Fighting Inflation With Fake Spending Cuts and Budget Cuts

In a piece reprinted from Inquiry Magazine, the author concludes the Reagan administration's tax cuts and spending cuts are a hoax and will accomplish little toward fighting inflation.
By Murray N. Rothbard
September/October 1981

The Reagan administration's vaunted tax cuts were more hype than reality, according to one analyst.
ILLUSTRATION: FOTOLIA/JOHN TAKAI


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This article is reprinted by permission from Inquiry Magazine.   


P.T. Barnum Was Right

The senators on the Budget Committee were feeling testy—or exultant, depending on their party preference—after three days of grappling with President Reagan's budget. Said a depressed Daniel Moynihan: "We have undone 30 years of social legislation in three days."

The Republicans, too, were impressed with the magnitude of the endeavor. "Extraordinary times demand extraordinary efforts," said Pete Domenici of New Mexico. Added Robert Kasten of Wisconsin: "We simply must break from the policies of the past." All around the country the newspapers said the same thing. Whether you were for it or against it, the editorial pages agreed, the Reagan budget was revolutionary, the most sweeping change in American policy since the New Deal.

But if we look closely at the Reagan budget, what we can see is that it's really the most sweeping success in American public relations since William McKinley persuaded the country that the Holy Bible ordained American control of the Philippines.

There are two aspects of this supposed revolution ...deep and startling budget cuts (which reverse the seemingly inexorable trend of the last several decades toward bigger government) and a deep cut in taxes for business and upper-income groups, as prescribed by supply-side economics. These tax cuts are supposed to stimulate large increases in saving, investment, and productivity.

[EDITOR'S NOTE: Put very simply, supply-side theory holds that by reducing taxes, the government can cause more people to save money which — in turn — will make more capital available to businesses, which can borrow the cash to upgrade equipment and so forth ...raising our national level of productivity and resulting in more money for the government and for the rest of us as well.] 

Curiously, the budget cuts seem to have met with surprisingly little disapproval from Democrats and other critics of the Reagan administration, except of course from the bureaucrats directly affected. "It's a phenomenal thing for Ronald Reagan," crows White House aide Michael Deaver, "for the New York Times, the Washington Post, Time magazine to say, 'Maybe it's time to reassess, maybe we don't need so much government.' The public mood is there."

The income tax cuts, in contrast, have drawn heavy criticism for being unsound and "inflationary." In early April the Senate Budget Committee voted 12 to 8 to reject Reagan's tax and spending package ... a "stunning" blow dealt by Democrats and "balanced budget" Republicans who tremble at the thought of the deficits that Kemp-Roth tax cuts will bring in their wake. In reply, the supply-siders in and out of the Reagan administration maintain that tax cuts will so stimulate production that government revenue will increase.

The anti-supply-siders, both Republican and Democratic, are implicitly saying that inflation is caused by too much spending, private and public. If spending increases, prices will rise. Net government spending can be gauged by the deficits: If the government takes in, say, $600 billion, and spends $700 billion, that will add $100 billion to the inflationary spending stream.

Anti-supply-siders sternly oppose tax cuts in an inflationary economy because they will encourage inflation, by increasing private spending and government deficits. For these critics of supply-side theory, government spending must be cut first, and at least proportionately to any tax cuts. In fact, they would prefer to cut spending and leave taxes alone until a balanced budget is achieved.

To the charge of fueling inflation, supply-siders—despite their claim to new and revolutionary doctrine—tend to reply within the same framework. While conceding that the money saved by tax cuts that goes into consumer spending would be inflationary, the supply-siders want to skew the tax cuts so that the money will be channeled largely into saving and investment. Then, they maintain, the increased investment and productivity will generate a larger supply of goods and services, which will tend to combat inflation. Furthermore, the increased work, thrift, and investment stimulated by the tax cuts should eventually increase government revenue.

In the extreme version popularized by Arthur Laffer, large tax cuts will instantaneously increase government revenue. In this scenario, government spending can remain the same, and we can make massive tax cuts and still balance the budget as tax revenues increase. We can enjoy at the same time three seemingly inconsistent sets of goodies that the public is supposed to want: keeping up the level of government "services," cutting taxes, and balancing the budget. Thanks to Laffer, there is such a thing as a free lunch.

Critics of supply-side economics are right, though not always for the right reasons, when they attack the Laffer curve as "voodoo economics." There are many grave fallacies in the Laffer theory. First, production can never increase instantaneously, and any Laffer effect would take years to develop. Second, there is no reason to suspect that the Laffer effect would be enough to balance the budget or counteract the inflationary effect of turning on the money taps. Third, there would probably be no Laffer effect at all: that is, a deep tax cut would probably lead to a deep revenue cut, though perhaps not equally deep. I wait in trepidation for some liberal critic of the Laffer curve to throw down the gauntlet as follows: "Okay, let's test the Laffer curve. Let's raise income taxes by 30% and see if total revenue drops." I'd bet my bottom dollar that total revenue would rise.

