`8`

`Reaganomics and the Clash between Monetary and Fiscal Policy`

[O]ur kind of tax cut will so stimulate our economy that we will actually increase government revenues

—RONALD REAGAN, JULY 1981

There is probably no episode in U.S. history that illustrates better what can happen when monetary and fiscal policy clash than the Reagan years. A combination of the terrible stagflation and tight money discussed in previous chapters, the wrath of Ayatollah Ruhollah Khomeini in Iran, and the genial appeal of Ronald Reagan as a candidate combined to produce an electoral landslide in November 1980, ushering Jimmy Carter out of office. Reagan’s victory opened the door to an abrupt turn in fiscal policy toward far lower taxes and much bigger budget deficits. Carter fretted about fiscal deficits but didn’t do much about them. Reagan had pipe dreams about deficits (see the epigraph above) and pursued policies that made them explode.

But before getting enmeshed in the details, we should pause to consider two important antecedents to what became known as Reaganomics.

`Setting the Stage`

One of those antecedents was the doctrine that came to be called “supply-side economics,” in particular the Kemp-Roth tax cut proposal, named for its two sponsors, Congressman Jack Kemp (R-NY) and Senator William Roth (R-DE). Their plan, which was first announced and promoted during Carter’s presidency, called for a 30 percent reduction in personal income tax rates phased in at 10 percent per year over three years. Kemp-Roth garnered a great deal of attention. After all, tax cuts always have political allure, and this one was massive. But President Carter, a believer in fiscal responsibility, steadfastly opposed the drastic Kemp-Roth tax cuts. They were budget busters.

The tide of history, however, was flowing toward lower tax rates, whipped up by high inflation that had turned bracket creep into bracket gallop. In 1978 Carter reluctantly agreed to a substantial reduction in the tax rate on capital gains, proposed by Congressman William Steiger (R-WI), that dropped the top rate on gains from 40 percent to 28 percent. But the Steiger amendment just seemed to whet tax cutters’ appetites. That same year witnessed a full-scale tax revolt in California—not coincidentally, Reagan’s home state—that led to the famous/infamous (take your pick) Proposition 13, which slashed property taxes to the bone.

While all this was going on, and related to it of course, economist Arthur Laffer and journalist Jude Wanniski, among others, were promoting a stunning new doctrine called supply-side economics. Their argument, in brief, was that reducing income tax rates would have such powerful incentive effects on decisions to work, save, and invest that the tax base would grow so fast that tax revenue would actually rise, not fall, despite lower rates. The government could add by subtracting!

It was a seductive vision, first explained by Laffer to Wanniski in 1974 by sketching what came to be called a “Laffer curve” on a napkin in a Washington, DC, restaurant.¹ Wanniski became Laffer’s publicist, using the editorial pages of the Wall Street Journal unrelentingly and effectively to spread the word. In 1978, he even published a book with the immodest title The Way the World Works (Wanniski 1978).

To economists, there was just one big problem: supply-side economics did not describe the way the world works; its extreme claims were never backed up by evidence. Yes, it is true that higher income taxes dull incentives to earn income. It is also true that tax rates can be set so high that cutting them actually produces more revenue. That’s a simple matter of mathematics that any beginning student of calculus can prove for you. But Laffer, Wanniski, and others never offered any serious evidence that the income tax rates then prevailing in the United States were in or even near that prohibitive range. It was that gross exaggeration that induced Charles Schultze, Carter’s top economic adviser, to quip in 1980 that “there’s absolutely nothing wrong with supply side economics you couldn’t cure by dividing its claims by a factor of ten.”² Incentive effects from taxation? Sure. A free lunch? No.

But did Reagan or his team ever make the preposterous claim that the U.S. tax system was on the downhill side of the Laffer curve? This question may seem ridiculous on its face given, for example, this chapter’s epigraph.³ The answer is clearly yes. But in August 1991, I was forced to engage in a “debate,” if you want to call it that, in the pages of the Wall Street Journal over exactly that point with Martin Anderson, who had been Reagan’s top domestic and economic policy adviser in both the 1980 campaign and the early years of the Reagan presidency.⁴ Anderson insisted that Reagan never made the extreme supply-side claim. Really?

