Bush Imitates Reagan's Economic Policy

Every incumbent President seeks the cooperation of the Federal Reserve Board in the 12 months that precede a presidential election year. No President wants to go into November with a sagging economy. The last time an incumbent President faced a recession in an election year, he lost. That was George Bush, Sr. His son does not want to repeat that experience.

The advent of recession in March, 2001, followed Reagan’s experience of a recession in 1981. Reagan countered with tax cuts for the top income tax brackets. He kept government spending very high. This was traditional Keynesian policy, and it was called that in 1961, when President Kennedy followed the same procedure. But it was labeled “supply-side economics” in 1981.

The Federal Reserve had been tightening money since October, 1979. That was what pushed the economy into recession in 1981, which cost Jimmy Carter his job. These tight money policies created a crisis for the Mexican peso, forcing it way down, thereby increasing its dollar-denominated debt burden. In the summer of 1982, Mexico responded by nationalizing the banks and threatening to default on its debt. The FED started pumping money, and it has not looked back.

Then Reagan hiked Social Security taxes in 1983 because the system had technically gone bankrupt: more outflow than income.

Reagan ran enormous deficits throughout his time in office — the largest in peacetime American history. Again, this was Keynesianism, but it was called supply-side economics, even by supply-siders.


Spending more money than it takes in is easy whenever a nation gets into a war. No President has to justify war expenses and a rising deficit when the country is at war. The Bush Administration was able to get us into two wars because of 9/11. The Iraq war is now costing the taxpayers and debt buyers about $2 billion a week.

This war came with a tax cut. This is the equivalent of Lyndon Johnson’s “guns and butter” taxing and spending policies. Johnson refused for four years to raise taxes to pay for the war in Vietnam, but he did not lower them. He had inherited lower tax rates from Kennedy. He did not raise taxes until he imposed a mild 10% income tax surcharge in 1968. By then, the FED had pumped in so much money to fund the debt that price inflation was becoming a problem, not to mention an outflow of American gold.

The rumor mill has it that the President’s senior election strategist, Karl Rove, has told him, “No war in the fall of 2004.” The move by Secretary of State Powell to get NATO to replace the U.S. in Iraq indicates that the rumor is true. The UN refused to take up the slack, so Powell went to NATO. It sounds as though NATO is willing. I’ll believe this when I see our troops being brought home. The recent call-up of Army reserves doesn’t indicate that there will be an easy retreat from the region next year. But there may nevertheless be a not-so-easy retreat, following Iraqi elections. We will declare a victory and leave. It is likely that chaos will result, when the “warring” Iraqi factions actually go to war. It is also likely that almost nobody in America will care. American voters are ready to be told that Iraq is behind us.

So, I think American troops will probably be out of Iraq by the end of next summer. Those few that remain will be adjuncts of NATO.

Why NATO would be willing to shoulder this burden is unclear to me, other than because of U.S. pressure. This new mission surely has nothing to do with the defense of Western Europe against the Soviet Union, which is why NATO was created in 1949. But the March of Dimes still marches, despite the conquest of polio after 1955. Bureaucracies don’t close down just because their original justifications disappear.

What is unlikely to change is the size of the Federal deficit. War costs will not disappear overnight, and Medicare costs will absorb any spare dollars in the budget. The on-budget national debt will continue to rise rapidly for the foreseeable future.

The policy of massive deficit spending can go on for as long as investors are willing to buy government debt at interest rates of 5% or less. But they are willing to do this now because they have not yet come to believe that the booming stock market is permanent. Why would anyone buy bonds at 3% or 4% when the stock market is producing a 20% annual return? Only because investors don’t yet have confidence in the stock market.

Why would foreigners buy T-bills at under 1.5%? The fall in the dollar more than wipes out that rate of return. The answer is simple: they are trying to keep the exchange rate from moving against their export-based manufacturers.

They are willing to buy an investment — the dollar — that has moved against them by 15% because they are under pressure from special-interest groups in the exporting sector of their economies. Foreign demand for T-bills is heavily influenced by central bank purchases. Doug Noland reported on December 5,

The Bank of Japan increased foreign exchange reserves by another $18.3 billion during November to $623.8 billion. Year-to-date, foreign reserves are up $172.3 billion, or 42% annualized. Japanese foreign reserves increased $63.7 billion during all of 2002. Taiwan’s central bank foreign reserves increased $6.2 billion during November to $202.8 billion, with reserves expanding at a 28% rate through the first 11 months of 2003. South Korea increased its foreign reserve position by $6.0 billion during November to $150.3 billion, expanding reserves at a 26% growth rate so far this year.

This willingness of central banks to expand their own currencies to keep them from rising against the dollar is keeping pressure on American manufacturers. This keeps them from passing on all of their cost increases to customers.

What cost increases? Raw materials.


Natural gas prices are going through the roof. They are up by close to 40% in the past few weeks. (Since I live on a property that has its own natural gas well, this doesn’t affect me. If I used propane, it would.)

Tyson Foods, a local company that supplies a big percentage of the nation’s beef, has raised beef prices due to increasing demand. Honda is charging almost 10% more on its Acura TL than it did a year ago. The rich will pay, so they will be asked to pay.

