TCS Daily

Reaganomics in Context

By Arnold Kling - June 9, 2004 12:00 AM

" Let me talk, rather, of those presidents who I've known in my own lifetime. And there, there's no doubt in my mind that Ronald Reagan was by far the greatest.

" took real principles to do what he did. For example, one of the things he was determined to do was to end inflation. Now, there's no way to end inflation without having recession. The month after Reagan became president, Paul Volcker (then head of the Federal Reserve) started to slow down the rate of monetary growth. And that did lead to a recession. And that recession led to a sharp decline in the President's poll ratings. In my mind there is no other president in my lifetime who would have stood by to support the Fed in those circumstances."

-- Milton Friedman, interviewed by David Asman of Fox News, May 15, 2004

If Milton Friedman is correct that it was a great act of courage for President Reagan to support the Fed Chairman as he induced a recession to wring inflation out of the economy, then it is Reagan's supply-side defenders who are the real cowards. In order to wipe the recession off of the Reagan record, they want to make 1983 the starting point of the Reagan era. Rather than have the courage to stand up for the monetary policy of 1981-1982, the supply-siders wish to treat it as something that Reagan inherited.

This controversy illustrates what to me is the intellectual bankruptcy of trying to evaluate a President's economic policies on the basis of the way that macroeconomic variables -- inflation, unemployment, growth, and the deficit -- played out during his term of office. Instead, each President's policies should be evaluated in context -- how wise were those policies given the economic and political situation in which he was placed? That is what I wish to do here.

From Nixon to Reagan

Richard Nixon, like Ronald Reagan, inherited an economy that needed a dose of tight money in order to bring inflation under control. However, Nixon took office at a time when liberal economists had been arguing for more than a decade that inflation could be contained without a recession by using "incomes policies," a euphemism for government interference in wage and price setting. In the fall of 1971, over the objections of his conservative economic advisers, Nixon decided to give "incomes policies" a try. The result, over the next several years, was that the cure was worse than the disease: "incomes policies" made inflation and unemployment higher, not lower.

In addition, as part of his 1972 re-election campaign, President Nixon undertook a large expansion of Social Security. Along with wage-price controls, this enlargement of the welfare state makes Nixon's economic policies worse than those of any subsequent President, at least from my perspective.

President Ford's brief administration, from 1974-1976, was ineffectual. Most notably, Ford failed to lift price controls on oil and natural gas, so that this was a period of gasoline rationing and an "energy shortage."

It was under President Carter that the tide began to turn against "incomes policies." In fact, much of the liberal agenda of government intervention in markets was discredited by this point. As a result, Carter undertook some major initiatives for deregulation, particularly in the transportation sector.

On the inflation front, Carter illustrated Winston Churchill's remark that Americans will do the right thing after they have tried everything else. Having tried all manner of incomes policies, Carter gave up and appointed Paul Volcker as Federal Reserve Chairman with a mandate to bring down inflation by controlling the growth of the money supply.

The Carter Administration also ended with fewer controls on energy prices than the Nixon-Ford Administrations. However, Carter failed to end oil price controls completely, and on energy policy he is best known for creating the Department of Energy, a sinkhole for billions of wasted research dollars.

The Reagan Difference

When Ronald Reagan defeated Carter's re-election bid, "incomes policies" were a proven failure. Notwithstanding Milton Friedman's comments quoted above, by 1980 it took a lot less courage to stand by a monetary approach to disinflation than it did a decade earlier. I believe that Carter would also have stuck with Volcker through the recession, and if that is the case, then the behavior of the economy in the 1980s would have been about the same regardless of who had been President. Of course, I generally believe that the business cycle follows its own course, and that giving credit or blame to a President is an attribution error. Thus, Presidents who enjoy strong economic performance, like Clinton, are over-rated in my opinion, while Carter, who suffered from the policy errors of previous Administrations and had began to undo those errors, is under-rated on economics. (I have plenty of issues with Carter on foreign policy, but that is another subject.)

I believe that President Reagan made a positive difference for the economy. However, unlike most analysts, I do not focus on his tax cuts. Instead, I think that Reagan's main contributions were on energy policy, tax reform, and resisting government expansion.

President Reagan's energy policy was to lift price controls and trust the market to take care of OPEC. In doing so, he ignored conventional wisdom at the time. I believe this took even more courage than standing by Paul Volcker, and even today it is difficult to find a politician who appreciates Oil Econ 101.

President Reagan's other big achievement was tax reform -- not the tax cuts of 1981 but the reform of 1986 which flattened the tax structure, eliminated loopholes, and removed some of the disincentive toward saving that plagues our tax system. Unfortunately, the tax system moved in the opposite direction under President Clinton, which is one reason that I believe that Clinton is over-rated on economics.

On the welfare state, President Reagan's record is mixed. He did not touch the "third rail" of Social Security, so he brought about no significant long-term reduction in government's role in the economy. A major examination of Social Security during the Reagan Administration resulted only in a large payroll tax increase that improved the system's financial condition but left its fundamental character unchanged.

However, nearly every other recent President has sought an expansion of the welfare state -- Nixon's enlargement of Social Security, Clinton's attempt at national health care, and George W. Bush's Leave No Educrat Behind and prescription drug benefit programs. So I give Reagan credit for simply holding the line, particularly since unlike George W. Bush, President Reagan had to contend with a Democratic Congress.

The Main Lesson

The main lesson that I believe one learns from examining the Reagan economic record in context is that his tax cuts are not the only thing, or even the main thing. In the Reagan era, monetary policy mattered a great deal. On the supply side, we must pay attention to the structure of the tax system and to regulatory policy, as Reagan did with energy.

Finally, the government's size ultimately will depend not on the tax rates that we set today but on the role that we choose for government long term in education, health care, and retirement security. If we continue to give government a large role in these fast-growing sectors, then spending and taxes as a share of GDP will inevitably increase. I call this The Great Race, and so far under President Bush it is a race that we are losing.


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