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.

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.

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Reagan Supply-Side Economics Did Not Work

The impediment to our economic progress is the dearth in supply of productive assets.Thirty five years after the introduction of supply-side economics by President Reagan, we are in the unenviable position being left with the trickle in a trickle down economy.The reason: low levels of direct investment in the real economy for many decades.

The Reagan revolution ushered in heavy investment in financial assets. From 1950 to 1980, financial assets were four times the entire economy, according to the Federal Reserve. By 2008, they reached an astonishing 10 times, which precipitated the financial and economic collapse.

The creation and trading of these assets manifested relatively little in terms of jobs and income for the masses, as compared with direct investment. Instead, they functioned to transfer wealth and concentrate it by promoting financial speculation and arbitrage, which tends to be a zero sum game.

From 1987 through 2008, U.S. research and development rose a mere 0.3 percent per annum, compared with 4.9 percent annually from 1953 through 1987, according to Information Technology & Innovation Foundation, a non-partisan research and educational institute. From 1980 through 2008, gross private domestic investment as a percentage of GDP fell 40 percent, resulting in a 60 percent decline in the turnover of money (monetary velocity), according to the Federal Reserve.

Diminished levels of investment in labor and capital have led to a dearth in supply and productivity. Since 1999, labor force participation has declined 5 percentage points, and labor productivity is growing at 1.3 percent per year, the lowest rate in nearly 40 years, according to the U.S. Department of Labor.

The labor force will continue to erode as the baby boomers enter retirement, which began in 2008. Since then, new retirees added to the social security system have risen 50 percent to 2.7 million per year, compared with 1.8 million in the prior decade. The labor force is projected to grow at a mere 0.5 percent rate in the coming decades, a third of the 1.5 percent rate since 1950, according to the Congressional Budget Office.

Another critical issue: there are not enough job vacancies to absorb the unemployed.

In 1999, the unemployment and job vacancy rates were both 4 percent. In an ideal setting, this would signal a perfect clearing of the labor supply by employers demanding employees. Today, unemployment is around 6 percent, while the job opening rate is 4 percent: there are not enough jobs to absorb those seeking work.

Moreover, this unemployment figure excludes the additional 5 percent of the labor market that is no longer counted as unemployed since 1999, bringing the possible supply of labor to an astonishing 11 percent.

Many of these individuals do not possess the skills required by business to compete globally. The poor education system over the past three or four decades undermined the cognitive, social and emotional skill acquisition of our population, This is evidenced by our grossly inadequate performance on standardized secondary examinations in math and english, low tertiary graduation rates, and insufficient pragmatic problem solving abilities.

Less labor and lower productivity will result in lower income and tax revenue, greater deficits and higher debt relative to income, making entitlement programs more at risk to cuts in benefits. In addition, the low supply of real goods and services will place upward pressure on prices in the real economy, which will undermine purchasing power, especially for the lower and middle classes.

Inflation has already impacted the financial economy, where stock and bond prices have increased substantially in the low interest rate environment.

Increasing the supply of productive assets is critical.

My tax plan will do this by eliminating and replacing all federal taxes with a 10 percent consumption tax on purchases above the federal poverty level and a 2 percent savings tax, which excludes retirement, educational and charitable entities. This plan would increase investment, employment and income while balancing the budget at current spending levels, providing a strong safety net to those disadvantaged, and sustaining strong purchasing power for the coming generations.

Future generations are depending on us.

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