ColombiaLink.com – REAGANOMICS – MACROECONOMICS

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also: List of Economic Topics

REAGANOMICS
– macroeconomics

The
term Reaganomics, a portmanteau of Reagan and economics, was used to describe,
and decry, the economic policies of U.S. President Ronald Reagan during the 1980s.
Reagan assumed office during a period of high inflation and unemployment, and
his economic theories are claimed by his supporters to have eventually led to
a strong recovery. The term is also used in comparison with Rubinomics

An
Explanation of Reaganomics

Reaganomics
or supply-side economics is a highly politicized term, which can be interpreted
many different ways. In brief, Reaganomics has two key ideas: lower taxes and
smaller government. Or in Reagan’s words “government is the problem.”

Classical
economists such as Adam Smith stress the importance of specialization and trade.
For example, if a farmer trades wheat for horseshoes from the blacksmith — the
farmer is more productive and society is better off — than the farmer attempting
to manufacture horseshoes himself. However, classical economists have struggled
mightily to explain and offer solutions to the periodic business cycles of boom
and bust.

During
the Great Depression, Keynesian economists saw the vast numbers of unemployed
workers and suggested that the government should “prime the pump” through
government borrowing to creat job programs. During the New Deal, the WPA and other
job creation programs put this theory into action. Keynesian economists justified
this government spending, by claiming through the multiplier effect — one employed
worker’s salary will benefit 5 other workers etc. Critics argued that government,
being a political entity, is an inept distributor of economic resources.

One
school of critics, the monetarists, argued that government can better stimulate
the economy by manipulating the money supply. When the economy is weak, the monetarists
argued that the government should lower interests rates and increase the money
supply. This additional money will seek businesses and start-ups to invest in,
via banks and other non-governmental means. The negative effect of an increased
money supply is inflation.

After
the Oil Shocks of the 1970s, a new economic phenomena took hold Stagflation. Stagflation
combined high unemployment with runaway inflation. Previously, the economy experienced
either high unemployment and low inflation, or low unemployment and high inflation.
The economy had not experienced both high unemployment and high inflation at the
same time. Stagflation meant, if one followed the Keynesian model to stimulate
the economy, the government must intervene via new spending programs. The new
spending to be financed either by new taxes or borrowing. On the other hand, if
one followed the monetarists, the government had to choose either to raise interest
rates to tame inflation and cause further unemployment; or lower interest rates
to stimulate the economy and cause further inflation.

A
new school of thought gradually arose. It argued that the competitive nature of
free markets (free of government regulation) made markets, the best means to distribute
economic resources. That businesses have to innovate and create wealth to survive.
This anti-government view saw businesses as the “goose that lays the golden
eggs” and government regulation and taxes as “strangling the goose”.
Reagan partially agreed with this anti-government view and sought to stimulate
the economy by lowering taxes, financed by borrowing. He argued that lowering
taxes will revive the economy. When the economy revived, the increased tax revenues
will be used to pay off the debt. Excluding military spending, he argued for broad
cuts in government spending, which he viewed as a drain on the economy. However,
Reagan raised military spending, as he saw defense as an integral government function,
especially in regards to the Cold War.

The
disagreement between “Reagonomics” and New classical economics (a modern
economic theory which emphasizes that free markets self-regulate most efficiently
and optimally) becomes clear with understanding Reagan’s exceptional military
spending. While Reagan did slash taxes and thus endorse that element of neoclassical
theory, Reagan’s massive military spending resulted in a massive budget deficit.
The 1983 deficit reached $207.8 billion, equivalent to 6 percent of the economy,
the highest level since the World War II era. This emphatic deficit spending violates
neoclassical economic theory emphasis on a balanced budget. Absent this, private
actors will rationally expect, as explained by the Ricardian equivalence, for
taxes to increase sometime in the future to offset this deficit, and will end
up saving enough to offset any increase in consumption resulting from government
spending. Furthermore, deficit spending is problematic under neoclassical theory
because even if the Federal Reserve lowers the fed funds rate to keep interest
rates low and combat this “crowding out (economics)” effect, the rational
public will see the lack of credibility with this merely fiscal-policy-reactionary
monetary policy.

