How Reaganomics Made the World Work
We’re all supply-siders now.

By Robert L. Bartley, editor of the Wall Street Journal
From the April 21, 1989, issue of National Review

n 1970 Keynesianism ruled, and we faced a decade of stagflation. But we're all supply-siders now, thanks in part to

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dinners at Michael I, and even George Bush has embraced voodoo economics.

The policy that came to be known as "Reaganomics" started more than two years before the election of Ronald Reagan. At least for me, the new era dawned on April 20, 1978. On that morning, a Wall Street Journal article on the House Ways and Means Committee's doubts about the Carter Administration tax proposals included the following paragraphs:

A major cause for worry on the part of liberals and the Administration is a proposal by Representative William Steiger (R., Wis.) to reduce the tax on capital gains. Representative Steiger claims to be close to the 19 votes he needs to win approval for his amendment from the 37-member committee….

Representative Steiger's amendment would roll back the maximum rate on capital gains — for both individuals and corporations — to 25 per cent, the top rate in effect prior to the Tax Reform Act of 1969.

While Representative Steiger argues that this tax cut would stimulate enough business activity and tax revenue to pay for itself, committee sources estimate the net annual revenue loss to the Treasury at between $ 2 billion and $ 3 billion.

Electrified by this news, I started my working day with a call to Jude Wanniski, who happened to be in Washington. Read this, I suggested, and, naturally, drop everything and go talk to Steiger. This, I said, may be what we've been looking for, the reason for the sudden surge in the stock market. For by then, these issues had been explored for innumerable hours at the Michael I restaurant and the Lehrman Institute by Jude, the already notable Canadian economist Robert Mundell, former OMB Chief Economist Arthur Laffer, and a few others.

Jude returned from Washington and produced a seminal editorial, "Stupendous Steiger" (April 26, 1978), asserting that the quiet, young, slightly built congressman from Wisconsin had "shaken the earth," that his amendment was "not one tax provision among many, but the cutting edge of an important intellectual and financial breakthrough." As he wrote, I got a call from Warren Phillips, chairman of Dow Jones & Co., publisher of the Journal. He said he had run into Jude while walking through the editorial-page office, that Jude had virtually grabbed him by the lapels and excitedly exclaimed that the market had bottomed, the market had bottomed. What's going on, Warren asked? Jude's a little overexcited, I explained, but watch.

Whatever the wear and tear on Warren's lapels, Jude was right, more or less. The Dow Jones average had been falling steadily since a few weeks before the Carter presidential victory, hitting a low of 742 on February 28, and hovering just above that figure into April. It turned up as Representative Steiger gathered his votes, climbing over 900 as the tax bill moved toward passage. The 1978 lows withstood two later tests as inflation was wrung out of the system, and the real stock-market boom started in 1983, with the first net tax cuts of the Reagan era.

At this remove, it's hard even to recall the pre-Reagan economic landscape. Do you remember the gasoline lines? How about Jimmy Carter's $ 50 rebate? Or his voluntary wage and price controls? Or even before that, Jerry Ford's WIN buttons, Whip Inflation Now? For the mid 1970s witnessed a crisis of not only economic policy but also economic thought. The prevailing Keynesian orthodoxy had nothing to say about stagnation. It had pretty much distilled itself down to the Phillips curve: To cure inflation, a little more unemployment; to cure unemployment, a little more inflation. For high and accelerating inflation accompanied by high and accelerating unemployment, it had no explanation and no prescription.

For every policy target you need a policy tool, Bob Mundell instructed the diners at Michael I on Trinity Place in downtown Manhattan. To combat stagnation plus inflation, you needed two levers: tight money to curb inflation, and tax cuts to promote growth.

In a Keynesian world, of course, tight money would merely offset tax cuts; one would contract aggregate demand while the other expanded it. The key was that supply-side tax cuts provided stimulus not by expanding aggregate demand — "putting money into people's pockets"but by stimulating supply, by increasing incentives to work and invest. Producing deficits by more spending would not work, and neither would tax "rebates" or other non-marginal tax cuts. The cuts had to be directed at the taxes that did the most to curb incentives, that is, at the highest marginal rates. Indeed, where marginal rates are the highest, as Art Laffer sketched on his famous napkin, a tax cut might actually produce more revenues.

