Reflections on Reaganomics
Morning in America?
In my last post, Exploring the Volcker Legacy, I probed the performance of Paul Volcker, the last Fed chair before Jay Powell to have battled significant inflationary pressures in the US economy, a topic discussed in William Greider’s 1987 book Secrets of the Temple. The Greider book was excellent, and I recommend it to students interested in the Fed, but this wasn’t the work for which the author was best known. Greider, who died a few years ago, wrote about American politics and economics for over four decades and was best known for an explosive article published by The Atlantic magazine in December 1981, The Education of David Stockman. I have had the opportunity recently to re-read this rather long article (18,000 words) and I recommend it to anyone who wants to understand what was really going on with respect to economic policy (and the related politics) in the early years of the Reagan Administration. (The Atlantic essay also appears in book form, with some additional material, which I also recommend.)
The Education of David Stockman was based on a series of interviews Greider conducted over several months with newly elected President Reagan’s young (35-year old) Director of OMB, David Stockman. Greider’s Atlantic article was a bombshell when it hit the newsstands, exposing publicly some of the unspoken truths underlying (and undermining) key tenets of President Reagan’s economic plan. Publication of the Atlantic article almost cost Stockman his job, and probably should have. In the article, Stockman was quoted as saying that Reagan’s “supply side” economic theories were little more than a “Trojan horse” for getting Congress on board with Reagan’s “trickle down” tax cuts targeted to upper income taxpayers. He also said that “no one really really understands the numbers” behind Reagan’s balanced budget forecasts, which isn’t the sort of admission one expects to hear from the Director of OMB. Despite his indiscretions, however, Stockman somehow survived four more years as Reagan’s budget czar, a testament to Stockman’s talent and indispensability but also perhaps to Reagan’s own forgiving nature.
In my last post, I wrote in some detail about monetary policy at the Volcker Fed, but I did not say much about the fiscal policies being pursued by the Reagan Administration. Monetary and fiscal policy generally work best when they are well coordinated and work together to achieve a common set of consistent economic policy objectives. But this was far from the case under the Reagan Administration, where the various planks of Reagan’s economic policies were not always internally consistent (as noted by Stockman) and where Reagan’s fiscal policies often clashed directly with Volcker’s monetary policies, which limited the economic efficacy of each.
[The tension between Volcker’s tight (constrictive) monetary policy and Reagan’s loose (stimulative) fiscal policy also raises broader questions about what we mean by central bank “independence” and why it is that we think having an independent central bank is such a good idea. This is an interesting and important topic which perhaps I can come back to in subsequent posts. In the meantime, if you are interested you can begin your reading here and here.]
But what do we mean by Reaganomics and why is this subject still so topical today? Let’s explore.
The four pillars of Reaganomics. President Reagan’s initial economic plan, his 1981 Program for Economic Recovery, had four major policy objectives: (1) reduce the rate of growth of government spending, to be accomplished in large part by cutting social welfare programs; (2) reduce the marginal tax rates on income from both labor and capital (top individual marginal tax rates on investment income were at 70% when Reagan took office, with 50% top rates on employment income), (3) reduce burdensome regulation of business, including financial regulation; and (4) reduce inflation, by managing the growth of the money supply (rather than directly targeting interest rates). As articulated, Reagan’s economic plan was intended to achieve a number of complementary results: increase the amount of aggregate saving and capital investment; increase economic growth; balance the federal budget; and reduce inflation and lower interest rates.
Accomplishing all of these objectives in one or two presidential terms would have been quite a feat to pull off even in a benign economic environment with control of Congress and a supportive Fed, but this was not the state of play during much of Reagan’s time in office. (Reagan depended on the “boll weevil” or “blue dog” Democrats for critical support of his early legislative accomplishments.) Nevertheless, the President and many of his followers genuinely believed that most or all of these objectives could be accomplished over time if only they could get the government off people’s backs, stimulating individual initiative and freeing up the latent power of the US economy suppressed during the prior decades of more activist government. As President Reagan liked to say, “Government is not the solution to our problem. Government is the problem.” (Reagan slogan tee shirts available here).
Supply Side (aka Voodoo) Economics. The articulated link between Reagan’s various policy objectives and the expected (hoped for) economic outcomes was the widely promoted (and often misunderstood) concept of “supply side economics”, a political slogan masquerading as economic theory. As Beltway legend has it, the essence of the supply-side argument, as understood and articulated by President Reagan in the context of tax policy, was based on little more than a conceptual diagram drawn on a restaurant napkin by the economist Arthur Laffer. This is a story which I always thought was apocryphal, but which is apparently true, and the infamous Laffer Curve Napkin now resides at the National Museum of American history, which is probably where it belongs.
Supply side economics postulated that tax cuts for the wealthy (as proposed by Reagan) would generate increased savings and investment that would stimulate the overall economy to the eventual benefit of lower income individuals, in the process generating increased tax revenues and reducing federal budget deficits. Those of you who have studied the Great Depression may recall the phrase “trickle down theory” from the Coolidge administration in the 1920s, which the comedian Will Rogers famously likened to “helping the birds by feeding the horses”. (After being accused of political bias in his commentary, Rogers retorted that he was not a member of any organized political party, he was a Democrat.) In his Greider interview, David Stockman said that supply side economics was just another name for trickle down theory, with across the board tax cuts used as a “Trojan horse” to get Congress on board with cutting the top marginal rates for the wealthiest taxpayers, which was Reagan’s primary objective. But of course Stockman’s comments. became public only after the supply side Trojan horse was already inside the Congressional gates. (Reagan signed the Economic Recovery Tax Act in August 1981, several months prior to publication of the Greider article.)
As you might imagine, Reagan’s economic plan was quite controversial at the time, and not only among Democrats. Candidate Reagan’s primary political rival in the Republican Party, George H.W. Bush, famously referred to Reagan’s plan as ‘voodoo economics’, a quote he was never able to disown even after becoming Reagan’s VP. And as a presidential candidate himself eight years later, Bush made a play for Reagan voters with his own no tax pledge (“Read my lips: No new taxes”), a pledge which he (like Reagan) was forced to break before the end of his one term in office.
Conflicts between the Reagan White House and the Volcker Fed. As recounted in Greider’s book, the monetary policies pursued by Volcker often conflicted with Reagan’s fiscal policies (and vice versa), much to the dismay of both the Reagan White House and Volcker’s Fed. Much of this conflict related to the continuing high level of interest rates on the one hand and the large and growing federal budget deficits on the other, which were of course not unrelated. Short-term interest rates peaked at 20% or so early in Reagan’s first term and nominal 10-year UST bond yields were still (or again) at 10% (and real rates at 5%) by the end of Reagan’s second term, with large and growing fiscal budget deficits unprecedented in peacetime and an exploding federal debt run up during each of Reagan’s eight years in office. (See the historical data here, here, here, here and here.)
Very few Presidents take kindly to the Fed increasing interest rates during their terms of office, particularly in election years, and few Fed chairs are keen advocates of large fiscal stimulus programs during inflationary times. And this was certainly true during the Reagan era, as recounted by Greider. But the high level of interest rates under Volcker was particularly problematic for President Reagan and his team, which had promised not only to defeat inflation while growing the economy, but also to reduce annual deficits while cutting taxes and increasing defense spending. High interest rates and restrictive credit expansion are not generally conducive to strong capital investment, real economic growth or deficit reduction, and the Reagan years were no exception. As a result of Volcker’s monetary policy, the US economy went into a deep recession early in Reagan’s first term, with the unemployment rate peaking at 10% before recovering gradually over the balance of Reagan’s time in office. (See the data here.)
Volcker’s high interest rate policies also drove up the foreign exchange market value of the US dollar, which increased by 50% or so from 1980-85. (Here is the graph of USD-JPY spot rates, with somewhat different dynamics.) Although the Reagan Administration initially supported the rising value of the USD—it considered a strong dollar policy as patriotic—the rising FX value of the US dollar caused many US export industries to become internationally uncompetitive, exacerbating longer-term trends, and made the US increasingly reliant on foreign capital flows to fund the growing current account deficit.
