ECN202: Macroeconomics1980s: Reaganomics

The Return of the Conservatives"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. "

1980s1980sIt was a bad decade – bad enough the voters turned to a peanut farmer and a B-rated former actor to lead the country in the presidential elections of 1976 and 1980. The culprit was stagflation and it marked the end of the line for liberal Keynesians and the reemergence of conservatives as the ideological pendulum swung back to the right where it had last been in the 1920s. The updated version of their policy was supply-side economics and Margaret Thatcher brought it the the UK and Ronald Reagan brought it to the US. There is considerable disagreement on the record of Thatcher & Reagan, but all can agree Reagan changed the trajectory of the US, just as Thatcher did in the UK. Under Reagan union membership began a death spiral with manufacturing jobs disappearing as globalization flattened the world, the deregulation of industry accelerated, he reversed the decline in military spending since the end of the Vietnam War, immigration increased with more of it coming from Mexico, and the gap between the rich and the rest was widened by his tax cuts. We’ll start with some headlines from the 80s.

In the newsIn the news

1. “DESPITE the rise in the unemployment rate to 6.2 percent of the labor force in December from 5.8 percent in November, it is still not clear that the recession has arrived.” 1980

2. “President Carter's comprehensive anti-inflation program, with its heavy stress on monetary and credit restraints, increases the likelihood of a steep recession later this year,” 1980

3. “Dow Sinks 19.71 Points; Volume Up; Drop Attributed To Rising Rates, Recession Fears” 1980

4. “Deep Recession Foretold At Economists' Meeting; Deep Recession Foretold” 1980

In the newsIn the news

5. “House Passes Bank Bill Ending Some Ceilings on Interest Rates” 1980

6. “High Interest Rates Blocking Sales” 1980

7. “Mortgages: A New Ball Game?; Flexible-Rate Plan Alarms Consumers Mortgages: A New Ball Game?” 1980

8. “17 % Mortgages Are Set on Coast” 1980

9. “Almost one-third of the nation's 3,120 savings and loan institutions lost money last year” 1988

10.“Deregulation Has Gone Too Far, Many Tell the New Administration” 1988

11.“F.D.I.C. Takes Over 47 More Savings Units” 1989

In the newsIn the news

12.“THE central dilemmas of economic policy today continue to be those that drove the Carter Administration out of office: Can we revitalize the economy, raise productivity, reduce unemployment, while at the same time reducing the stubbornly high inflation rate.”

13.“Spain's Daring Experiment In 'Supply-Side Socialism’” 1989

14.“WAS the economic recovery of 1983-84 the result of the Reagan Administration's supply-side policies or of the Keynesian stimulus resulting from big budget deficits?”

The macroeconomic setting

Ronald Reagan was unable to unseat a sitting president because of the sorry state of the economy that you can see in the following graphs. Take out that pad of paper and make notes on the situation facing the nation when it elected Reagan as president.

Confidence was down

Confidence in US industry down = drags down stock prices

Fear was in the air

Fear evident in the spike in gold’s price

Federal government was growing

Outlays

Receipts

Budgets were not balancing

Those persistent deficits

Inflation rate was up

Inflation up

Interest rates were up

Pushing interest rates up

Wages down

Inflation-adjusted wages falling

The malaise turns ugly

Misery Index (inflation + unemployment rates) soaring

The Ideological shift

The “revolution”

Reagan in USThatcher in England

“We want a society where people are free to make choices, to make mistakes, to be generous and compassionate. This is what we mean by a moral society; not a society where the state is responsible for everything, and no one is responsible for the state.”

“If you just set out to be liked, you would be prepared to compromise on anything at any time, and you would achieve nothing.”

Thatcher: in her words

“Thirty years ago [written 2009], over-regulation, over-taxation, mis-regulation, statism, state corporatism, and economic folly, cosiness and regulatory capture, and a crescent ideological enemy without, who were assisted by enemies – both fifth columnists and useful fools – within, had led to a crisis of confidence in the West, and in all lands that – and amongst all peoples, particularly those who were oppressed in their own lands, who – loved and desired liberty. Of course, thirty years ago, Britain had Margaret Thatcher to turn to.”

