Reaganomics: Olivier Jean Blanchard

Economic Policy October 1987 Printed in Great Britain
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Reaganomics
Olivier Jean Blanchard
Summary
President Reagan came to the White House promising a major shift

to conservative economic policies. His program included a supply-
side revolution, a scaling down of wasteful government activity,
lower taxes and less interference with the market economy. As a
result, it was expected, the US economy would become more efficient,
with faster growth and minimal inflation. Tax reductions would
pay for themselves so that the budget would soon return to balance.
Fiscal expansion did help bring down unemployment, but the
administration soon learned that tax cuts led to trade and budget
deficits. Though early dreams remain unfulfilled, the Reagan period
represents a turning point in US economic policy making. Inflation
has been much reduced, and the credibility of tight monetary policy
enhanced. More importantly, there are signs that Reagan has won
his political bet: early tax cuts generated budget deficits which exerted
the pressure required to turn the tide of rising government spending,
and change its composition.
The verdict on supply-side policies is not yet clear. Two major
tax reforms (in 1981-83 and 1986) have profoundly modified the
landscape. Investment has been shielded from the effects of a tight
anti-inflationary monetary policy and many distortions have been
reduced. So far, however, there is little evidence either of any increase
in private savings or of a boost to productivity.
On the liability side, the US now faces a larger public debt and
has become indebted to the rest of the world. Corrective actions will
have to be taken, and some are already under way. They will have
significant but not dramatic costs. With all its shortcomings,
Reaganomics has achieved more than most conservative policies in
Europe.
Reprinted from 77i« Washington Post, Nov. 15, 1983

T0TJ4E gOMlSEP LAW/
The prophet
MH*e»aiw,
Reaganomics

Olivier Jean Blanchard
Massachusetts Institute of Technology and NBER
1. Introduction
In a country suffering from low growth, inflation and the Carter malaise,
the Reagan administration began with promises of a supply-side revo-
lution. Lower inflation, lower taxes and a smaller government were
going to boost productivity and growth. Thanks to the Laffer curve,
cuts in taxes were going to generate increased revenues and help balance
the budget.
The dreams did not last long. As it became clear that tax cuts would
lead to deficits rather than to cuts in spending or a balanced budget
supply-side boom, the strategy was abruptly changed. The centerpiece
of the policy became and has remained a political bet, the bet that cuts
in taxes would create, via deficits, the political pressure to reduce
government spending. It is this bet which, more than anything else,
distinguishes the Reagan conservative strategy from its European
counterparts and their strategy of fiscal austerity. Tax-cut induced
deficits, with their supply and demand-side effects have determined
the strength and the shape of the recovery; and they will affect the
future for a long time. If successful, they will lead to lower taxation
and lower spending. Successful or unsuccessful, they will have per-
manently modified the structure of taxation and will leave a legacy of
higher internal and external debt. Was it all worth it? That is the
question that this paper attempts to answer.
The dynamics of policy were set in motion during 1981-83. The
monetary contraction started under Carter was followed by large tax
cuts from 1981 to 1983, leading to the tight-money loose-fiscal mix
I thank Athanasios Orphanides for excellent research assistance, Jim Poterba for help and
comments and Cary Brown, Franco Modigliani, Larry Summers and Charles Wyplosz for dis-
cussions. I thank Data Research Inc. (DRI) for access to their data and forecasts, and NSF for
financial assistance.
18 Olivier Jean Blanchard
which has characterized the last six years. From 1981 to 1985, as inflation
decreased and deficits mounted, the economy went successively through
a recession and a sustained expansion. In 1985, a process to achieve
the required spending cuts was put in place tentatively, and in 1986
tax cuts were consolidated and modified through a tax reform that is