I beat this seemingly dead horse for a simple reason: the horse never died. To this day, some Republicans—alas, it’s a political doctrine, not an economic one—insist that Laffer and Reagan were right all along: you can raise revenue by cutting tax rates. President George W. Bush used a Lafferite argument, among many others, to support his Reaganesque tax cut proposals in 2001. To cite just one example, looking back on the 2001–2003 tax cuts in a February 2006 speech, he asserted that “you cut taxes and the tax revenues increase” (Bush 2006).

Later in history, President Donald Trump’s secretary of the treasury, Steven Mnuchin, claimed in 2017—apparently with a straight face—that “not only will this tax plan pay for itself, but it will pay down debt” (Davidson 2017). Of course, the Trump tax cuts of December 2017 did not pay for themselves and certainly didn’t pay down the national debt. On the contrary, the federal budget deficit exploded into the trillion-dollar range well before the pandemic hit in early 2020. Nothing new there. The Bush tax cuts in 2001–2003 had also ballooned the deficit, as had the Reagan tax cuts years before them. While it is certainly possible to favor large tax cuts, raising revenue is not a valid reason.

The second antecedent to Reaganomics was discussed extensively in chapter 7: the excruciatingly tight monetary policy engineered by Fed Chair Paul Volcker to break inflation’s back. Remember, Volcker’s anti-inflation crusade began in October 1979, more than a year before the 1980 election. By the time Reagan took the oath of office in January 1981, the Fed’s tight monetary policy was in full force, and a severe recession was likely in the cards. (The National Bureau of Economic Research dates the 1981–1982 recession as starting in July 1981.) Contemporary forecasters, however, did not see it coming. For example, the Congressional Budget Office observed many years later that it had “failed to anticipate the start of the 1981–1982 recession, and after it had begun, how deep it would be” (CBO 2017a, 17).

The Reagan-Volcker policy mix, at least in its initial years, combined loose budgets with tight money. Elementary economic reasoning says that such a mix should produce high real interest rates—and it did, as we shall see. But the important point for now is that Volcker’s strongly contractionary policies came first. It is almost inconceivable that fiscal policy in 1981 could have headed off a recession even if it tried. Furthermore, supply-side doctrine actually embraced the use of tight money to fight inflation. In an odd blend of ideology and economics, supply-siders believed that monetary policy could be assigned to reducing inflation while tax cuts stimulated real economic growth at the same time (more on this belief shortly).

`Reaganomics`

This brings me back to Reaganomics. The supply-side vision of a free lunch was politically alluring in 1981, as it has been several times since. Furthermore, the idea that cutting the tax rates of rich people was the route to economic salvation was especially seductive to the rich, many of whom were enthusiastic Republican political donors. Who cared that virtually no mainstream economists signed up for supply-side economics (even though a number of them favored cutting taxes)? Republican politicians signed up in droves. One of them was the former governor of California, Ronald Reagan.

Candidate Reagan portrayed the Carter economy—not to mention the Carter budget deficit—as far worse than it actually was. Reagan scored what was seen as a virtual knockout punch in a televised debate in October 1980 by posing the famous rhetorical question “Are you better off now than you were four years ago?” It was a wonderful example of how bad economics often makes good politics. The fact was that real GDP per capita had risen about 8.5 percent over the four Carter years (1976:4 to 1980:4), so the answer for most Americans was undoubtedly yes. But Reagan’s cleverly posed question strongly suggested that the answer was no. And with inflation raging and the short but sharp 1980 recession fresh in peoples’ minds, many voters probably saw it that way. Perceptions lag behind realities. What we know for sure is that late-deciding voters broke overwhelmingly for Reagan (Dionne 1988).