And what's so great about increasing tax revenue anyway? Why must we try to arrange things so that the government will extract the maximum possible amount from the poor taxpayer? I should think that the alleged free market economists would be opting not only for cuts in crippling tax rates but also for cuts in total revenues, which indicate the total resources extracted from private citizens to support the bloated and unproductive government sector. Surely we should try for drastic cuts in both tax rates and revenues.

Once we dispose of the Laffer curve, we are still left with the dread problem of inflation. Aren't the orthodox economists right, then, and mustn't we tighten our belts and forgo tax cuts until we can cut government spending and get inflation under control?

The answer should be a resounding NO. First there are two strategic reasons for calling for full speed ahead on tax cuts regardless of inflation. As Milton Friedman has long been suggesting, if taxes are cut steeply, this will increase the pressure on Congress to cut government spending as well. The specter of bigger deficits may well force Congress to shrink the budget. Moreover, it is important for those who wish to roll back big government, cut the budget, slash taxes, and abolish regulations never to lock themselves into a restrictive set of priorities of their own making.

Finally, we come to the key problem: Granted that tax cuts should be made even if inflationary, are they in fact inflationary? This gets to the heart of the matter. What causes inflation anyway? Inflation is caused not by total spending, but by government—in our case, the Federal Reserve printing new money. The Fed has an exclusive legal right to print dollars; anyone else who dares to join in that activity goes to jail for a very long time, and no one bothers to find out whether the unfortunate counterfeiter came from a broken home or was deprived of playgrounds as a youth. No one bothers because no one wants to mitigate the extreme seriousness of this crime. Unlike robbers, rapists, and murderers, who merely injure individual citizens, the counterfeiter cuts into the federal government's monopoly on the counterfeiting business, and the government takes that very seriously indeed.

The more money the government prints, the more prices will be driven up as more money "chases" the same quantity of goods ...and the government, as we said earlier, can always print money faster than production can grow. Moreover, if the inflationary process goes on for many years, people will begin to expect continued high levels of inflation, and they will then spend faster before prices go even higher. The result will be still greater inflation. The only way to reverse inflationary expectations and end this disastrous upward spiral is for the federal government to stop printing money—to stop it permanently—and to convince the public that concrete action has at last replaced hot air, that the government has ended its inflationary penchant for counterfeiting.

If the Fed's printing press is the key, then won't federal deficits be inflationary, and don't we have to concentrate on getting a balanced budget? Not really. Federal deficits do not have to be financed by creating new money; they can be financed by issuing bonds and selling them to the public. If the deficit is $50 billion and it is financed by selling bonds to the public, then the government's increase in money assets of $50 billion is matched by the reduction of $50 billion from the bank accounts of the people and institutions who have bought the bonds. No new money has been created, therefore there is no inflationary impact.

On the other hand, a balanced budget would not necessarily stop the Fed from creating new money. Every time the Fed buys a financial asset, in whatever form, money flows into the banks. The banks in turn are permitted by law to lend out about seven times that much in new money. If the Fed buys $1 billion of U.S. bonds, the banking system will create $7 billion of newly issued money. This inflationary effect will occur whether or not the budget is balanced.

Consequently, all this emphasis on the budget is simply a smokescreen. What is needed to end inflation is to force the Fed to shut off the money taps: that is, to stop buying assets, to stop creating bank reserves. Anything else is a snare and a delusion. Therefore, cutting taxes and increasing deficits will not be inflationary if the Fed is forced to remain on the sidelines.

Admittedly, deficits—even if non-inflationary—do create grave problems. Deficits siphon resources away from the productive private sector and into unproductive government projects, and the taxpayers must eventually pay for these expenditures, plus hefty interest charges. But at least deficits don't have to be inflationary.

Whether for it or not, everyone assumes that Reagan's "supply-side budget" offers deep tax cuts, concentrating on business and on upper-income groups. But does it?

In the first place, contrary to myth and propaganda, taxes are not being cut at all! The piddling 10% cut in income tax rates will be more than offset by two kinds of tax increases: One is the programmed and unaltered rise in social security taxes, and the other is "bracket creep." The social security system, though inherently bankrupt, was picked by Reagan as one of the "sacred cows" in his budget. Bracket creep is an insidious process by which government delivers all of us a one-two punch: First, the Fed pumps in new counterfeit money, raising all incomes and prices. If your income increases by, say, 50%, and prices rise proportionately, then your "real" income in terms of purchasing power remains the same. You are no better off, but U.S. income tax laws being what they are, you are suddenly in a higher tax bracket and have to pay considerably more than a 50% boost in your tax bill.

During his campaign, President Reagan promised to "index" all of our income taxes so as to eliminate bracket creep and to keep us all in our original brackets, but that promise has been forgotten. Reagan now expects tax revenues to rise by $50 billion in 1982.

