The basis for Reaganomics can be traced back to the late 1960s and 1970s when after two decades of steady growth and very low inflation the US economy suffered from exceptionally high inflation along with a very slow growth rate, a phenomena that became known as Stagflation. The continuously high unemployment rates throughout the 1970s were another feature of stagflation. This was caused by a number of different factors namely the failure of the dominant post-war Keynesian policies to deal with the rising inflation and unemployment which primarily were focused on the demand management side of economics through expansionary fiscal and monetary policies. Furthermore the Keynesian belief that unemployment and inflation were mutually exclusive based on the Phillips Curve led to persistent efforts to promote artificially low levels of unemployment through increasing government spending and establishing price controls which worsened the soaring inflation rates.
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In addition to the Keynesians failures to deal with the domestic issues the US economy faced competition from industrial and developed countries such as Britain, France, Germany and Japan for the first time since the end of second world war. The US benefited from massive expansion of its economy during and after the war years whilst other nations suffered from substantial damages to their infrastructures. However by the mid 1960s the European and Japan’s economies had recovered and had developed technologically more advance and productive economies compared to America. During the period 1950 to 1973, fixed capital stock in the United States grew at an annual rate of 2.9% – a rate that would prove impossible to achieve once stagflation dominated the economy. In contrast, Britain, Germany, Japan and France had annual average growth rates in capital stock of 4%, 6.1%, 7.6% and 4.5%, respectively (Marc Eisner , 1995). As well as increased international competition the external shocks to the US economy in the 1970s such as the oil crisis of 1973 where price of oil quadrupled, along with higher commodities prices caused an even greater pressure on price levels.
The economic and social difficulties caused by the combinations of these factors led to a major demand for a shift in economic policies and was the main promise of Ronald Reagan’s 1980 election campaign. In February 1981 the new administration revealed its Program for Economic Recovery. This program was based on a mixture of different theories namely Monetarism which calls for the Federal Reserve to limit the growth of the money supply in order to curb inflation and Supply Side policies that require a reduction in taxes to increase the incentive to work, save and invest. (John Palmer 1982). These became to be known as Reaganomics and its basic elements were; controlling inflation by restricting the supply of money, reducing income and capital gains marginal tax rates, reducing regulation and intervention in markets and reducing government expenditure whilst increasing defence spending. The objective of Reaganomics was relatively clear, it was designed to increase saving and investments which combined with deregulation and having healthier markets would lead to a higher economic growth. Reducing government expenditure and controlling the supply of money was assumed to not only bring inflation down but also to reduce the ever increasing government deficit.
The success of the program largely depended on the success of all of its individual elements. The administration believed by restricting the supply of money, the rate of increase of total spending in the economy, nominal GNP would go down and this was a necessary condition for reducing inflation. In order to curb inflation and spending whilst reducing unemployment at the same time there had to be a degree of control over inflationary expectations and a significant rise in productivity to counter the rise of labour costs. The administration’s commitment to monetary control and balancing the federal budget would help to correct the inflationary expectations whilst the increase in productivity would be achieved by the increase of nation’s savings to encourage private and productivity-raising investments as a result of tax cuts and elimination of government deficit. Furthermore the stimulus to productivity and production resulting from such tax cuts would increase the national income which in turn would offset the revenue loss that lower tax rates cause. (Herbert Stein, 1988)
Thus the failure of any individual element of the program would lead to the collapse of the whole program or at the very least significantly reduce its desired effect on the economy.
Restoring price stability by curbing inflation therefore was one of the major priorities of the Economic Recovery Program. This was based on the monetarist view that a steady reduction in money supply growth whilst managing inflationary expectations effectively would be the best way to reduce inflation. The Reagan administration hoped to achieved this without causing a painful transition period of high unemployment and loss of output therefore it was essential for businesses, workers and investors to fully have confidence in government’s ability to succeed and thus react accordingly. Although neo-Keynesians argued monetary restrain would almost certainly lead to a further increase in unemployment and would push the economy into a recession as prices and wages are sticky or sluggish and relatively unresponsive to monetary policies in the short run. (32) However according to the Rational Expectations school of thought individuals would realise and anticipate the benefits of a well advertised monetary policy and would be willing to accept lower wages and prices for their goods and services and hence would avoid any unpleasant consequence of a drop in output levels. (31).
