Reaganomics / Supply-side Economics

The crisis in confidence Carter identified in 1979 was certainly not helped by a campaign debacle.  After a heated and surprisingly close Democratic primary in which Carter beat Edward Kennedy, Carter selected Alan Eagleton as his vice presidential candidate, but had to quickly replace him due to some previous medical problems.  The timing was perfect for a candidate with a simple cure for the Carter malaise, and the Republicans responded with a crowded field of candidates including Ronald Reagan and George Bush.

Ronald Reagan received the nod and chose George Bush as his running mate.  The message delivered by Reagan was a simple one.  He challenged the American people to reflect on the past four years and ask the question: 

"Can you look at the record of this administration and say, 'Well done'?  Can anyone compare the state of the economy when the Carter administration took office with where you are today and say, 'Keep up the good work'?  Can you look at our reduced standing in the world and say, 'Let's have four more years of this'?"

The answer for too many people was NO, and Ronald Reagan was elected president.  At an abstract level, the solution should be obvious to everyone.   If the economy has been hit by an adverse supply shock, the appropriate policy would be to trigger a compensating supply shift.  It was time to break with the Keynesian demand-management tradition and focus attention on aggregate supply - hence the term "supply-side" economics. 

Diagram 1
Stagflation

The election of Ronald Reagan as President reflected a worldwide move to the political right, a response to the lack of confidence in government's ability to guide the economy that grew during the stagflation of the 1970.  One of the more notable steps in that direction was the decisive Conservative Party victory in the United kingdom's 1979 election that brought Margaret Thatcher to Downing Street and "Thatcherism" to the country.  As Ms. Thatcher described things in Bolton on May 1, 1979:

"[u]nless we change our ways and our direction, our greatness as a nation will soon be a footnote in the history books, a distant memory of an offshore island lost in the mists of time-like Camelot remembered for its noble past."  

Ms. Thatcher assumed the job at a time where prices and wages were rising at an average rate exceeding 15 percent, spurred on by money supply (M1) growth that peaked at 22 percent in 1978.  The unemployment rate was in the mid 5 percent range, up from the mid 2 percent range before the 1975 recession, economic growth put it at the bottom of the OECD countries, and productivity growth was limited.  The result was unit labor costs rising at double digit rates and import competitiveness falling sharply.  The exchange rate continued to fall throughout the decade, falling a full 20 percent between 1975 and 1978, while the balance of trade deficit continued to rise.  In fact in December 1976 the IMF needed to 'rescue" the pound.  As economists Richard Caves and Lawrence Krause saw things, "Britain's economic malaise stems largely from its productivity problem whose origins lie deep in the social system."₁   The people of the United Kingdom and the United States were ready to listen to, and elect, someone who offered them a way forward, and that person was Margaret Thatcher in the UK and Ronald Reagan in the US.

The "malaise' in the two countries, although on the surface sounding quite similar, was quite different in the two countries because of different institutions and policies.  One of the BIG differences between the UK and the US was the fact that in the UK most of the major industries were nationalized.  On the policy side, the UK experimented extensively with incomes policies during the decade as a means of dealing with inflation.  The result was little good news on the inflation front and plenty of bad news on the strike front -  low points being a miners' strike in the winter of 1974-75 that forced the country onto a three-day work week and a series of disruptive strikes in the winter of 1978-79.  

For Margaret Thatcher, a "disciple" of Milton Friedman and Freidrich von Hayek, the "solution" to the economic malaise had three major components.  First, strict monetarism was the answer to inflation, as could be seen in the Conservative manifesto of 1979: "to master inflation, proper monetary discipline is essential, with publicly stated targets for the growth of the money supply."₂  Second, government interferences with the economy needed to be reduced - in large part to be accomplished by "rolling back" the reach of the public sector.  She also set about to reduce government spending, but she was less successful at achieving the second of these goals.  Third, productivity growth needed to be increased, an outcome that relied on increases in incentives.  Again from the Conservative manifesto; "To become more prosperous, Britain must become more productive and the British people must be given more incentive."   Part of the incentives came in the form of tax changes.  In the first Conservative budget, income taxes were cut, especially at the high end, and consumption taxes (Value added tax (VAT)) were raised.  