In the Mundell-Laffer world, the tight-money half of the prescription was also quite specific. Money-supply numbers told you little. For one thing, Mundell kept repeating, the only closed economy is the world economy. The national money supply means little when the demand for the dollar is global; a debate raged, and still smolders, over whether money creation takes place in the Eurodollar market. More broadly, monetary aggregates are useful guides only if the demand for money is stable or predictable, as monetarist theory assumes. This stability ended, as Mundell predicted it would, when President Nixon in 1971 tore the dollar from its golden anchor and allowed it to float in value against other currencies and commodities.

So to incorporate both the supply and the demand for money you need a measure priced by the marketplace: an index of sensitive commodity prices, for example, or simply the price of gold. And to adapt to the one-world economy, you need one world money, so that price signals can be accurately reflected and transmitted. A world unitary currency can be simulated by a system of fixed exchange rates. When the dollar and pound and peso and franc and D-mark and yen have definite values in relation to each other and to gold, global finance and commerce are based on one set of prices, unhampered by the confusion of constantly changing yardsticks.

By now, when we dismiss gasoline lines as quaint history, it's hard even to remember how foreign these intrinsically simple ideas seemed in a Keynesian-trained world. In 1976, Herbert Stein coined the phrase "supply-side fiscalists" as a pejorative; as I remember, the phrase first appeared in print in the Wall Street Journal. Jude, audaciously ignoring the intended negative connotation, quickly appropriated Stein's label, dropping the clumsy and misleading "fiscalists." Supply-side economics it was.

We only slowly came to understand that similar debates were going on in other cloisters. In Washington Norman Ture and Paul Craig Roberts developed the tax-incentive side of the model. They, like Jude, captured the attention of Representative Jack Kemp. Craig joined the congressional staff, where he worked with Kemp and others, and tilted with the Congressional Budget Office. He captured the congressional battles in his article "The Breakdown of the Keynesian Model" in The Public Interest of Summer 1978. As the Journal Op-Ed page provided a daily bulletin board for such ideas, other volunteers appeared. But to me, supply-side economics remained essentially the policy mix we had debated in those dinners and seminars in New York.

On the monetary side of the model, a sliding dollar forced President Carter to appoint Paul Voicker chairman of the Federal Reserve in July 1979, and to give him his head on policy in October. The attempt to use monetary aggregates led to some policy confusions, with an initial burst of inflation. But when the gold price rocketed to a peak of $ 850 in February 1980, Volcker began tightening in earnest.

On the tax side, the Steiger Amendment quickly proved a success. Collections on long-term capital gains jumped to a record $ 10.6 billion in 1979, from $ 8.5 billion in 1978 (they maintained that level through the 1982 recession, and jumped to $ 16.5 billion in 1983, $ 20.1 billion in 1984, and $ 23.7 billion in 1985). The supply-side idea began to run rampant, with or without the Reagan campaign. In the waning days of 1980, the Senate passed a Kemp-Roth lookalike, and the House directed its conferees to accept it. In the wee hours of the morning, the conferees rejected it; "too big a deal," declared Chairman Russell Long.

So it fell to the Reagan Administration to enact supplyside tax cuts. When Mr. Reagan took office, marginal rates for the federal income tax reached 70 per cent on "unearned" income (which is to say, returns on savings and investment). As he left office, the highest rate in the tax code was 33 per cent in certain notches, dropping to 28 per cent at the highest level.

With these tax rates in place, the nation remains in the longest sustained peacetime economic recovery ever recorded. The double-digit inflation of the 1970s is only a memory. The economy's problem is not unemployment but a labor shortage. The "misery index" devised by the late Arthur Okun — unemployment plus inflation — shows a spectacular success, having fallen from nearly 20 per cent in 1980 to under 10 per cent in 1988. Perhaps the best way to encapsulate economic policy in the decade of the 1980s is to say that we have succeeded in checking an impending worldwide inflation without causing the world depression many would have predicted — a spectacular success by any historical standard.

For all this success, the ending of the Reagan Presidency was marked by a wide unease. Especially after the October 19 stock-market crash of 1987, the conventional wisdom is that six years of prosperity is only transitory, that some kind of economic disaster lies around the corner.

