David Stockman
David Stockman; drawing by David Levine

The following testimony was given by Felix G. Rohatyn before the Committee on Ways and Means of the US House of Representatives on March 5.

Mr. Chairman, I am delighted to testify before your committee. The president’s economic plan, put in its simplest form, calls for a huge budget cut coupled with a huge tax cut and restrictive monetary policy. Putting this plan into effect in a period of high deficits, high inflation, and slow growth obviously raises the possibility that monetary and fiscal policy will increase the potential for a credit crunch and a choked-off recovery. For such a plan to be effective, a dramatic change must take place in investor and public psychology, resulting in lower interest rates and greater savings.

When it comes to economics I am neither a Friedmanite nor a Keynesian; I am a skeptic and a pragmatist. I have seen, at the corporate as well as at various governmental levels, too many economic forecasts and projections to have much confidence in any. There are too many variables, too many unforeseeable and uncontrollable events to make economic forecasting all that reliable and to give real confidence in any set of theories. The record so far should make everyone very humble and very careful.

Having said that, I believe the Reagan program should be given a full and fair trial, although I believe it to involve large risks with the odds rather against its achieving its goals within a reasonable time. However, it is clear to me that this program, or something very much like it, is what the voters have firmly demanded, and, unless disaster would clearly result, I believe that a democracy should heed the will of its majority. Even though I believe it would be reckless to assure you of the success of such a program, I cannot tell you with assurance that it will fail. Its chances of success depend largely on psychology, but maybe, just maybe, thanks to the mood of the country, that psychology could emerge.

Credit, it must be remembered, comes from the Latin verb “to believe.” The Reagan administration has been elected on a wave of belief in a program which promises a great deal; that is its chance of success as well as its greatest danger. If I seem ambivalent, and I am, it is because I live in the world of markets and their psychology, and I am fully convinced that many very different types of economic programs can succeed or fail because of psychological reactions. I also believe that denying to the voters the right to a fair trial of this program would be exceedingly divisive at a time when national unity is sorely needed. And last, but not least, unless this program is perceived as having received a fair trial, no very different or major program for change is likely to get the public support it would require should the need for it arise.

Having said that, we should clearly try to identify and limit the risks, and identify the weaknesses that could be amended without gutting the program. Nothing is easier than criticism of an economic program; a great deal of the criticism of the present program comes from people who brought us to our present predicament, liberals and conservatives, Republicans and Democrats. The president was absolutely right when he stated that continuation of the status quo would lead to disaster; that seems inevitable. So could the present program if it goes off the tracks.

I would suggest we follow the most basic rule of business: never bet the whole company. And there is some risk of that in the president’s program. The potential for increased inflation and a credit crunch if the tax cuts are not matched by budget cuts is severe and is an unacceptable risk. It seems to me, therefore, that the program should be a year-by-year one in which verifiable budget cuts would match equal tax reduction, and where growth would have to be achieved to trigger the next round of tax cuts. Only thus could inflationary expectations be reduced rather than enhanced with a resulting reduction in the high interest rates that are now our biggest immediate economic problem.

There should, however, be further safety nets in case the program fails either because it is flawed or because of extraneous factors such as oil prices, crop failures, supply disruptions, etc. A look at England shows that such a program can go off the tracks with dire results. To define these safety nets, I would like to examine the major weaknesses of our present economic structures. They are several:

1) Energy imports are still the most vulnerable part of our economy. During the next five years, we will spend half a trillion dollars—half the value of every company on the New York Stock Exchange—to import the crude oil we burn every day. Decontrol is not an energy policy, and nothing in the current program shows an awareness of the need for vastly more drastic measures to provide self-sufficiency.


2) Important sectors of the economy cannot stand another twelve months of interest rates at or near the present levels. Chrysler may have lots of company. Other major industrial firms, some airlines, the entire savings industry, and other financial institutions as well have seen their financial position dramatically eroded. The possibility of major bankruptcies looms very large.