What came of these policies?  The recession of 1980-1981 was deep and troubling - prompting comparisons between the early 1980s and the 1930s.  Rising interest rates drove up exchange rates that made it hard for manufacturing firms to compete, and between 1979 and 1981 manufacturing employment fell by 16 percent.  In addition to the economic slide, there was also a notable increase in inequality, with the manufacturing centers in the North and West experiencing double digit unemployment rates.  One success, however, was a sharp reduction in inflation which was down to 4.5 percent in 1983.  

In the US, Ronald Reagan was leading the conservative movement with three key elements on its agenda: reduce inflation, balance the budget, and reduce the size of the government.  The American workers had seen inflation erode their buying power as the progressive tax system drove them into higher tax brackets which was viewed as a means to finance an expansion in the size and scope of government.  This anti-government sentiment was expressed in passage of Proposition 13 in California in 1978 that rolled back property taxes. There was a tax revolt underway and a candidate would be well served with a platform including a tax cut. 

But there was a problem with each piece of the agenda.   First, significant reductions in inflation would require substantial increases in unemployment - the old Phillips Curve tradeoff.  Second, balancing the budget would mean that tax cuts, long a favorite Republican proposal, would be impossible to achieve.  Third, the budget could not be improved with substantial cuts in government spending without a loss in benefits received from the government. 

Margaret Thatcher had approached a similar situation in England with "Thatcherism" based explicitly on the premise that the economic ills could only be cured after a painful period of transition.   Ronald Reagan offered the American people an alternative to the Carter drift and the Thatcher austerity -  what George Bush called "voodoo economics" and Herbert Stein called "the economics of joy."  Ronald Reagan had lost the Republican candidacy on an austerity campaign in 1976 and he would not make that mistake again.  The most striking feature of Reaganomics was it offered a painless solution to stagflation.  

"Reaganism was the rejection of traditional Republican policies of "austerity" - sometimes called castor-oil economics or deep-root-canal economics.  But it was more than that.  It was an assertion these policies could be rejected without also rejecting many conservative objectives or totems. "

One thing was certain, the move would need to be dramatic and quick as Reagan and his supporters felt it was essential to change expectations.   As Reagan's supporters and policy advisors saw it:

"Thatcherism' can only be avoided if the initial economic policy package simultaneously spurs the output side of the economy and elicits a swift downward revision of inflationary expectations in the financial markets...President Reagan should declare a national economic emergency soon after inauguration. He should tell the Congress and the nation that the economic, financial, budget, energy, and regulatory conditions he inherited are far worse than anyone imagined.  He should request that Congress organize quickly and clear the decks for exclusive action during the next 100 days on an Emergency Economic Stabilization and Recovery Program he would soon announce."

If Reaganomics was to deliver on its promises, then the assumptions upon which it was based would need to be accurate since it was a finely balanced plan. "The edifice [Supply-side Economics] was delicately balanced on a set of simultaneous policy actions and a set of equations describing the effects of the policy actions on the economy."  

One equation that helps us understand the problem, and solution, is a very simple equation - a production function. 

Q = Q(K,L,t)

(Q), the supply of output (GDP - the horizontal axis on the AS-AD model) is dependent upon the size of the capital stock (K), the size of the labor force (L), and the rate of technological change (t).   If the US were to increase aggregate supply, it would be because it was successful at increasing the resources the nation employed and the technology its worker's used.

We will now look briefly at the equations / the theory upon which Reaganomics was based, how it attempted to simultaneously expand output, cut taxes, and eliminate the budget deficit. 

The theory

The recovery package was grounded in three ideas circulating at the time.

