Nearly four decades ago, political pundits were shocked as voters turned away President Jimmy Carter and voted in Ronald Reagan, who promised to bring fundamental change to Washington and the indwelling political establishment. At the time, unemployment was rising quickly and inflation raged in double-digits, and Reagan had promised to deal with the economic failures by cutting income tax rates, slashing government spending, and reducing the regulatory burden.
As we know, Reagan succeeded in convincing Congress to do one of those three things — cut income tax rates — but the spending and regulatory monster continued to grow. The Carter administration already had initiated most of the major deregulation initiatives, and Reagan’s role in that area was minor at best. Reagan had to deal with something else in 1982 that threatened to turn his presidency into a one-term failure: a major recession in which the nation’s unemployment rate rose to above 10 percent and the disappearance of whole swaths of the nation’s industrial sector, resulting in what has been called the “Rust Belt” of the northern United States.
Ending 1970s-Style Inflation
We know the rest of the story. The economy recovered (despite interest rates that were above 10 percent) and Reagan won re-election in 1984 in a huge electoral landslide. We also know that while the Reagan administration had many failures, capital investment nonetheless turned toward the “high-technology” sectors and telecommunications.
The one thing that was on no one’s political agenda in 1980 was on Federal Reserve Chairman Paul Volcker’s mind: how to wring inflation out of the system and reestablish some balance in the monetary sector. Reagan claimed that by cutting tax rates, businesses would follow with new investments and increase the supply of goods available to consumers, thus reducing inflation on the “supply side.” This is why the Reaganites referred to their plan as “Supply-side Economics.”
Volcker understood, however, that while supply-side’s boosters might have claimed it to be a painless way to end inflation, it clearly would be doomed to failure, something Austrian economists like Murray Rothbard and others also comprehended. Inflation is first and foremost a monetary phenomenon and reducing inflation would not come about by just cutting taxes and producing more goods. Instead, Volcker and the Fed needed to stop expanding the economy’s money supply and also allow interest rates to rise — and rise they did.
Unfortunately, the pundits (along with most economists — who should have known better) employed the post hoc ergo propter hoc fallacy, claiming that higher interest rates caused the severe recession of 1982. Instead, the higher interest rates exposed the economic malinvestments that needed to be liquidated before the economy could have a real recovery, and while Austrian economists are not necessarily satisfied with what the Fed and US government did during the 1980s, some positive things happened with the economy during the 1980s.
Will Trump Pop the Bubble?
Donald Trump faces a much different situation post-election than did Ronald Reagan, but nonetheless a recession looms, as the Federal Reserve policies of the past two decades have piled up a mountain of malinvestments, and especially since 2008, when the housing bubble finally crashed.
Since then, the economic “game plan” for the Fed and the Barack Obama administration has been to prop up the weak sectors of the economy through a combination of outright subsidies and Fed security purchases. The stunning diagram below explains in part why both interest rates are extraordinarily low and the US economy remains sluggish.
As one can readily see, Fed purchases pre-2008 meltdown consisted mostly of six-month U.S. Treasury Bills, with the dollar amount being about 5 percent of US Gross Domestic Product (GDP). Post-meltdown purchases, however, have skyrocketed, and the Fed, while cutting back on six-month T-bills, has engaged in two very questionable activities, including the purchase of massive numbers of mortgage securities to continue what is left of the housing bubble, and buying long-term US bonds in order to decrease the interest rate spread between short-term and long-term securities. This is something that former Fed Chairman Ben Bernanke called “Operation Twist” (or what Peter Schiff more aptly said should be named “Operation Screw”).
The purchases tended to level off after 2014, but not until the Fed was propping up a quarter of U.S. GDP through its purchases. Yes, the official rate of unemployment in this country is less than 5 percent, but no one — not even Paul Krugman — is claiming that all is well. Certainly, both Bernie Sanders and Donald Trump were able to generate a lot of political enthusiasm for saying the economy is in peril.
The Real Problems Underlying This “Expansion”
Because Keynesians are wedded to the false “theory” of aggregate demand and aggregate supply, they are incapable of understanding the real issues facing the economy, and no one should be surprised. After all, Japan’s political and business leaders have been delusional for a quarter of a century, as the government now is trying to “stimulate” the economy via negative interest rates, something that truly places the government in a war with nature. For that matter, Krugman’s recent claims that future “austerity” measures — presumably imposed by the future Trump administration — will lead to a recession actually demonstrates a terrible ignorance of what actually causes economic downturns.