Reagenomics
ultimately exists in two forms, theory and the actual historical experience. While
most Americans know of Reagenomics as increased defense spending and large federal
deficits, the true Reagenomic theory of controlled spending by Congress was never
implement largely due to a lack of politcal will by the American people who continuously
elected an obstructionist House of Representatives who resisted spending reductions.

History

The
large, across the board tax cuts initiated by Reagan at the start of his administration
were based on principles from supply side economics or the trickle down effect.
This was contrary to the demand side economics of traditional Keynesianism, which
tries to bring the economy to its existing full capacity by means of increasing
demand, primarily through fiscal policy. In the 1970s, many on the right became
critical of Keynesianism, which they claimed brought higher inflation without
any gains in employment. However, true Keynesianism, which called for deficit
spending during recessions and surplus saving during periods of prosperity, was
rarely implemented in its totality in American politics, usually because political
considerations overshadowed fiscal policy.

The
early Reagan tax cuts of August 1981 embodied Reagan’s supply-side economics.
Economist Robert J. Gordon writes in his textbook Macroeconomics (9th ed. 2003,
p. 392) that this was “the most dramatic shift in fiscal policy of the postwar
era not related to the financing of wars.”

The
Tax Reform Act of 1986, which had broad bipartisan support, partly implemented
the principles of supply-side economics in a more moderate way. It simplified
the tax code and eliminated tax loopholes.

Part
of what Reagan implemented was in fact not supply side economics, but rather his
own version of Keynesianism. Reagan advocated initiating deep tax cuts and simultaneous
increases in military spending, while at the same time claiming that the Federal
deficit would be erased. Critics argued that while Keynesian economics promoted
the idea of consumers (including the poorest) creating jobs by increasing the
demand for goods and services, Reaganomics relied on giving more money to producers
by giving tax cuts especially to the wealthiest citizens, who would then create
jobs that would somehow find a demand. This type of economic theory has also been
referred to derisively as “trickle-down economics.”

The
belief of Reaganomics that the tax cuts would more than pay for themselves was
influenced by the Laffer curve, a theoretical taxation model that was particularly
in vogue among some American conservatives during the 1970s. Laffer’s model predicts
that excessive tax rates actually reduce potential tax revenues, by lowering the
incentive to produce. The rise, rather than fall, in government deficits during
the Reagan era caused many to question the validity of the Laffer curve. In addition,
although the Laffer curve was used to justify tax cuts, its main emphasis was
on showing how to maximize government revenues through fiscal policy; because
this conflicted with the aim of conservatives to reduce spending as well as revenues,
the Laffer curve has more recently been deemphasized by conservatives in recent
years. Nonetheless, Federal Government tax revenues did increase significantly
following the tax cuts of the Reagan years; it was the dramatic increase in spending
that produced the budget deficits of that era.

Before
Reagan’s election, Reaganomics was considered extreme by the liberal wing of the
Republican Party. While running against Reagan for the Presidential nomination
in 1980, George Bush had derided Reaganomics as “voodoo economics”,
a term that held currency long after the recession ended. Similarly, in 1976,
Gerald Ford had severely criticized Reagan’s proposal to turn back a large part
of the Federal budget to the states. After the Reagan election, however, most
Republicans endorsed Reaganomics, including Bush, who became Reagan’s Vice President.

In
recent years Democrats like Governor Bill Richardson have adopted both Reaganomic
theory and rhetoric to justify tax cuts to spur growth and incentive (http://www.upi.com/view.cfm?StoryID=20030219-071745-7704r).

Support
for Reaganomics

A
study from the Cato Institute (a Libertarian think tank, which supports many of
the premises that lie behind Reaganomics) said: