After Fed chairman Paul Volcker eradicated inflation in 1982, interest rates fell, the recession ended, and a period of strong growth began, which lasted from 1983 through 1990. This was the “King Dollar” sound money era. Contrary to popular mythology, Reagan was not a fiscal conservative; he was a big spender. Reagan saw the low debt ratio he inherited as a tool to help win the Cold War. He set out to win with the same determination as previous wartime presidents Lincoln and FDR.
The Cold War was as much an existential conflict as the Civil War or World War II. Reagan used fiscal deficits and borrowing power to finance a huge military expansion, including the Strategic Defensive Initiative (the so-called Star Wars) antimissile technology, and a six-hundred-ship navy. By the mid-1980s, the Kremlin leadership realized they could not keep pace with the U.S. militarily or financially.
Mikhail Gorbachev became head of the Soviet Union in 1985 and engaged in negotiations with Reagan designed to de-escalate the military buildup, open up Soviet society, and give the Soviets space to modernize their economy. The negotiations were successful. Yet the Soviet opening process, called glasnost, combined with guarantees included in the Helsinki Accords, spun out of control and led to liberal resistance in Central Europe and the Soviet Union’s eventual collapse in 1991. In addition to massive new Cold War spending, Reagan also pushed through major tax cuts early in his administration, which put added pressure on debt and deficits. During the Reagan years, the U.S. debt-to-GDP ratio grew from 32.5 percent to 53.1 percent, the highest level seen since the early 1960s.
To Reagan’s credit, he won the Cold War. The Soviet Union’s demise occurred on December 25, 1991, while Bush 41 was president, yet historians rightly credit Reagan’s military and technology policies with impelling the victory. Reagan had reason to believe America would follow its historic pattern of running up the debt to win a war, then reducing debt once the war was over.
Yet a new dynamic was in play. The early years of the Reagan administration were an example of a feed-the-beast approach consisting of tax cuts and big spending increases. Resulting deficits would force later administrations to cut spending, the strategy called starve-the-beast. The dynamic was that tax cuts deprive the government of revenue and the high debt ratio forces the government to reduce deficits. The only way to reduce deficits in a low-tax regime is to cut spending. That’s exactly what fiscal conservatives around Reagan wanted.
The Reagan administration’s big-spending, tax-cutting policies were highly successful at growing the economy and winning the Cold War. A deficit day of reckoning would fall on subsequent administrations, which would have to pursue unpopular measures such as tax increases or spending cuts. Original feed-the-beast politics would morph into starve-the-beast and tie the hands of subsequent administrations. Over the course of the next two administrations, one Republican and one Democratic, that’s exactly what happened.
By the summer of 1988, the Reagan administration was winding down and the next presidential election campaign was in full swing. The 1988 campaign pitted Reagan’s vice president, George H. W. Bush, against Democrat Michael Dukakis. The Democrats were already calling for tax increases to offset the Reagan deficits.
At the Republican nominating convention on August 18, 1988, in New Orleans, Bush declared, “The Congress will push me to raise taxes and I’ll say no.3 And they’ll push, and I’ll say no, and they’ll push again, and I’ll say, to them, ‘Read my lips: no new taxes.’” That pledge was intended to shore up Bush’s support from the conservative wing of the Republican Party, which favored spending cuts and opposed tax increases. It worked. Bush easily obtained the nomination and just as easily defeated Dukakis in the general election. The no-tax pledge was the most memorable line Bush ever said on economics, and the American people remembered it.
Unfortunately, the deficit numbers did not buttress Bush’s pledge. Midway through Bush’s term, the debt-to-GDP ratio crossed the 60 percent threshold. Economists consider this a red line. The 60 percent level is the one used under the Maastricht Treaty, which governs the European Union, as the maximum that is tolerated under unified EU fiscal policies.
Bush’s advisers, led by Richard Darman, needed to reach a budget compromise with a Congress controlled by Democrats to reconcile conflicting fiscal priorities. The Democrats insisted that tax increases be part of any package that included spending reductions or entitlement reforms. Bush agreed and received support from Republican leaders. However, he lost the support of Republican voters.4 In 1990, The New York Post ran the headline READ MY LIPS … I LIED.