1. There is no link between inflation and unemployment.
2. There is no "cost" in terms of reduced benefits to reduced government spending.
3. The budget can be balanced with a tax cut.

No cost lower inflation

The Phillips Curve had been an accepted piece of the Keynesian macro model in the 1960s and the gradualism of Carter was grounded in the belief that lower inflation's short term cost was higher unemployment.  Carter, accepting the trade-off as inescapable, had hoped to use wage and price guidelines to reduce inflation without incurring the cost of higher inflation.  This was not an option for the Republicans who had no interest in increased government intervention.  

The key piece of the no-cost solution to lower inflation was expectations.  Once we accept the importance of expectations, there is a need to explain how to build them into macroeconomic analysis and how the expectations are formed. As we saw in our discussion of the 1970s, a first step toward solving the issue of expectations formation, ask yourself the question: what will the weather be tomorrow?  

The simplest answer would be: tomorrow will be just like today - what is called adaptive expectations. For example, consider the problem of forecasting inflation. Inflation next period (i₊₁) would simply be equal to the current inflation rate (i).  This is equivalent to a weather forecasting strategy of forecasting tomorrow to be the same as today.   If the inflation rate last year was 5%, then you would expect it would be 5% this year.

Adaptive expectations I

i₊₁ = i

A more sophisticated model would express expected inflation (i₊₁) to equal the current rate (i) plus the change in inflation between this year (i) and last (i_-1). 

Adaptive expectations II

i₊₁ = i + (i - i_-1 )

A weaknesses of these models of expectations is they are backward looking and people are going to get fooled by any changes.  

The implication of this approach was reflected in the Phelps-Friedman inflation-augmented Phillips Curve where the inflation-unemployment trade-off existed, but only in the short run because decision makers' estimate of the inflation rate turned out to be wrong.   The prospect of a painful, slow adjustment downward in inflationary expectations would tend to limit the use of discretionary policies designed to wring inflation out of the system. The gradualism of Carter was grounded in the belief that lower inflation's short term cost was higher unemployment. If inflation was to be reduced / eliminated, it would come at a substantial cost as the economy slowly adjusted its inflationary expectations. The problem was American people had come to expect inflation and built it into their thinking - workers built it into their wage demands and bankers built it into their interest rates.

There was, however, reason for optimism - reason to believe that the transition form high to low inflation rates did not have to be painful.  The solution could be found in the emerging theory of rational expectations introduced by Robert Lucas,  work that earned him the Nobel Prize in economics in 1995. According to Lucas, decision makers formed their expectations rationally with forward looking rather than the backward looking expectations of the adaptive expectations model.  Rather than the adaptive expectations model where people will continually be fooled because they will not learn, Lucas believed people could learn and this would make it difficult to fool people continuously. Furthermore, Lucas felt that if macroeconomic policies were credible, then decision makers' inflation expectations would adjust quickly and the economy would adjust quickly to the new equilibrium. 

To see how this works, let's look back at what we learned about inflation earlier - that inflation is a monetary phenomenon.  The Quantity Theory of Money (MV = PY) linked the price level and the money supply so if you knew the money supply was increasing, then you would adjust your estimate of inflation.  For example, if people knew the inflation rate would equal the growth rate in the money supply (m), then they would immediately adjust their expectations for inflation downward if the Fed embarked on a tight money policy.  Rational expectations offered policy makers a painless cure to inflation.

Rational expectations

i₊₁ = m

In Diagram 1, the movement from C to A was expected to move us slowly through pt D. Only after people's expectations had been realized would we see a return to a long-run equilibrium. If expectations were formed "rationally," however,  then an announced reduction in the growth rate in the money supply would translate immediately into a lower expected rate of inflation.  This would lower the Phillips curve and the economy would go straight from C to A.  In this situation there was no necessary connection between inflation and unemployment and we could therefore break inflation without any increase in unemployment - a no pain decline in inflation could be accomplished by the restrictive monetary polices being followed by the Fed as Reagan took office. The research focus thus shifted to how macroeconomic policies could gain the credibility needed to influence the expectations.