The US economy clearly is sluggish, yet interest rates are very low, thanks to Fed programs like quantitative easing. Yet, while Keynesians call for increased amounts of government borrowing and spending (called “fiscal policy” in Keynesian jargon), the problem isn’t a lack of government-bred “stimulus.” The problem is that of large-scale malinvestments. When the Fed finds it necessary to use its large checkbook to manipulate huge swaths of the economy through playing with interest rates, there is no doubt that there are large underlying weaknesses throughout the economic system. Combine that with the vast government subsidies of “green” energy and the gargantuan amounts of money being poured into the unproductive US Armed Forces, and one can see that the government is cannibalizing the productive sectors in order to prop up the unproductive ones.
What Must Be Done
What needs to be done, or more specifically, what must the government not do so that a real economic recovery can occur? First, and most important, the Fed must stop purchasing mortgage securities and long-term treasuries. That means that both mortgage rates and long-term interest rates will rise, and this also will pull up short-term rates. The economy cannot have a recovery if the Fed fails to do this.
All of this seems to be counterintuitive, since both Keynesians and Austrians agree that the immediate effect of the Fed’s discontinuation of such purchases would mean a steep, short-term recession. Permitting interest rates to rise means that both housing and related industries will be hit hard (as was the case in 1982 — and the industry demanded a bailout). The current economy — sluggish as it is — is addicted to low rates, and this cannot go on if the USA is going to avoid the fate of Japan and Europe, where the economy also is weak.
Austrians vs. Keynesians
However, Austrians and Keynesians diverge at interpreting what actually is happening after interest rates increase. Keynesians claim that aggregate demand is falling and will continue to fall until the economy reaches bottom unless government intervenes through spending and more money creation. Austrians, on the other hand, realize that in the short term, malinvestments that built up during the credit-caused boom are being liquidated, and if government and monetary authorities permit the liquidation and do not block the redirection of resources, entrepreneurs will lead the economy into a real recovery.
For that matter, Austrians and Keynesians are not even on the same planet when it comes to interpreting the role of interest. Austrians note that interest rates are connected to time preferences of borrowers and savers, and that interest rates send signals regarding the direction of capital goods and consumer goods. Keynesians, on the other hand, see interest rates as the gateway for aggregate demand, and suggest that interest rates generally should be lower than they would be if set by the market.
This difference of thinking is crucial. Keynesians demand an economic version of the alleged Einstein definition of insanity: doing the same thing repeatedly and expecting different results. Japan has engaged both in massive government spending (read that, building tunnels, roads, and bridges to nowhere) and monetary manipulation, even resorting to negative interest rates, and yet Japan suffers from anemic economic growth — and will continue to experience the same until someone is willing to admit that 25 years of “stimulus” does not an economy make.
Donald Trump will face this moment, like it or not. Barack Obama faced it and decided to kick the can down the road and opt for yet more “stimulus.” How Trump deals with it will determine whether or not the US economy recovers from bad policies, or goes the way of Japan and Europe.
The irony (at least for Keynesians and fellow True Believers) is that the very thing that Keynesians believe will create long-term economic downturn — raising interest rates — is what the US economy needs most. More than a decade of artificially-low interest rates has distorted the economy’s structures of production to the point where it will take a sharp recession to bring back productive balance — as counterintuitive as that may seem to many readers. There is no doubt that should Trump agree to allow rates to rise, he will pay a steep political price, as there is no doubt that the Dow Jones Average will tank and short-run liquidation of malinvestments will create some havoc.
What should Trump do when higher interest rates expose many of the dislocations? In a word, nothing. When the 1982 recession was in full force and much of official Washington, along with journalists, was calling for reflation of the economy, bailouts, and other “corrective” measures, President Reagan simply replied, “Stay the course.” Although, as noted earlier, Reagan did a number of things that were both politically and economically harmful throughout his presidency, nonetheless, he was right on that point, and ultimately his stubbornness bore some economic fruit.
William L. Anderson is professor of economics at Frostburg State University in Frostburg, Maryland, and is an Associated Scholar of the Mises Institute. His Ph.D. in economics is from Auburn University, where he was a Mises Fellow.
