The conservative revolution of the 1980s has failed. It was undermined by an inability to understand the role of international capital flow in the modern world. The apparent willingness of the Bush administration to discuss tax increases as part of a solution to the budgetary impasse is merely the latest sign of its failure.
The real conservative agenda was not Arthur Laffer's famous, or infamous, supply-side curve that said tax cuts would spur economic growth and the tax revenues that come with growth. It was something else: the idea to use a 25 percent cut in income tax rates as a way to take money away from the Congress. Social welfare and other domestic programs would then be caught between the scissor blades of lower tax revenues and a more expensive military, resulting in a return of the federal government to its narrower domestic role of the 1950s.
Nine years later, this conservative blueprint turns out to have been a mirage. The role of the government in the economy has declined slightly if at all, and nonmilitary expenditures have not fallen as a share of gross national product. Some programs have been cut, but others have grown, and the entitlements that conservatives particularly dislike have continued to expand.
Although federal nonmilitary expenditures did not rise quite as fast as in the 1960s and 1970s, they still increased from 16.7 percent of GNP in fiscal 1980 to 17.8 percent in 1989. Total transfer payments (Social Security, welfare, etc.) rose from 11.9 percent of GNP in 1980 to 12.1 percent in 1989. Medicare and other health programs grew faster than the economy through the 1980s, and the Department of Agriculture used the same share of GNP at the end of the decade as at the beginning.
In brief, the tax cut of 1981 did not have the effect of compelling spending cuts, but instead merely left us with massive budget deficits.
The reason for the collapse of the conservative dream begins with the mechanism through which tax reductions were supposed to compel spending cuts, namely the expected pain of sustaining large budget deficits.
It was thought that heavy Treasury borrowing would drive interest rates up to levels at which people could not buy houses or cars and at which businesses could not finance productive investment. The outcry from the private sector, as it felt the pinch of Treasury borrowing, would force Congress to act. As long as conservatives saw to it that taxes were not increased and that military spending was maintained, the only alternative would be to cut domestic programs.
The conservative scenario failed because it did not allow for the role of foreign investors in general and the Japanese in particular. Foreign money came into the United States in sufficient volume throughout the 1980s to allow the maintenance of normal investment levels despite a need to finance huge federal budget deficits.
Foreign lending to the United States has been in the range of 2 percent to 3 percent of GNP in recent years, which roughly matches the size of federal budget deficits. U.S. trade deficits of approximately the same size have provided a net inflow of goods to fill the gap between total domestic savings (including federal dissaving) of about 15 percent of GNP and investment of 17 percent to 18 percent.
With foreign investors providing almost $150 billion a year in both funds and real resources, the U.S. economy has been able to maintain a reasonable investment and growth path despite massive government borrowing. The only unfortunate result is that the United States has shifted from being a net creditor in the amount of $140 billion early in the decade to a position of net debtor of well over $600 billion by the end of 1989.
Foreign investors made it possible for Americans to live in relative comfort through the 1980s, despite budget deficits that were expected to cause financial havoc. The conservative agenda failed, but the rest of the economy was able to enjoy both tax cuts and continuing government expenditures without a serious squeeze on investment and growth.
Foreign lenders sustained this comfortable era through the 1980s, but where does this leave us now?
In theory, the United States could continue to borrow abroad in order to invest more than it saves, finance chronic federal budget deficits and quite literally live beyond its means. There are reasons to believe, however, that problems are approaching:
The recent decline in the Tokyo stock exchange, increases in interest rates and declines in savings rates in Japan suggest that less Japanese capital will be available during the 1990s.
Germany will no longer be lending the rest of the world $50 billion a year but instead will be bringing money home as it raises enormous sums for the reconstruction of its new eastern sector.
Poland, Hungary and their neighbors will all need large inflows of funds, and if the Soviet Union turns firmly in the direction of a market economy, it will represent an endless demand for foreign capital.
The 1990s looks like a very difficult decade for borrowers and like a particularly bad time for the United States to depend on capital flows.
If foreign investment is no longer available at reasonable interest rates to finance our federal budget deficits and fill the gap between investment and savings, the United States might face the intended conservative squeeze on domestic expenditures. In the new international environment, a failure to close the budget deficit would produce much higher U.S. interest rates and major disruptions of housing and of investment in plant and equipment. Political pressure to eliminate the budget deficit, and Treasury borrowing as a source of crowding out, would become intense.
Will a change in the international environment do what the conservatives could not do?
Probably not. This time tax increases are an option and expenditure reductions would not have to be in domestic programs. The decline in the Soviet Union as a military threat means that a great deal of the money can come from the Pentagon budget. If even more money is needed, user charges on a variety of products, such as liquor, cigarettes and gasoline, are an alternative. A modified version of the Rostenkowski plan provides the necessary funds if combined with serious reductions in military spending. The recent budget discussions between the administration and congressional lenders suggest that such a budgetary package may be on the way.
The conservative vision failed in the 1980s because foreign lenders made it unnecessary for the United States to balance its budget, thereby protecting domestic programs that otherwise might have been cut. Now that the budget deficit will have to be curtailed, reduced military expenditures and tax increases offer an obvious alternative to domestic program cuts. The conservatives will probably lose again.
Robert Dunn is a professor of economics at George Washington University.