The challenger campaigned on sharp cuts in income tax rates—basically the Kemp-Roth proposal—and won easily. Once installed as president, Reagan quickly pushed through a slightly slimmed-down version of Kemp-Roth. Instead of 10%–10%–10% over three years (which amounts to 27% in total), it was 5%–10%–10% in October 1981, July 1982, and July 1983 (which amounted to 23% in total). Top earners were not asked to wait that long, however; their need was apparently urgent. The highest bracket rate, which was 70 percent at the time, was dropped to 50 percent all at once in October 1981.⁵

The Economic Recovery Tax Act (ERTA) of 1981 also indexed individual tax brackets for inflation, a provision that had little effect on revenue in the short run but huge effects in the long run. Economists generally support indexing the tax code. After all, why should the rate of inflation, rather than the U.S. Congress, decide the tax rate? But arithmetic matters: if nothing was done to make up the lost revenue, indexing would add to future deficits.

Finally, although largely forgotten by now, ERTA also included truly massive reductions in corporate taxes, achieved mainly by accelerating depreciation allowances under the Accelerated Cost Recovery System, which was so generous that had it been allowed to go into effect with interest expenses remaining tax deductible, effective corporate “tax rates” on many types of equipment would have turned negative, that is, turned into subsidies. In fact, some of those subsidies would have been so large that the overall effective tax rates on these types of capital, including now corporate and personal taxes, would have become negative (Fullerton and Henderson 1984). Amazing! But it never happened. In the calmer atmosphere of 1982, Congress looked back at its 1981 handiwork and decided to repeal most of the corporate tax cuts in the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982.

The sharp tax reductions embodied in ERTA, even net of the TEFRA increases, should have been expected to blow a big hole in the federal budget deficit. And they did. The U.S. Treasury subsequently estimated the revenue loss from ERTA in the fourth year after enactment to be 4.15 percent of GDP and the revenue gain from TEFRA in its fourth year to be 1.23 percent of GDP (Tempalski 2006). But Reaganite rhetoric denied that obvious piece of arithmetic. Led by its young and ideologically driven budget director, David Stockman, the Reagan economic team cobbled together budget numbers that projected massive tax cuts, a huge military buildup, and a balanced budget by fiscal year 1984 (White House 1981). (By way of contrast, Carter’s last budget, for fiscal year 1981, had projected a deficit of 2.5% of GDP.) It looked like smoke and mirrors. And it was.

Unfortunately for the budget, though not for Reagan’s political fortunes, magic tricks based on sleight of hand are illusions. That was the case for Reagan’s original budget numbers. Stockman later confessed as much:

Designing a comprehensive plan to bring about a sweeping change in national economic governance in forty days is a preposterous, wantonly reckless notion.… I soon became a veritable incubator of shortcuts, schemes, and devices to overcome the truth … that the budget gap couldn’t be closed except by a dictator.… My expedients saw to it that critical loose ends were left unresolved everywhere. They ensured that the whole fiscal plan was embedded with contradictions and booby-trapped with hidden pressures. (Stockman 1986, 80, 105, 123)

As it turned out, the contradictions and booby traps prevailed, and the federal budget deficit ballooned from 2.5 percent of GDP in fiscal year 1981 to 5.7 percent of GDP in fiscal 1983. The latter was the largest figure since 1946, a time when demobilization from World War II was still in progress.

Table 8.1 displays the major budget categories in fiscal years 1981 and 1984, all as shares of GDP, plus, in italics, the Reagan team’s February 1981 projection for fiscal 1984. The table makes a few things obvious. First, the increase in military spending (0.8% of GDP) was more than offset by decreases in civilian spending (1.2% of GDP), so total noninterest spending fell a bit as a share of GDP. The drop in civilian spending was what Reagan and the Republicans wanted, though the magnitude was too small to truly “starve the beast.” Maybe just put him on a diet.

`TABLE 8.1.` Federal Budget (as percent of GDP)
Fiscal Year	Receipts	Total Outlays	Defense	Interest	Other	Deficit
1981	19.1	21.6	5.0	2.2	14.4	2.5
1984 (actual)	16.9	21.6	5.8	2.6	13.2	4.7
1984 (projected)	19.3	19.3	8.0	2.8	8.5	0.0
Change 1981–1984	−2.2	0.0	0.8	0.4	−1.2	2.2
Source: White House (1981) and Office of Management and Budget.