3) The international monetary system is in severe difficulty. The current strength of the dollar, caused by our high interest rates, is creating balance-of-payments difficulties as well as a recession for European countries. Simultaneously, the third world’s current balance-of-payments deficits of $70 billion, which are rising, will have to be financed by a Western banking system overextended already. A trillion dollars in the Eurodollar market are floating outside any control, while talk of recycling petrodollars becomes more and more a fairy tale. The West cannot handle the financing problems of the third world, but our banking system has become its hostage. A vastly enlarged role for the International Monetary Fund and for the World Bank with huge OPEC contributions has to be envisaged. Any US economic program must speak to the international monetary situation.

4) The problems of our older cities and our older regions, together with our older industries, are serious whether they are acknowledged or not. They will only get worse with unforeseeable but, quite probably, most unpleasant consequences, social and economic. No democracy is workable half rich, half poor. The current economic plan is bound to aggravate and accelerate, this problem. Budget cuts will have heavy effects on many of the northern states. Tax cuts will encourage industry to move Oil price decontrol and defense increases clearly benefit the Sun Belt. The combination of these factors will create an economic and social momentum potentially devastating to the northern half of this country. The reaction of the inner city ghettos to benign neglect may be anything but benign.

5) Finally, two problems remain largely unaffected by the administration program: the problem of wages and prices that have not responded to economic market forces; and the deeply embedded indexation of inflation that takes place throughout the economy as pensions and contracts are driven upward by Cost of Living Allowances (COLAs).

As the Congress deals with the president’s program, adjustments and safety nets should be considered to deal with each of these weaknesses. It is disingenuous to pretend that the administration’s program will protect the needy and will spread sacrifice evenly. When government cutbacks occur, the needy always get hurt. New York City was kept out of bankruptcy by a wage freeze, a 20 percent reduction in manpower, shifts in pension costs, a tuition charge at the City University, transit fare increases, and savage cost control, coupled with a variety of state tax cuts, and inflation-driven revenue increases; but it was the lower-income families that got hurt.

This result is unfair, but it is to some degree inevitable and its consequences must be faced. The magnitude of the proposed budget cuts still allows for some choices that could mitigate the effects on the poor: excessive COLAs in social security and federal pensions—which continue—are no less inflationary than food stamps; putting a limit on Medicare increases—which is not part of the program—is at least as desirable as cutting mass transit subsidies. I detect an inconsistency in a policy that correctly refuses to “throw money” at social problems while seeming to be carelessly throwing a great deal of it at defense problems. I am for a strong defense, including a draft army, but defense budgets should be submitted to Mr. Stockman’s scrutiny with the same fervor as the CETA program.

On the specific list of tax cuts, as long as they are made on a year-by-year basis and balanced against budget cuts, I am, frankly, less of a purist and less dogmatic than supply-siders or demand-siders. It seems to me that, as in everything else, a mix of both is needed. This program is clearly not a supply-side program, but since I believe supply-side economics to be somewhat simplistic, I am not bothered by it. What is being proposed seems to me to be more like a classical countercyclical tax cut, somewhat tilted in favor of upper-income families and business.

I am concerned, however, by the possibility that some of the budget cuts may result in local tax increases by city and state governments that are unable to cut services further. This would obviously occur in the part of the country already hardest hit, namely the North-east and Midwest, and would result in a further slowdown of those economics. It would also reduce federal income tax receipts and be doubly counterproductive. I have always believed that the federal government should create programs for incentives for local tax reductions as a way to give stimulus to the areas suffering the greatest economic hardship. This program would tend to have the opposite effect and should be carefully monitored.


Time seems to me at the heart of the problem. Whatever the Congress chooses to do should be done soon. The economy is in a delicate condition, and appears to be weakening; the simultaneous weakening of the European economies could create a serious recession of the entire West and the risk of even greater economic failure. At the same time, the danger of continued stagnation and high inflation, caused by a restrictive monetary policy choking off any recovery, while federal deficits of $70 to $90 billion are created, cannot be denied. That Henry Kaufman of Salomon Brothers predicts a year-end prime rate in excess of 20 percent while David Stockman predicts a rate below 10 percent underlines the unpredictable nature of the situation.

