THE POLITICAL ECONOMY IN PERSPECTIVE -- THE DEFICIT THEORY

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP83M00914R002200180001-2
• Release Decision: RIPPUB
• Original Classification: K
• Document Page Count: 10
• Document Creation Date: December 20, 2016
• Document Release Date: August 3, 2006
• Sequence Number: 1
• Publication Date: May 4, 1982
• Content Type: REPORT

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THE SECRETARY OF TRANSPORTATION 8 - All
WASHINGTON, D.C. 20590
May 13, 1982
Honorable William J. Casey
Director, Central Intelligence
Agency
Washington, D.C. 20505
Pursuant to our conversation, you might find the attached
article by Jude Wanniski interesting.
I hope all is well with you.
Sincerely,
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POLYCONOMICS, INC.
Political and Economic Communications
The Political Economy in Perspective
THE DEFICIT THEORY
By Jude Wanniski
The theory that current and projected federal deficits are causing the re-
cession through high interest rates has now overtaken the President. Al-
though the theory is not supported by any academic school nor by evidence,
it now engulfs almost the entire Establishment, as it did exactly fifty years
ago. A Mob psychology has gripped Washington and Wall Street in a par-
allel of the mood against which the Revenue Act of 1932 was passed. The
Mob has concocted the $182 billion federal deficit projection for fiscal
1983 as its main lever, a deficit that can be reached only if the Mob's pol-
icies are embraced. At full employment, though, the current economy
yields an extra $400 billion in real output, covering any projected deficit.
The House Republicans, behind Kemp-Gingrich, can block a 1932 replay,
but perhaps only-if the Stockman projections are discredited.
May 4, 1982
66 Macculloch Avenue ? Morristown, N.J. 07960 ? 201 / 267-4640
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 Approved For Release 2006/08/09: CIA-RDP83M00914R002200180001-2
? 1981 Jude Wanniski. All rights reserved.
Provided by Capital Institutional Services, Inc., Dallas, Tx.
No portion of this report may be reproduced in any form without prior written consent. The information has been compiled from
sources we believe to be reliable, but we do not hold ourselves responsible for its correctness. Opinions are presented without guarantee.
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Polyconomics, Inc. THE DEFICIT THEORY
THE DEFICIT THEORY
Last August, it was facetiously suggested in this corner that the "public flogging of Beryl Sprinkel
would do wonders for the bond market." That is, as long as Sprinkel remains Treasury Undersecretary
for Monetary Affairs, his mentor, Milton Friedman, will continue to dominate monetary policy
in the Reagan Administration with his single-variable, money-supply model. The idea that the national
economy can be managed to an optimum condition by control of a defined quantity of money -
without regard to either the price of money or the demand for money - is the equivalent in geometry
of trying to determine three sides of a triangle with only one side given.
It takes a certain kind of intelligence to believe in single-variable models anyway. But Sprinkel
seemed totally unashamed on April 28 when, in announcing Treasury's quarterly refunding needs,
he acknowledged the possibility of a second variable in his model. According to The Wall Street
Journal of April 29, Sprinkel "said stabilization of money-supply growth and reduction of projected
federal deficits over the next several years were the most important elements in bringing interest
rates down. If those can be accomplished, he said, there would be a 'significant' decline in interest
rates over the next few months. He added that he doesn't believe there is a relationship between
large federal deficits and high interest rates. `But if the market believes it, that's all that counts,'
he said."
In other words, if the market believes in the correlation and establishes the correlation, Sprinkel
will observe the correlation and accept it, but he still won't believe it. It must be comforting to Treas-
ury Secretary Regan to have at his side a flexible mind like Sprinkel's, which can accept on faith
correlations that do not exist.
Then again, we can sympathize with Sprinkel on this point. He has to get along with the Mob in
Washington that has come to believe in the Deficit-is-the-Root-of-all-Evil Theory, a competing single-
variable model. The Deficit Theory has had such a demonic grip on the Mob that it has been prepared
to crush anything in its path. If you do not at least pay lip service to the DT, as Sprinkel does, you
are certain to be branded an enemy of the people these days. Senator Pete Domenici and his staff
at the Senate Budget Committee are almost half-crazed with fear and loathing of the deficit pro-
jections. Enveloped by the force of darkness, they are the ringleaders of the Mob.