No cost lower government spending

Reduced government spending was a traditional part of Republican platforms, but Congressman Jack Kemp had warned Republicans of any attack on the New Deal programs.  Despite the fact government bashing was a popular national sport, the voting public would not be likely to support a dismantling of the welfare state.  Fortunately for Reagan, this would not be a problem since he could appeal to the traditional Republicans with a call for lower government spending without raising the specter of losses in favorite entitlement programs.  Government spending could be cut without cost because of the extraordinary amount of waste in the government.  The reduction in government spending which Reagan pushed for would not create hardship since the government was a bloated bureaucracy. Government expenditures could be reduced without pain since the savings could be found in eliminating costs associated with waste and needless regulations which raised production costs in the private sector. The effect would be an inward shift in the AD curve (waste reduction) and an outward shift in the AS curve (reduction in regulation).

Tax cuts and a balanced budget

Ronald Reagan, living in California, had seen first hand the impact of the decline in defense spending and the power of the tax revolt. Defense contractors were major employers in southern California, and Proposition 13, a roll-back in property taxes, had gotten the attention of government officials everywhere.  At the center of Reaganomics were tax cuts to the nation's businesses and individuals - a policy borrowed from  Margaret Thatcher and president Kennedy.   Thatcherism was based on the premise that  "[t]o become more prosperous, Britain must become more productive and the British people must be given more incentive" while president Kennedy, the first presidential candidate to promise to get the economy moving, believed that   "[t]o raise the nation's capacity to produce ... we must invest, and we must grow.... As a first step we have already provided important new tax incentives for productive investment." 

To increase the capital stock (K), investment spending needed to increase which would happen if the cost of it could be lowered, or the return on it could be raised. On the cost side, Reagan could not depend upon the FED helping since Volcker had only recently embarked on his contractionary monetary policy designed to raise interest rates.  He could, however, attempt to increase the pool of available funds which would put downward pressure on interest rates. To accomplish this, a tax deduction on savings was proposed, but this was only a small part of the fiscal package. 

Reagan also intended to follow Kennedy's lead and lower the cost of investment directly through tax breaks for investment - accelerated depreciation and an investment tax credit as well as a general decrease in corporate income tax rates. The nature of these taxes can be seen in a simple example.  Let's assume a business with physical assets (building) valued at $200,000 that earns a profit of $100,000.  The business is able to write off the cost of the asset over twenty years, so each year the business reduces its income by $10,000 (5%*$200,000).  With a corporate profit tax rate of 20% of the profit of $190,000 (4200,000-$10,000), the business' total tax bill is $18,000.

Here is what the situation would look like after the depreciation schedule is accelerated to ten years.  Now the business can write off $20,000 for depreciation which lowers net profit by $10,000 and corporate taxes by $2,000.   With the extra money the firm might have an incentive to increase their spending on new machines and buildings.  The incentive could be made even stronger with an investment tax credit, part of the Kennedy tax cuts nearly twenty years earlier. 

Let's assume the government passes a 10 percent investment tax credit.  This allows the business to write off 10 percent of the value of any money spent on new capital. The tax credit on investment spending of $50,000 would be $5,000.  Subtracting this from net taxes would reduce total taxes to $13,000.  The business, by spending $50,000 on machines and buildings saves taxes of $5,000, so the cost of the spending would be $45,000.  The lower cost should prompt some to spend now to take advantage of the rate.  

On the return side of the ledger, Reagan promoted a defense build-up which would provide an incentive for investment in defense related industries - and certainly helped out Southern California.  

The center-piece of Reagan's tax package was a thirty percent cut in the personal tax rates. As we will see in the next unit, this tax break turned out to favor those earning big money, but these are the one's who would likely save and funnel these savings into the capital market which would recycle this into higher investment spending. You give a politically powerful tax cut to those who will help channel the savings into businesses that would use the money to modernize its plants to more effectively compete with foreign competition.  

