Crackpot theories

Back in March 2020, my blog “You just couldn’t make it up, could you?” started as follows:

The relationship between politicians and economists has fascinated me for a long time. When I was an economics student back in the 1970’s (yes, really), inflation was the enemy, running at double digit rates, burning capital and income. Politicians were desperate for new tactics to bring it under control.

I was reminded of this during the 2019 UK general election, when repeatedly hearing an oft-cited economic ‘law’, in support of low taxation and a small state. Reduce taxes and more money will flow into the state’s coffers, and high earners will spend more thus wealth will ‘trickle down’ to everyone, so the theory goes.

I find myself drawn back to this issue, not least since it has resurfaced in the claims made by our new Prime Minister, Liz Truss, during her campaign for leadership of the Conservative Party. A central plank of her platform is to cut taxes, which will ‘unleash’ productivity growth and reduce deficits, whilst raising defence spending.

In my March 2020 blog, I wrote about the way in which Ronald Reagan and Margaret Thatcher embraced ‘supply-side’ economics in the 1980’s, in a bid to combat the evil twins of high inflation and stagnant growth in productivity. As I wrote previously, a catalyst for this was the scribbling on the back of a napkin by economist, Art Laffer, in September 1974, over lunch with Donald Rumsfeld and Dick Cheney, senior Republican politicians. At that time, Rumsfeld was White House Chief of Staff under President Ford.

Some felt Laffer did not go far enough. When President Reagan took office in 1981, he appointed a young and newly converted supply-side disciple, David Stockman, as budget director of the Office of Management and Budget (OMB). This is a small, complex and powerful hub at the centre of the federal government, through which the President assesses competing funding demands among all federal agencies and sets funding policies. Stockman had come to prominence as a Republican Congressman, making his name as a conservative, attacking federal budgets and proposing leaner alternatives in the name of smaller government.

Reagan invited him to do the same from within his new administration. Stockman was confronted by a three-sided problem, created by Reagan’s contradictory election promises to raise defence spending by 7% real (above inflation), cut the top rate of income tax from 70% to 50% and to balance the budget, all at the same time.

Stockman thought it would not be that hard to pull off. He assumed the commitment to a reduction in taxes over three years, coupled with tight monetary control, would signal to financial markets that a new (low inflation) era was dawning, where the growth of government would be displaced by the growth of private capital. Swift and dramatic action by the President would reverse the gloomy assumptions in the disordered financial markets. As inflation fell, so would interest rates, productivity and employment would grow, and these would balance the budget.

When Stockman took office in January 1981, the OMB presented him with some shocking economic forecasts, showing a ballooning deficit. He did the obvious: change the model and use the original projections as a lever to push for drastic cuts in the federal budget.

He had been confident that this approach would trigger a bull market in equities by April (1981). Markets not only failed to rise but went into decline. Inflation started to fall, but only through luck – record grain harvests and increased oil supplies.

Investment analysts had been poring over Stockman’s figures and could not make them add up. Their own models predicted huge deficits in the years ahead. Their loud and clear message was that cutting taxes and raising defence spending would produce inflationary deficits, not balanced budgets.

Stockman’s internal response at the OMB was to use the ‘magic asterisk’, which replaced numbers to denote all future deficits that were to be taken care of with additional budget restrictions, to be announced by the President at a later date. This was soon foiled by Senate Budget Committee staff, who simply put the numbers back in.

However, as a late convert to supply side theology, Stockman was beginning to leave the church. By June 1981, it had all fallen apart. By August, the Reagan program was supposed to create a boom, instead, financial markets sagged, interest rates went up, and recession loomed.

Stockman commented:

“Whenever there are great strains or changes in the economic system, it tends to generate crackpot theories, which find their way into legislative channels”.

Now that is something I can agree with him about.

On this side of the Atlantic, ever since the 1980’s, Professor Patrick Minford has been making the case for radical cutting of taxes and has been an outlier for four decades. He was one of Margaret Thatcher’s gurus and has been cited by Truss during the leadership campaign.

Of course, academics do and should enjoy freedom of thought and speech; but those who are accountable for their actions in public life might perhaps pause to reflect on the past and have a plan just in case their guru proves to be wrong (again). Let’s hope so.

On the other hand, as Stockman found to his cost, the machinery of democratic government moves very slowly, and is not capable of abrupt turns and changes. This might, after all, be our saviour from crackpot theories.