The Reuters Commodity Research Bureau’s index of commodity prices is up by almost 10% since last March. This indicates that there is rising demand for raw materials, even though users — manufacturers — are unable to pass on these rising costs to consumers. There soon will be a squeeze: rising raw materials costs, rising consumer demand, and strong competition from imports. Something has to give, and what is most likely to give is the international value of the dollar.

The National Association of Purchasing Management-Chicago (its new name: Institute for Supply Management) reported in November that prices paid jumped by 15 points to 67.3 in just two months, the highest since July, 2000.

A former Federal Reserve economist, Roger Kubarych, told a Bloomberg reporter that he worries about rising price inflation, despite assurances to the contrary by FED Board Vice Chairman Roger Ferguson. A December 2 Bloomberg story reported:

The dollar’s 15 percent decline against the euro this year has made some imports more expensive. Crude oil prices stood at $29.85 a barrel yesterday on the New York Mercantile Exchange, up from $25.24 on April 29. Inflation in the costs of services, which account for 85 percent of the U.S. economy, rose 3.2 percent in the 12 months ended in October, with increases in everything from medical costs to education.

Producer prices rose 0.8 percent in October while the costs of goods excluding food and energy jumped 0.5 percent. Gold prices, often a barometer of inflation, topped $400 an ounce the week ended Nov. 21 for the first time since 1996.

The American economy is slowly recovering, though unemployment remains high at 5.9%. This is good for the Administration. But the dark cloud on the horizon is the tightening supply of raw materials and the falling dollar. The Bank of England has raised its equivalent of the federal funds rate to 3.75% from 3.5% in order to keep price inflation from exceeding 2%. Except for Japan, which remains in a slightly price deflationary mode (-0.3%), the world’s price level is inching above 2%.

This means that anyone who holds T-bills or a commercial CD is losing money. He pays an income tax on his earnings, yet even if his income were tax-free, he would be falling behind. Are people nuts? Why are they willing to do this? Because they don’t think the stock market will hold up. They don’t want to go into real estate.

Why not? Because they know the truth: rising inflation will produce higher interest rates, which will end the recovery or place limits on it. The booming stock market is the result of falling interest rates. But price inflation will force an increase in interest rates.

Noland reports that China is no longer buying U.S. bonds. Instead, the country is using its dollars to buy oil.

Although still intervening heavily in the foreign-exchange market, in the last few months China has radically scaled back its purchases of United States bonds. In September, Chinese institutions were actually net sellers of U.S. government and agency debt by $2.8 billion, even though foreign reserves rose by $19 billion. Now, economists and market strategists are beginning to wonder what Beijing is doing with all the dollars it is buying. Chinese state media provided a partial answer in early December, reporting that Beijing plans to build up a 90-day, 50-million-tonne strategic oil reserve. At current crude prices of around $30 a barrel, that will cost China $10 billion. Bankers and brokers in Hong Kong predict further large purchases of strategic materials, together with the possible acquisition of equity stakes in overseas suppliers over the coming year. If pursued, China’s diversification away from U.S. government bonds will be bad news for Washington, which has relied heavily on China’s debt purchases to fund its fiscal and current-account deficits. In Asia, some economists even say Washington had it coming, suggesting that the switch is subtle retaliation for current U.S. trade pressures on Beijing.

This is consistent with my belief that China will become a competitor in the consumption of raw materials. This is also the view of “investment biker” James Rogers.

Rising demand cannot be concealed on world markets.


Into this market of skepticism regarding stocks, companies are issuing huge amounts of bonds. As of last week according to Noland, “it was a huge week for debt issuance, with almost $20 billion sold.”

Smart investment money is buying bonds. This tells me that smart investment money is not impressed by the increase in stocks. But if smart investment money is convinced that locking in rates of 5% is a good idea, smart corporate money is saying, “Let’s stick it to them, good and hard.” Corporations are replacing higher-yield debt with lower-yield debt. Corporate insiders are saying, “let’s take their money.” They are saying, “rates will rise later.”

Corporate insiders are also unloading their own stock at unprecedented levels. This says that they expect to make more money by going for diversification rather than trading on the knowledge of their own industries. They are losing faith in the traditional way to wealth: buy stock in your own company, where you have a competitive advantage in knowledge. They are thereby announcing: “Our knowledge of our specific industries reveals to us that we are losing our ability to compete, both as companies and as senior managers.” As Nixon’s Attorney General John Mitchell famously said, before he was imprisoned, “Watch what we do, not what we say.”


The stock market has hit a ceiling: Dow 10,000. It may break through, but when it comes to ceiling breaking, gold’s penetration of $400 is more impressive.

The ability of the stock market to maintain its pace is facing a challenge by the falling value of the dollar. Consumers are shopping, but they are not saving. The future of capitalism is dependent on saving. When foreigners decide not to bankroll the America’s Federal deficit of $500 billion a year and its balance of payments deficit of $500 billion a year, then the consumer will find out that there are no free lunches in life. Interest rates will rise, bonds will fall, mortgage investments will fall, and the stock market’s giddy increase, which is not based on rising profits, will end.

Your best investment is still you.

December 10, 2003

Gary North [send him mail] is the author of Mises on Money. Visit http://www.freebooks.com. For a free subscription to Gary North’s newsletter on gold, click here.

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