Second, the explosion of the deficit is more than accounted for by sharply reduced tax revenue (2.2% of GDP) and correspondingly higher interest payments (0.4% of GDP), the latter being an arithmetical consequence of the larger budget deficits in the intervening years. Thus, the tax cut explains more than 100 percent of the deficit explosion under Reagan. In rhetoric, the Reagan revolution was supposed to spur so much growth that the deficit would shrink despite massive tax cuts, with some help from reductions in civilian spending. In reality, the tax cuts ballooned the deficit while the military buildup offset most of the civilian cuts. Incidentally, economic growth was about the same as under Carter, giving the lie to supply-side economics. One consequence of all this was that the deficit rose to levels unheard of in the United States since World War II.

This straightforward numerical comparison might be thought unfair, however, because one cause of the widening deficit was the severe recession, a by-product of Volcker’s tight money, not Reagan’s tax cuts, which were surely expansionary. That is true and quantitatively important for the fiscal 1982 and 1983 budgets. But the effect of the recession on the budget was already fading by fiscal 1984, which was a year of rapid growth. In fact, Congressional Budget Office numbers show almost the same cyclical effect on the budget in 1984 as in 1981, which is hardly surprising since the unemployment rates of those two years were nearly identical (CBO 2019, 134, table C-1). Reaganomics created a deficit problem that remained at or near the top of the national agenda until Bill Clinton’s second term.

This device does not support SVG — `FIGURE 8.1.` Federal budget deficit (or surplus) as percent of GDP, 1948–1993.

*Source*: Office of Management and Budget.

Figure 8.1 illustrates just how unprecedented the Reagan peacetime deficits were. Between fiscal year 1948 and fiscal year 1981 (Carter’s last budget), the federal budget deficit exceeded 3 percent of GDP only twice, in the recession-plagued fiscal years 1975 and 1976. The deficit over this time span averaged just 1.7 percent of GDP, and the debt-to-GDP ratio fell steadily even though the period included both the Korean War and the Vietnam War. Then came the Reagan budgets, starting in fiscal 1982, and the deficit-to-GDP ratio peaked at 5.9 percent in fiscal 1983 and came in under 3 percent of GDP only once over the next twelve fiscal years. The debt-to-GDP ratio rose sharply.

The Reagan budgetary episode also illustrates an important asymmetry in fiscal policy. It is easy, politically, to cut taxes or raise spending, a lesson that was not lost on Presidents George W. Bush and Donald Trump. But it is difficult, politically, to raise taxes or cut spending. Thus, while expansionary fiscal policy may be useful in fighting slumps, contractionary fiscal policy will probably not be deployed to limit booms. The latter job was left, by default, to the Federal Reserve.

Unlike Richard Nixon, no one has accused Reagan of deliberately orchestrating a political business cycle to win reelection in 1984. But the ups and downs of the U.S. economy were just about ideal for that purpose, as shown in figure 8.2). As mentioned earlier, a deep recession began early in Reagan’s first term, which from a crassly political perspective is exactly when an incumbent president would like to “take” his recession. Simple economics tells you that the sharp Volcker-Reagan clash between contractionary monetary policy and expansionary fiscal policy should have pushed up real interest rates, as it did. But it does not tell you to expect the dramatic bust-boom cycle that the United States experienced in the 1981–1984 period. Why did that happen?

The answer, in a word, is timing. Specifically, tight money and loose budgets were out of synch, with the former coming well before the latter. Volcker’s tight monetary policy, it will be recalled, started late in 1979, was shelved for a while by the blowback from the credit controls disaster in 1980, and then took some time to gather steam once it resumed later that year. Allowing for the usual lags, we would expect the resulting drag on the economy to have begun in 1981 and to have been much stronger in 1982. The phased-in Reagan tax cuts had barely started by then, but they gathered steam in 1983 and 1984. So, while the tax cuts came too late to prevent the Volcker slump, they were perfectly timed to help slingshot the economy out of the recession in 1983 and 1984. Remember, monetary policy also turned expansionary around October 1982.