now being implemented. The speed at which spending cuts will be
achieved is still highly uncertain. Section 1 gives a factual account of
those policies, setting the stage for the analysis of the rest of the paper.
Section 2 studies the effects of policy on the macroeconomy since
1981. It first looks at the initial disinflation. It then shows the role of
tax cuts and deficits in shaping the subsequent recovery. Finally it
speculates as to what would have happened had the administration
followed a no-deficit strategy. The evidence suggests that tax cuts and
deficits deserve a good part of the credit for the prolonged recovery.
The rest of the paper looks at the implications of the policy for the
future.
Section 3 assesses the likely outcome of the political bet. It concludes
that even if, as now seems likely, future deficit reductions come both
from tax increases and spending cuts, the size and composition of
government spending will have been affected by Reagan policies. Those
effects however pale in significance when compared to the build-up in
social entitlement programs of the post-war period. They show the
stringent limits faced by conservative policies, for better or for worse,
in changing the role of government in the economy.
Section 4 examines the potential medium and long-run effects of
deficits and debt. It concludes that there is little justification for the
belief that debt accumulation will eventually prove disastrous. But debts,
both internal and external, carry a cost. US fiscal deficits have reduced
and will reduce world saving, capital accumulation and future output,
and have imposed a burden not only on the US but also on the rest of
the world. Higher internal debt also implies higher taxation and larger
distortions in the future. Finally, induced US trade deficits have led to5
a transfer of wealth, which must be either reversed or permanently
financed, through a trade surplus and real dollar depreciation. Those
costs are hard to quantify; back-of-the-envelope computations suggest
that they are neither very large nor insignificant.
Section 5 returns to the supply-side effects which were the focus of
the initial strategy. To date the most obvious effects are those on
investment, through the tax-shielding of capital accumulation from high
interest rates. But the investment incentives of 1981 were largely
removed by the 1986 tax reform. Other supply-side effects have been
hard to detect, harder indeed than even many skeptics expected. Despite
deficits, higher real interest rates and tax incentives, private saving has
Reaganomics 19
not increased. There is at this stage little or no hard evidence of a
current or impending productivity boom.
The concluding section gives a brief summary of the findings.
Whether one judges the policy a success depends ultimately on one's
values. The policy has not led to a supply-side explosion, which would

be applauded from all quarters. But it has reduced inflation and
redefined the role of the government, two of the main items on the
conservative agenda. And it has done so without wreaking major havoc
on the economy, a feat unmatched in Europe.
2. Monetary and fiscal policy

The first two years of the Reagan administration largely set the stage
for what was to follow. Monetary disinflation had been set in motion
under Carter; the role of Reagan was to give it more credibility. The
drastic change in fiscal policy was however the administration's own
doing. The tax cuts voted in 1981, and implemented over the following
three years, were to trigger increasingly larger deficits over time. Tight
money and increasingly expansionary fiscal policy were to lead first to
recession and disinflation, then to a sustained expansion. The basic mix
remained the same until 1985-86, when tax changes were consolidated
and modified in a tax reform, and when, because of the mounting
political pressure from large deficits, new rules of the budget game and
a tentative schedule of spending cuts were agreed.
2.1. Fighting inflation: monetary contraction
The decision to fight inflation through monetary contraction had been

taken in October 1979, more than a year before the election. Neverthe-
less, there had been considerable uncertainty during 1980 as to the
Federal Reserve's resolve. Fears had been fueled, in particular in the
spring and summer of 1980, by the decrease in short nominal rates in
the face of a recession. The election of the new administration was
important in increasing the credibility of tight monetary policy. Credibil-
ity was further strengthened when, in June 1981, nominal rates were
sharply increased in the face of a new impending recession.
Table 1 gives nominal and real short interest rates for the period
1979-86. It also gives both the target ranges and the actual values of
the rates of growth of the main monetary aggregates. Focusing first on
the disinflation period 1981-83, two aspects of the table are striking.
The first is the large increase in real interest rates starting in 1981. The
second is the absence of any slowdown in the rate of growth of measured
monetary aggregates. Target ranges for M l , M2 and M3 were rarely
Table 1. Monetary policy, 1979-86. Short real interest rates and monetary
aggregates (% per year)
1979 1980 1981 1982 1983 1984 1985 1986

Nominal interest
rate 10.0 11.5 14.0 10.6 8.6 9.5 7.5 5.9
Expected inflation 8.4 9.0 9.5 6.0 4.0 3.9 3.0 3.0
Real interest rate 1.6 2.5 4.5 4.6 4.6 5.6 4.5 2.9
Growth rate of M l b
Target 1.5/4.5 4.0/6.5 3.5/6.0 2.5/5.5 4.0/8.0 4.0/8.0 4.0/7.0 3.0/8.0
Actual 5.0 7.3 5.7 8.5 7.2 5.2 11.9 15.3
Growth rate of M2
Target 5.0/8.0 6.0/9.0 6.0/9.0 6.0/9.0 7.0/10.0 6.0/9.0 6.0/9.0 6.0/9.0
Actual 9.0 9.8 9.4 9.8 8.3 7.7 8.6 9.1
Growth rate of M3
Target 6.0/9.0 6.5/9.5 6.5/9.5 6.5/9.5 6.5/9.5 6.0/9.0 6.0/9.5 6.0/9.0
Actual 9.8 9.9 11.4 10.3 9.7 10.5 7.4 9.0
Source: DRI Database.

Note: Nominal interest rate: yearly average of the values of the 3 month Treasury Bill
rates for January, April, July and October. Expected inflation: yearly average of the
December, March, June and September DRI forecasts of inflation over the following
three months. Real interest rate: difference between the nominal rate and expected
inflation. Monetary aggregates: Target ranges: targets published in February of year
t, for the percentage change from the 4th quarter of year (— 1 to the 4th quarter of
year t (source: Modigliani, 1987); actual values: percentage change from 4th quarter
of year / — 1 to 4th quarter of year (.
achieved in any of the years 1979 to 1982; credibility was clearly achieved
without strict adherence to any particular growth rate for M l , M2 or
M3. The Volcker disinflation was surely one of the most pragamatic of
recent disinflations.
By 1983, inflation was down to 4%, the recession was over and the
economy was growing. Deficits had swollen and monetary policy was
no longer center-stage, but it still played an important role. Table 1
shows that the Fed, faced with high fiscal deficits, decided to maintain
high real interest rates, and in the process to accept high and fluctuating
growth rates of the monetary aggregates. Real interest rates were, until
the end of 1985, high and roughly constant; they have since declined.
Neither the systematic failure to achieve monetary targets, nor the move
towards interest rate targets, nor even the decline in real interest rates
as activity slowed down in 1986 seem to have undermined the credibility
of the anti-inflation commitment of the Fed.
2.2. Putting on the pressure: the tax cuts of 1981-83
The rest of the action has been in fiscal policy. Table 2 gives data for
spending, taxes and deficits as a percentage of GNP for 1964, 1970
Reaganomics 21
Table 2. Government spending, receipts and deficits (% of GNP)
Fiscal Years 1964 1970 1980 1981 1982 1983 1984 1985 1986
Spending 18.8 20.0 22.0 22.8 24.0 25.0 23.7 24.4 24.6

Interest 1.2 1.4 1.9 2.0 2.6 2.7 3.0 3.3 3.2
Non-interest purchases 17.6 18.6 20.1 20.6 21.4 22.3 20.7 21.1 21.3
Defense 8.2 7.9 5.1 5.4 6.0 6.3 6.2 6.5 6.5
Non-defense 2.5 2.2 2.4 2.4 2.4 2.3 1.9 2.2 2.2
Transfers 4.4 5.6 8.8 9.2 9.7 10.2 9.3 9.1 9.4
Others 2.5 2.9 3.8 3.6 3.3 3.5 3.3 3.3 3.3
Receipts 18.6 20.0 20.2 20.8 20.5 19.4 19.2 19.6 19.8
Personal taxes 8.1 9.5 9.4 9.6 9.9 8.8 8.2 8.7 8.6
Corporate taxes 4.1 3.3 2.6 2.3 1.6 1.6 2.0 1.7 2.1
Social insurance 4.0 5.3 6.8 7.1 7.3 7.4 7.5 7.7 7.8
Others 2.4 1.9 1.4 1.8 1.7 1.6 1.5 1.5 1.3
Balance -0.2 0.0 - 1 . 8 -2.0 -3.5 -5.6 -4.5 -4.8 -4.8
Inflation-adjusted 0.4 1.2 0.2 0.3 - 1 . 8 - 4 . 3 - 2 . 7 - 3 . 7 - 3 . 8
Primary 1.0 1.4 0.1 -0.2 -0.9 -2.9 -1.3 -1.5 -1.6
Source: Historical Tables, Office of Management and Budget, Washington.

Notes: Numbers are for fiscal year. Inflation-adjusted deficits are computed by taking
out of nominal interest payments the product of the inflation rate for the fiscal year
times the level of debt at the beginning of the fiscal year.
and 1980-86.' Deficits rose because of all three components: non-

interest spending, interest payments and tax cuts. Tax cuts can be traced
in turn to the very first tax change, the 'Economic Recovery Act' (ERTA,
or less formally Kemp-Roth) of August 1981.
Kemp-Roth had three main components: the first was a cut in personal
taxes, coming from decreases in income tix rates phased over three
years, and from tax breaks on savings. Income tax rates were decreased
in three instalments, (5%, 10% and 8%) over the following three fiscal
years. Table 3 shows the effects of those cuts on marginal and average
tax rates for families with different incomes. The proportional decrease
in average tax rates for 1984 is similar across income levels. Other tax
breaks were targeted at savings. Of those, the most significant was a
$2,000 income deduction per worker for contributions to an individual
retirement account (IRA). 2
The second component of Kemp-Roth was a cut in business taxes.
The main element was an acceleration of depreciation for tax purposes.
1
Whenever they exist, I report numbers on a national income accounts basis. The government
and the budgetary process however use and report numbers on a 'unified budget' basis, which
uses slightly different accounting conventions. For example, asset sales are counted as revenues
in the unified budget accounts, but not in the national income accounts. Some of the numbers
below, such as CBO projections, or Gramm-Rudman targets, are 'unified budget' numbers.
2
Income from those accounts is untaxed as it accrues, and taxed as ordinary income when
withdrawn. There is a penalty for withdrawals before age 59.5.
Table 3. Effects of the 1981-84 income tax cuts on marginal and average tax
rates (%)
Average tax rates

Marginal Excluding social Including social
tax rates insurance insurance
Families with:
5 median income
with ERTA 16 6.7 13.4
without ERTA 21 8.7 15.5
median income
with ERTA 25 10.3 17.0
twice median income
with ERTA 38 16.7 20.8
Source: Hulten and O'Neill (1982).

Notes: Rates computed on the basis of 1983 projections for 1984 incomes.
Assets were grouped in four categories and given write-off periods of

3, 5, 10 and 15 years. For most assets, this implied much faster write-off
and larger depreciation deductions. The rate of investment tax credit
was also increased. To a large extent, these tax breaks were offset by
the increase in real interest rates stemming from tight money. To think
about the relative effects of tight money versus tax breaks I use in Table
4 a procedure developed by Auerbach (1987). The user cost of capital
(the implicit cost of capital services) is directly proportional to the sum
of the required real rate of return and the rate of depreciation. The
coefficient of proportionality is related to the corporate income tax, the
investment tax credit and the present value of depreciation deductions.
The required real rate of return itself is the weighted average of the
real after-tax interest rate on debt and the real rate of return on equity,
with weights proportional to the relative shares of debt and equity
financing. The effect of tight money is to increase the user cost of capital
roughly one-for-one with the increase of the required real rate of return,
as both rates on debt and equity rise. The effect of tax reform is to
increase the present value of depreciation deductions by shortening
the write-off period. Simple calculations (see Appendix) suggest that
the tax measures reduced the user cost by 1.5 to 3 percentage points,
only partially offsetting the tight money effect which added 3 to 5
percentage points to the user cost.
The results of a more detailed computation are given in Table 4,
which gives user costs and effective tax rates for equipment and struc-
tures, under the 1980,1981 and 1986 tax laws, and under three different
Reaganomics 23
Table 4. User costs and effective tax rates under the 1980, 1981 and 1986 laws
and alternative inflation and real rates of return (%)
1980 legislation 1981 legislation 1986 legislation

Effective Effective Effective
User Cost tax rates User Cost tax rates User cost tax rates
(1)
£ = 1 0 % r=1.5%
structures 7.6 63.5 6.9 56.1 6.5 51.5
equipment 11.8 54.5 11.3 45.5 11.8 54.3
(2)
p=5%, r=3.75%
structures 10.6 47.8 9.6 38.8 9.3 35.5
equipment 13.9 30.7 13.2 21.0 14.1 32.9
(3)
p=5%, r=5%
structures 12.7 58.2 11.5 47.4 11.0 45.2
equipment 15.6 37.5 14.9 20.5 15.7 44.8
Source: Author's computations following a program adapted from Auerbach (1987).

User costs, effective user costs and effective tax rates for 34 types of investment goods
are computed and then aggregated into two classes, equipment and structures.
Notes: p is the inflation rate; r is the required after tax of return. The effective tax rate
is T=l—(r/(c—d)), where c is the user cost and d the rate of depreciation. For details
see Appendix.
assumptions about inflation and the required rate of return. The

effective tax rate is defined as that rate which, if imposed on the true
income from a new investment, would have created the same incentive
to invest as the existing combination of corporate taxes, depreciation
deductions and investment tax credits. It measures the effect of taxation
on the incentive to invest. The table gives results in line with the above
rough computation. Effective tax rates decreased by 25% on average
as a result of the 1981 tax changes. But the decrease was probably
insufficient to cancel the effect of the increase in the real interest rate.
The third part of Kemp-Roth, which was delayed until 1985, was the
indexation of tax brackets and minimum taxable income. To a large
extent, the decrease in inflation has made indexation less important,
at least for the time being. But together, through the elimination of
fiscal drag, this decrease has affected the dynamics of the budget process
in an important way. This can be seen by looking at 'baseline projections'
constructed by the Congressional Budget Office before and after
Reagan's action. These baseline projections are not forecasts, but projec-
tions assuming roughly no change in the current tax structure and in
the level of real spending. Previously, those projections always showed
very large surpluses over the long run. For fiscal year 1980 for example,
while the current surplus was projected at —1.6%, the five-year-ahead
projection had surpluses of 6.6%. For fiscal year 1981, the numbers
were respectively —1.7% and 4.3%. To a large extent, what was left to
Congress was then to decide how much of this fiscal drag to offset

through lower nominal tax brackets, and how much to use for increased
spending. Since 1981 however, the projections for each year show no
improvement as the horizon increases. For fiscal year 1984 for example,
the current surplus was projected at —5.3%, the five-year-ahead surplus
at —6.1%. The issue is no longer how much of the fiscal drag to
redistribute.
After Kemp-Roth, there was little fiscal policy action until 1986. Some
of the decrease in corporate taxation was undone by the 1982 Tax
Equity and Fiscal Responsibility Act (TEFRA). Minor adjustments were
made in the Deficit Reduction Act of 1984. These were quantitatively
much less important. The main effects were to decrease personal and
corporate income taxes, which if there had been no further change in
legislation, would have led to shortfalls in revenues respectively of $225b
and $54b for fiscal year 1986, larger than the actual deficit for that
year, $216b.
The increase in deficits also had little to do with changes in the level
of spending; this is apparent in Table 2. Total non-interest spending,
as a percentage of GNP, increased from 1981 to 1983, in large part
due to the recession, but subsequently decreased. By 1986 it was
approximately back to its 1981 value; (changes in composition however
were important; I shall look at them later). From 1981 to 1985 (fiscal
years), deficits increased from 2.0% to 4.8% of GNP. 3 As real interest
rates increased, inflation-adjusted deficits increased even more, from
a surplus of 0.3% to a deficit of 3.7%. Primary deficits (that is, deficits
excluding interest payments) increased from 0.2% to 1.5%. By 1985-86
the administration moved again, to push for a more comprehensive tax
reform and a progressive reduction in spending.
2.3. O v e r h a u l i n g the tax system: the 1986 tax reform
The stated purpose of the tax reform, signed in October 1986, was not
to reduce taxes further or to reduce deficits, but to reduce distortions.
The reform, not surprisingly, did not go as far as the initial proposals,
known as 'Treasury V and 'Treasury II'. In particular, it did not take
3
When the architects of the policy realized that tax cuts were going to lead to deficits is an
interesting question, but of more relevance to historians than to economists. Stockman's
autobiography (1986) suggests that he understood it very soon, as early as February 1981.
Reaganornics 25
the tax system in the direction of a consumption tax, as had initially
been considered, nor did it solve the problem of double taxation of
corporate earnings. But it was a wide-ranging reform, with effects on
both personal and corporate taxation.

The personal tax rate schedule that ran from 11 % to 50% will, when
the reform is fully implemented, include only two rates, 15% and 28%.
Because of phase-out provisions for deductions and exemptions
however, taxpayers with incomes between approximately 2 to 4 times
the median income will face marginal rates of 33%. At the same time,
and partly offsetting the effect of higher marginal tax rates at low income
levels, the reform has raised both personal exemptions and standard
deductions. Partly offsetting the effects of lower marginal tax rates at
higher levels of income, the reform has eliminated a number of tax
shelters and the favorable treatment of long-term capital gains. In doing
so, it has cancelled some of the earlier tax changes. In particular, it has
decreased the extent to which individual retirement contributions (IRA)
are deductible. The $2,000 dollar income deduction passed in 1981
remains available only to those with approximately median income, and
decreases as the income level increases. The net effect of those changes,
when the reform is fully implemented, will be to reduce marginal tax
rates for most taxpayers. Yet, computations by Hausman and Poterba
(1987) suggest that, except for the approximately 6 million taxpayers
who will no longer pay taxes, the effects on marginal tax rates will not
be very large: only 7% of taxpayers will see a change of more than 10%,
up or down, in marginal tax rates.
Corporate taxation has been substantially affected. The corporate
income tax rate has been reduced from 46% to 34%. At the same time,
the investment tax credit on equipment has been eliminated. In sharp
contrast to the 1981 changes, write-off periods have been lengthened
to get depreciation for tax purposes closer to economic depreciation.
The decrease in the corporate income tax reduces the user cost of
capital. The elimination of the investment tax credit and the longer
write-off periods, which imply a lower value of depreciation deductions,
increase user cost. Table 4 shows the changes in user costs and effective
tax rates which result from the tax reform. Effective tax rates on
equipment which, under the 1981 legislation, were lower than those
on structures are now approximately the same and there is a small
increase in the overall effective tax rate.
The tax reform is expected to be approximately revenue-neutral.
Current projections by the Treasury are of an implied cumulative
decrease in revenues from personal taxation of $130b for 1987 to 1991
together with a cumulative increase in revenues from corporate taxation
of $129b over the same period.
2.4. R e d u c i n g s p e n d i n g : G r a m m - R u d m a n
Political pressure on spending from the large deficits led in August

1985 to the 'Balanced Budget and Emergency Control Act', better
known as the Gramm-Rudman-Hollings bill. It stipulates a ceiling for

the deficit for each fiscal year: $l72b for fiscal year 1986, $144b for
1987, decreasing to zero by 1991. Starting with fiscal year 1987 (special
rules applied to 1986, in effect allowing the deficit to exceed the target
for that year), the process should be the following. By August, the
Congressional Budget Office and the Office of Management and Budget
estimate the deficits implied by the current budget plans for the follow-
ing fiscal year. If the amount exceeds the limit set by the act, automatic
cuts bring it within the limits.4 The cuts in spending should fall in equal
amounts on defense and non-defense spending. Some programs, such
as Social Security, are exempt and some programs are protected: cuts
in retirement programs are limited to cost-of-living adjustments, cuts
in Medicare are limited to 2% per year. This implies for example that,
of the $ 1,000b in outlays for fiscal year 1986, only $100b could be
subject to across-the-board cuts. The act, as voted, has few escape clauses.
One of them is that the act will be suspended should growth be negative
for two successive quarters.
Just like the introduction of indexation, Gramm-Rudman changes
the rules of the game. Indexation and the decrease in inflation elimi-
nated automatic tax increases. Gramm-Rudman introduces automatic
spending decreases. Both alter the nature of the status quo. It takes
explicit action, and the associated political risks, either to increase taxes,
or not to reduce spending.
What have we learned from the first round of Gramm-Rudman ? In
August 1986, the Office of Management and Budget and the Con-
gressional Budget Office estimated the (unified budget basis) deficit
implied by decisions of Congress to total $164b for fiscal year 1987,
$20b above the target. The cuts for the most part were illusory: $8b
from the sale of assets, such as Conrail, a federally owned railroad, and
a $ l l b windfall from a reform on the timing of taxes which will be
reversed in the next fiscal year. While this appears to be bad news, it
may well underestimate the self-restraint effect of Gramm-Rudman: as
we shall see when we look at forecasts of spending below, many cuts
were made before August in order to avoid the automatic cuts. Thus,
the message of the first round of Gramm-Rudman is ambiguous. I
4
In the original act, those cuts were to be made by the Comptroller General. After this provision
was declared unconstitutional in 1986, it was decided that the decisions would be made by a
joint committee of Congress.
Reaganomics 27
return to forecasts and guesses about the future course of deficits and
spending in Section 4.
3. Policy and the macroeconomy: 1981-86

After briefly reviewing the main macroeconomic events of the last five
years, I concentrate on two issues. The first concerns the cost of disinfla-
tion, the other the contribution of the deficits to the recovery.
3.1. T h e effects of the tight-money loose-fiscal m i x
From 1981 to 1986, the US economy went through three phases. The
first was dominated by monetary contraction, the second by fiscal
expansion. Anticipations of changes in the money-fiscal mix have
characterized the recent past. 5 The behavior of the main macroeconomic
variables is given in Table 5. Until 1982, the macroeconomy was domi-
nated by the effects of monetary policy. Deficits were still not large and
the main event was the increase in short real rates of interest. Once
financial markets believed that the Fed was committed to disinflation,
and thus to high real rates for some time, long real rates also increased.
Examination of the yield curve suggests that this happened in mid-1981
(see Blanchard, 1984). Distinguishing these credibility effects from
anticipations of high real rates due to anticipated higher deficits is not
easy, so that there is room for disagreement as to the precise timing.
By 1982 the increase in real interest rates had led to a sharp recession,
with unemployment reaching nearly 11 % by the end of the year. As
the increase in real interest rates was not fully matched by foreign
central banks, real actual and expected interest rate differentials also
led to a sharp dollar appreciation. The recession and the dollar appreci-
ation both contributed to the decrease in inflation, from 9.7% in 1981
to 3.8% in 1983.
By the end of 1982, budget deficits had become the dominant
macroeconomic force. Large deficits were strongly increasing aggregate
demand and putting pressure on interest rates. The policy of the Fed
was to only partially accommodate; the policy of foreign central banks
was to only partially respond to the US interest rates. The result was
an increase in US interest rates, a smaller increase in foreign interest
rates and further dollar appreciation. (See for example Blanchard and
Dornbusch; 1986; Feldstein, 1986). For the next three years, short and
5
The relation of monetary and fiscal policy to interest rates, exchange rates and activity is
remarkably well captured by the Mundell-Fleming model, spiced with expectational effects. See
for example the various essays in Dornbusch (1986).
Table 5. Basic macroeconomic statistics
1980 1981 1982 1983 1984 1985 1986
Unemployment rate (%) 7.0 7.5 9.5 9.5 7.4 7.1 7.0

GNP growth (%) -0.2 1.9 -2.5 3.5 6.5 2.7 2.6
Inflation (%) 9.0 9.7 6.4 3.8 4.1 3.3 2.7
Real short rates (%) 2.5 4.5 4.6 4.6 5.6 4.5 2.9
Real long rates (%) 2.5 4.9 6.0 5.1 5.9 6.6 3.9
Dividend-price
ratio (%) 5.2 5.2 5.8 4.0 4.2 4.2 3.4
S & P index,
(in 82 dollars) 138.5 136.1 119.7 154.1 148.1 167.2 208.5
Real exchange rates 84.8 100.8 111.7 117.3 128.5 132.0 109.5
Trade balance ($b) 33.2 34.4 26.3 -5.3 -59.2 -74.4 -105.7
Current acct
balance (fb) 13.0 10.6 -1.0 -32.7 -91.0 -111.0 -142.0
Source: DRI Database.

Notes: Inflation is the % change in the GNP deflator; Short real interest rates are
computed by subtracting from the three-month nominal rate DRI's forecast of inflation
in the month preceding the quarter, and taking yearly averages; Long real interest
rates are constructed using the following formula:
Rt = I-(l-a'-:)/(l-a) £ o-'£(ft +i |t-l)

where / is the 10 year bond rate, T is equal to 40 quarters, a is equal to 1.025, and
E(Pl+i\t— 1) is DRI's forecast of inflation at t+i as of t— 1; Dividend price ratio: ratio
of dividends to prices for the S & P index of 500 common stocks; S & P index: Standard
and Poor index of 500 common stocks; Trade balance: goods and services balance.
long real rates remained close to their 1982 values. Dollar appreciation
and higher real interest rates were not enough to offset the increase in
aggregate demand and there was sustained growth starting in 1983.
Dollar appreciation and growth combined to turn a trade surplus of
$26b in 1982 into a trade deficit of $75b in 1985, and to increase the
current account deficit from $ l b in 1982 to $11 lb in 1985.
By 1985 it had become clear that a shift in the money-fiscal mix was
required and might indeed be forthcoming. Anticipations of a decrease
in deficits, and the assumption that the Fed would again partly
accommodate any fiscal contraction, this time by a decrease in interest
rates, led to (or at least coincided with) a dollar depreciation starting
in early 1985. By 1987 signs of an actual shift in the mix are more
apparent. As a result of Gramm-Rudman, deficits are expected to
decrease from their 1986 high. Real short and long rates have decreased
by 2-3%. Dollar depreciation has not yet translated into trade balance
improvement: the trade deficit for 1986 was $106b, and the current
account deficit was $142b.
Reaganomics 29
This overview is in many ways too cut and dried. Various pieces of
the puzzle do not fit well.6 Two of them are relevant here. The first is
the behavior of the dollar exchange rate. While its movements are
broadly consistent with economic theory, the magnitudes and the timing
of the changes are more difficult to explain. (For a review of dynamic

effects of a fiscal expansion on the exchange rate, see for example Sachs
and Wyplosz, 1984. For a development of the view that the exchange
rate in 1985 was higher than could be explained by fundamentals, see
Krugman, 1985). In particular, the steady increase between 1983 and
1985 is not clearly related either to international interest rate differen-
tials or changes in the underlying value of the zero current account
equilibrium exchange rate. This is important because one of the legacies
of the deficits will be their effect on the exchange rate; I therefore
return to it in Section 5. The second issue is the behavior of the stock
market throughout the period (see Blanchard and Summers, 1984).
The stock market has increased in real terms by 84% since 1981, the
dividend-price ratio has decreased from 5.2% in 1981 to 3.4% in 1986.
This is not easy to reconcile with the behavior of long real interest rates:
one possibility is that the stock market anticipates faster growth of
dividends in the future. I return to this issue when discussing long-run
supply-side effects in Section 6.
3.2. T h e cost o f disinflation
One question which was much debated in the early 1980s was whether
the cost of disinflation in terms of foregone output, the 'sacrifice ratio',
would be lower if disinflation were more credible. There is little question
that, despite its lack of adherence to target ranges, the commitment of
the Fed to disinflation, backed by the support of the administration,
had become credible by the end of 1981. 7 Did credibility decrease the
sacrifice ratio?
To answer this question, I concentrate on the behavior of the Phillips
curve during the period. It is clear that monetary contraction, to the
extent that it led to high interest rates, a large dollar appreciation, and
thus to a decrease in the relative price of imported goods, brought a
faster decrease in inflation than it would have in the absence of such
an appreciation. This effect has been emphasized by Buiter and Miller
(1983) in their analysis of the Thatcher disinflation. By looking only at
" And not everybody has the same reading of the evidence. Barro (1987), reviewing the same set
of events, concludes instead that there is no evidence against the 'Ricardian equivalence' proposi-
tion that tax cut-induced deficits have no effect on economic activity.
7
The credibility effect was dubbed the PATCO effect for the President's firing in 1981 of air
controllers belonging to the PATCO union when they refused to go back to work.
the wage equation - rather than at the price and wage equations, or the
reduced form relation between inflation and unemployment - 1 exclude
this effect from consideration. I adopt a fairly standard specification of
the Phillips curve, relating quarterly wage inflation to price inflation

