This article first appeared in the Summer 1992 issue of the Harvard International Review.
The election of the Reagan-Bush ticket in 1980 brought drastic changes in US economic policies. By any historic measure, US elections are seldom revolutionary. Despite campaign rhetoric, when a President of the opposite party takes over he usually makes only cautious and gradual alterations in the courses selected by his predecessors. This was true from the election of Franklin Roosevelt in 1932 until 1980. Ronald Reagan’s nomination as the Republican candidate in 1980, however, signaled the capture of the US Republican Party by the ideological right wing of the party. George Bush had labeled Reagan’s views as “voodoo economics” as he competed for the 1980 nomination. When Reagan offered him the consolation prize of the vice-presidential nomination, Bush, a pragmatist with political ambitions and no strong convictions, was easily converted to Reaganomics and other tenets of conservative ideology.
After nearly three full Presidential terms of Reagan-Bush policies, now is a good time to assess the present state and the future prospects of the US economy. What are the legacies of Reaganomics?
President Reagan was inaugurated during a brief interlude between two recessions, one in 1979-80 which helped him to win the election and one in 1981-82. Both were the consequences of a determined crusade by Federal Reserve Chairman Paul Volcker to kill the inflationary dragon. Triggered by the second OPEC shock, which was accompanied by the Iranian revolution, inflation hit double digits in 1979-80. Volcker’s crusade pushed up unemployment to 9.7 percent for the year 1982—the highest since 1941—and succeeded in bringing inflation down to about 5 percent per year.
The central banks of other major economies were enthusiastic participants in the anti-inflationary crusade of 1979-82. The US recovered more promptly and more completely than either Europe or Japan. The Federal Reserve managed—one could say, fine-tuned—the 1982-89 recovery as it had managed the prior recessions. Annual average US unemployment rates fell from 9.5 percent in 1982 to 5.2 percent in 1989, lower than the 5.8 percent rate at 1979’s cyclical peak in business activity. Eighteen million persons got jobs. By contrast, unemployment in Europe remained high and even now has not fallen to the rates that prevailed before 1979 or the even lower rates customary prior to the first oil shock of 1973-74.
The deficit spending that resulted from Reagan’s 1981 program of tax cuts and defense buildup became a powerful demand stimulus beginning in 1983. Reagan’s fiscal policy had helped Volcker to get a brisk recovery started—even though demand stimulus had not been a rationale for the Reagan program. With federal budget deficits soon reaching more than five percent of GNP, Reagan budgets were the most massive Keynesian fiscal stimuli ever given to the US economy in peacetime, extending beyond what any consciously Keynesian administration would have done. In effect, the fiscal policy gave the Fed too much help. To keep the economy from overheating, the Fed had to keep interest rates much higher than in normal cyclical recoveries.
Presidents are held politically responsible for poor macroeconomic performance during their tenure, even if they are not at fault, so naturally they deserve credit for good performance, even if they did not bring it about. The cyclical recovery of the 1980s was certainly welcome after the deep recession, but it was nothing unusual—definitely nothing that could be attributed to the supply-side policies of Reaganomics. Between 1982 and 1988, just as in the recovery twenty years earlier between 1962 and 1968, non-farm payroll employment increased by 22 percent. But the 1960s period saw a production increase of 31.5 percent, while in the 1980s productivity rose by only 25.5 percent. To the extent that Reagan fiscal policies contributed to recovery, it was not because they were supply-side measures but because they were demand stimuli. The same recovery could have been achieved by normal fiscal and monetary polices, with lower budget deficits and lower interest rates and without the unfortunate by-products of the fiscal and monetary policies than actually followed.
Victory over Inflation
An important beneficial legacy of the last twelve years is a stable, low inflation rate. The 1979-82 crusade was painful but successful. The subsequent recovery was achieved without escalation of inflation, which remained in the range of four to five percent per year. In 1979, no economist would have predicted that a 5.5 percent unemployment rate could be achieved ten years late without spiraling inflation. Like the period 1961-64, the period 1983-88 demonstrates that recovery from recession need not entail increasing inflation. In 1992, after three years of slowdown, recession and stagnation, inflation has fallen further to around 3 percent per year.