The first answer to this is Burke's "Men have no right to put the well-being of the present generation wholly out of the question. Perhaps the only moral trust with any certainty in our hands is the care of our own time." If some calamity does lie ahead, it is as likely to be the result not of old mistakes but of fresh ones. Yet the unease provokes comment on three areas: the 1982 recession, the problem of the deficit, and the remaining agenda of exchange rates. Passage of the first Reagan tax cuts in 1981 was promptly followed by the 1982 recession, with a dip in government revenues and soaring deficits. In the debate over this bill, the Laffer curve came to be understood not merely as a truism that at some point raising marginal rates will reduce revenues, but as an assertion that any tax cut will always pay for itself immediately. Tax-cut opponents promoted this interpretation to ridicule the whole idea, and advocates promoted it to build support for a tax cut that politically had to deliver some benefit to lower-income people with lower marginal rates. As the recession took hold, opponents crowed that the Laffer curve and supplyside economics were forever refuted.

In fact, as the tax cuts passed, the consensus economic forecast was for a mild upturn, and only supply-siders were worried about 1982. In the inevitable congressional compromise, concern over the deficit resulted in a tax cut staggered over three years. And already enacted Social Security increases and bracket creep offset the first two tranches of rate reduction. The impending cuts actually created incentives to postpone income out of 1982. Moreover, with Volcker at the Fed, the tight-money side of the Mundell prescription was already firmly in place. This ground inflation out of the economy more rapidly than most thought possible, but there would be no net tax cut to offset tight money until 1983.

None of this, of course, prevented conventional wisdom from blaming the 1982 recession on deficits, tax cuts, and supply-siders. Especially so with the defection of OMB Director David Stockman, who announced $ 200-billion deficits as far as the eye could see. But if deficits and anticipation of deficits caused the 1982 recession, what caused the 1983 recovery?

As 1983 opened, the first headline in the editorial columns of the Wall Street Journal was "At Last, a Tax Cut." By then the conventional wisdom held that deficits doomed the economy to sluggish growth at best, but supply-siders were talking boom. Alan Reynolds of Jude Wanniski's Polyconomics hit the growth number on the head6.5 per cent growth for the fourth quarter of 1983 over the fourth quarter of 1982.

This was the start of the recovery we still enjoyed as Ronald Reagan left office. Properly read, the record suggests that Mundell's two-pronged prescription worked. Inflation was conquered far more quickly than the conventional wisdom believed possible. And once tax cuts were actually applied, growth resumed and, helped by further marginal-rate reduction in 1986, continued for an unprecedented time. Taking any relative historical view, and recalling the actual economic conditions of 1978, this was a considerable achievement indeed.

Now, a few remarks on the deficit, the twin deficits, Mr. Reagan's "riverboat gamble," and his "$ 200 billion in hot checks." To begin with, the deficit is a problem of spending, not of tax cuts. During the Reagan prosperity, government revenues grew smartly, along with the rest of the economy. As a percentage of GNP, tax revenues are about where they've been for decades, but spending has grown even faster.

In part, President Reagan's tolerance of deficits was a political calculation to fight the size-of-government issue on the tax side rather than the spending side. Republicans have of course preached the smaller-government gospel for years. But holding out the carrot of lower taxes only after spending cuts had been introduced left Republicans with the worst of both worlds; indeed, it left them repeatedly urging higher taxes to validate Democratic spending increases. Mr. Reagan cut this Gordian knot by putting tax cuts first and letting spenders worry about deficits.

On the evidence so far, the success of this strategy has been, if by no means complete, greater than usually understood. Under pressure of the deficit, spending as a percentage of GNP peaked in 1983 and showed a gradually declining trend for the remainder of the Reagan Presidency. There is, of course, reason to wonder what will happen in the Bush Administration, especially as we have watched drought-relief and catastrophic-illness bills roll through Congress with even the Reagan Administration's blessing. But the post-1983 trend does suggest that there is nothing at all wrong with the mathematics of President Bush's "flexible freeze." Moderate budget restraint will close the deficit; the only question is whether our current institutions allow it to be implemented politically.

For another thing, everyone talks about the federal deficit being the instrument of Keynesian fine tuning. But in measuring, say, supply and demand in the credit markets, much of the federal deficit is offset by the surplus in state- and local-government pension funds. Other nations measure not a federal deficit but a public-sector borrowing requirement, including all levels of government. When appropriate adjustments are made, as they regularly are by the OECD, the current U.S. deficit is not out of line with that of other industrial nations. The official federal deficit fell from 6.3 per cent of GNP in FY1983 to 3.2 per cent in FY1988, with no effect on the decibel level of the concern about it.