“What I said was Britain was ready for another Hitler, which is quite a different thing to saying it needs another Hitler. I stand by that opinion - in fact I was ahead of my time in voicing it. There are in Britain right now parallels with the rise of the Nazi Party in pre-war Germany. A demoralised nation whose empire had disintegrated." Two years later, Margaret Thatcher was elected.

Thatcher: in other’s words

"This year, as in 1932, our country is divided, our people are out of work, and our national leaders do not lead.  Roosevelt's opponent in that year was also an incumbent president, a decent and well-intentioned man who sincerely believed our government could and should not with bold action try to correct the economic ills of our nation.” Jimmy Carter stated in his Labor Day speech

in 1976

The presidential campaign rhetoric

1. "I regret to say that we are in the worst economic mess since the Great Depression." Ronald Reagan New York Times Feb 6, 1981

2. "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'?" Reagan

The presidential campaign rhetoric

1980 Presidential Election

An Ideological Shift to the Right

Whereas "'market failures' were the paramount economic concern of the 1960s and 1970s… 'government failure' became the preoccupation of the 1980s and 1990s. Of course, communism was the greatest 'government failure' of them all. And with that failure, the markets inexorably rose to take control of the 'high economic ground' on the world stage, and in the battle of ideas."

The Reagan Revolution: Promise

1. Defeat communism & reestablish US supremacy1. Rebuild the military (Star Wars)

2. Increase value of stock market

3. Strengthen US $

2. Reduce size and scope of government1. Deregulate, cut spending, reduce transfer payments (welfare,

unemployment), cut taxes & balance the budget

2. Tax cuts

3. Move emphasis from short-term to long-term1. AS replaces AD as focus of policies

2. Worry less about stabilization and more about growth1. Increase savings

4. Reduce inflation AND unemployment AND Increase SOL of US workers

1. Increase the openness of the US economy

Reaganomics according to Reagan

"This plan is aimed at reducing the growth in government spending and taxing, reforming and eliminating regulations which are unnecessary and counterproductive, and encouraging a consistent monetary policy aimed at maintaining the value of the currency"

Reaganomics according to others"a delicately balanced on a set of simultaneous policy

actions and a set of equations describing the effects of the policy actions on the economy."

Reaganomics according to Peanuts

Reaganomics according to Peanuts

StagflationStagflation The “scourge” of the 1970s

Input prices up = AS shifts inward

Inflation - up

Output - down

Unemployment - up

Price level

GDP

Alternative “solutions” to in AS: The Keynesian Dilemma

Price levelPrice level

GDP GDP

“Fix” unemployment

Same GDP>inflation

ThTh

The inward shift in the AS drives the price level higher and GDP lower. Keynesians focus on AD, so in this situation where they want to fix unemployment they need to get GDP back to its old level.

They would do this with an expansionary fiscal or monetary policy – the AD shifts right enough so the new equilibrium is at the same level of GDP

Problem is: Now we have even more inflation

Alternative “solutions” to in AS: The Keynesian Dilemma

Price levelPrice level

GDP GDP

“Fix” inflationThe inward shift in the AS drives the price level higher and GDP lower. Keynesians focus on AD, so in this situation where they want to fix unemployment they need to get GDP back to its old level.

They would do this with an contractionary fiscal or monetary policy – the AD shifts left enough so the new equilibrium is at the same price level so no inflation.