What were the reasons for this achievement? The length and depth of the recessions of 1979- 82, the Reagan political climate, the President’s stern treatment of striking air controllers in 1981 and the persistent challenges of foreign competition brought important changes to labor relations. Trade unions dwindled in numbers and strength as employers became more assertive. Wage concessions and “givebacks” of fringe benefits and work rules, which would have been unthinkable in the 1970s, have become commonplace. At the same time, the oil shocks that triggered inflation in the 1970s gave way to oil gluts. Relative to prices in general, gasoline is as cheap as it has been since World War II.
George Bush had the misfortune of taking office when the recovery was ending. Again, the major culprit was the Federal Reserve. The Fed was afraid that momentum from the recovery would take demand too far, overheating the economy and causing new inflation. In 1988, Chairman Alan Greenspan and his colleagues began to tighten monetary policy, and it turned out that they overdid it. After the first quarter of 1989, the real growth of the economy feel below its sustainable rate of 2-2.5 percent (normal labor force and productivity growth) and has stayed below that rate ever since. A “growth recession” evolved into actual decline in the third quarter of 1990. Apparent signs of recovery in the second and third quarters of 1991 proved to be transient. A more robust recovery may begin in 1992, but this time the first year of recovery is likely to be weaker than usual and reduce unemployment very little.
Although the state of the economy by statistical measures is not nearly as depressed as in 1982, the mood of the country is more pessimistic and much angrier. Compared to 10.6 percent of the 1982 trough, the current unemployment rate of 7.3 percent does not adequately measure the degree of distress and discontent. Despite the recovery of the 1980s, workers’ real wages have actually been declining throughout the past two decades, not even keeping up with the low rate of productivity growth. Now, in addition, their jobs are in jeopardy.
The Fed did not begin to ease the money supply until the end of 1990, and until December 1991 its actions were consistently too little or too late. The public and private debts inherited from the 1980s today weigh heavily on governments, businesses, households and financial institutions. It is by no means certain that the Fed by itself can promote a vigorous recovery in this environment. Fiscal policy—deficit spending—has in past business cycles helped to stimulate demand and to fuel recovery. An unfortunate legacy of the chronic high budget deficits of the past decade is that fiscal policy is now crippled, virtually immobilized. Neither the President nor Congress wants to increase the deficit—even to get the economy moving again.
Supply-side Policy Failure
Reaganomics was supply-side economics. The tax cuts of 1981, sacrificing about 2.5 percent of GDP, were intended as supply-side incentives that would release the shackled energies of the American people and encourage them to work harder, save more, invest more, start more entrepreneurial businesses and take more risks. The productive capacity of the economy would take off.
Supply-side claims have been proven false by experience. The “Laffer Curve” idea that tax cuts’ would actually increase revenues turned out to deserve the ridicule with which sober economists had greeted it in 1981. Net savings and investment declined to pitifully low rates. The tax incentives that were supposed to increase them were counterproductive because much of the revenue they gave away was spent in consumption. Tax incentives for real estate developments were disastrous. Coupled with ill-advised deregulation, they contributed to the collapse of federally insured savings and loan associations and commercial banks at enormous costs to taxpayers. Empty office buildings and condominiums will be haunting these markets for a decade. Tax laws, deregulation and the general climate of the era created a mania of corporate mergers, acquisitions and leveraged buy-outs; diverting entrepreneurial talent from production of goods and services to the “paper economy” and leaving in their wake many dangerously debt-ridden companies.
The Reagan recovery of 1983- 89 was largely a consumption and defense spending recovery. Although these uses took 70.2 percent of real GDP in 1978, they took 73.4 percent in 1988, a year of comparative cyclical prosperity. Consumption and defense devoured 84.8 percent of the 32 percent increment in constantdollar GDP between 1978 and 1988. Thanks to budget deficits and high interest rates, capital investment was below par. Moreover, high interest rates in the United States drew funds in US financial markets, appreciated the dollar and made US goods uncompetitive at home and abroad. Trade deficits rose to three percent of GNP, and their accumulation year after year made the United States a debtor nation. The problem remains although the trade deficit is gradually declining.