But there is plenty of credit to go around. Senator Bob Dole and Senate Majority Leader Howard
Baker, Jr., are up front with their flaming torches, and Sen. Paul Laxalt has thrown in with them.
David Stockman, who we have come to think of as Rosemary's Baby, has been relentless in fanning
the flames. Jim Baker and David Gergen at the White House have become foam-flecked, as has Rep.
Bob Michel and Rep. Jim Jones in the lower House. The madness, sadly, has spread to President
Reagan, who opened his televised address on the fiscal 1983 budget impasse with the statement:
"To get our economy moving again, it's imperative that we enact a Federal budget that will bring
down deficits and bring down interest rates."
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THE DEFICIT THEORY Polyconomics, Inc.
The Mob has embraced almost the entire national press corps, which of course reflects conven-
tional wisdom, and it is now hardly possible to turn on the TV news without hearing from the Wall
Street Deficit Theorists who are suddenly in great demand. Irwin Kellner, chief economist of Man-
ufacturer's Hanover, is among the leading ranters and ravers along with David Jones of Aubrey Lanston
and Edward Yardeni of E. F. Hutton. They have begun to outshout Henry Kaufman and Albert
Wojnilower ("Dr. Doom and Dr. Gloom") in their dire forecasts tied to the Deficit Theory. Indeed,
Kaufman has taken to sniping at monetarists lately and Wojnilower has become positively sunny in
his outlook, waving aside the budget impasse as inconsequential and predicting a decline in interest
rates anyway. Kellner of Manny Hanny, by contrast, warns of a 5- to 6- percent climb in interest rates
because of the budget breakdown. Alan Greenspan, who helped father Rosemary's Baby, is still lurk-
ing in the shadows, always sounding reasonable in his ominous forecasts off the Deficit Theory, at
least as long as he's sitting next to David Jones.
The fact that Beryl Sprinkel is right, that there is no observable correlation between deficits and
interest rates, cuts no ice with the Mob. They know what they know. The most precious headline
of the year reflected this intellectual eccentricity. It appeared on the first business page of The New
York Times on April 30, over a story on the bond market's reaction to the budget. "IMPASSE DIS-
MAYS BOND TRADE," it read, with a subhead in smaller type: "But Rates Don't Rise." Ah, the
BOND TRADE is dismayed, but the market isn't. The Wall Street journal was no better. "BOND
ACTIVITY SLOWS AMID TRADER ANXIETY OVER IMPASSE ON FEDERAL BUDGET DEF-
ICITS," headlined the bond column, which waited until the third paragraph to break the news:
"Prices of most Treasury notes and bonds inched higher."
This was the story all through 1981 and David Stockman's budget victories, which should, accord-
ing to Deficit Theory, have been accompanied by surges in bond prices but instead were greeted with
yawns. Stockman's only defense of his Deficit Theory was that the markets really did not believe he
was going to be successful in cutting spending.
Evidence doesn't count in this current madness, nor do correlations. The Deficit "Theory" itself
is not so much a theory as a political weapon. How absolutely amazing it is that it could exist in this
supposedly Keynesian world, flourishing to the point where the leading Keynesians of our time march
under its banner. The very notion of raising taxes and cutting spending in order to climb out of the
deep recession is antithetical to all Keynesian theory. Yet the prescription is embraced not only by the
Wall Streeters, the commercial Keynesians, but also by the academics, the Brookings people, the
Yale school, Lester Thurow. What do these people stand for?
We have to go back a long time before we find a similar period in history, when the Deficit Theory
was so rampant that a President would make a bipartisan deal with a Congress of the opposing party
to rationalize tax increases. In 1932, Herbert Hoover pushed through an enormous tax increase with
the help of the Democrats at a time of 15 percent unemployment. The hike was to have increased
projected revenues by one-third and balanced the budget. Of course, it merely lengthened unemploy-
ment lines and ballooned the federal deficit.
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Polyconomics, Inc. THE DEFICIT THEORY
On December 8, 1931, in his State of the Union address, Hoover called for support of this tax
program:
Our first step toward recovery is to reestablish confidence and thus restore the flow
of credit which is the very basis of our economic life.
The first requirement of confidence and of economic recovery is financial stability
of the United States Government.
Even with increased taxation, the Government will reach the utmost safe limit of its
borrowing capacity by the expenditures for which we are already obligated and the
recommendations here proposed.
Hoover's Treasury Secretary, Ogden Mills, followed up with a Deficit Theory speech to the New
York Economic Club on December 14, 1931:
Our longterm bonds are selling today at a discount, even those bearing as high an in-
terest as 3 3/4 percent. Allowing for tightened money conditions, and for all the un-
usual circumstances which surround us, there is no doubt that some of the weakness
manifested reflects the response of the investing public to the possibility that we may
be confronted with a rapid increase in the public debt, and in the volume of Govern-
ment securities outstanding.
Herbert Stein, in whose book "The Fiscal Revolution in America" this history can be found,
commented on the scene fifty years ago:
There is no need here to trace the Revenue Act of 1932 through the Congress. There
was a long and bitter fight, but the fight was over the nature of the tax increase, not
over the wisdom of raising taxes by such a staggering amount at a time of massive
unemployment. Once the President and his financial experts had said that balancing
the budget was imperative, there were few, in the Congress or in the country, who
would take the responsibility for denying it. Some congressmen did rise to say that the
tax increase was unnecessary, that the Treasury was having no difficulty in borrowing,
that the debt was smaller than it had been ten years earlier, that the citizens would be
better able to pay $10 after the Depression than $1 during it, and so on. But these
were backbenchers or mavericks. For the Democratic leadership in the Congress the
President's tax proposal was an invitation either to take responsibility for a big deficit
or to share responsibility for a big tax increase. Their riposte was to support the idea
of a tax increase, thus aligning themselves with "sound finance," but to attack the par-
ticular tax increase the President proposed as a "rich man's tax bill," thus escaping
the wrath of the majority of tax payers.
- "Fiscal Revolution," p. 32.
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Polyconomics, Inc.
Stein, of course, is the very same Stein who chaired Richard Nixon's Council of Economic Ad-
visers in 1972-73, a position from which he loudly touted the "full-employment budget concept."
This was an idea that had been kicking around the Committee for Economic Development since 1946,
when Stein was associated with the CED. It held that the federal deficit should be as large as the extra
revenues that would be collected if the economy were at full employment. This is pure "demand
management" theorizing, and it does not address itself to tax-incentive effects or the composition
of the deficit. But it was Herb Stein's baby and he pushed it hard.
It was Hegel who supposedly said that the only thing we learn from history is that we never learn
from history. He could have said that it is often the historians who learn less from history than anyone
else. Here we have Stein, who clearly observes the destructiveness of the incorrect policies of the
1930's, leading the same charge 50 years later. Indeed, Stein has not uttered a public word that I
am aware of in these last few years that did not in some way harp against the federal deficits as a
source of our difficulties and recommend tax increases as a solution.
Where are we on the full-employment budget concept now? At 4 percent unemployment, the
usual guide, Robert Mundell reckons the economy would be producing $400 billion more in goods
and services than the $3 trillion we are cranking out now. On the federal tax side alone, the extra
$400 billion in output would generate almost $100 billion more in revenues. The decline in federal
spending that would accompany full employment would be colossal - as would the pressures on the
Government to spend. At full employment, there would be roughly $100 billion surplus that the Con-
gress could divide, paying down some of the national debt, repairing the highways, rebuilding the
military, and having money left over for social programs that are worthy but are being starved along
with everything else in a high unemployment economy.
The biggest gains at full employment, though, are realized in the private sector. Leaving $50
billion out for state and local tax take, there remains one-quarter of a trillion dollars in aftertax
private income. This is equivalent to the economy of Canada. The $400 billion we are losing now
because of the mismanagement of the economy is about equal to the output of California.
It is not possible, though, in the world inhabited by the Deficit Theorists for the economy to in-
crease its real output of goods and services by $400 billion from where it is today. David Stockman's
computer model at the Office of Management and Budget is only capable of projecting deficits of
those colossal amounts into 1985 and beyond. "None of us really understands what's going on with
all these numbers," Stockman told the Atlantic Monthly. Everyone now agrees that the projected
federal deficit for fiscal 1983 is $182 billion. Where did that number come from and what does it
imply about the future of the economy?
The projections come out of a computer model built by the same people who built Herb Stein's
model when he was in Government, i.e., "demand-siders," otherwise known as "Phillips Curvers."
In this model, it is not possible for an economy at 9 percent unemployment to get to 4 percent un-
employment, at least not without a horrendous "inflation." In the Stockman computer model, the
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Polyconomics, Inc. THE DEFICIT THEORY
best thing that can happen to an economy afflicted with a Deficit that is keeping interest rates high
is a bunch of inflation. With rising prices and tax-bracket creep, the computer can clickety-clack
zooming federal revenues that swallow up the projected deficits. Kellner, Jones, Yardeni, Kaufman
et al would presumably tell us that the elimination of projected deficits in this fashion would en-
courage the bond market. But Deficit Theorists usually insist on making ad hoc pronouncements,
without any known standard of evidence or logic against which their pronouncements can be tested.
The OMB computer model, which projects this $182 billion deficit in fiscal 1983, does so largely
based on the following assumptions: (1) the inflation rate will be low,,. preventing revenues from
rising via bracket creep, etc.; (2) economy growth will be anemic because - in a demand-side com-
puter - you can't have high growth and low inflation simultaneously, and assumption (2) must con-
form to assumption (1); (3) real interest rates will remain high, adding greatly to the cost of debt
service.
Assumption (3) is interesting in a special way because it implies a high federal deficit! As OMB
put it on page 2-15 of the budget document:
Interest costs are expected to be especially burdensome in the next few years because
interest rates are expected to remain high relative to inflation. Interest rates reflect
borrowers' expectations about inflation. These expectations, reflecting the inflation-
ary fiscal and monetary policies of the last decade, can be expected to adjust only
slowly to the disinflationary policies currently in effect.
The end of inflation, we see in this model, has three major effects. It raises the federal deficit
by reducing revenues. It increases federal expenditures for debt service because of past "expectations"
effects. And it reduces the level of economic growth below what it would be with higher inflation
rates.
This is the model that has Senator Domenici seeing red all over Capital Hill, Senator Dole gnashing
his teeth, James Baker III and Howard Baker, Jr., foaming at the mouth. And it is this nitwit computer
that is the central source of all the silly deficit projections in Washington.
This doesn't mean we will not have a $182 billion deficit as projected. We would have one and
then some if the same minds that devised the computer program were put in charge of national econ-
omic policy. To put it another way, if Kellner, Jones, Yardeni, Kaufman, Greenspan, et al, were in
charge of national economic policy, we would have to assume that their policy prescriptions would
have the same effect as they did in 1932, when the earlier cohort of Deficit Theorists moaned and
groaned about the effect of projected deficits on the financial markets and pushed through the tax
hikes that did produce the deficits. To put it another way, we might say that Kellner, Jones, Yardeni,
Kaufman and Greenspan have been in charge of national economic policy except for President Reagan.
The Deficit Theory long ago swallowed Stockman via Alan Greenspan and Henry Kaufman. It has
now twice come close to swallowing up President Reagan and the Mob has not given up. As we ob-
served, while the "compromise" broke down, Reagan did come out of the negotiating process with
the Deficit Theory wedged in his head: It's imperative that we enact a Federal budget that will bring
down deficits and bring down interest rates."
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THE DEFICIT THEORY Polyconomics, Inc.
Senator Domenici has every right to be encouraged. Reagan's willingness to "go ,the extra mile"
revealed to Domenici not only Reagan's infection by the DT, but also a frontier against which the
Mob can push: the President's willingness to raise "taxes" by $122 billion over the Fiscal 1983-
85 period. As in 1932, the "wisdom" of raising taxes is no longer being debated - except among the
supply-side "backbenchers and mavericks." The notion that taxes won't be increased in a recession
year that is an election year to boot also must be weighed against the reality of the 1932 Revenue
Act, coming in a recession year that was also a Presidential election year. Then, as now, the Pres-
ident was a Republican, the Senate controlled by Republicans, the House controlled by the Democrats.
Given all these parallels, the chances that history would repeat itself this year have to be very
low. Hollywood would never buy a movie script based on these improbabilities. Besides, the main
actor is not a Hoover establishmentarian but a Coolidge populist. Fifty years ago next month he
graduated from Eureka College, Illinois, with a sheepskin in supply-side economics. The Revenue Act
of 1932 had just been signed into law and the Dow-Jones Industrial Average within weeks, on July
8, 1932, hit its low for the century, 41. The "index" could then buy two ounces of gold, so that if the
parallels held up, and Reagan does get swallowed up by the Deficit Theorists, the DJI would test a
low of 700, a dollar index number double the current gold price.
The only thing standing in the way of this dismal scenario is the contingent of House Republicans
led by Jack Kemp and now Rep. Newt Gingrich of Georgia, who have mobilized all but a minority of
their colleagues against the Mob of Deficit Theorists. Jim Baker, who is masterminding the budget
"negotiations" from the White House, can really get nowhere as long as this opposition exists. Tip
O'Neill and the House Democratic strategists in the end spurned the Reagan $122 billion "com-
promise" because it did not guarantee an outflanking of the younger GOP House members.
To accomplish this, the Democrats must now get the $122 billion established as the baseline for
future negotiations. If they can get the House GOP leadership to accept the hoked-up $182 billion
deficit projection, one thing will lead to another and we will have a big tax bill, even the Kemp-
Gingrich coalition melting to a hardcore of bankbenchers and mavericks. The Washington press corps
is dutifully doing its job of reporting the $182 billion projection as if it were already engraved in
history.
The longer the delay, the better, because the Mob eventually will be overwhelmed by reality.
There is already a problem of where to hide the revenues piling up in Treasury in fiscal 1982, with
OMB constantly embarrassed as its monthly upward adjustments become obsolete in a matter of
weeks and new excuses have to be found on why good news now means worse news later. The de-
ception going on in this game rivals the field in the Kentucky Derby for the Pinocchio Award of
1982 (although Stockman would win by more than a nose). Once you start, you just can't stop.
The President himself is trapped in the White House, held prisoner by his staff. They are appar-
ently so determined to save the country from Ronald Reagan and "voodoo economics" that he is
swamped with Deficit Theorists, breakfast, lunch and dinner. The occasional minute or two he gets
with a Kemp, never alone, are overwhelmed by the constant pounding from the Mob. The only thing
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that gets through this screen are prayers and Cable Network News, which covers the proceedings
of the House on C-Span and which Reagan at times watches. He called Gingrich and several other
young Republicans late in the evening recently after seeing the C-Span tapes of their anti-tax speeches,
offering congratulations and well-done.
The Mob doesn't know how far it can move Reagan and keep Kemp from blowing up, which
would cause unforeseen problems at the White House. Kemp on April 30 was quoted on the front
page of the Washington Post, warning that Reagan had come "dangerously close" to abandoning
all of his supply-side principles (and supporters).
Meanwhile, we wait. The first paychecks of July are important, providing political relief, a pay-
off for Reagan's stubbornness in resisting the Mob so far. The Mob probably has to get its way be-
fore those first paychecks, reflecting the 10 percent cuts. At.the-same time, we watch the price of
gold, now hoping that Volcker is keeping his eye on it too. Since March 17, when I called him and
pleaded that he not let the price fall below $300, because of the deflationary implications, the gold
price climbed from its low that day of $312 to about $375 (according to the demand-siders because
of the Falkland Islands). But it has since hovered around $350, which is where I would like to see
it stay. If Volcker spends one minute more every day thinking about the price of gold and one minute
less each day thinking about M1, every day we will be one minute closer to a gold standard and a
steady decline in interest rates. A minute at a time, and before you know it, Stockman (or his suc-
cessor) will be projecting budget surpluses.
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