From the perspective of fiscal prudence, Bush 41’s actions were justified. The debt-to-GDP ratio first leveled off then began to decline slightly, back toward the critical 60 percent level. His policy may have been sound economics, but it was lousy politics. Bush lost the 1992 election to Bill Clinton partly because of voter dissatisfaction with his breach of the no-tax pledge. Starve-the-beast worked. The United States was back on a path of a reduced debt-to-GDP ratio. Unfortunately for Bush 41, the beast devoured his chances at reelection. The new president, Bill Clinton, would now have to deal with Reagan’s starve-the-beast legacy.
Clinton was the first Democratic president in twelve years. The last Democrat before Clinton was Jimmy Carter, a fiscally conservative southern governor and technocrat. Carter’s spending options were severely limited by runaway inflation and the dollar’s near collapse that occurred on his watch. Before Carter, Republicans held the White House for eight years. The last big-spending liberal Democratic president was Johnson, who left office in 1969. Liberal Democrats had waited a generation, twenty-four years from LBJ to Clinton, for a chance to revive big social-spending programs of the kind they associated with FDR, Harry Truman, and LBJ. Clinton embodied the liberals’ hope that big spending would return.
They were soon disappointed. Clinton was faced with the same tough budget realities as Bush 41. The ghost of Reagan’s starve-the-beast policies haunted the West Wing. Democrats and Republicans agreed on the need for fiscal prudence to bring the debt ratio back below 60 percent. The only disagreement was on the right mix of taxes, spending cuts, and entitlement reforms to achieve that goal. Clinton’s first economic adviser, Bob Rubin, warned Clinton of a new danger—the so-called bond vigilantes. The vigilantes were major bank bond dealers and institutional investors who were hypersensitive to the threat of inflation. The 1990s vigilante heyday was long before the deflation scares of the early 2000s. Large deficits were considered potentially inflationary at the time because it was feared the Fed would monetize the debt as it had in the 1970s. Higher interest rates caused by inflation fears could slow economic growth. Rubin urged Clinton to cut spending and raise taxes to reassure the bond vigilantes that the deficit was not out of control. Clinton’s closest political adviser, James Carville, said: “I used to think if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter.5 But now I would like to come back as the bond market. You can intimidate everybody.” That remark captured the reality facing Bill Clinton at the start of his first term.
Fortunately for Clinton, the Democrats controlled congress until January 1995, and were able to push his tax increases through in the Deficit Reduction Act of 1993. This raised the top individual tax rate from 31 percent to 39.6 percent, where it remained until the 2017 Trump tax cuts. Clinton was also the beneficiary of the so-called peace dividend, a cut in defense spending. The Reagan-Bush victory in the Cold War was so complete that defense spending could be reduced substantially without jeopardizing national security. The impact of lower defense spending on the debt-to-GDP ratio was no different after the Cold War than after World War II; the debt ratio came down. This combination of higher taxes, lower defense spending, and sound monetary policy by Fed chair Alan Greenspan worked wonders on the debt ratio. It fell steadily during the Clinton years, dropping to 56.4 percent by the end of Clinton’s second term, decisively below the 60 percent critical threshold.
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bsp; Despite political opposition, and impeachment, Clinton’s personal popularity remained high. He presided over the longest peacetime economic expansion in U.S. history. At the end of Clinton’s presidency, he even produced a small budget surplus for the first time since 1969. There was talk among the bond vigilantes that the U.S. Treasury market might disappear because Clinton’s policies could retire the national debt for the first time since Andrew Jackson.
Bush 41 and Bill Clinton both succumbed to the starve-the-beast trap laid by Ronald Reagan. Both raised taxes as a result and paid a political price. Bush lost reelection in 1992 and Clinton lost Congress in 1994. Still, their policies brought the debt ratio back under control. That progress toward a sustainable debt-to-GDP ratio ended abruptly with Bush 43’s inauguration in January 2001 and the 9/11 attacks. Less than eight months after George W. Bush was sworn in, America was again at war. This was not a cold war, it was a red-hot shooting war, yet not against a nation-state. Bush waged the War on Terror. Not surprisingly, the U.S. debt-to-GDP ratio began to rise again as in the Revolutionary War, Civil War, World War I, World War II, and the Cold War. The difference was that the increase started from a higher level. The Cold War victory had not been paid for by the time the War on Terror emerged.
Bush 43 promptly pivoted from Clinton’s and Bush 41’s starve-the-beast policy to a new version of Reagan’s original feed-the-beast approach. Bush pushed through two major tax cuts in 2001 and 2003 and drastically ramped up defense and intelligence spending. By 2003, Bush was fighting three wars at once, in Afghanistan, Iraq, and against global terror. Most Americans did not initially question these wars and the increased spending that went with them because of the trauma of the 9/11 attacks and the perceived need to defend U.S. interests in the Middle East. Most Americans also welcomed the Bush tax cuts as relief from the 2000–2001 recession, the dot-com market crash, and the high taxes of the Clinton years.
Nevertheless, the impact on the debt ratio was swift and predictable. The ratio rose from 56.4 percent when Bush took office to 82.4 percent by the end of his two terms in office, the highest since the Truman administration and the aftermath of the Second World War, and well beyond the 60 percent critical threshold that Clinton salvaged. Yet this debt ratio increase fit the historical pattern of increased debt during wartime, albeit from a higher level. By the end of Bush’s term, the war in Iraq was over, and the war in Afghanistan and War on Terror turned into long-term struggles that were costly but did not involve big spending increases of the kind seen from 2002 to 2007. Bush 43 was ready to repeat the Reagan playbook. He governed on a feed-the-beast approach, but now wanted to serve a starve-the-beast menu to his successor, Barack Obama. Bush would tie Obama’s hands by leaving him no choice but to reduce spending to get the debt ratio back under control. Bush 43 intended to do to Obama what Reagan did to Bush 41 and Clinton.
Fate intervened. In the final months of Bush 43’s term, the United States was struck with the worst financial crisis since the Great Depression. This gave Obama the perfect rationale to increase spending to offset the financial crisis, rather than to reduce spending. Instead of starve-the-beast, Obama doubled down with more feed-the-beast. In 2009, under Obama’s leadership, the United States took a decisive turn toward complete financial ruin.
Obama’s massive first-term deficits (2009–13), should be understood not only in the context of Bush 43’s starve-the-beast gambit, but also in the long sweep of progressive Democratic presidents and their vision for America. Neither Bill Clinton nor Jimmy Carter lived up to the expectations of progressive Democrats for expanded spending and entitlement programs. Carter was a fiscal conservative constrained by hyperinflation. Clinton was a moderate constrained by bond vigilantes and a Republican Congress after 1994.
Progressives had to look back to LBJ’s Great Society (1965), and before that to FDR’s first one hundred days (1933) to find the kind of government activism they wanted. The landmark Social Security and Medicare programs were passed by FDR and LBJ. There was no social legislation of comparable magnitude for over forty years by the time Obama was sworn in. Progressives were hungry for social spending. Obama seemed the progressive leader they had been waiting for.
Obama had ready-made cover to do exactly what progressives wanted without having to nod in their direction. The 2008 global financial crisis sent the economy crashing and unemployment skyrocketing. The White House economic team of Christina Romer, Larry Summers, Austan Goolsbee, and Steve Rattner were not radical progressives; they were conventional neo-Keynesians. Their solution was predictable—massive deficit spending to stimulate the economy. Stimulus would come from a mystical Keynesian multiplier. Each $1.00 of deficit spending would produce more than $1.50 of growth, according to Christina Romer’s estimates.
It was left to Obama and his closest political adviser, Valerie Jarrett, to blend the progressive wish list with neo-Keynesian stimulus into what became known as the American Recovery and Reinvestment Act of 2009. This was an $831 billion deficit-spending package piled on top of both preapproved baseline spending and automatic stabilizer spending for unemployment insurance and food stamps, which rise in recessions.
The 2009 stimulus act was touted as facilitating shovel-ready infrastructure. This was a Larry Summers fraud. Only a small portion was directed at critical infrastructure or productive capacity. The money went mostly to support liberal interest groups such as teachers, municipal workers, health-care workers, community organizers, and others who might have been laid off in the recession. The 2009 stimulus was the greatest progressive spending spree in U.S. history.
