How the Defeat of Inflation Wrecked the U.S. Budget

Federal Reserve Chairman Paul A. Volcker’s unsung achievement is the destruction of the budget process in the United States. Consider first the demise of the process, and then Volcker’s role in bringing it about.

The budget for fiscal 1982 was the last time that Congress carried out the responsibilities that it gave itself in the Congressional Budget Act of 1974. Since then the budget process has collapsed so completely that even Sen. Pete V. Domenici (R-N.M.), the chairman of the Senate Budget Committee during 1981-86, has affirmed the shambles: “Deadlines are regularly missed,” “Senate rules are ignored” and “the year’s legislation is compressed into a few major bills, each of them hundreds of pages in length, well beyond the individual member’s ability to comprehend or influence.”

The budget process of the United States was broken apart by the large deficits of the 1980s, and the abandonment of budget procedures in turn has reduced the U.S. budget to the status of a political football. Indeed, the situation today is little better than a shouting match between the Administration and Congress over who is responsible. The White House claims that the deficit is the result of Congress’ refusal to cut domestic spending. Congress claims that the deficit is the result of the Administration’s excessive tax reduction and defense buildup. Neither claim is truly correct.

The “triple-digit” budget deficit of the 1980s has a single major cause: the unexpected collapse of inflation. Normally, Administrations predict better performance in reducing inflation than is achieved. The Reagan Administration, however, forecast worse inflation than occurred. This threw the budget off, in terms of both revenues and spending.

Budgets are prepared in nominal terms. So when inflation falls below the forecast, it costs the Treasury revenues. It also means that spending is higher in real terms than was intended. For example, if the government budgets for 10% inflation and by the end of the year inflation has fallen to 5%, the government ends up spending far more than intended and collecting far less revenues than expected. Every year that inflation is overbudgeted adds to the deficit. Indeed, according to former Budget Director David A. Stockman, the more-rapid-than-expected decline in inflation cost the government a tax base equal to half of last year’s gross national product--roughly $2.15 trillion.

Although it was hard on the deficit, farmers, exporters and the energy industry, the collapse of inflation was a good thing overall. Nevertheless, it was an accident in the sense that it was not predicted by anyone, including the Federal Reserve that brought it about. The Federal Reserve vastly overestimated the inflationary effect of the 1981 tax cut and, as a result, overcompensated with an excessively tight monetary policy. The cost of curing inflation faster than the Administration had planned was triple-digit budget deficits.

The appropriate response to the deficit is a one-year budget freeze together with Federal Reserve support for a higher rate of real economic growth. The combination of a spending freeze and faster economic growth would quickly cut the deficit and terminate the speculation about U.S. economic credibility.

Even more important, it would end a budget impasse that is now five years old--too long for a democracy to be immobilized by such a critical operating feature as the annual budget. The festering budget stalemate between Congress and the White House has produced an escalation of rhetoric that is undermining peoples’ confidence in government and creating concerns abroad.

The budget will cease to be a political football the day that the government explains to the public the effect on the deficit of the unexpectedly quick victory over inflation. The easiest way to put the issue behind us is to adjust the budget to the unanticipated change in inflation with a one-year spending freeze. This approach would avoid the fight over budget shares that has stalemated the government, and it would pose no threat to the Federal Reserve’s disinflationary policy or to President Reagan’s tax policy. Moreover, it would encourage Volcker to allow faster growth by sending a signal that he would not raise interest rates if the economy picked up steam.

This approach also has the advantage of being one that the public can understand and accept. The deficit is too large to be handled by a rearrangement of budget shares. People can more easily accept the fairness of a freeze that would not alter the relative shares of the various constituencies. Getting the deficit under control is the best way to assure a continuation of the defense buildup, because there is no guarantee that defense can win a fight over budget shares or that higher taxes would be allocated to defense.

Once the politicians adjust the budget for the disinflation, they can resume the fight over budget shares. But the attempt to do both at once has overwhelmed the process. A solution is at hand if the politicians are interested in making government work.