But aren't the upper-income groups getting a bigger tax break to stimulate saving and investment? No indeed. In fact, if the Reagan 10% cut is passed, an individual making $200,000 a year in 1982 will receive a decrease of only 3.4%, and someone making $10,000 will get a 15.3% reduction. Furthermore, the disastrous 70% maximum rate on interest and dividends (contrasted with the current 50% maximum on wages and salaries) will remain in force. No cuts here. And there are no cuts at all in many other critical business taxes, including the capital gains tax and the corporate income tax. Even the grotesque Carter "windfall profits" tax on domestic crude oil production at the wellhead remains in effect. This misnamed levy, actually a graduated excise tax on crude oil, is bound to have a crippling effect on crude oil production and on the search for new crude oil reserves. The Reagan excuse: "We need the money."

Whatever else it is, then, the Reagan budget is not any sort of application or test of supply-side economics. Taxes are increased, not cut, and the cuts that are made fall mainly in the lower income groups.

If there are no tax cuts to test supply-side economics, what of the vaunted "massive" spending cuts of the Reagan budget? Aren't those at least a big step toward dismantling the leviathan state? Yet here, where the propaganda-pro and con has been the fiercest, the fraud is the most blatant. For the budget is not being cut at all.

When Dwight Eisenhower became President, his first full year's budget, fiscal 1954, cut spending from the $74.3 billion of the previous year to $67.8 billion, a modest but not insubstantial reduction of 8.7%. And Eisenhower was thought at the time to have performed the function of consolidating the New Deal-Fair Deal and preventing any concerted action for its repeal. But this year President Reagan, an avowed right-wing critic of the political mainstream for most of his career, is proposing to increase his first full year's budget, from $855.2 billion in 1981 to $895.3 billion in fiscal 1982. This is an increase of $40.1 billion, or 8.1 %. The Congressional Budget Office goes further and predicts that Reagan's budget will actually cost between $715 billion and $720 billion, and the Republican-dominated staff of the Senate Budget Committee claims that his cuts amount to only $42.9 billion, not $48.8 billion. Eisenhower's first budget included a real cut, Reagan's a considerable increase. So why is Reagan's attempt called a "historic" and "massive" budget cut? Because Reagan has eliminated from his budget many of Jimmy Carter's proposed and projected massive increases for 1982. In short, Reagan is not in the slightest interested in cutting the actual budget, only in cutting its rate of increase.

Furthermore, not one single agency is being abolished, not even among the handful that are really being cut. Even the Council of Wage and Price Stability, a totally ineffective and even counterproductive means of fighting inflation, continues in existence, though sharply cut back. It is dangerous to leave bureaucrats in place with the chance to return to fight again another day.

So forget for a moment about the uglier side of Reagan's policies: the blank check being offered to the Pentagon, the subtle escalation in El Salvador so chillingly reminiscent of Vietnam, the threat to unleash the CIA, the ominous silence about registration and the draft. Forget these, and concentrate on the domestic economic arena, supposedly the area that best epitomizes Reagan's "small is beautiful" philosophy of government. Here we find that—despite the media hype—there is no test of supply-side economics, there is no tax cut, there is no budget cut. Taxes and government spending are going up, not down, under the Reagan plan. There is no Reagan revolution.

Why then the massive hype? Why are both conservatives and liberals in a sense collaborating in propounding a gigantic hoax on the American people?

For different reasons. The Reagan administration sees fraudulent propaganda as the key to success, and hopes that if it puts up a good pretense of cutting taxes and cutting the budget, the public will be conned to the point at which its inflationary expectations will be reversed and its spending slowed down. In short, it expects to be able to moderate our grave inflation problem by what used to be called "jawboning": talking big and making grandiose claims. The hope is that in this way inflation can be brought down without scrapping the same old policies—printing of money, high taxes, high spending—that brought us to our current economic morass in the first place.

The Reaganites, then, are concocting the myth of their nonexistent "revolution" in order to con the nation. The liberals have longer-range aims: They do not want to be put in the position of "obstructing" the President's program in Congress and hence being blamed for its inevitable failure. Far better from the political point of view for them to "give the President a chance" and then, in a year or two, pick up the pieces.

The liberal strategy in going along with the hype is far shrewder than that of the conservatives, who are bound to go toppling down to defeat in four years' time. But the group in greatest peril, aside from the nation as a whole, is that small but growing band of people genuinely dedicated to free market economics and to the total rollback of big government. For when Ronald Reagan's phony revolution turns out to be a flop, and inflation continues and accelerates once more, the public will understandably blame free markets, hard money, minimal government, and supply-side economics. In this way, economic freedom may well be discredited for decades to come, regardless of the fact that it was never given a chance. The only way to save the economic principles that Reagan claims to stand for is to denounce his program for the gigantic hoax that it is.


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