Figure 8.2 shows that the growth rate of real GDP over the final quarter of 1981 and the first quarter of 1982 averaged a miserable −5.2 percent (seasonally adjusted annual rate), while growth over the four quarters beginning 1983:2 averaged an astounding 8.6 percent. That remarkable turnaround was trumpeted effectively in President Reagan’s famous “It’s morning in America again” reelection commercial, and he annihilated his Democratic opponent, Walter Mondale, in the 1984 election.

Did the Reagan tax cuts spur growth? Certainly, but mainly from the demand side. No one seemed to notice or care at the time—or know even today—that the growth rate over Reagan’s entire first term (3.26%) was almost exactly the same as during Carter’s four years (3.19%). The United States experienced a bust followed by a boom in 1981–1984, producing a quadrennium of growth rates that was just about average. There was no supply-side miracle. But critically for Reagan’s landslide victory, the demand-driven boom was going full steam when voters went to the polls in November 1984.

`The Policy Mix`

According to the standard mainstream view, contractionary monetary policy (à la Volcker) raises real interest rates, though perhaps only transitorily, and slows the growth of aggregate demand. According to that same mainstream view, expansionary fiscal policy (à la Reagan) raises real interest rates and speeds up the growth of aggregate demand. Put them both together at the same time, as Reagan and Volcker did, and you should expect real interest rates to rise sharply while the net effect on real output depends on how the tug-of-war just sketched works out. The rise in real interest rates will in turn dull incentives to invest. So, the Reagan-Volcker policy mix should hurt investment.

But supply-siders, led intellectually by the godfather of their doctrine, economist Robert Mundell, did not buy into this logic. Rather, they claimed, tax cuts would fuel an acceleration of real economic growth, while tight money held inflation in check. The argument leaned on a rump version of the classical dichotomy asserted by Mundell, a brilliantly creative thinker who would later win the Nobel Prize (though not for supply-side economics). He had put it this way in a 1971 paper: “Monetary acceleration is not the appropriate starting point from which to initiate the expansion [in 1971], because of the risk of igniting inflationary expectations. Tax reduction is the appropriate method. It increases demand for consumer goods, which reverberates on supply.… Because of the idle capacity and unemployment, in many industries increased supply can be generated without causing economy-wide increases in costs. Tax reduction is not, therefore, inflationary from the standpoint of the economy as a whole” (Mundell 1971, 25).

Keynes thought he had demolished the classical dichotomy, which holds that the money supply alone controls the price level while other “real” factors (but not money) determine real output, in 1936. Apparently not. Mundell brought the classical dichotomy back as part of the supply-side revolution, thereby contradicting his own previous work on monetary and fiscal policy in the 1960s, seminal work that did win him the Nobel Prize (Mundell 1960). Under this new/old view, policy makers could simultaneously aim one weapon (tight money) at inflation and another (tax cuts) at growth.

Mundell communicated this unconventional view of the policy mix to Jack Kemp in 1976 (Wanniski introduced them), and it quickly became part of the supply-side canon. Largely on this basis, the Reagan team claimed that its hugely expansive fiscal program would not be inflationary. There was, they asserted, no policy-relevant trade-off between inflation and unemployment; anti-inflation monetary policy would take care of that. The Reagan-Volcker policy mix was thus a bold experiment though certainly not a controlled experiment (many other things were going on at the same time). How did the experiment work out? Which side of the policy mix debate came out looking better?

The answer is the conventional side, by a country mile. Figure 8.3 shows what happened to the real interest rate on ten-year Treasury securities from 1979 to 1989.⁶ It clearly rose sharply in 1981–1983 as the Reagan program was first being proposed, then legislated, and then promulgated. Standard macroanalysis suggests that an upward leap in real long rates should reduce the investment share in GDP and push up the dollar exchange rate. The investment share did indeed fall, from 13.6 percent in 1981 to 12.1 percent in 1982 and 12.6 percent in 1983. But that’s far from a clean comparison because recessions always take a toll on investment.

