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Lessons from the Reagan Era on Managing Twin Deficits

Below is a guest post from Norman Mogil and Arthur Donner.

Lessons from the Reagan Era on Managing Twin Deficits

Many in the U.S. are harking back to the Reagan era for guidance on how to implement the pro-growth policies advocated by President Donald Trump and the Republican Congress. When Ronald Reagan took over the leadership of the United States in 1981, he inherited an economy that had endured nearly a decade of stagnant growth combined with accelerating consumer prices.

Tax cuts lay at the heart of the so-called Reagan revolution. Reagan believed that high taxes threatened individual freedom, suppressed overall economic growth, and encouraged wasteful government spending. Thus, the tax laws of 1981 were the single most important piece of legislation to emerge from Reagan’s first term. The sweeping tax cuts slashed federal income tax rates, for taxpayers in every income bracket, by 25% over a three-year period. However, slashing taxes came at high price.

On the fiscal side, Reagan’s failure was his inability to restrain government spending. Reagan ran for office in 1980 as a harsh critic of “tax and spend” liberalism, vowing as President to shrink the size of the government by slashing federal spending. Once in office, however, Reagan found it impossible to deliver on his promises. Simply stated, the Reagan Administration blew up the federal deficit to 6 per cent of GDP in 1985 from just 2 per cent in 1980. (See accompanying table). It was not until the first term of President Clinton that a balanced budget was restored.

1980 1985 1988
U.S. Budget Deficit as % of GDP 2% 6% 3%
U.S. Trade Deficit as % of GDP 0% 3% 4%
U.S. $ Index      100 142      90
U.S. 10-year bond yield 11% 12% 8%


First
, while still fighting the high inflation created in the 1970s, the Federal Reserve continued with its tight-fisted monetary policy. Long term interest rates remained above 10 per cent for much of the decade and really did not start to make their long decent until the first half of the 1990s. The cost of government debt finance was part of the problem of containing the steep budget deficit. The United States had to fight internal inflationary pressures and at the same attract foreign savings to fund the deficit.The tripling of the American budget deficit was highly stimulating to the economy. In effect, it was the application of a Keynesian strategy that used government to prime the pump of the economy. But the surge in the U.S. budget deficit had unintended consequences.

Second, high interest rates led to a surge in the external value of the U.S. dollar. The U.S. exchange rate index soared by over 40 per cent in the period 1980-85. Because of the fiscal stimulus, the U.S. economy was growing again and savings from abroad contributed to a rapid appreciation of the dollar.

Third, the presence of an expensive dollar and a growing economy took a heavy toll on the U.S. trade account. In 1980 the American trade account was roughly in balance, but it soared into a deficit of 4 per cent of GDP by 1985 and remained so until the end of the decade. There also was a big push in the United States to introduce protectionist policies to deal with the trade deficits. Does this not sound familiar today?

Fourth, a soaring U.S. dollar and a rapidly deteriorating trade deficit obliged the international community to intervene alongside with the U.S. The “Plaza Accord” of 1985 called for the United States to devalue its currency in response to its rising current account deficit. The central banks of United States, West Germany, Japan, France, U.K. agreed to intervene in the exchange markets to bring about an orderly devaluation. By the end of the decade, the U.S. dollar declined by about 50 per cent.

Summing up, the Trump Administration is proposing to cut taxes dramatically and simultaneously spend up to $1 trillion over the next decade towards improving the country’s deteriorating infrastructure. Hence, there is a deep concern that the federal budget will explode. The Trump tax cuts will likely result in higher budget deficits, not lower deficits.

And as a reserve currency in uncertain times, the U.S. dollar will likely remain too strong, and increase even further due to the tax cuts and rising interest rates in the United States. A higher dollar will likely lead to a widening of the trade deficit as imports becomes relatively cheaper than today.

As for a new Plaza Accord agreement, this seems most unlikely. The Trump Administration has adopted a very aggressive stance towards it trading partners, and in all likelihood, it has eliminated the goodwill necessary to reach any new agreement.

Lastly, it is hard to see the Canadian dollar strengthening against the U.S. dollar in the early stages of the Trump Presidency.

More likely, as negotiations on revamping NAFTA begin we can expect the Canadian dollar to come under downward pressure, especially if the United States takes a hard line and unilaterally slaps on a broadly based border tax. Right now, the jury is out on the future price of the Loonie.

 

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Comments

Comment from Ron Waller
Time: February 14, 2017, 11:28 pm

What is with all this “border tax” talk? Is that what the establishment is calling tariffs these days? More cognitive framing nonsense like calling tax cuts “tax relief”?

It might make sense to call Trump’s rejigging of the corporate tax a ‘border tax’ because it’s a ‘border-adjusted corporate tax.’ (Which The Economist has an article on. Then again it might just be more agitprop. IDK.)

But clearly a “progressive” economist calling a tariff a “broadly based border tax” to be fashionable is being completely oblivious to the political agenda behind it: i.e., to save free-trade outsourcing schemes which have looted so much wealth from the Western economy it now teeters on the verge of collapse into fascist revolutions and world war.

This economic theology is for mental midgets in any case. They say a “baby boom” was responsible for a 30-year economic boom when it’s obvious it was rising real incomes (which more than doubled.) They call the US Fed jacking up interest rates to fight external price-shock inflation like business cycle inflation (which is either dumb or corrupt) “stagflation.” They call bringing back boom-to-bust business cycles the “Great Moderation”!

How people can be trained in math and statistics and not know that their field is complete and utter garbage is beyond me.

But I would call this a “good economic analysis” as in: it predicts nothing that can be substantiated and offers no real insights into whatever Trump’s economic plan is. (Which has to be, at least, somewhat more than simple Bush-style looting given he killed the TPP and plans on bringing back tariffs. Of course, an economist wouldn’t know that exported production means lost GDP — despite this being economics 101. But perhaps Trump DOES which is why he’s doing it: to bring back GDP growth to fund “tax relief” for the rich — especially estate tax cuts given he’s an obvious dynasty builder.)

“Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again.” JM Keynes

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