OT - Why Reagan's 1981 tax cut was not what caused the 1983 recovery
- From: "Mr Soul" <google@xxxxxxxxxxxxxxx>
- Date: 17 Oct 2005 15:20:18 -0700
Since you took your car in, it steers more precisely and absorbs
potholes better. "It's the alloy wheels," says the dealer who talked
you into buying them. Yet you also got new shock absorbers, springs,
and tires. How can he prove that the wheels made much difference?
Claims about the 1981 Reagan tax cut face the same problem. The tax
reform had good features, such as indexing tax brackets to inflation.
And top marginal rates had been too high at 70% (even if Reagan went
too far in cutting rates - more on that later). But what about the big
claim - that the "supply-side" effects of the tax cut caused the
economic surge that followed, from 1983-89?
The evidence undermines it. The cuts played a small part in spurring
the expansion, not a leading role. The real stars were other economic
factors that improved markedly during the era. And as we'll see later,
evidence shows that the contribution the cuts did make had nothing to
do with supply-side theory. Here are six things that really mattered to
the recovery:
1. Business cycles go down and up David Stockman, Reagan's director of
the Office of Management and Budget and a key architect of Reaganomics,
didn't think the tax cut caused the growth of the 1980s. He wrote,
"There was nothing new, revolutionary, or sustainable about this
favorable turn of events [the growth of 1983-89]. The cycle of boom and
bust had been going on for decades and ...its oscillations had reached
the high end of the charts. That was all." [The Triumph of Politics, p.
377.]
Business cycles - the growth-bust cycle Stockman referred to - have
oscillated, if irregularly, since the dawn of capitalism. They swung
more widely than usual during Ronald Reagan's first term. The term
began with the worst recession since World War II, but Stockman has
good reasons to say that it would have ended without the 1981 tax cut:
most economists agree that this recession was caused and ended mainly
by Federal Reserve policy, as I'll explain next. And it is typical of
business cycles that the quickest growth comes right when the recovery
starts, so we should not to be impressed by the zippy 7.5% growth in
1983, the year of the rebound. That kind of catch-up growth usually
follows recessions, as idled factories and laid-off employees get to
work again. Since the 1981-82 recession was exceptionally bad, the
rebound was likely to be extra strong with or without a tax cut.
Still, just referring to "business cycles" doesn't actually explain
much by itself. Business cycles are not a force of nature; they have
human causes. Economists have argued about these causes for a long time
(see this excellent survey). It is becoming increasingly clear that
there is by no means just one cause; both sides of transactions -
selling and buying, or "supply" and "demand" - can pull the economy up
and down. As we'll see, both sides contributed to the Reagan cycle.
2. Paul Volcker slays inflation and slashes interest rates The key
"supply-slide" cause of the Reagan recession and boom, to which
Stockman does give some credit, was the inflation-beating strategy of
Paul Volcker, chair of the Federal Reserve Board from 1979-87. In 1981,
Volcker curbed the growth of the money supply, which pushed interest
rates to levels not seen since the Great Depression. The "effective
Federal Funds Rate" (below 6% in 1977) soared, sometimes to around
20%.4 A recent textbook calls Volcker's policy the "well understood"
cause of the recession early in Reagan's term.
Why such a draconian Fed policy? Because Volcker focused on slaying
what he called the "dragon" of inflation, which had scorched the
country throughout the 1970s. The inflation rate hovered between 5 and
10% for most of the decade, hitting double-digits twice. Volcker
believed that "the economy will work better, more efficiently, and more
fairly, with better prospects and more savings, in an environment of
reasonable price stability." Price stability is "a situation in which
ordinary people do not feel that they have to take expectations of
price increases into account in making their investment plans or
running their lives." (Volcker and Toyoo Gyohten, Changing Fortunes, p.
177-79). When Volcker came to office, there had been no price stability
for a long time.
Volcker's tight money slew the inflation dragon, but at a cost: an
economic slowdown, then called the "Volcker Recession." With interest
rates so high, banks rationed credit, businesses wouldn't borrow to
invest, and residential investment fell by 40% - who would invest in
housing when a 30-year fixed mortgage cost 18.5%? Unemployment reached
almost 11%, and consumer spending on "durables" (like appliances and
cars) plummeted.
In later 1982, with inflation down, Volcker decided to ease up. The Fed
Funds Rate dropped below 9% by the end of 1982, and below 6% by
mid-1986. Inflation-adjusted interest rates (the ones that matter to
businesses) remained high until the mid 1980s, partly because of the
high borrowing by the US government discussed below. But rates
gradually dropped through the mid-1980s. As mortgages finally became
affordable, people bought housing - so much of it that residential
investment rose by a stunning 46%. Housing is what led the 1980s boom.
And Volcker's policy gave America the price stability he'd sought.
Inflation settled in at around 3%. America's renewed sense of
stability, says Volcker, laid "the essential base" for the recovery of
the 1980s.
Paul Krugman writes that the Reagan expansion "should be called the
Volcker expansion." (Peddling Prosperity, p. 122). Volcker was
appointed not by Reagan, but by Jimmy Carter. Admittedly, Carter chose
Volcker without realizing what he was getting into; and Reagan deserves
credit for letting Volcker proceed even after it was obvious what he
was up to. But Reagan's admirers still have to admit that the inflation
battle was won by a Carter appointee - and that faster money growth
(after the slowdown) and lower expectations of inflation were the real
bases of the 1980s boom, and were not caused by the tax cuts.