Robert A. Mundell (1932–2021)

Intellectual Father of Supply-Side Economics—and of Much Else

The brilliantly original and eccentric Robert “Bob” Mundell was born in Kingston, Ontario, Canada, in 1932 and earned his PhD in economics in 1956 from MIT. (Notice his age at the time.) After stints at Stanford University and Johns Hopkins University and on the staff of the International Monetary Fund, his academic career truly flourished at the University of Chicago, where in a scant five years (1966–1971) he influenced many of the top international monetary economists of the next generation.

But it was at the International Monetary Fund in the 1960s that Mundell and J. Marcus Fleming penned a pair of classic articles on monetary and fiscal policies under fixed versus floating exchange rates, forever known as the Mundell-Fleming model. That work, plus Mundell’s pioneering analysis of optimum currency areas, won him the Nobel Prize in 1999. Ironically, Mundell is sometimes called the “father of the euro” because of his work on optimum currency areas even though his research clearly points to the opposite conclusion: that the countries that constitute the eurozone are almost certainly not an optimum currency area.

Mundell’s Princeton essay on the supply-side policy mix, cited in the text, was far less noteworthy academically. But it turned out to be extremely noteworthy in the policy arena. There, Mundell suggested the policy mix of tax cuts to spur real growth plus tight money to fight inflation, a recipe later incorporated into supply-side economics.

The impact on the dollar exchange rate perhaps offers a cleaner comparison (figure 8.4).⁷ The trade-weighted value of the U.S. dollar against a basket of other major currencies soared by 54 percent between September 1980 and March 1985, with only a few minor interruptions. By 1985, pressure was mounting on the U.S. government to do something about the overvalued dollar, which was, among other things, hollowing out the manufacturing base in the Midwest. (The term “Rust Belt” became common parlance in the early 1980s.) This pressure eventually led to the September 1985 Plaza Accord, named after the location of the negotiations at the Plaza Hotel in New York City. There the G5 nations (the United States, West Germany, the United Kingdom, Japan, and France) agreed to intervene in the foreign exchange markets to push the dollar down, something the market had been doing anyway since March 1985. When you give a push to a snowball that is already rolling downhill, the odds are with you. And the Plaza Accord succeeded. The dollar fell 10 percent between September 1985 and April 1986.

This Reagan-era experience with exchanges rates and the trade balance reminded American economists, who often lapse lazily into a closed-economy frame of mind, that large government budget deficits are likely to crowd out net exports as much as or more so than they crowd out domestic investment. As a share of real GDP, the trade deficit rose from roughly zero in 1980–1982 to about 2.4 percent of GDP in 1984, wreaking havoc on U.S. manufacturers and on exporters in general.

The response of policy makers was, as just noted, to knock down the value of the dollar via the Plaza Accord. In principle, the pressure on the dollar could have been alleviated instead by pairing tighter fiscal policy with the far easier monetary policy that the Volcker Fed began to pursue in October 1982. But by then there was a deep recession to fight, and the administration was not at all inclined to repeal the centerpiece of Reaganomics.8 Income tax rate cuts took place in 1983 and 1984, right on the schedule that had been legislated in 1981. Fiscal expansion was in full force.

`The Great Disinflation`

I mentioned earlier that the Reagan team came to Washington promising near miracles on both the budget side (a balanced budget by 1984) and the growth side (a sharp acceleration of real GDP growth). They also came to town promising to slay the inflationary dragon, adopting the Mundellian dichotomy as their model. So, most supply-siders firmly supported the Federal Reserve’s war on inflation, at least initially. According to supply-side doctrine, inflation would fall without a recession. In fact, it would fall while growth accelerated and unemployment fell. Or so it was claimed.

Mainstream economists were highly skeptical of this halcyon view; I presume that Volcker was, too. Instead, many (including myself but probably not including Volcker) placed their bets on what I used to call the “Brookings rule of thumb,” named mainly for Robert Gordon’s series of Phillips curve papers published in the Brookings Papers on Economic Activity in the 1970s and 1980s (Blinder 2021).