Finally, the deficit is measured on a cash basis, rather than on the basis of generally accepted accounting principles. Under GAAP accrual accounting, you would measure all future obligations undertaken, not merely those for which bonds have been issued, As it happens, Arthur Andersen & Co. has periodically undertaken to put the government's accounts on a GAAP basis. Its studies show a total deficit roughly twice that measured by the conventional measure, principally because the latter does not include the unfunded liabilities of the Social Security system. While the conventional deficit grew in the Reagan years, however, unfunded Social Security liabilities declined, and more of the spending was on long-lived assets such as aircraft carriers, The Andersen studies show that while the federal deficit grew to 5.2 per cent of GNP in 1984 from 2.9 per cent in 1980, over the same years the GAAP deficit fell to 9.3 per centof GNP from 12.5 per cent. Under Reaganomics, the burden we are leaving to our grandchildren has not been mushrooming; it's been shrinking.

The federal deficit's "twin," the trade deficit, is of even less consequence. In a one-world economy, the trade deficit is merely an artifact of history — a reflection of where politics has drawn lines on a map. If comparable statistics were collected, Manhattan Island would be terrified by an astronomical trade deficit. For that matter, the trade deficit is also an artifact of economic fashion: a reflection of where economists currently choose to draw lines in a great circle of transactions. Once everything — goods, services, bonds, and so on — is included, the accounts must balance; for every buyer there has to be a seller.

This is scarcely to say there are no big problems in international economics, but they are rather the opposite of what the conventional wisdom believes. In its focus on the merchandise trade deficit, the conventional wisdom believes the tail wags the dog. In fact, a year's worth of world trade amounts to only about two weeks' worth of world capital movement.

The trade deficit first arose when the Reagan tax cuts stimulated the U.S. economy, making it the only growth opportunity in the world. This resulted in a tremendous net capital inflow; at the same time U.S. banks stopped exporting capital through Third World loans. With the capital accounts showing a huge surplus, a merchandise trade deficit was necessary to balance the equation. As inflation was brought to a sharp halt in the early 1980s, indeed, the U.S. trade deficit was probably the only thing standing between the world and a second Great Depression.

Still, of course, all cannot be well economically while interest rates remain at historically unprecedented levels even while inflation declines. Nor can all be well when the world's strongest economy imports capital instead of exporting it to developing nations where opportunities ought to be greater. The original prescription worked out at Michael I has an answer to these puzzles, for part of the agenda remains unfinished. In particular, the nations of the world are still trying to run one economy with a gamut of different moneys.

The seemingly arbitrary movement of exchange rates wipes out investments, closes and opens factories, and destroys and creates jobs throughout the world. No wonder interest rates are high; no wonder many people feel economically insecure; no wonder different nations toy with the poisonous nostrum of protectionism.

On the exchange-rate issue, the Reagan Administration reflected the conflicts among conservative economists who otherwise agree. Martin Feldstein, for example, advocated/ predicted a lower dollar to balance the trade accounts. Milton Friedman, a powerful voice in any crowd, strongly believes in the positive virtues of floating exchange rates. On early indications, the Bush Administration will be no more inclined to a reform of the exchange-rate mechanism. Yet the power of events does seem to be pushing the world, both practically and intellectually, toward the kind of international monetary reform that Bob Mundell, Art Laffer, and Jude Wanniski talked about in the mid 1970s.

The international meetings of finance ministers and central bankers do, after all, represent a movement away from floating rates, In the Plaza agreement in September 1985, Treasury Secretary Baker acknowledged U.S. global responsibility for dollar policy, ending the long period of "benign neglect" of the dollar's international value. The G5 nations agreed that the dollar was too strong, In the Louvre accord in February 1987, the expanded G-7 nations agreed its depreciation had gone too far, disrupting the world economy. And at the 1987 World Bank-IMF annual meeting, Treasury Secretary Baker, now Mr. Bush's Secretary of State, talked of an international economic policy based on "the relationship among our currencies and a basket of commodities, including gold."