Problem is: Now we have even bigger recession and more unemployment

THE Reagan “Solution”

Problem: stagflation due to adverse supply shock = higher inflation & lower GDP

Solution: favorable supply shock

Reverse stagflation

So how do you do this? How do you shift the AS curve to the right? The answer is in the factors that affect AS that you looked at earlier

Reaganomics – expand the capital stock

(incentives matter)

K cost of capital

1. Investment tax credit (see example)

2. Accelerated depreciation (see example)

pool of capital– 401K plan– Tax cut to wealthy

corporate profit taxFill in the following tables to see how Reagan would increase AS

Investment Tax Credit: Before

Profit Profit taxCost of

machine10% I tax

credit

Profit tax + tax credit

Tax saving

Net Cost of

Machine

1,000 500 100No tax credit

1,000 500 100

10% tax

credit

-10

50% tax rate

Investment Tax Credit: Before

Profit Profit taxCost of

machine10% I tax

credit

Profit tax + tax credit

Tax saving

Net Cost of

Machine

1,000 500 100No tax credit 500 0 100

1,000 500 100

10% tax

credit

-10 500-10 10 90

50% tax rate

The investment tax credit reduces the cost of the machine = incentive to invest in machine

Accelerated Depreciation: Before for business ($1,000s)

Value of building

Depreciation @ 25 year

life

Depreciation @ 10 year

lifeGross

IncomeNet

IncomeTaxes@

50%

$1,000 $40 No tax credit $10,000 $9,960

$1,000

Accelerated Depreciation: Before for business ($1,000s)

Value of building

Depreciation @ 25 year

life

Depreciation @ 10 year

lifeGross

IncomeNet

IncomeTaxes@

50%

$1,000 $40 $10,000 $9,960 $4,980

$1,000 $100 $10,000 $9,900 $4,950The accelerated depreciation reduces the cost of the machine = incentive to

invest in machines

Reaganomics – expand the labor force

(incentives matter)

L return to working

taxes

return to not working welfare unemployment benefits

Two examples of the use of incentives appear in the following two tables

Tax-bracket creep with inflation (10%)

 Actual income tax rate

Taxes paid

Net income Prices

Real Net

income

1978 40,000 40% 16,000 24,000 100 24,000

1979 50,000 50% 25,000 25,000 110 22,727

R = N/PI*100

With inflation the tax rate increases because of progressive tax = pushed into higher tax bracket without any increase in inflation-adjusted income

30% Across-the-Board Tax Cut

Actual income

Old tax rate

Old Taxes paid

Old Net income

New rate after 30% rate cut

New Taxes paid

New Net income

Income gain

based on original taxes

40,000 20% 8,000 32,000 14% 5,600 34,4002,400 8%

200,000 70% 140,000 60,000 49% 98,000 102,00036,000 60%

Look at how a 30% across the board tax cut favors the high income earners when there is a progressive tax system. The “plan” was for this cut to give high

income workers an incentive to work more because they keep more

Reaganomics: pursue conservative agenda

government & retain government programs1. Promise to waste by cutting unspecified

programs

taxes 1. 30% across board on personal income taxes

3. balance budget1. Laffer curve

Laffer Curve

@ A what do you do to raise tax revenue?Raise tax rate

@ B what do you do to raise tax revenue?Lower tax rate

Answer depends and Reagan said we were in B range

Tax revenue

Tax rate

A B

A* B*

1984 Presidential Election

The Reagan Years

The good news

Confidence up

Interest rates down

The Reagan Years

The not so good news

Cities emptiedFactories closed

The numbers are spectacular – in the nation’s biggest cities white-flight continued as non Hispanic Whites left the central cities for the suburbs. In the decade NYC lost .5 million, while Chicago lost .25 million. And with those people went jobs. In the country’s 10 largest cities manufacturing employment fell over 60%, with NYC losing almocy .5 million jobs – more than a 75% loss.

“Evacuation” of cities and loss on manufacturing jobs

Bill Testa, “Manufacturing exit tough on Midwest central cities,” Chicago Fed

Manufacturing jobs down

Wages down

Polarization: Increasing Inequality

Up to 1980 incomes of all groups rose together, but around 1980 the top 5% started separating themselves from the rest

Unions down

Share of workers covered by unions down by 1/3rd in the 1980s

Savings down

Household savings drops sharply in the 1980s – access to more funds through deregulation

Real interest rates up

Sky-high interest rates

Trade deficit up

There was no balanced budget

And the housing bubble sustaining growth would burst

Growth was unsustainable – driven by housing boom that would “bust.”

1988 Presidential Election