Suppose the Phillips curve takes the simple form introduced in chapter 3, which, in the linear case, is

$π_{t} = θ + π_{t}^{e} + β U_{t} + ε_{t} .$ (1)

If we use lagged inflation as a reasonable empirical proxy for expected inflation, equation (1) becomes

Δπt = β(U* − Ut) + εt, (2)

where U*, the natural rate of unemployment, is U* = θ/β. With β around ½, equation (2) says that each point year of additional unemployment reduces the inflation rate by about 0.5 point. That is the Brookings rule of thumb.

How well did this rule of thumb work in the Great Disinflation of the 1980s? Using 5.8 percent (the actual unemployment rate of 1979) as the estimated natural rate at the time, the Volcker disinflation featured 13.9 point years of “extra” unemployment during the six years 1980–1985, inclusive. And it brought the core Consumer Price Index (CPI) inflation rate down by 6.2 percentage points over that same period.⁹ The ratio of the two implies a Phillips curve slope, β, of 6.2/13.9 = 0.45. Not bad unless you were a believer in either the separation between the real and nominal sides of the economy advanced by Mundell or in the rational expectations view of the (vertical) Phillips curve of Lucas and Sargent.

As I emphasized in chapter 6, it is hard to understand how rational expectations triumphed in the academy while such a painful and preannounced disinflation was proceeding in the real world. Blissfully, however, supply-side economics never made serious inroads in the academy. It was and remains to this day a political doctrine.

`The Legacy of Reaganomics`

Ronald Reagan left a multifaceted legacy. His military spending spree surely helped win the Cold War by crippling the Soviet Union, which tried like a drunken sailor to match the big spending of the much-richer United States but failed. He also pulled the Republican Party sharply to the right, compared to more moderate predecessors such as Gerald Ford, Richard Nixon, and Dwight Eisenhower. Reagan deserves to be viewed as a major historical figure (Wilentz 2008). But I will stick to macroeconomics here. What difference did Reaganomics make?

A naive answer might start with inflation, which was 11.8 percent (on a twelve-month CPI basis) when Reagan was inaugurated and 4.5 percent eight years later. That sounds like a big victory. But as we saw in chapter 7, that disinflation was largely the handiwork of Volcker and his colleagues at the Federal Reserve. Apart from giving the Fed verbal running room early in Reagan’s first term, which was important, nothing the Reagan administration did was actually anti-inflationary.

On the growth front, nothing notable happened under Reagan. Yes, the sharp bounce-back from the 1981–1982 recession was impressive, and the tax cuts no doubt gave it extra strength. Incentives do matter. But in terms of real growth, the eight-year Reagan period looks about the same as the four Carter years that preceded it and is slightly worse than the eight Clinton years that followed it. Supply-siders promised a growth miracle, but they did not deliver one.

The biggest economic impacts of Reaganomics were probably on tax policy and the budget. Before the Reagan presidency, there was a bipartisan understanding that tax cuts—which everyone likes—had to be constrained by deficit considerations. There was also an unspoken consensus that the federal budget deficit should not exceed 3 percent of GDP (see figure 8.1). Reagan’s political success blew both of those norms out of the water. As Vice President Dick Cheney would later put it, “Reagan proved deficits don’t matter” (Suskind 2004, 291). I’m pretty sure he meant they don’t matter politically.

In any case, federal budget deficits averaged 3.3 percent of GDP from Reagan until the coronavirus pandemic struck, a period that includes Clinton’s string of budget surpluses. By comparison, deficits averaged just 0.9 percent of GDP from fiscal year 1947 until the Reagan presidency. Furthermore, two of the three Republican presidents since Reagan have pushed massive tax cuts through Congress. And the third, George H. W. Bush, may have lost his 1992 reelection bid because he broke his “no new taxes” pledge in order to shrink the deficit. Republicans after Reagan forgot about fiscal prudence and became the party of tax cuts.