The administration believed the war against inflation would be relatively short and pain free. Thus the Federal Reserve under the leadership of Paul Volcker attempted to decrease inflation rates by controlling the adjusted monetary base which is the total amount of currency in circulation or in the commercial banks deposits in the Federal Reserve. This was done by controlling the reserves supplies to the banking system through the Federal Reserve’s purchases and sales of government securities and the amount it required banks to maintain in reserves against their deposits. The Federal Reserve also controlled -albeit to a lesser extent- the money supply especially the narrower form of money (i.e. M1) such as currency and checkable deposits. (R.E)
As a consequence the inflation fell from its double digits peak in 1980 to below 4% by the summer of 1982, however this success in curbing the inflation had a devastating impact on the economy. The tight credit control led to further increases in interest rates as investment fell. The gross national product fell by more than 2.5% whilst unemployment rates peaked at 11% in 1982. It seemed clear Reagan’s ambitious plans to reduce inflation and maintain a healthy economic growth simultaneously had failed. (State Blue book). Although by July 1982 the Federal Reserve eased up its tight grip on the money supply and the expansionary fiscal policies by the administration led to the recovery from the recession. The economy grew by 6.8% by 1984 with unemployment figures dropping to 7.4% first and then to 5.4% in 1988 whilst the GNP also increased, standing at 4.5%. Inflation remained low for the remainder of Reagan’s administration dropping to as low as 1.1% in 1986 before standing at around 4% towards the end of the decade.
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However despite this positive economic figures it’s important to take into account the external factors that created a far more favourable economic environment throughout the 1980s compared to the previous decade. The main cause of inflation in the late 1970s was the high food and energy prices partly caused by the oil crisis of the 1973 and the Energy crisis of 1979 (in the wake of the Iranian revolution) however as a result of the sharp decrease in demand for oil in developed countries and the virtual collapse of OPEC, the oil prices decreased by two third between 1980 and 1985. (state source). Moreover expansionary fiscal policies such as federal subsidies for farmers and an inflated dollar despite having a negative impact on the budget deficit, contributed to price stabilisation as food prices fall and imports became cheaper. “the collapse of OPEC, food surpluses, the debt inflated dollar and measurement corrections in the role of home ownership sots in calculating the Consumer Price Index accounted for 52.3% of the reduction in inflation with the remainder attributable to the rescission induced unemployment rates”. (end with a conclusive sentence?).
Balancing the budget was another top priority of the Reagan’s administration however throughout his two term as president the deficit continued to grow as a result of the loss in government revenue caused by the Economy Recovery Tax Act of 1981 and the largest peace time defence spending since the Second World War. (Midterm report). The deficit that was under 35% of the GDP in 1980 had increased to over 55% of the GDP by the end of the decade. The idea that having an unbalanced budget would have damaging consequences for the economy was another monetarist element of the Reagan’s administration. This was a clear rejection of the Keynesian view that stated the government could stimulate the economy by increasing its deficit which in turn allows it to increase expenditure and investment in the private sector resulting in an increase in aggregate demand, total output and employment levels as long as the economy isn’t performing at its maximum capacity hence outweighing the costs of financing the deficit. In contrast the monetarist insisted on the need for a balanced budget claiming that even though government on one hand could give money to people through higher expenditure it would have to take an equal or higher amount back to finance its debts.
The administration therefore attempted to decrease the deficit and eventually balance the budget by as early as 1984.It intended to do this by reducing government expenditure as a percentage of the GDP from 23% to 19.5%. (industrial book) In its Program for Economic Recovery it introduced substantial cuts in state aid programs such as Medicaid, food and nutrition programs, extended unemployment benefits and housing assistance whilst reducing subsidies for new energy technologies, public service employment and student aids. (Mid term). Although the effectiveness of such cuts in expenditure and the target of balancing the budget by 1984 turned out to be extremely optimist and unrealistic. The administration failed to achieve its objective mainly because of its inconsistent policies. For instance whilst trying to reduce the deficit it introduced the Economic Recovery Tax Act in the summer of 1981 reducing marginal income tax rates by 25% causing a major loss of revenue for the government. The administration argued such revenue loss would be offset by a rise in savings, investments and output levels however as the economy entered a recession in 1981 – mainly due to its tight monetary policy – the deficit continued to rise. Furthermore the government increased defence spending steadily throughout the decade, in 1982 the defence budget rose by $7.3b and later by $33.1 in 1986. (R.E).
The government’s failure to reduce its deficit had severe consequences for the economy especially during the 81-82 recession. The major problem with the deficit was the financial cost of financing the debt itself, this was estimated to be close to $184.2b or 14.7% of the budget in 1990. (s.bb) The administration attempted to raise funds by selling securities such as government bounds which due to their secure nature and high rates of return attracted investors and capital. However this had a negative knock on effect on the economy too since by extracting billions of dollars per year from the national saving pool which had already been in decline since the 1950s (shrinking to 2.4% of GDP in 1988 from 7.8% in the 1970s) the government took away scarce capital from the private sector leading to the crowding out phenomena. This is when the government and the private sector compete for the same limited capital available in the market hence causing a reduction in the expansion of businesses and firms. This loss of capital further translates into higher interest rates and lower levels of investment which in turn leads to a loss of competitiveness and reduction in the output levels, subsequently increasing unemployment and pushing the economy deeper into the recession.
Overall it had quickly become apparent that the administration’s goal of balancing the budget was clearly unrealistic. Despite it’s desire to reduce the deficit the introduction of tax reductions and increasing the defence spending more than offset any gains made from the cutbacks in the federal expenditure. The centrepiece of Reagan’s tax cuts was the Economic Recovery Act signed into law in 1981.