For seventy years, from 1946 to 2016, the average annual budget deficit was 2.11 percent of GDP. In contrast, deficits as a percentage of GDP for the early Obama years were 9.8 percent in 2009, 8.7 percent in 2010, 8.5 percent in 2011, and 6.8 percent in 2012. Not until 2014 did budget deficits move closer to the historical norm. The Obama years, 2009 to 2017, saw the national debt more than double, from $9 trillion to almost $20 trillion. The debt-to-GDP ratio soared above 100 percent, the opposite of what George W. Bush expected from his attempt to impose a starve-the-beast policy.
Obama produced the worst possible combination of massive deficits, a skyrocketing debt-to-GDP ratio, and substantial tax increases. This might have been acceptable if the economy had yielded the robust growth expected by the neo-Keynesians. Obama’s advisers believed that if debt increased by $11 trillion, then $15 trillion would be added to growth, mitigating the impact of the debt on the debt-to-GDP ratio. This never happened. Instead, the economy grew at a 2.05 percent average annual rate from the beginning of the Obama recovery in June 2009 until the end of 2016, the weakest recovery in U.S. history. Growth was far below the 3.19 percent annual average for post-1980 economic expansions, and the 5 percent average annual growth in the early years of the Reagan expansion (1983–86).
Ominously, the dismal Obama economic performance was produced in peacetime, not in a time of war. There was no peace dividend, as there had been for Bill Clinton. There was no deferred consumption, labor-market slack, or investment catchup as there was in the aftermath of past wars. Far from deferring consumption and investment, Obama’s deficits brought growth forward, leaving a permanent output gap and little prospect for strong growth in the next administration.
Donald Trump was sworn in as the forty-fifth president on January 20, 2017, amid great expectations from the U.S. stock market and global investors. Trump’s declared policies of tax cuts, reduced regulation, and larger deficit spending on defense and critical infrastructure were ripped from Ronald Reagan’s playbook. Indeed, some of Trump’s closest economic advisers, including David Malpass, Steve Moore, Larry Kudlow, Art Laffer, Steve Forbes, and Judy Shelton, were veterans of the 1980s Reagan Revolution. Trump was ready to feed the beast again with tax cuts and larger deficits. But the beast had already been fed $14.4 trillion by Bush 43 and Obama through war debt and progressive party payoffs. Trump’s cupboard was bare.
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dvisers urged him to run the Reagan playbook, yet the conditions that prevailed in 1981 were absent in 2017. Reagan’s debt-to-GDP ratio of 35 percent was a distant memory. Trump inherited a 105 percent debt-to-GDP ratio. His administration had no space for fiscal stimulus, and there is considerable doubt that so-called stimulus would work given the high debt burdens already in place.
The looming loss of confidence in U.S. credit was no impediment to reckless fiscal policy by the White House and a Republican Congress in the first two years of the Trump administration. In late 2017, Congress passed the Trump tax cuts, which added $2.3 trillion of debt over ten years, after quietly abandoning a requirement that tax cuts be revenue neutral. In place of revenue-neutral tax costs, Congress and the White House relied on the Laffer Curve, which, as we’ve seen, says that tax rate cuts stimulate enough growth so that added taxes on the growth mitigate lost revenue from the cuts. There is no empirical support for the Laffer Curve in the real world, except at extremely high starting tax rates. The Laffer Curve is largely a fiction, as was the neo-Keynesian multiplier on which Obama relied.
In January 2018, just a few weeks after passing the tax cuts, Congress removed spending caps on defense and discretionary domestic spending. Republicans wanted to increase defense spending and Democrats wanted to increase domestic spending; they compromised by doing both. Removal of these spending caps added over $300 billion to the deficit over two years. (These spending increases do not include approximately $140 billion of unbudgeted disaster relief in fiscal year 2017 for Hurricanes Harvey, Irma, and Maria, and the California wildfires). This combination of tax cuts and increased spending signaled the return of trillion-dollar annual deficits that will soon push the U.S. debt-to-GDP ratio from 105 percent to 115 percent. Foreign investors sense the coming debt crack-up and are reducing their exposure to U.S. Treasury securities. Net buying of U.S. Treasury securities by foreign investors began to decline after 2010, when the Obama deficits emerged. Buying shrank steadily until 2016, when net buying turned to net selling. A slow stampede out of U.S. government debt in anticipation of a debt crisis has started and will gain momentum.
Aftermath Page 8