And this uncertainty, after all, should not be surprising. We are living through an unprecedented sequence of economic and social developments in this country. A nation built on cheap energy and credit has seen the cost of both explode within a decade. A nation which considered 5 percent inflation and unemployment a menace, and a $3 billion balance-of-payments deficit a crisis, has now gotten accustomed to double-digit inflation, 8 percent unemployment, and a $30 billion deficit in its balance of payments. We refuse to accept the fact that our escalating payments to OPEC are a tax imposed on the West with devastating effects, both inflationary on prices and a drag on the economy. McDonald’s hamburger chain employs more people than US Steel, which is hailed as a victory for the service society concept, while labor, management, and government all share equally in the decline of our productivity and our basic industries. Half our country is booming while the other half is in severe difficulty. Most of our children go to public schools which fail to provide a serious education while their families fail to provide them with serious ethical principles. As a result, the gap between economic and social classes grows greater. In less than twenty-five years, we have gone from the American Century to the American Crisis, and it will take more than an economic program to turn it around.

Predictions based on past performance must be suspect. The certainty of supply-siders about their current theology must be viewed with some skepticism. A recent Wall Street Journal editorial hailed the rescue of New York City as a prime example of supply-side theory working its magic. For the Journal, which strenuously campaigned for the bankruptcy of New York, to make this claim now is a little like Pravda claiming the Red Army saved democracy in Czechoslovakia. Cooperation among business, labor, and government, coupled with a wage freeze, cost control, and sales tax revenues driven up by inflation saved New York City.

Claims such as the Journal’s, however, are among the main dangers of President Reagan’s program. Where psychology is so important, raising public expectations by making a dangerous, complicated program sound too easy and too certain of success can be self-defeating. At the first sign of faltering, overexpectations will be replaced by premature condemnation. That federal expenditures were recently underestimated by $3 to $6 billion should give a clue to the shifting quality of all these numbers. We saved New York City because we had a program, because we required sacrifice from everybody, because nobody else had a program, and because we told the truth. And the truth included the fact that we could not always be sure of our numbers and that we played against long odds. The public is quite intelligent enough and quite mature enough to understand this.

No prudent man takes big risks against long odds without also planning for a fallback position. I would urge the Congress to do the same. If this program fails, for whatever reasons, we are likely to be faced with an economic crisis within two years. If that were to occur you may have to consider the following, in addition to, and not instead of, budget and tax cuts:

1) A temporary freeze of wages and prices to deal with inflationary behavior that does not respond to other measures.

2) A stiff gasoline tax to close budget gaps more rapidly, reduce oil imports, and bring down interest rates without bringing about a collapse of the dollar. Energy prices should simultaneously be removed from the Consumer Price Index.

3) An updated version of the Reconstruction Finance Corporation to deal with companies and industries in difficulties as well as related regional and urban problems.

This is the road I would follow now. It is not what the voters asked for, and it is inconsistent with the philosophy of this administration. The reason I believe the Reagan program should be given its chance, with some modifications, is that it has the support of the people, which gives it its legitimacy as well as being its main chance for success. It is quite impossible to impose an economic program and a philosophy inconsistent with the will of the people and of those elected to carry it out. It simply cannot work. I do, however, strongly disagree with the philosophy expressed by the president’s statement that tax policy should not be used for social change. I believe just the opposite: that this country was built on the notion that all its public policies should be aimed at social improvement and not at maintaining the status quo.

I profoundly hope the Reagan program turns out to be a smashing success; this country cannot afford many more disappointments, many more turns in the road. This is either the last or the next-to-the-last change in direction we can stand in this century; we may hope that success will make it the last. We must, nevertheless, not delude ourselves and be ready with an alternative if positive results do not appear within a reasonable period of time. We are embarking on an experiment of high risk for high stakes and high potential benefits. It will, however, not take place in the remote environment of a test tube in a laboratory; I am sure, Mr. Chairman, that you and your colleagues will bear in mind that, in this experiment, we are the test tube.

This Issue

April 16, 1981