Reagan's new policy had yet another disadvantage. It was being introduced at a time when inflation was high and people were on the point of panic. Few people understood the new policy, and as tax cuts had been explained for 40 years as an expansionary policy that increased aggregate demand, it made no sense in terms of traditional thinking to add demand stimulus to an economy suffering from high inflation. Predictions began appearing that Reagan's policy would cause inflation to explode.
Certainly Paul Volcker thought so. The Treasury met with Volcker weekly hoping to bring him on board with the new policy, but Volcker simply could not get his mind around the new policy. He had never heard of such. Tax cuts had always been in the category of expansionary policy. They would mean fiscal deficits, and fiscal deficits were described in every economics textbook as a method of increasing consumer demand to fight unemployment. They were the antithesis of an anti-inflationary policy.
Volcker's outside advisors had the same opinion. Alan Greenspan told Volcker in my presence that Reagan's fiscal policy would overwhelm even the tightest monetary policy. Using language that feminists no longer permit, Greenspan told Volcker that in view of such an expansionary fiscal policy "monetary policy is a weak sister and at best can conduct a weak rearguard action." Inflation would break loose and ravage the economy.
The Treasury asked Volcker to gradually reduce the growth rate of money as the marginal tax rate reductions fed into the economy. If this policy could be coordinated, there was a chance to bring down inflation without sending the economy into recession.
However, the advice Volcker received from his advisors reinforced his own view that the Reagan administration's policy would send inflation higher and that he would be blamed. To protect himself and his institution, Volcker turned off the money before the tax rate reductions, which in a compromise with deficit-conscious Republicans were reduced, delayed and phased in over three years, went into effect. Thus, the economy received monetary restraint and no offsetting supply-side stimulus.
By collapsing the economy, Volcker exploded the budget deficit. The financial press and Reagan's enemies blamed the deficit on tax reductions that had not yet gone into effect.
The Volcker Deficits put tremendous pressure on Stockman. Conservative Republicans and most of the financial community feared the consequences of deficits. Republicans feared for the Republic and Wall Street feared for their stock and bond portfolios. Deficits meant inflation. Republicans thought inflation would destroy the political order, and Wall Street knew that inflation would drop bond and stock prices.
The supply-side policy was also disadvantaged because it had to be introduced before the Treasury's traditional static revenue estimating model could be updated to one that included the revenue increases from higher GDP growth. The Treasury model assumed that every dollar in tax cuts lost a dollar of tax revenue. Even Keynesian economists disagreed with this. Walter Heller, who was Chairman of President John F. Kennedy's Council of Economic Advisers, said that the Kennedy tax cuts paid for themselves in higher tax revenues resulting from more employment, higher GDP growth, and reductions in unemployment and welfare benefits as a result of lower unemployment. Every economist agreed that some percentage of the lost revenues were regained because of the economic expansion.
Nevertheless, the Treasury's model had never been updated to reflect this consensus. Stockman's budget forecast was faced with large deficit projections reflecting the Treasury's static revenue estimates.
In left-wing mythology, the Reagan administration forecast that the tax cuts would pay for themselves, but as every official document shows, the Reagan administration forecast that every dollar of tax cut would lose a dollar of revenue. After experiencing the Clinton, George W. Bush and Obama regimes, the ease with which propaganda substitutes lies for facts should by now be well known.
Reagan's economic policy was also disadvantaged by being caught up in a fight over political succession. Reagan as a result of his popular support was able to take the presidential nomination away from George H.W. Bush, the Republican Establishment's choice. The Establishment was faced with a loss of control. Outsiders would come into prominent positions, gain influence and become rivals to established insiders. Additionally, the new economic policy arose from outside the establishment. It was identified with Rep. Jack F. Kemp, a former pro-football quarterback and proven leader. The Republican establishment reckoned that eight years of Reagan followed by eight years of Kemp would leave them permanently out of power. It would be their end.
Obstacles to the new policy came from the Bush people inside the administration. They had a fine line to walk. If they caused the policy to fail or to be stillborn, Republican discredit would take them down also. Their plan was to present the policy as largely correct but too extreme. The story that they fed the media was that the Establishment would reform the extreme policy and turn it into something workable. This would allow the establishment to claim credit for Reagan's success and keep what they saw as the Jack Kemp threat at bay.
This made it difficult for me to get Reagan's policy out of his administration in anything close to its original form.
As if these disadvantages were not enough, White House chief-of-staff Jim Baker decided that he would make the tax cut into a Republican victory over Democrats. Therefore, Baker picked a fight with House Speaker Tip O'Neill, who, far from opposing the policy, had an alternative supply-side tax-cut bill, and Baker cut the Senate Democrats, who had given the new policy much of its credibility, out of the administration's bill.
I argued that a new policy needs consensus and that a compromise with O'Neill and inclusion of the Senate Democrats was the way to obtain it. Otherwise, I argued, the Democrats will have no stake in the new policy, and a wound would be opened that would fester.
It was at this point, I believe, that Don Regan realized that he needed to be White House chief-of-staff, not Secretary of the Treasury, if the president's policies were to be safe. At the beginning of Reagan's second term, Regan engineered the switch, but by then it was too late. The Democrats who had endorsed the policy in the late 1970s no longer had any stake in its success.
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