Low growth in the productivity of labor is the chronic main failing of the US economy. It transcends business cycles and slows down economic and social progress in times of prosperity as well as during recessions, regardless of whether unemployment is low or high. It is, in fact, a much more difficult malady to cure than a cyclical recession. US economy-wide productivity growth is lower than growth in Japan, in Europe and in the rapidly emerging newly industrialized economies of Asia. At 1.0 to 1.5 percent per year, it is considerably lower than the 2.5 to 3.0 percent rates we experienced in the first quarter after World War II.
The bottom line of supply-side policy is productivity growth. Although Reaganomics cannot be blamed for the slowdown that began around 1973, its well-advertised remedies were policy failures. Throughout the 1980s, productivity growth remained disappointingly low for the economy as a whole, though productivity in manufacturing began to revive under the spur of global competition. Overall, the recovery of the 1980s was not a recovery in efficiency, productivity, enterprise or competitiveness.
Growth in real wages cannot exceed labor productivity growth for very long. Recently, real wages have not even kept up. They have been stagnant or declining. The high interest rates resulting from Reagan deficits, paid by corporations on their increasing indebtedness, have apparently cut into the wage share of the national income.
During the last 12 years, consumption and defense commandeered resources that businesses and government might have used for future investments: modern plants and equipment, public infrastructure, research and development, environmental protection and education. Likewise, as a nation the United States has acquired large debts to foreigners by importing more than it exported. One consequence of below-par productivity growth is that to be competitive internationally. US citizens now must settle for a low value of the dollar and unfavorable terms of trade.
Poverty and Inequality
The most ominous threat to the nation’s future has been the persistence of poverty and the increasing inequalities of wealth, income and opportunity. Rapid progress in reducing the proportion of the population living in poverty (as measured by a constant absolute real income threshold adjusted for family size) diminished the proportion of persons living in poverty from 22 percent in 1959 to 11 percent in 1973. The major factors were the overall progress of the economy and government “war on poverty” programs. But in the prosperous year 1989, the rate was 13 percent and rising. Twenty percent of US children, and 45 percent of black US children, live in poor households. The economy-wide slowdown since 1973 is one culprit; the erosion of governmental anti-poverty transfers and programs is another.
The increasing poverty of urban neighborhoods is a national disaster. These neighborhoods are caught in a vicious downward spiral, in which each of the several pathologies accentuate the others: drugs, guns, homicide, crime, broken families, teenage pregnancies, unemployment and unemployability, ineffective schools, high morbidity and mortality. We are failing in the primary task of a civilized society: to socialize its young so as to perpetuate its civilization.
These programs are formidable, especially because they are bound inextricably to the old US dilemma—the status of black Americans. Those who do not live in poverty-impacted neighborhoods or in poverty may well prefer to ignore and to forget the victims, but they must not. While “throwing money at the problems” will not by itself solve the, neither will a failure to provide funds improve the situation. It is really up to the President to make their solution a task of the highest priority, and neither Reagan nor Bush has undertaken such leadership.
Income inequality has increased since 1980. The income share of the lowest quintile of families fell from 5.1 percent to 4.6 percent in 1989, while the share of the highest quintile rose from 41.6 to 44.6 percent. The income share of the top five percent alone rose from 15.3 to 17.9 percent. US business executives are paid much more relative to the wages of production workers than their Japanese counterparts. The affluent did extremely well in the 1980s and their taxes were cut at the same time. Their lifestyles are celebrated on TV and paraded before the poor kids who have no hope for their own lives. Can a society with such visible extremes hold together? In the United States, anarchy and mindless violence are more likely reactions than organized political revolt.
The Lack of Public Funds
The public sector is impoverished. A principal objective of Reagan and his conservative supporters was to deprive government of budgetary resources. They succeeded. The federal deficits generated by their tax cuts and defense spending still inhibit civilian spending.
