What We Haven't Learned From The Reagan Recovery

Yesterday's Wall Street Journal featured an editorial by economist Judy Shelton entitled "The Message of Dollar Disdain."

Quite by accident, since I had yet to turn to that page, I had a discussion with a business colleague over lunch about the same topic that Shelton mentioned at the end of her piece. I had told my friend about this recent post, based upon another Journal editorial, as well as a cross-post from my political blog featuring two video clips of Steve Wynn on fiscal policy. Both concerned the impact of proposed, costly social programs on a federal debt already bloated by roughly six decades of deficit spending.

Ms. Shelton wrote,

"Sadly, due to our fiscal quagmire, the Federal Reserve may be forced to raise interest rates as a sop to attract foreign capital even if it hurts our domestic economy. Unfortunately, that's the price of having already succumbed to symbiotic fiscal and monetary policy. If we could forge a genuine commitment to private-sector economic growth by reducing taxes, and at the same time significantly cut future spending, it might be possible to turn things around. Under President Reagan in the 1980s, Fed Chairman Paul Volcker slashed inflation and strengthened the dollar by dramatically tightening credit. Though it was a painful process, the economy ultimately boomed."

I mused to my friend about the same scenario. That is, I suggested that, if the long term effect of the weak dollar is, as David Malpass wrote in yet another Journal editorial, a fate much like Britain, the "hollowing out" of the US economy, then the solution is to raise interest rates on US Treasuries. Combined with more prudent fiscal policy, a la Wynn's observation that 'no government spending ever increased its country's standard of living,' in the form of restrained/reduced spending and lower taxes, genuine private economic activity would be resuscitated.

Such a move would, of course, sink various marginal business activity. But it would set off a chain reaction of virtuous consequences.

Banks would cut their lending to more viable projects which would clear hurdle rates of perhaps 3-5%, plus risk premium.

New capital would flow into the US to earn decent rates on fairly low-risk Treasuries.

That capital would flow to new business activity.

Money kept by taxpayers, instead of taken and spent by government, as well as not used to pay interest on higher deficits, would also seek investment returns, resulting in greater available capital for business activity.

As Ms. Shelton points out, this is precisely what occurred under the Reagan-Volcker regime.

The essential starting point is a commitment to the future, rather than the protection of past mistakes. In a word, an economy dedicated to Schumpeterian dynamics.

From this viewpoint, the mid-late Bush and certainly current administration's actions are exactly backwards. Rather than protecting existing, failed investments and propping up their value with taxpayer funds and borrowed capital from abroad, the more robust economic path would have been to let companies like GM, Chrysler, AIG, Goldman Sachs and Citigroup fail.

As Anna Schwartz noted in an interview she gave to the Journal last fall, on which I posted here. In that interview were the following passages,

"Ms. Schwartz won't say so, but this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he's shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down.

But perhaps this is actually Mr. Bernanke's biggest problem. Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job." "

Ms. Schwartz noted that liquidity was never the issue last fall, or even two years ago, when Helicopter Ben began reducing rates in a panic. Rather, she observed, the problem has been guessing which institutions were still actually solvent, as asset values spiraled downwards.

Monetary and fiscal policy which seek to protect past actions of private capital investors, at the expense of future ones, are doomed to stultify and cement an economy in the past.

Ms. Shelton's focus, while slightly different than that of Malpass or Lawrence Kadish, is never the less chilling. Whereas Malpass focused on exchange rate consequences, and Kadish on mounting interest and rates on the national debt, Shelton concentrated her analysis on the companion measure of US debt/GDP. On that measure, she notes, we will have vaulted, on the basis of current government estimates, from 23rd last year to 7th in 2011. The result? Ms. Shelton writes,

"The U.S. is thus slated to enter the ranks of those countries—Zimbabwe, Japan, Lebanon, Singapore, Jamaica, Italy—with the highest government debt-to-GDP ratio (which measures the debt burden against a nation's capacity to generate sufficient wealth to repay its creditors)."

Economic loss brings pain somewhere in an economy. Schumpeter's genius was to identify that this is the natural order of a healthy, growing capitalist economic system. Our policymakers cannot allow themselves to be unduly affected by the plight of those in the rearward areas of economic decay.

Transfer payments for employees of yesterday's now-faded economic titans is one thing. Actually rushing to preserve those enterprises with taxpayer funds is quite another. Or, worse, with borrowed funds from abroad.

When you assemble the views of the recent Journal economics editorialists- Malpass, Kadish and Shelton- you get a truly chilling picture of US monetary and fiscal policy gone mad.

Perhaps for the same reason so few of us seem to recall the economic horrors of the Carter years, for which Reagan's and Volcker's solutions were so effective, few also realize the danger we are in today.

Or that there is a fairly simple, if painful, way out now, as well.