That said, the need to reduce the budget deficit via what Jude Wanniski had derisively called “root canal economics” (tax hikes and spending cuts) became the central economic policy concern of the next three presidential terms (Bush, Clinton, Clinton). If fiscal policy is focused on reducing the deficit regardless of whether the economy is booming or slumping, the job of stabilization policy is ceded to the central bank, which, of course, is precisely what happened in the United States.

Last but certainly not least, the desirability of tax cuts, whether the budget is near balance or showing a big deficit and regardless of whether the economy is soaring or sagging, has become the central tenet of Republican economics. For example, when Trump came into office, the federal government already had a large budget deficit (about 3.5% of GDP), and the nation had a low unemployment rate (4.7%). These preconditions do not obviously militate for a tax cut. But Trump proposed a large tax cut anyway, and the Republican-controlled Congress gleefully passed it. Would that have happened without Reagan’s legacy?

`Chapter Summary`

When Ronald Reagan took office in January 1981, Paul Volcker’s excruciatingly tight monetary policy was in the pipeline, but the severe recession of 1981–1982 was not yet in sight. Furthermore, the supply-side doctrine that the Reagan team embraced held that tax cuts could expand the economy while tight money fought inflation. So, there was no conflict between Reagan and Volcker at first. The new president supported tight money.

This uneasy peace fell apart, however, as the Reagan-Volcker policy mix of loose fiscal policy and tight monetary policy met up with reality. The huge Reagan tax cuts, which were largely accomplished by cutting personal income tax rates, ballooned the federal budget deficit (as a share of GDP) to levels not seen in the United States since 1946. Meanwhile, the Federal Reserve’s allegedly monetarist policy sent both interest rates and the dollar exchange rate through the roof and, not incidentally, made Volcker and the Fed politically unpopular.

Higher interest rates took a toll on domestic investment, though perhaps not as large a toll as expected. More sizable effects were seen on U.S.net exports, which taught U.S. economists to be more open-economy minded when it comes to thinking about crowding out. Meanwhile, inflation disappeared rapidly as a consequence of two back-to-back recessions, the dwindling effects of supply shocks, and the rising dollar. Conventional Phillips curves of the day, which had been modified to account for supply shocks, tracked the disinflation quite well.

There are two lasting and important legacies of the Reagan-Volcker episode on monetary and fiscal policy. First, the traditional aversion to budgets deficits disappeared, at least within the Republican Party.¹⁰ Deficits have been systematically larger (as shares of GDP) since Reagan than before him, and the attraction of “supply-side” tax cuts to Republicans has never died. Second and related, the job of stabilization policy was essentially delegated to monetary policy for over a quarter century. After all, if one party promotes tax cuts regardless of the macroeconomic situation and the other party is bent on reducing the deficits it inherits, fiscal stabilization policy has essentially been thrown out the window.

______________

. The Laffer curve showed the tax rate on one axis and tax revenue on the other and took the shape of a hill, rising as comparatively low tax rates rose but then falling as high tax rates went even higher.

. This remark has been cited and repeated in numerous places. I take these exact words from Schultze (2011, 13).

. Quoted in Feldstein (1994, 21n).

. “Forced” may be an exaggeration. In a 1991 op-ed in the Wall Street Journal, Anderson (1991, A16) had accused me of making an “unexpectedly reckless” attack on Reaganomics in my 1987 book Hard Heads, Soft Hearts (Blinder 1987a). I could have ignored him, but I thought even then that history should be written accurately. See Blinder (1991, A13).

. Because October 1981 was near the end of the tax year, the 50 percent rate actually became fully effective only in 1982.

. There were no Treasury Inflation-Protected Securities in the 1980s, so the monthly real interest rates shown here are calculated by subtracting the CPI inflation rate (over the past twelve months) from the nominal ten-year Treasury rate.

. The exchange rate shown is the Federal Reserve’s old index of the trade-weighted dollar against major foreign currencies.

. Except that, as noted earlier, much of the corporate cut that Congress had passed in 1981 was repealed in 1982.

. The research CPI discussed in chapter 7 measures the decline in core inflation as 5.6 percentage points.

. Bill Clinton would later dedicate part of his presidency to deficit reduction. See chapter 11.