The Republicans were constrained by the mathematics of governmental finance - the budget deficit (D) equals the difference between the level of tax receipts (T) and outlays (G).  The equation would seem to suggest a budget Deficit (D >0) could be eliminated only by an increase in Taxes or a decrease in Government outlays.  The task facing Republicans was to find a way to cut taxes without raising the budget deficit, and to devise a tax cut that would be recognized as fair and not designed to help the already wealthy.

D = G - T

One such proposal was contained in the Kemp-Roth bill proposed in 1978 that would cut income tax rates by 30 percent.  Although the proposal was never passed, it was a piece of Congressman Kemp's platform in his bid for the presidency in 1980 and eventually it was adopted by Reagan.  As for the budgetary impact of such a tax cut, there was a new theory circulating that suggested a cut in tax rates would actually help reduce the budget deficit.  It was now believed reductions in taxes and a balanced budget were possible. This theory had been developed by Arthur Laffer and was being pushed by Jude Wanniski and others on the pages of the Wall Street Journal.  On August 4, 1976 the idea surfaced in an editorial that maintained, "It is far from clear that a tax cut will always cause a deficit.  It depends on whether it succeeds in stimulating the economy enough that the lower tax rates yield a larger net revenue." 

Part of the success in selling this idea can certainly be attributed to the simplicity with which it could be presented to the public using the Laffer Curve [Diagram 3]. Tax revenue would increase with tax rates, but only to a certain point.   Once tax rates reached a certain unspecified level, then any additional increase would result in lower revenues. Republicans argued that high income tax rates had pushed the U.S. economy into the range where a tax cut would actually raise revenue - a movement left from point B in Diagram 3. This was the basis of the Republican National Committee's endorsement of the Kemp-Roth tax bill that contained a cut in personal income tax rates of 10 percent per year for three years.

Diagram 3
The Laffer Curve

How could this counter intuitive result be explained?   The "mathematics" of the answer are straightforward.  The level of tax income (T) is simply the product of the tax rate (t) and the level of income (Y). If the reduced tax rate could stimulate the economy and increase income, then the level of tax revenue could increase and the budget deficit would be reduced.

T = t*Y

The secret was in the incentives determining the supply of resources used in the production of "stuff".  The aggregate supply of stuff (Y) depends on the level of inputs used in the production of that stuff -  labor (L) and capital (K) - and the technology (A) so an increase in supply could be accomplished if it were possible to get faster input growth and faster technological / institutional change that increased the output from existing inputs.  For Ronald Reagan and his advisors, the solution was to be found in conventional / conservative theory based on the rational decision maker.

The supply of labor (L) could be increased if the price of labor was raised and / or the price of leisure / idleness was reduced. To achieve the first of these, income taxes would be cut, leaving workers with more of their income. This would not be a traditional Republican tax cut on investment income earned primarily by the wealthy and designed to have a trickle down effect on those in the middle and lower income. To tap into the fears and anxieties of the mainstream voter, it would need to be a broad based tax cut. Reagan's thirty percent across the board over three years had such an appeal even though its effect was felt more by the wealthy. To reduce the appeal of idleness, Reagan's position on the PATCO strike made it clear that strikes would not be tolerated.  He also intended to reduce government transfer payments by reducing fraud and tightening the welfare system which would lower the benefit of not working.

The performance

The rest as they say is history.  Once again, things did not work out quite as planned. The delicately balanced set of equations did not perform as planned.  It turns out that Reagan had a difficult time moving from the cost-cutting candidate to the cost-cutting president.  Once in office, Reagan inherited a larger than expected deficit and found it impossible to continue using his budget forecasts built upon an 8.7 percent inflation rate used in his projections during the campaign.  It was also impossible to identify the promised expenditure cuts, and the defense build-up was more costly than originally estimated.  As a result Reagan began to back-track on his promises almost immediately. The budget delivered in 1981 included a one-year delay in the eventual budget balance (1983 to 1984), a new element - an asterisk - in the budget representing unspecified future cuts, and a six-month postponement in the starting date for the first-round of the tax cuts.

