Reaganomics
From Wikipedia, the free encyclopedia.
The term Reaganomics, a portmanteau of Reagan and economics, was used to describe, and decry, the economic policies of U.S. President Ronald Reagan during the 1980s. Reagan assumed office during a period of high inflation and unemployment, and his economic theories eventually led to a strong recovery.
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An Explanation of Reaganomics
Reaganomics or supply-side economics is a highly politicized term, which can be interpreted many different ways. In brief, Reaganomics has two key ideas: lower taxes and smaller government. Or in Reagan's words "government is the problem."
Classical economists such as Adam Smith stress the importance of specialization and trade. For example, if a farmer trades wheat for horseshoes from a blacksmith, then the farmer is more productive and society is better off than if the farmer had attempted to manufacture horseshoes himself. However, classical economists have struggled mightily to explain and offer solutions to the periodic business cycles of boom and bust.
During the Great Depression, Keynesian economists saw the vast numbers of unemployed workers and suggested that the government should "prime the pump" through government borrowing for job creation programs. During the New Deal, the WPA and other programs put this theory into action. Keynesian economists justified this government spending, by claiming through the multiplier effect -- one employed worker's salary will benefit 5 other workers etc. Critics argued that government, being a political entity, is an inept distributor of economic resources.
One school of critics, the monetarists, argued that government can better stimulate the economy by manipulating the money supply. When the economy is weak, the monetarists argued that the government should lower interests rates and increase the money supply. This additional money will seek businesses and start-ups to invest in, via banks and other non-governmental means. The negative effect of an increased money supply is inflation.
After the Oil Shocks of the 1970s, a new economic phenomenon took hold: Stagflation. Stagflation combined high unemployment with runaway inflation. Previously, the economy experienced either high unemployment and low inflation, or low unemployment and high inflation. The economy had not experienced both high unemployment and high inflation at the same time. Stagflation meant that if one followed the Keynesian model to stimulate the economy, the government must intervene via new spending programs. The new spending is to be financed either by new taxes or borrowing. On the other hand, if one followed the monetarists, the government had to choose either to raise interest rates to tame inflation and cause further unemployment, or lower interest rates to stimulate the economy and cause further inflation.
A new school of thought gradually arose. It argued that the competitive nature of free markets (free of government regulation) made markets the best means to distribute economic resources. Businesses have to be innovative and create wealth to survive. This anti-government view saw businesses as the "goose that lays the golden eggs" and government regulation and taxes as "strangling the goose". Reagan partially agreed with this anti-government view and sought to stimulate the economy by lowering taxes, financed by borrowing. He argued that lowering taxes will revive the economy. When the economy revived, the increased tax revenues will be used to pay off the debt. Excluding military spending, he argued for broad cuts in government spending, which he viewed as a drain on the economy. Reagan raised military spending, however, as he saw defense as an integral government function, especially in regards to the Cold War.
The disagreement between "Reaganomics" and New classical economics (a modern economic theory which emphasizes that free markets self-regulate most efficiently and optimally) becomes clear with understanding Reagan's exceptional military spending. While taxes were cut and thus endorsing that element of neoclassical theory, massive military spending in the Reagan era resulted in a massive budget deficit. The 1983 deficit reached $207.8 billion, equivalent to 6 percent of the economy, the highest level since the World War II era. This emphatic deficit spending violates neoclassical economic theory emphasis on a balanced budget. Absent this, private actors will rationally expect, as explained by the Ricardian equivalence, for taxes to increase sometime in the future to offset this deficit, and will end up saving enough to offset any increase in consumption resulting from government spending. Furthermore, deficit spending is problematic under neoclassical theory because even if the Federal Reserve lowers the federal funds rate to keep interest rates low and combat this "crowding out" effect, the rational public will see the lack of credibility with this merely fiscal-policy-reactionary monetary policy.
Reaganomics ultimately exists in two forms, actual historical experience and theory. The historical experience of Reaganomics is of increased defense spending and large federal deficits. But the theoretical Reaganomic initiative of smaller government and spending restraint was never implemented, due to a lack of political will.
History
The large, across the board tax cuts initiated by Reagan at the start of his administration were based on principles from supply side economics or the trickle down effect. This was contrary to the demand side economics of traditional Keynesianism, which tries to bring the economy to its existing full capacity by means of increasing demand, primarily through fiscal policy. In the 1970s, many on the right became critical of Keynesianism, which they claimed brought higher inflation without any gains in employment. However, true Keynesianism, which called for deficit spending during recessions and surplus saving during periods of prosperity, was rarely implemented in its totality in American politics, usually because political considerations overshadowed fiscal policy.
The early Reagan tax cuts of August 1981 embodied Reagan's supply-side economics. Economist Robert J. Gordon writes in his textbook Macroeconomics (9th ed. 2003, p. 392) that this was "the most dramatic shift in fiscal policy of the postwar era not related to the financing of wars."
