Did Reaganomics kick-off with a Keynesian stimulus?

Did Reaganomics kick-off with a Keynesian stimulus?

Joey Moloney
April 7, 2014

Ronald Reagan was elected in 1980 on a radically new economic platform promising an end to the 1970s stagflation and the perceived failures of Keynesian demand management.  Among his promises were drastic cuts to taxes and government spending, and a balanced budget by 1984.

Upon entering office in early 1981, the Reagan administration was confronted with a looming recession. Recently appointed Federal Reserve Chair Paul Volcker – under the monetarist assumption that inflation is always and everywhere a monetary phenomenon – had aggressively tightened the money supply to combat the high rates of inflation. Consequently, interest rates hit a peak of around 19%. This heavy-handed approach may have had adverse consequences. By 1982, the country had plunged into recession, with a 1.9% contraction in GDP, and unemployment hitting 10.8%.

From around mid-1981 the Reagan administration set about implementing their key election promise of tax cuts, but without too much thought for their flipside promise of spending cuts. In fact, government expenditure grew significantly – by about 2.5% of GDP by the end of 1982. This situation is illustrated by the significant divergence in Figure 1 below, which shows the federal government’s tax revenue and expenditure as percentages of GDP over Reagan’s first term.

Figure 1 – Federal government tax revenue and expenditure as a percentage of GDP

What Figure 1 also demonstrates is essentially the Keynesian prescription for combatting a recession. Namely, cutting taxes to give consumers more disposable income and confidence, and increasing government consumption to make up for shortfalls in aggregate demand.

So, the question begs – did  this unintended stimulus work?

Figure 2 below shows economic growth over the same period. The recession in 1982 is obvious. What follows it is two years of strong and increasing growth. Figure 3 is also in support, showing a hasty turnaround and improvement in the unemployment rate starting in 1983.

Figure 2 – Economic growth

Figure 3 – Unemployment rate

However, this could all be coincidence. Just because one event follows another does not imply causation. But given historical precedents of similar policy prescriptions having similar effects in similar situations, it is not unconsidered to subscribe to the view that the stimulus did indeed induce the recovery.

This is the opinion of economist Paul Krugman. He heralds a 14.4% increase in real government spending across President Reagan’s first term as the cure for a recession induced by excessively contractionary monetary policy. Nobel Laureate Robert Solow is also in support. He stated that “the boom that lasted from 1982 to 1990 was engineered by the Reagan administration in a straightforward Keynesian way by rising spending and lowered taxes, a classic case of an expansionary budget deficit”.[1]

John Kenneth Galbraith noted an amusing reality that a Keynesian stimulus was undertaken by people who did not actually understand Keynes and were in fact ardent critics of him. He quipped that the policies could be described as “involuntary anonymous Keynesianism”.[2]

Moderate to left-leaning economists are not alone in the contention that the administration, whether intentionally or not, exhibited Keynesian tendencies. Taking a similar position was Austrian economist Murray Rothbard. Writing in 1987 he poured scorn on the myth of Reaganomics as a small-government revolution. In acknowledging the increased government spending, he labelled the administration and its policies as simply “conservative Keynesianism”.[3]

In the August 1984 Monthly Labor Review, the US Bureau of Labor Statistics described the recovery as “unusually strong” – the strongest since that of the 1953 recession. A closer look sees that consumption increased 41% from 1981 to 1984, while business investment increased by only 12%. Economist and historian Marc Levinson contends that this is indisputable proof of a recovery driven by the demand of millions of consumers. Exactly what Lord Keynes would have predicted.[4]

Perhaps one of the more detailed analyses came from distinguished Post-Keynesian economist Alfred Eichner. Eichner identified three groups of economists inside the administration; 1) monetarists who were primarily concerned with limiting the growth of the money supply to control inflation; 2) supply-siders who were primarily concerned with lowering tax rates; and 3) fiscal conservatives who were primarily concerned with balancing the budget. He identifies two periods; 1981-1982, and 1982 onwards, in which the relative influence of two of these groups shifted. In the first period the monetarists proved most influential, evidenced by the tight monetary policy and high interest rates. However, by the second period, lower tax rates and a reversal of the restrictive monetary policy indicates an increase in the relative influence of the supply-siders.[5]

The supply-siders suspected that the previous tax arrangements sat on the downward sloping portion of the Laffer curve  (meaning rates were too high, to the point where economic activity was being discouraged and potential revenue lost). The fiscal expansion undertaken by the administration was to be funded by the extra revenue the tax cuts were supposed to generate . This incorrect forecast was the ultimate cause of the deficit blowouts and according to Eichner, provided the perfect fiscal policy automatic stabiliser to put the economy back on track.[6]

History holds the Reagan administration as a critical period in which supply-side economics gained the ascendency, while the influence of Keynesianism declined. As a general comment, this is certainly the case. However, it is hard to not be convinced that the Reagan administration rode through their first term on the back of Keynesian stimulus. As James K. Galbraith put it, “on fiscal matters supply-siders have behaved, more than not, much as pragmatic Keynesians would have done”.[7]

Read more:

[1] Nicholas Wapshott, Keynes, Hayek: The Clash That Defined Modern Economics (US: Norton, 2011), 265.

[2] Wapshott, Keynes, Hayek: The Clash That Defined Modern Economics, 265.

[3]Murray Rothbard, “The Myth of Reaganomics” in The Free Market Reader, ed. LH Rothwell Jnr (US: Mises Institute, 1988), 342-362.

[4] Marc Levinson, Beyond Free Markets: The Revival of Activist Economics (US: Lexington Books, 1988), 27-28.

[5] Alfred Eichner, “The Reagan Record: A Post Keynesian View,” Journal of Post Keynesian Economics 10.4 (1988); 543-544.

[6] Eichner, “The Reagan Record: A Post Keynesian View,” 548, 553.

[7] James K. Galbraith, ”Paradox Among the Paradigms: A Comment on Eichner, Meltzer, Bowles and Co-Workers, and Miles,” Journal of Post Keynesian Economics 10:4 (1988); 571.