What, finally, of the 1987 "crash"? The Wanniski explanation of the 1929 crash and Great Depresssion in The Way the World Works is the epitome of his original and controversial observations, and deserves an updating in the light of the events of October 1987. The '29 crash came, he argues, when political maneuvering in Washington made it apparent that the impending tariff would not after all be confined to agriculture. The Depression, in turn, was caused by the Smoot-Hawley tariff, the trade war that followed, and the Hoover tax increases wrongheadedly designed to calm Wall Street.

Skeptics argue that even if you persuade yourself that Jude has identified the politically crucial moment in the tariff debate, it seems a small event and a large crash. While Smoot-Hawley may have played a key role in the Great Depression, they see the 1929 crash as the bursting of a speculative bubble.

Perhaps. But with the "rational expectations" work on the stock market, we now understand much more acutely that markets anticipate events; a crash some months before the enactment of an economically catastrophic law is precisely what we would expect. And Jude's evidence consists not of one isolated incident but of a long string of coincidences.

Indeed "bubble" is scarcely an apt metaphor for the 1929-1930 stock fluctuations. Bubbles collapse, and the Dow Jones Industrials fell from 298 on October 28 to 230 on October 29 of 1929. But bubbles do not reinflate, as the Dow did to 294 the next April, after a November low of 198. Jude's comments on the 1929-1930 crash, at the very least, prove that what needs to be explained is not October 1929, but the drop from 294 (or 244 when Hoover announced he would sign the tariff), to 41 a few months before the election of Franklin Roosevelt in 1932.

In October 1987, the market crashed 500 points in one day. From the August high of 2,722 it fell to the October 19 low of 1,738, a total of 36 per cent. By comparison, from the 1929 high of 381 in September to the November low was a fall of 48 per cent. The 1987 collapse was more concentrated, probably because computers and global communications make speculation more efficient. But the real economy, at least to this writing, has rolled along unimpeded.

This bubble, if that is what it was, was certainly not punctured in a vacuum. The collapse came the week the Ways and Means Committee suddenly concocted a bill to stop the takeovers that had boosted the stock market. The arbitrage community collapsed overnight, with a decline in takeover stocks preceding the general debacle on the 19th.

Even more to the point, at least to anyone at Michael I, the collapse came in the context of a breakdown of the international monetary order. In mid October, the Louvre agreement was foundering as Treasury Secretary Baker and the Germans fought over whether the dollar should be defended by printing fewer dollars or more marks, whether the exchange rate should be defended by contracting or expanding world liquidity.

The crash on Monday followed Sunday's televised warning by Secretary Baker that "we will not sit back in this country and watch surplus countries jack up their interest rates and squeeze growth world wide on the expectation that the United States somehow will follow by raising its interest rates." On the same day, the New York Times carried a story asserting Treasury's willingness to see the dollar fall in its dispute with the Bundesbank. I'm convinced that the market-makers' eyes were glued to Secretary Baker's Sunday appearance; I know mine were.

A sense of crisis, I also know, dominated the financial markets through the rest of 1987. But the mood bottomed out with the advent of the new year. And as it happened, in the first week of January the world's central banks intervened massively in support of the dollar. The Louvre agreement was back in business. During 1988, the banks demonstrated an ability to control the dollar-mark rate, and to a lesser extent the dollar-yen rate. Stocks rose through the year, and the sense of crisis ebbed as the world economy prospered.

Why was the bursting of the 1929 "bubble" followed by a Great Depression, while the bursting of the 1987 "bubble" has, at least so far, had no impact on the real economy. Dumb luck, perhaps? Or perhaps it is because markets don't ordain but warn. And perhaps because in 1929, the crash panicked policy-makers into compounding their errors, while in 1987 policy-makers somehow got the message and corrected their errors. In trying to work both events into a coherent and useful model, so far as I can see, this mode of thought offers the only explanation on the table.

The new president is not a supply-side firebrand. Rather, he is a man who once described these policies as "voodoo economics." But George Bush no longer talks that way; instead, it's "read my lips." And this victory is made more delicious by irony. In the tugging and pushing over the last tax cuts, Bill Steiger's capital-gains rate got shoved up to 28 per cent from the 20 per cent low it reached during the manic phase of Reagan supply-side thinking. George Bush wants to chop it back down; the President who coined the phrase "voodoo economics" says that will produce more revenue.