The Reagan Administration abruptly reversed course on its strong dollar policy in September 1985, when the US signed an international agreement with its major trading counterparts to act collaboratively to weaken the market value of the US dollar, an agreement known as the Plaza Accord. (The agreement was signed at the famous NY City hotel, a few years before it was purchased and quickly bankrupted by Donald Trump.) The Plaza Accord had its intended effect on the market value of the USD, but failed to reverse much of the economic damage already caused to parts of the US economy and had little apparent impact on the growing and very consequential trade deficit with Japan, which thereafter suffered from its “lost decade” of sluggish economic growth and deflation.
Was Reaganomics Successful? The answer to this question depends I suppose on how one defines success, what one thinks the various counterfactual scenarios might have been and how one thinks about the impact of Volcker’s monetary policies relative to Reagan’s fiscal policies. But here are a few observations for your consideration:
First, Volcker’s Fed was clearly successful in the war on inflation, albeit at a high cost, setting the stage for several decades of moderate economic growth with little or no inflation in the price of goods and services consumed in the real economy. This is the so-called Great Moderation that some of you will recall from reading Bernanke and which is still very much a celebrated part of Fed lore.
Second, Volcker’s victory in the war on inflation did bring down the nominal level of interest rates, and eventually real rates. The big drop in interest rates had many economic benefits but also triggered a long period of inflation in the price of financial assets, including stocks and bonds, and a massive transfer of wealth from debtors and workers to creditors and investors.
Third, although the US economy did bounce back strongly following the recession of 1981-2, it is not clear that Reagan’s tax cuts had any major positive impact on longer-term capital investment or economic growth—despite what supply side theory predicted—although again this conclusion depends on what one thinks the counterfactuals might have been. Suffice it to say however that with the exception of the two recession recovery years of 1983 and 1984, real economic growth during Reagan’s eight years in office was empirically unexceptional by the standards of previous or subsequent decades. (See the data here and here.)
Fourth, Reagan not only failed to balance the budget, an accomplishment that was achieved subsequently by Democratic President Bill Clinton, his large and growing annual deficits increased the federal debt substantially more in relative (not absolute) terms than occurred under any of his Republican or Democratic predecessors or successors, including those who financed the Vietnam War and the Great Society programs, suffered through the 1970’s oil embargoes, or who had to deal with the fallout of the 2008 global financial crisis or the 2020 covid pandemics. (See the data here, here and here.) The exploding fiscal deficit under Reagan was in part the result of Volcker’s sky high interest rates and the Fed-induced economic contractions, but Reagan’s large tax cuts and defense spending increases were also major contributors.
Fifth, Reagan’s economic policies do not appear to have significantly reduced the rate of growth in federal government spending, due to Reagan’s massive increase in defense spending, strong Congressional (and public) pushback on Reagan’s proposed cuts to social programs (including Social Security and Medicare), the impact of high interest rates on the cost of federal debt service, and the operation of automatic stabilizers during the severe recession early in Reagan’s first term. (See the data here.)
And so the impact of Reagan’s economic policies on the real economy during his time in office would seem to have been ‘mixed’ at best, particularly if we attribute the victory over inflation more to Volcker rather than to Reagan. But this does not mean that Reagan’s economic policies were not impactful in a broader context, particularly when viewed over a longer time horizon, or that the Reagan Administration’s legacy was not significant. In fact one can make the case that Ronald Reagan was the most consequential modern President since FDR, for better or worse, and his legacy is still very much with us today.
The Reagan legacy. The success of US presidential administrations is often judged by voters in real time with reference to the current state of the economy. As campaign strategist James Carville famously advised his client, William Jefferson Clinton: “It’s the economy, stupid”. But whatever one thinks about voter rationality in elections, this is a pretty poor basis on which to judge historically the overall success of any given presidential administration, including Reagan’s.
More than any other President in recent US history (since FDR), Ronald Reagan changed the parameters within which we debate and formulate economic policy in this country. Reagan’s economic platform of low tax rates, strong defense spending and reduced government regulation won over large swaths of the American population—not just the Tea Party nutters—and is now considered mainstream by the majority of elected officials in this country, certainly those in the Republican Party, even if the meaning of these goals and the best methods for achieving them remains hotly contested between and within the two major political parties.