The Tax Reform Act of 1986, which had broad bipartisan support, partly implemented the principles of supply-side economics in a more moderate way. It simplified the tax code and eliminated tax loopholes.
Part of what Reagan implemented was in fact not supply side economics, but rather his own version of Keynesianism. Reagan advocated initiating deep tax cuts and simultaneous increases in military spending, while at the same time claiming that the Federal deficit would be erased. Critics argued that while Keynesian economics promoted the idea of consumers (including the poorest) creating jobs by increasing the demand for goods and services, Reaganomics relied on giving more money to producers by giving tax cuts especially to the wealthiest citizens, who would then create jobs that would somehow find a demand. This type of economic theory has also been referred to derisively as "trickle-down economics."
The belief by some proponents of Reaganomics that the tax cuts would more than pay for themselves [n.b., neither Regan nor anyone in his administration ever claimed the tax cuts would pay for themselves] was influenced by the Laffer curve, a theoretical taxation model that was particularly in vogue among some American conservatives during the 1970s. Arthur Laffer's model predicts that excessive tax rates actually reduce potential tax revenues, by lowering the incentive to produce. The rise, rather than fall, in government deficits during the Reagan era caused many to question the validity of the Laffer curve. In addition, although the Laffer curve was used to justify tax cuts, its main emphasis was on showing how to maximize government revenues through fiscal policy; because this conflicted with the aim of conservatives to reduce spending as well as revenues, the Laffer curve has more recently been deemphasized by conservatives. Nonetheless, Federal Government tax revenues did increase significantly following the tax cuts of the Reagan years; it was the dramatic increase in spending that produced the budget deficits of that era.
Before Reagan's election, Reaganomics was considered extreme by the liberal wing of the Republican Party. While running against Reagan for the Presidential nomination in 1980, George Bush had derided Reaganomics as "voodoo economics", a term that held currency long after the recession ended. Similarly, in 1976, Gerald Ford had severely criticized Reagan's proposal to turn back a large part of the Federal budget to the states. After the Reagan election, however, most Republicans endorsed Reaganomics, including Bush, who became Reagan's Vice President.
Support for Reaganomics
A study from the Cato Institute (a Libertarian think tank, which supports many of the premises that lie behind Reaganomics) said:
- Real economic growth averaged 3.2 percent during the Reagan years versus 2.8 percent during the Ford-Carter years and 2.1 percent during the Bush-Clinton years.
- Real median family income grew by $4,000 during the Reagan period after experiencing no growth in the pre-Reagan years; it experienced a loss of almost $1,500 in the post-Reagan years. (source)
Laffer and Reagan were vindicated by the results of the Reagan tax cuts. Real per capita GDP increased at an annual rate of 2.6% from 1981 to 1989, after languishing at a 1.6% rate during the Carter years of 1977 to 1981. Citation: Louis Johnston and Samuel H. Williamson, "The Annual Real and Nominal GDP for the United States, 1789 - Present." Economic History Services, March 2004, URL : http://www.eh.net/hmit/gdp/
Reagan's supply-side model changed the paradigm of government involvement in the economy. Keynesian economists were at a loss to explain why the aggregate demand increases of the 1970's did not result in improved national economic performance. Likewise, they could not explain how to reverse the shift in the Phillips curve. The Reagan-Laffer-Volcker-Milton Friedman model of improving economic performance by reducing government involvement in the economy has since gained wide currency. President Clinton ran as a "New Democrat": fiscally conservative and trade-friendly. Estonia, Latvia, Slovakia, Serbia, Romania, Georgia, Ukraine, as well as Russia and Iraq have variations of the flat tax. Governor Bill Richardson of New Mexico cut personal income taxes in 2003 "to spur growth and investment". [1]
Replies to this Defense
The arguments quoted above from a Cato study show the importance of not drawing conclusions from a cursory analysis of a small subset of the available data. The study calculates the average real GDP growth during a pre-Reagan period (1974-81), Reagan period (1981-89), and post-Reagan period (1989-95). The averages from the 1996 Economic Report of the President are 2.8, 3.2, and 2.1 percent, respectively. Updating them from Table B-2 in the 2005 Economic Report of the President, the averages are 2.97, 3.55, and 2.37 percent, respectively. In looking at all of the data, however, it appears that the economy has been following a 10-year cycle during the past several decades. There were recessions in 2001, 1990-91, 1980-82 (a double-dip recession), 1974-75, 1969-70, and 1960-61. Hence, except for the recession in the mid 70s, the recessions have come at the beginning of each and every decade. For this reason, it makes more sense to measure the average growth in GDP over 10-year periods since 1960. Doing this gives average GDP growths of 4.21 percent (1960-70), 3.23 percent (1970-80), 3.28 percent (1980-90), and 3.29 percent (1990-2000). Hence, this measure suggests that GDP growth was stronger during the 60s but was about the same in the 70s, 80s, and 90s.
