Ronald Reagan: Supply-Side Economics

Ronald Reagan’s landslide victory in the 1980 election and the dramatic shift in power in Congress—particularly in the Senate—to the Republicans provided both a mandate for change and the coalition to realize it. As soon as the Reagan administration was formed, it moved swiftly to implement Reagan’s economic campaign promises. These centered on a large tax cut achieved by lowering marginal tax rates (especially for very high incomes), elimination of the federal deficit, a reduction in the role of the federal government in terms of spending and regulation, and a buildup of the armed forces.

Once again, a new school of economic thought was influential in altering the course of economic policy. “Supply-side” economists such as Arthur Laffer argued that high tax rates were inhibiting growth. Lowering rates would give people more incentive to work, invest, and innovate. Lowering rates would even produce more tax revenue by expanding the tax base, thus helping to balance the budget. The relationship between tax rates and tax revenues became known as the Laffer curve: Over some range, raising rates would increase revenues, but at some point, additional increases would reduce work effort and increase tax evasion; then total tax revenue would fall. Laffer and other supply-siders believed that the economy reached that point. Although most economists agreed that high tax rates tended in some degree to discourage productive effort—this is after all Economic Reasoning Proposition 3, incentives matter—many doubted that the effects of cutting rates would be as large as the supply-siders thought. In the campaign for the Republican nomination, George Bush, then Reagan’s rival, spoke for many economists and ordinary citizens when he denounced the idea of balancing the budget through tax cuts as “voodoo economics.” After Reagan’s election, Congress moved swiftly to reduce income taxes and other taxes by 23 percent over a three-year period, but reductions in spending were much harder to achieve. As David A. Stockman, who was in charge of planning the spending cuts, tells us in his memoir, The Triumph of Politics (1986), even the most commonsense cuts were strongly resisted by an “iron triangle”: the beneficiaries of government spending, the government bureaucrats who administered the program, and the members of Congress who were beholden to the beneficiaries.

Tax cuts, the failure to make extensive spending cuts, increases in the military budget, and the recession (which also reduced tax revenues) produced deficits in the federal budget unprecedented in peacetime. Table 28.3 reveals both the acceleration of growth in the deficit under President Reagan and the long-term nature of the problem. As Table 28.3 shows, the deficit reached 5.1 percent of GDP in 1985, a peacetime record, and remained a high, although declining, proportion of GDP for the following decade.

What were the consequences of such deficits? Some economists predicted that large federal deficits would lead to skyrocketing real interest rates (the market rate less inflation) because deficits meant that a much-augmented demand for credit would face the same supply. But the supply of credit proved more elastic than had been anticipated. Foreign lenders rushed into the U. S. market, purchasing government bonds, private securities, real estate, and other assets. Real interest rates did not rocket upward, and the dollar remained strong (worth a large number of units of foreign currency) despite a growing gap between exports and imports. There was always the possibility that foreign lenders would some day lose confidence in the U. S. economy, but the “day of reckoning” proved to be longer in coming than many had expected.

There was, then, much concern about the federal deficit when President George H. W. Bush took office in January 1989. During the campaign, Bush had promised to

TABLE 28.3 THE FEDERAL GOVERNMENT'S SURPLUS ( + ) OR DEFICIT (-), SELECTED YEARS

Source: Economic Report of the President, 2012. Http://www. gpo. gov/fdsys/pkg/ERP-2012/content-detaii. htmi

Alan Greenspan was appointed chairman of the Fed Board in 1987. His deft handling of monetary policy was given much of the credit for the economic expansion of the 1990s.

Ben Bernanke replaced Alan Greenspan as chair of the Federal Reserve Board in February 2006. An academic economist famed for his studies of the banking crisis of the 1930s, Bernanke faced the real thing when a severe financial panic hit in 2008.

Continue Reagan’s policies and laid down the gauntlet to the Democrats by declaring, “Read my lips: no new taxes.” He abandoned this pledge, however, when the recession of 1990 and 1991 helped drive the budget deficit higher. The deficit was still a major issue when Bill Clinton took the oath of office in January 1993. Rapid economic growth, however, solved the problem. By 2000, as Table 28.3 shows, there was a large surplus and the new worry (that proved to be fleeting) was how to spend the surplus rather than how to pay for the deficit.