Why Reagan Supply-Side Economics Did Not Work: Part III

While President Reagan had excellent intentions and some good policy prescriptions, his economic platform ultimately fell far short, as I suggested in two previous columns: Part I and Part II.

The key underlying fault lines were tax reform and monetary reform.

He succeeded in lowering tax rates — the individual rate from 70 percent to 28 percent, and the corporate rate from 46 percent to 39 percent, according to the Tax Foundation. The problem: tax rates on personal income were lower than that for corporate income for all income levels.

This dynamic caused a huge increase in the formation of Subchapter S corporations, whereby proprietors transform corporate income into personal income to minimize tax liability. By 2003, nearly 62 percent of all corporations were S corps, according to the Internal Revenue Service. This environment lowered the incentive to retain earnings and reinvest in employees, equipment and infrastructure.

Investment as a share of GDP fell from 21.75 percent at the start of 1981 to 19.5 percent in the beginning of 1989, a 10 percent decline, according to the International Monetary Fund. Following the financial collapse in 2009, investment relative to GDP hovered near 15 percent, a 31 percent drop from 1981.

Concurrently, consumption as a share of GDP began to rise, from approximately 60 percent in 1981 to 64 percent in 1989. For the previous three decades, this figure held steady at 60 percent. Consumption is now approaching 70 percent of the economy.

High levels of consumption have less of an impact on overall economic growth than does investment, since the expenditure comes at the end of the production process instead of at the beginning. With investment, collateral spending takes place, which acts as an economic multiplier that sustains activity for the long term.

As consumption grew, the merchandise trade deficit as a share of GDP expanded, from close to zero to as high as 3 percent, before declining briefly when the U.S. dollar was devalued during the Plaza Accord of 1985, according to Haver Analytics. This deficit caused a drain on domestic savings, falling from 10 percent to 8 percent, according to the Federal Reserve. Lower savings reduced the quantity of funds available for investment.

Monetary velocity, or money turnover, declined 23 percent during Reagan’s presidency (33 percent in the first six years alone). While some of the decline was due to high interest rates that reduced demand and inflation, the decline was significant. Today, this figure is 61 percent below the 1981 level.

Less direct investment in the real economy was replaced with the creation of huge swaths of financial products and services, which began in earnest during the 1980s. From 1950 to 1980, financial assets were four times the size of the economy. By 2007, this figure rose to 10 times. Financial speculation and arbitrage became the order of the day, which tend to transfer income and wealth rather than create it.

Irresponsible financial deregulation was another impediment. Despite large losses for the savings & loan industry due to mismatched assets and liabilities (they received lower rates on long-term loans than what they paid for short-term deposits), S&Ls were permitted to operate with lower capital standards and received greater deposit insurance. The implicit loan guarantees provided by the government lead to a $124 billion taxpayer financed bailout of the industry in the late 1980s and 1990s, an ominous precursor of the 2008 financial and economic collapse.

As investment declined and consumption rose, income and wealth inequality began to increase after declining for the previous four or five decades, according Emmanuel Saez and Gabriel Zucman of the National Bureau of Economic Research in the graphic below.

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Today, we are starting to near the disparities that existed prior to the Great Depression.

The principal reason that our economy was able to transform from a real economy to a financial one was the ability of the Fed to extend massive amounts of credit to the financial institutions, which was then transferred to their clients many times over.

When the U.S. completely abandoned the gold standard in 1971, credit and debt were created more readily, since they were no longer backed by a real resource produced with an efficient allocation of land, labor and capital.

During Reagan’s term, total debt relative to GDP rose from roughly 160 percent to 230 percent, the steepest rise since the Great Depression, according to the Bureau of Economic Analysis and the Fed.

This type of irresponsible credit and debt creation would not have been attainable if Reagan instituted an asset-backed currency that was included in both the 1980 and 1984 republican presidential platform.

Money creation that is partially backed by tangible assets, such as gold, silver and virtual currencies, provide incentive for responsible growth that maintains purchasing power.

The assets backing the money stock would serve as a capital cushion to absorb potential losses due to insufficient management or uncertain and unpredictable geopolitical and economic conditions. Embedded in the value of the currency is the production cost of these products, thereby acting as a proxy for price control through market mechanisms. This monetary mechanism would be less susceptible to manipulation by sovereign or special interests.

Unlike the previous gold standards that had a fixed price of gold, this model would be based on a floating rate that could adjust to changing economic conditions. The Bretton Woods agreement in 1944 collapsed in the early 1970s because the U.S. dollar was not permitted to fluctuate fully relative to global currencies and the price of gold was fixed at a specific dollar value.

Foreign entities were able to purchase gold and dollars relatively cheaply. By the early 1970s, the quantity of U.S. dollars abroad exceeded the value of gold in the United States at the fixed price. In 1971, President Nixon disbanded the gold standard policy.

A strong economy is predicated on major tax and monetary reform.

© 2015 Newsmax Finance. All rights reserved.

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