Reagan and Bush flourished politically by cutting taxes and by promising never to raise them. They could not quite keep that promise, but they made it politically impossible for Democrats in Congress or Democratic presidential aspirants to propose tax increases that a Republican president would veto. The US government taxes its people less than any other major capitalist democracy. “Peace dividends” made possible by the end of the Cold War might be expected to relax budgetary stringency, but the Pentagon and the Bush Administration resisted substantial cuts in military spending by ingeniously discovering new threats in the world. In these hard times, they gain allies from politicians in the constituencies that are most dependent on defense contracts. In any case, there is great political pressure from the Republican right to use peace dividends for still further tax cuts in addition to understandable pressure from financial circles and from economists to use them to reduce the deficit. There may be nothing left for other claims, domestic or international, on the United States’ resources.
After paying for defense, debt interest and veterans’ benefits, 1978 federal receipts (other than payroll taxes and contributions earmarked for social insurance) were sufficient to pay for nondefense discretionary programs equal to 5.4 percent of GDP. Ten years later this figure had declined to 2.1 percent. The actual nondefense discretionary outlays were larger by the amounts of deficit spending in the two years, 2.2 percent of GDP in 1978 and 3.2 percent in 1988. Current five-year federal budget projections hold little hope for increasing discretionary spending, domestic or international, as a proportion of GDP even though the 1997 deficit is projected to be no lower than 3.0 percent of GDP and the defense share of GDP is supposed to decline by 3.0 percentage points.
The civilian public sector is mainly the province of states and local governments. Their finances are fiscal disasters. National and local economic difficulties have cut their revenues and increased the need for their social services. The federal government has assigned them greater responsibilities while cutting back their grants in aid. Reagan-Bush demagoguery on taxes has infected state and local politics and hamstrings those governments as well. Altogether, this wealthy country pleads “lack of funds” in the face of the host of domestic needs neglected since 1980. Among them are public investments in education, research, transportation, infrastructure, and environmental protection. These are important for future productivity. It is false economy to sacrifice them either to deficit reduction or to the politics of “no new taxes” or to interest groups benefiting from wasteful government expenditure or tax privileges.
Leadership does not mean being number one in some world economic Olympics. Japan and Germany do not threaten us by competing with our automobile or electronics industry or by having now or in the future (by some measures) higher wages or higher standards of living. Their success should be a matter of pride for us since it began with the humane and far-sighted assistance we gave them after World War II and continued under the international trading and financial institutions we took initiatives to establish.
The United States needs to accelerate its productivity, not because other countries have become more productive but because we will be better off ourselves. Faster productivity growth will make us more competitive, it is true, but we would want it for its own sake even if we were not having problems in foreign trade.
The United States after World War II found the resources to live up to its stature as the leader of the world. Today we are again, geopolitically and militarily, the unchallenged world leader. But our own political leaders, unlike the statesmen of 1940s and 1950s, have turned this nation economically into a pitiful, helpless giant, incapable of finding the funds needed to help democratic reforms and economic reconstruction in Eastern Europe and the former Soviet Union or to take any other initiatives toward a “new world order.”
Our country’s commitment to free trade has been the casualty of our trade deficits in the last twelve years, thus a casualty of the fiscal and monetary policies that led to such large and persistent deficits. Some Congressional Democrats, abandoning the historical position of their party, became outright protectionists. Presidents Reagan and Bush, while talking free trade, have actually multiplied our non-tariff barriers to imports competing with domestic businesses and our unilateral retaliations and threats against foreign competitors and their governments. We are on the edge of a trade war with Japan and Europe. The United States should instead be leading the world to a new regime of internationally agreed upon and respected rules of the game.
Note from the Editor
Tobin stands firmly on the Keynesian side of the debate as a strong opponent of Reaganomics. As Laffer was to Reagan, Tobin was a key member of President Kennedy’s Council of Economic Advisors, and served on the Board of Governors of the Federal Reserve. Although he is now remembered for his idea of the ‘Tobin Tax’—a tax on foreign exchange transactions designed to maintain stability in potentially volatile markets, which has gained traction following the 2008 financial crisis—many of the ideas he discusses in this article, such as rising inequality and growing US discontent with international trade, remain relevant today.