Unforeseen Factors Behind the Deficits of Commodity

Why then did the deficit refuse to shrink, once the economy recovered its stride in 1982? The answer lies in three factors quite unforeseen by Reagan administration economists or, for that matter, by economists anywhere. 

First was a legacy of the inflation that was rampant as the administration came in, namely the high level of entitlements like Social Security and Medicare payments. Because of the cost of living adjustments (COLAs), the payments jumped sharply in 1979, 1980, and 1981. They were $400 billion higher in those three years than they would have been using the average COLA from 1973-1980. 

Second was the drop in tax revenues due to the severe recession that resulted from the anti-inflationary stance of the Fed. When Paul Volcker took over as Chairman of the Fed in 1979, his primary challenge was to break the wage-price inflationary spiral that had been building for several years. The recession that ensued from the tight money policy of the Fed was implicitly endorsed by most of the Reagan economists.  

Third was the problem of interest on the national debt. When the debt was growing most rapidly from 1981 to 1983, interest rates were still very high. As a result, the government's bill for interest began to rise very rapidly. As the government borrowed to counteract the recession of the early 1980s, it had to pay the high interest rates that were a holdover from the inflation era. 

In summary, even in the absence of tax cuts or any military buildup, we would still have had exploding deficits because of inflation-swollen entitlements, inflation boosted interest rates, and post-inflation effect on tax revenues.  

Volcker's Contribution to the Deficit 

The authors lay a lot of blame on Volcker for having overdone the fight against inflation, creating a very serious recession that contributed to the deficit. This is of course debatable since Volcker was fighting the inflation battle without much support on the fiscal side. The origin of the inflationary spiral goes back many years, probably to the guns and butter fiscal policy of Lyndon Johnson, the easy money period under Fed Chairman Arthur Burns, and to the two OPEC oil shocks. However it does appear that Volcker could have eased up some months before he did without danger of reigniting the inflation, and with less downside to the economy..