer curve forecast,” but because of the inflation rate unexpectedly collapsed. This surprised almost everyone, especially the critics who had repeatedly claimed that the Reagan tax cuts would be inflationary. Since monetary policy was a “weak sister,” pundits proclaimed that not even tight money (itself unlikely) could subdue the inflationary impact of such a large tax cut.

As any economist should know, a budget forecast is based on an assumption about the growth path of nominal GNP. If the inflation forecast is wrong, so will be the GNP, revenue, and deficit forecasts. The consumer price index tells the story: For 1981 the Reagan Administration forecast 11 per cent inflation versus 8.9 per cent actual; for 1982, 8.2 per cent versus 3.9 per cent; for 1983 6.2 per cent versus 3.8 per cent; for 1984, 5.4 per cent versus 4.0 per cent. (In 1981 critics had derided what turned out to be a pessimistic inflation forecast as “optimistic,” a “rosy scenario,” and “not credible.”) The unanticipated disinflation, together with the loss in real output from the 1981-82 recession resulted in GNP during 1981-86 being $2.5 trillion less then forecast–with an estimated loss of federal revenue of $500 billion, and higher real spending than intended. This is the cause of the budget deficits.

Lest we forget, supply-side economics was controversial because of its claim that worsening “Phillips curve” tradeoffs between inflation and employment were the product of a policy mix that pumped up demand while reducing incentives to supply. By reducing the growth rate of money while improving incentives, the economy could escape from its malaise.

Supply-side economics made good on its promise, and Ronald Reagan delivered both the longest peacetime U.S. expansion and disinflation. This achievement has been buried under a pack of lies told by people whose reputations exceed what their integrity warrants. They succeeded in their goal of pushing the Bush Administration away from successful policies and toward self-destruction.

At the time of this writing Mr. Roberts, Assistant Secretary of the Treasury for Economic Policy in 1981-82, holds the William E. Simon Chair in Political Economy at the Center for Strategic and International Studies.


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