Reagan did get his tax cuts and his increased defense spending.  Congress passed the Economic Recovery and Tax Act of 1981 in the summer.  The program included the three-step, across-the-board reduction in personal income tax rates.  It also included substantial subsidies for business investment in plant and equipment.  The subsidies came in the form of accelerated depreciation and investment tax credits. 

What Reagan did not get was the balanced budget.  It soon became clear that things did not work out as planned.  There was a serious inconsistency in Reaganomics' goals and Reagan would give up the balanced budget to pursue the other goals. Over the next few years we witnessed the battle of the deficits - each side continuously providing "proof" of the rising and falling deficit, but the battle had been lost. 

As for the overall economy, the results were mixed and depended very much on the time-horizon chosen.  A sample of the results in the major aggregate markets is presented in the graphs below.  In the output market, inflation did drop rather precipitously - from a high of 18 percent in early 1980 to 0 percent in March, 1982 - the first time that this had happened in a decade.  The cost, at least initially, was higher unemployment, but eventually the unemployment rate began to fall and by 1989 it was 5.3 percent, the lowest rate since 1973 before the OPEC induced recession. The improvement in the unemployment situation and significant employment gains were not reflected in earnings that continued to fall during the decade.  By 1989 real earnings for American workers were lower than they were in 1959. 

In the output market GDP grew at faster rates than in the 1970s, but below the average for the 1960s.  There was also no rebound in productivity growth which was lower in the 1980s than in either the 1960s or 1970s. 

The capital market reacted to the Fed's restrictive policies Reagan's deficits with higher real interest rates and a rebound in the stock market which managed to move beyond the 1987 shock. 

The higher real interest rates helped push the dollar higher, rising over 70 percent by 1985.  This severely hampered the traded-goods sectors of the US economy and the balance of trade, which had turned negative in the late 1970s, moved sharply negative in the 1980s and bottomed out at nearly $160 billion in 1986.  Farmers were clearly hurt - agricultural exports down sharply and farmland prices following - and the news was filled with stories of bankrupt farmers.  It was also a time where we began to hear much about the de-industrialization of the US economy as manufacturing firms began to lose out to foreign competitors.  Employment in the steel industry, for example, declined from 400,000 in 1980 to 150,000 in 1986.  These were tough times for the "Rust-Belt", but they were good time along the Atlantic and Pacific coasts.  This was the beginning of the boom known in New England as the "Massachusetts Miracle."

By 1984 the economy was again growing and the country was a peace - enough to re-elect Ronald Reagan in a landslide over Walter Mondale who made the fatal mistake of mentioning tax increases in his bid for the presidency.  When Mondale uttered the words, "Let's tell the truth. Mr. Reagan will raise taxes, and so will I.  He won't tell you.  I just did" he sealed his fate in the election.  Reagan's second term, as well as George Bush's presidency, were both affected by the budget deficits that became one of the defining issues of this period.  In fact, in Reagan's first term there were two significant tax increases passed to reduce the deficit - the Tax Equity and Fiscal Responsibility Act (TEFRA) in 1982 and the Deficit Reduction Act (DEFRA) of 1984 - and these were resisted by those who saw tax increases more as an opportunity to spend additional money on new programs and less as a means to reducing the deficit.  The situation was described by Gary Becker as: "I do not claim an iron law of democratic politics that expenditures always increase by more than additional revenue, but powerful forces do push us in this direction."₃ 

What was clear to all, was the US had entered a period of exceptionally high budget deficits, which is the focus of the Unit on the 1990s.  First, however, we will look more closely at the concept of economic growth.

1 Richard Caves and Lawrence Krause, Britain's Economic Performance, Brookings Institute, 1980
2 Rukstad p117

3 Rukstad, Clinton case - p 2