An even more surprising result comes from looking more closely at real median family income. The Cato study states that it experienced no growth during the pre-Reagan period, grew by $4,000 (1994 dollars) during the Reagan period, and shrunk by almost $1,500 dollars during the post-Reagan period. Looking at recent census data, real median family income did grow a mere $55 (2003 dollars) from 1973 to 1981, grew $5,740 from 1981 to 1989, and shrank $335 from 1989 to 1995. However, Figure 2 in the Cato report shows the reason for this. During the Reagan period, the author is measuring very nearly from a trough to a peak in family earnings. This means that the pre-Reagan period is measuring TO a trough and the post-Reagan period is measuring FROM a peak. In fact, real median family income has been reaching a peak about every ten years since about 1969. It reached peaks in 2000, 1989, 1979, and 1969. Measuring the growth every ten years since 1969 gives growths of $5,426 (1969-79), $3,025 (1979-89) and $4,887 (1989-99). Incidentally, the growth from 1959 to 1969 was $11,539. Hence, over the four decades since 1959, this measure gives the growth of real median family income during the Reagan decade to have been the lowest, not the highest.
Much of the liberalization (telecoms, break up of AT&T, air travel etc.) that many claim helped to reinvigorate the American economy was initiated in the 1970s under President Carter and received broad bipartisan support. For example, deregulation of the airlines was initiated under the leadership of Alfred Kahn in 1978. It can also be argued that liberalization has increased the amount of insecurity suffered by the average citizen, while encouraging wage cuts, the decline of unionization, the rise of profits, and the like.
Reagan's tax policies were accused of pushing both the international transactions current account and the federal budget into deficit and led to a significant increase in public debt. Advocates of the Laffer Curve contend that the tax cuts did lead to a near doubling of tax receipts ($517 billion in 1980 to $1,032 billion in 1990), so that the deficits were actually caused by an increase in government spending. However, Historical Table 1.3 in the 2006 U.S. Budget shows that revenues had likewise doubled (or better) during every decade since the Great Depression. They went up 506% during the 40's, 135% during the 50's, 108% during the 60's, and 168% during the 70's. At 96 percent, they nearly doubled in the 90s as well. Furthermore, according to Historical Table 2.1, the receipts from individual income taxes (the only receipts directly affected by the tax cuts) went up just 91 percent during the 80's. Meanwhile, receipts from Social Insurance, which is directly affected by the FICA tax rate, went up 141 percent. This larger increase was largely due to the fact that the FICA tax rate went up 25% from 6.13 to 7.65 percent of payroll. Hence, the increase in revenues in the 80s was no larger than other recent decades and a portion of that increase was arguably due to the FICA tax hike.
In addition, old-fashioned Keynesian economics has argued for many decades that any fiscal stimulus helps "pay for itself" by increasing aggregate demand and gross domestic product and lowering unemployment. These forces automatically raise tax revenues and lowers transfer payments such as unemployment insurance. No supply-side effects are needed to understand this story.
The disinflation had been initiated by Fed chairman Volcker before Reagan assumed office. An anti-inflation monetary policy program had been begun by Fed Chair Volcker in the latter days of the Carter administration, but it took awhile to take hold, so that inflation was still near a historical peak around the time of the 1980 elections.
A recession occurred in 1982, his second year in office. Almost no one blames this on the Reagan administration. Instead, it was central to Volcker's campaign against inflation: applying either the Phillips Curve or the NAIRU theory, high unemployment (almost 10 percent of the labor force in both 1982 and 1983) undercuts inflation. Reagan benefited from the fact that Volcker relented (shifting to more expansionary monetary policy) after inflation had largely been beaten. Further, the sudden fall in oil prices around 1986 helped the economy attain demand growth without inflation in the late 1980s.
The job growth under the Reagan administration was an average of 2.1% per year, while much better than most recent Republicans, was worse than every Democratic President from the last 80 years.
Tax incentives for Commercial Real Estate
The 1981 Tax bill created huge incentives for the Commercial Real Estate market across the U.S.. Investors could deduct 30% of principal investments each year from their regular taxable income. The incentive created a nationwide glut of commercial real estate. The impact on the economy was tremendous, with millions spent on new commercial construction, stimulating significant jobs growth in construction sectors. The commercial real estate market languished for years with stagering 30% and greater vacancy rates. The 1986 tax bill repealed these tax incentives, leaving the Bush administration a double blow on that eras economy with reduced construction activity and Commercial real estate owners operating at a loss for several years. The upsurge in the Real Estate Industries had a far greater impact on the economy than the increases in defence spending.
External links
Proponent Think Tank Papers:
Topics From WWW.EconLib.Org:
