Download Slide 1

ECN202: Macroeconomics
1980s: 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. "
1980s
It 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 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 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 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
Index of Dow Jones Industrial Stock Average:
Real
140
120
100
80
60
40
Confidence in US industry down = drags down
stock prices
20
0
1960
1965
1970
1975
1980
Fear was in the air
Price of gold
800
700
600
500
400
300
Fear evident in the spike in gold’s price
200
100
0
1800
1820
1840
1860
1880
1900
1920
1940
1960
1980
Federal government was growing
Federal Outlays & Receipts
24.0
Government running persistent deficits
Outlays
22.0
20.0
18.0
Receipts
16.0
14.0
1960
1965
1970
1975
1980
Budgets were not balancing
Federal Deficit / GDP
5.0
4.0
Those persistent deficits
3.0
2.0
1.0
0.0
1950
-1.0
-2.0
-3.0
-4.0
-5.0
1955
1960
1965
1970
1975
1980
Inflation rate was up
16.0
14.0
Inflation up
12.0
10.0
8.0
6.0
4.0
2.0
0.0
1960
-2.0
-4.0
1965
1970
1975
1980
Interest rates were up
US Treasury rate (10-year)
12.00
Pushing interest rates up
8.00
4.00
0.00
1960
1965
1970
1975
1980
Wages down
Average Weekly Earnings: Inflation Adjusted
Inflation-adjusted wages falling
$330
$310
$290
$270
$250
1960
1965
1970
1975
1980
The malaise turns ugly
Misery Index
20
Misery Index (inflation + unemployment rates)
soaring
16
12
8
4
0
1950
1955
1960
1965
1970
1975
1980
The Ideological shift
The “revolution”
Thatcher in England
Reagan in US
Thatcher: in her words
“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 other’s 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.
The presidential campaign rhetoric
"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
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 supremacy
1.
2.
3.
2.
Reduce size and scope of government
1.
2.
3.
Rebuild the military (Star Wars)
Increase value of stock market
Strengthen US $
Deregulate, cut spending, reduce transfer payments (welfare,
unemployment), cut taxes & balance the budget
Tax cuts
Move emphasis from short-term to long-term
1.
2.
AS replaces AD as focus of policies
Worry less about stabilization and more about growth
1.
4.
Increase savings
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
Stagflation The “scourge” of the 1970s
Input prices up = AS
shifts inward
Price level
Inflation - up
Output - down
Unemployment - up
GDP
Alternative “solutions” to  in AS:
The Keynesian Dilemma
“Fix” unemployment
The inward shift in the AS drives
the price level higher and GDP
interest rate
lower.
Keynesians focus on AD, so
Price level
Same
GDPthey want to
in this situation
where
>inflation
fix unemployment
they need to get
GDP back to its old level.
interestlevel
rate
Price
Th
0
0
GDP
money
They would do this with an
expansionary fiscal or monetary
policy – the AD shifts right enough
so
0 the new equilibrium is at the
same
level of GDP
GDP
0
money
Problem is: Now we have even
more inflation
Alternative “solutions” to  in AS:
The Keynesian Dilemma
“Fix” inflation
The inward shift in the AS drives
the price level higher and GDP
lower. Keynesians focus on AD, so
rate
Price
ininterest
thislevel
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.
0
GDP
0
money
Problem is: Now we have even
bigger recession and more
unemployment
interest rate
Price level
0
0
GDP
money
THE Reagan “Solution”
Problem:
stagflation due to
adverse supply
shock = higher
inflation & lower
GDP
AS
Price Level
Solution:
favorable supply
shock
AS-AD
AD
0.0
Reverse
stagflation
0
National Output
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
1.  cost of capital
1. Investment tax credit (see example)
2. Accelerated depreciation (see example)
3.  pool of capital
– 401K plan
– Tax cut to wealthy
2.  corporate profit tax
Fill in the following tables to see how Reagan would increase AS
Investment Tax Credit: Before
50% tax rate
Profit
1,000
Cost of 10% I tax
Profit tax machine
credit
500
100
No tax
credit
10%
tax
credit
1,000
500
100
-10
Profit tax
+ tax
credit
Tax
saving
Net Cost
of
Machine
Investment Tax Credit: Before
50% tax rate
Profit
1,000
Cost of 10% I tax
Profit tax machine
credit
500
100
No tax
credit
Profit tax
+ tax
credit
Tax
saving
Net Cost
of
Machine
500
0
100
500-10
10
90
10%
tax
credit
1,000
500
100
-10
The investment tax credit reduces the cost of the machine = incentive to invest
in machine
Accelerated Depreciation: Before
for business ($1,000s)
Deprecia Deprecia
tion @
tion @
Value of 25 year
10 year
building
life
life
$1,000
$1,000
$40
Gross
Income
Net
Income
No tax
credit $10,000 $9,960
Taxes@
50%
Accelerated Depreciation: Before
for business ($1,000s)
Deprecia Deprecia
tion @
tion @
Value of 25 year
10 year
building
life
life
$1,000
$1,000
$40
$100
Gross
Income
Net
Income
Taxes@
50%
$10,000 $9,960
$4,980
$10,000 $9,900
$4,950
The accelerated depreciation reduces the cost of the machine = incentive to
invest in machines
Reaganomics – expand the labor force
(incentives matter)
L
1.  return to working
–  taxes
2.  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
40,000
200,000
Old
tax
rate
20%
70%
Old
Taxes
paid
8,000
140,000
Old Net
income
32,000
60,000
New rate
after 30%
rate cut
14%
49%
New Net
income
Income
gain
based on
original
taxes
34,400
2,400
8%
98,000 102,000
36,000
60%
New
Taxes
paid
5,600
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
1.  government & retain government programs
1. Promise to  waste by cutting unspecified
programs
2.  taxes
1. 30% across board on personal income taxes
3. balance budget
1. 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
60
Tax revenue
50
A*
40
30
B*
B
A
20
Answer depends and
Reagan said we were in
B range
10
0
1960
1965
1970
1975
1980
1985
2000
Tax1995rate
1990
2005
1984 Presidential Election
The Reagan Years
The good news
Confidence up
Index of Dow Jones Industrial Stock Average: Real
140
120
100
80
60
40
20
0
1960
1965
1970
1975
1980
1985
1990
Interest rates down
US Treasury rate (10-year)
12.0
8.0
4.0
0.0
1960
1965
1970
1975
1980
1985
1990
The Reagan Years
The not so good news
Cities emptied
Factories 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
Average Weekly Earnings: Inflation Adjusted
$330
$310
$290
$270
$250
1960
1965
1970
1975
1980
1985
1990
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
Treasury 3-month real interest rate:
7.00
Sky-high interest rates
5.00
3.00
1.00
1960
-1.00
-3.00
-5.00
1965
1970
1975
1980
1985
1990
Trade deficit up
US Merchandise Trade Deficit/GDP
0.40%
0.20%
0.00%
1960
-0.20%
1965
1970
1975
-0.40%
-0.60%
-0.80%
-1.00%
Monster trade deficits as
those factories close
1980
1985
1990
There was no balanced budget
Federal Deficit / GDP
2.0
1.0
0.0
1960
1965
1970
-1.0
-2.0
-3.0
-4.0
-5.0
-6.0
The Laffer Curve does not
produce those budget
surpluses.
1975
1980
1985
1990
And the housing bubble sustaining growth
would burst
Growth was unsustainable – driven by housing boom that would “bust.”
1988 Presidential Election