3. Oil prices come back to earth Did anything else affect the economy
during this period? Yes - so many that even conservative economists
have sometimes admitted that too many factors were at work to support
the simple tax-cut claim.
One supply-side variable was oil. You need it to produce or transport a
huge range of goods. That's why since World War II, whenever oil prices
have risen by 60% or more, a recession has almost always followed.
Research has shown that other forces can't account for this effect.2
How does this apply to the Reagan era? From 1978 to 1981, the
inflation-adjusted US price of crude oil doubled.3 In terms of 2005
dollars, it went from about $40/barrel to $86/barrel. The spike was
largely caused by revolution and war in Iran and Iraq, which greatly
reduced the oil supply.That spike came on top of a previous quadrupling
of oil prices during the Arab oil embargo of 1973. In the 1970s and
early 80s, few things could stress the economy like a spike in oil
prices, and few things could bring relief like oil prices coming back
to earth, as they did during Reagan's presidency - a 33% real decline
between 1981 and 1983. By 1986, when the OPEC oil cartel collapsed,
prices bottomed at about $20/barrel (in 2005 dollars). Lower oil prices
were a "supply side" economic boost to the economy - and they certainly
did not result from Reagan's tax cut.
To Reagan's credit, the January, 1981 deregulation of gasoline prices
did help reduce US gasoline shortages. This deregulation removed
ill-considered price controls that had been imposed during the Nixon
administration in response to the Arab oil embargo - and Reagan gets
credit for wisely going along with Congress on removing this control.
But doing so didn't increase world supply; all it did was improve the
incentives of gas stations to supply gasoline to motorists. We can't
credit the end of the oil shock to this policy any more than to the tax
cut.
4. A "financial revolution" makes it easier to fund and grow a business
Another piece of the puzzle - a big one - is that financing a business,
and giving it entry into markets, became significantly easier.
University of Chicago economists Raghuram Rajan and Luigi Zingales
speak of "a veritable revolution"(5) in finance. As Rajan writes in a
recent paper, "People can borrow greater amounts at cheaper rates than
ever before, invest in a multitude of instruments catering to every
possible profile of risk and return, and share risks with strangers
across the globe." New methods of sharing and isolating risk have made
it easier for lenders to take it on. The raising of capital is far more
likely to be at "arms-length," depending less on personal connections
and family advantages. These changes especially benefited small and
young midsize firms, giving them much more access to funding than ever
before. In addition, deregulation made it much easier for new
businesses to enter markets that were previously protected.
There is no doubt that this revolution has reduced the volatility of
economic growth since the 1970s. So why did the revolution take place?
Rajan lists three main forces: technical change (which greatly reduced
the costs of computation and communication); institutional change,
which "created new entities within the financial sector such as private
equity firms and hedge funds, as well as new political, legal, and
regulatory arrangements"; and deregulation, which "removed artificial
barriers preventing entry, or competition," thus giving new firms more
access to markets.
The three forces interacted with each other. For example, as Rajan
writes, "Information technology improved the ability of banks to lend
and borrow from customers at a distance" - a development which forced
states to rescind regulations protecting local bank monopolies. States
that did relax such rules had faster economic growth than states that
continued to protect their banks. New financial realities also led to
the collapse the system of government-controlled international exchange
rates, the Bretton Woods agreement, in 1971. In 1973, US policy began
to favor the free cross-border capital transactions that had proved
impossible to control in any case. The resulting freer international
flow of capital made it more difficult for governments to support
cartels or subsidize large incumbent firms - as they previously had
done, with policies that had reduced competition and innovation.
None of these forces result from Reagan or his tax cuts, and indeed all
began before Reagan. (Click here for three examples of pre-Reagan
governmental changes that contributed to the financial revolution.)
Consider deregulation. The Wall Street Journal may give credit for
deregulation to Reagan, but he deserves far less of it than Carter. In
1978, Carter deregulated the trucking and railroad businesses. His
administration also deregulated, or started deregulation of, airlines,
telephones, natural gas, and interest rates. Trucking and railroads had
been regulated monopolies, with very high barriers to entry for new
competitors, so that incumbents could get away with providing poor
service at high prices. Transportation was a key element of the economy
- it let firms get their goods to markets - so deregulation made an
economic difference. But Reagan wasn't behind it.
To give more credit for deregulation to Carter than to Reagan is not
"liberal." According to William Niskanen, a conservative economist who
was a member of Reagan's Council of Economic Advisers and later
chairman of the Cato Institute, deregulation had the "lowest priority"
of all the items on the Reagan agenda; the administration was not
"willing to sustain the momentum for deregulation." Not that the
momentum Niskanen speaks of came from the vision of Carter. Larger
trends were at work - the three forces Rajan spoke of, not to mention
growing research showing that the costs of regulation were higher than
was previously understood.
All of this would have happened, then, without Carter - and without
Reagan.
5...6... "Demand-side" factors Many other factors contributed to the
growth of the 1980s, notably the "demand-side effects" of the tax cut,
which I'll discuss next. Increased defense spending by the Federal
government also boosted "aggregate demand" in the US economy.
.
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