And this is true even though much of Reagan’s economic policy consisted of smoke and mirrors, as conceded by David Stockman, and much of we now refer to as Reaganomics is more myth than reality.
But politics is about much more than economics—a lesson we are reminded of daily on Fox News and MSNBC—and it is in some of these non-economic areas that Reagan had perhaps his greatest long-term impact, for good or ill. To select just two examples, think about how Reagan influenced the trajectory of the Cold War and how he laid the basis for our current Supreme Court. Bill Clinton would perhaps not have had his ‘peace dividend’ (a slogan popularized by GHW Bush and Margaret Thatcher) but for Reagan’s bellicose rhetoric and increased defense spending, although the true story of the collapse of the Soviet Union is obviously more complicated than this. And we would not likely have the Supreme Court we do today had Ronald Reagan not appointed to the bench my old University of Chicago Law professor and Federalist Society favorite, Antonin Scalia. (Followed of course by GHW Bush’s fateful appointment of Clarence Thomas, a move he greatly regretted in later years). And however you might feel about these two topics, defense spending and the Supreme Court, I think we can probably agree that Reagan’s actions were historically very consequential.
Yes, I know, Reagan routinely lied to the American people, committed illegal and impeachable offenses in conjunction with the Iran-Contra scandal, laid the basis for much of today’s culture wars, and appeared to be largely non compos mentis by the end of his second term. And much of what he did or attempted to do on the domestic front was at the time hugely unpopular with the American public, often targeting our most vulnerable citizens and throwing fuel on the fire of racial and class animosity in this country.
For many Americans today, however, the Reagan years were perfectly captured in this 1984 campaign ad, “It’s Morning Again in America” . (Please watch it!) The Reagan era, they say, was a great time to be an American, with inflation defeated, interest rates cut in half, Americans going back to work and several generations of (mostly white) folks joining together once again to raise the American flag with pride. But for many others, the Reagan era meant years of high and often permanent unemployment, the shuttering of large sectors of the US economy, the destruction of many working class communities, growing income and wealth inequality, and continuing racial discrimination and insensitivity.
From the perspective of the financial services industry, the Reagan years were not only the beginning of a decades-long bull market but also the go-go days of hostile takeovers, junk bonds, insider trading and the leveraging up of corporate America. During the Reagan years we experienced the failures of the Penn Square and Continental Illinois banks, the Latin American debt crisis and the collapse of the US savings and loan industry (along with the criminal conviction of close to 1,000 S&L executives). This was also the period in which Wall Street firms shifted from private to public ownership, often with disastrous impacts on their firm cultures, risk management practices and business ethics. Much of this was memorably captured in popular culture, as in Gordon Gekko’s ‘greed is good’ speech from the film Wall Street and in the books Barbarians at the Gate, Bonfire of the Vanities, Liar’s Poker and The Predator’s Ball. The 1980s were I suppose a good time to be working on Wall Street, but perhaps not so much in corporate American or on Main Street.
I came of age during the Reagan era and many of my college and law school classmates went to work in the Reagan Administration, some of whom (like David Stockman) ended up in positions of great authority at improbably young ages, a continuing DC phenomenon which should give us all pause for concern. This was also the period when I bought my first home (mortgage rate 13.5%) and began to work in private equity law (annual starting salary $30,000) and then in investment banking (a bit higher). And my personal and professional memories of this era, faded thought they may be, are entirely consistent with all of the various conflicting perspectives described above. When I left college in 1978, America looked very different than it did just ten years later, and much of this change had a lot to do with Ronald Reagan, for better and/or for worse.
Heritage is not history, myths are not men and we should not confuse pageantry with the hard act of governing responsibly. But there are times when ‘great’ individuals really do change the course of history, and Ronald Reagan I think was one of them.
Links:
The Education of David Stockman, The Atlantic, December 1981
President Reagan’s Program for Economic Recovery, White House Report, February 1981
Reaganomics, Econlib, Niskanen 1988
International Report: A Year After the Plaza Accord, NY Times, September 1996
The Dollar’s Wild Ride, Gilpen NY Times, June 1998
The Plaza Accord 30 Years Later, Frankel NBER Working Paper 2015