(measured by the consumption deflator) observed over the previous
period, 'expected' inflation as of the previous period, and (the log of)
the male unemployment rate. Expected inflation is expressed as a
geometric distributed lag of current and past inflation, with a decay
coefficient of 15% per quarter.
I first estimate the relation over 1964Q2 to 1979Q3.1 then reestimate
it adding one year at a time, until the sample ends in 1985Q3. The first
part of Table 6 presents the estimated coefficients. I also use the relation
estimated over 1964Q2 to 1979Q3 to generate forecasts of wage inflation
given actual values of price inflation and unemployment for the period
1980Q1 to 1986Q1. The forecast errors are reported in the lower half
of Table 6. Both parts of the table lead to roughly the same conclusion.
The Phillips curve is stable until the end of 1982; thereafter the rate
of wage inflation becomes steadily more sensitive to the level of unem-
ployment. Forecast errors turn negative in 1981Q2 and remain con-
sistently and significantly so throughout, even after unemployment has
decreased. There is therefore evidence of a shift in the relation between
unemployment and wages. While this is evidence in favor of a credibility
effect, it is obviously not a proof. Alternative explanations, such as a
direct effect of foreign prices and import penetration on wages, have
been suggested. Microeconomic evidence however does not seem to
support this last hypothesis (Abowd, 1986).
3.3. Deficits and the recovery
Deficits have clearly shaped the recovery. But before attributing the
recovery to fiscal policy, one would want to know what would have
happened if the US had followed a policy of fiscal orthodoxy as in
Europe. Would there have been a recovery and how would it have
differed? This is obviously an important question to answer. 8 Still, some
progress can be made by comparing this recovery with previous ones.
Table 7 presents the rate of growth of GNP, domestic spending and
its main components for the last four expansions. The current recovery
8
The main difficulty resides in the need to define what monetary policy would have been in the
absence of deficits. Blinder (1984) makes a courageous attempt to answer the question, using
three econometric models and comparing the behavior of the economy with and without the
fiscal changes. He assumes that the growth of M2 would have been the same. Doing his simulations
in 1982, Blinder however underestimated the size of the coming deficits and his simulations end
up shedding little light on the question at hand.
Reaganomics 31
Table 6. The changing cost of disinflation
Quarterly equation for wage inflation (Phillips curve)
Estimated coefficient on:

Expected
Sample Price inflation price
period Constant last quarter inflation Unemployment
1964Q2-79Q3 0.05 0.05 0.79 -1.9

-80Q3 0.05 0.05 0.79 -1.9
-81Q3 0.05 0.07 0.74 -1\8
-82Q3 0.06 0.11 0.67 -1.9
-83Q3 0.06 0.09 0.79 -2.8
-84Q3 0.07 0.09 0.87 -3.3
-85Q3 0.07 0.06 0.95 -3.8
Forecast errors
1980Q1 0.15 1983Q1 -1.11
Q2 0.09 Q2 -2.16
Q3 0.01 Q3 -2.70
Q4 0.72 Q4 -1.38
1981Q1 0.32 1984Q1 -3.07
Q2 -1.61 Q2 -2.74
Q3 -0.71 Q3 -2.53
Q4 -1.51 Q4 -2.35
1982Q1 -0.64 1985Q1 -1.90
Q2 -1.63 Q2 -2.09
Q3 -0.12 Q3 -2.55
Q4 -2.08 Q4 -1.78
Source: Author's estimates using DRI Database.

Notes: Unemployment in logarithms. For all sample periods in top part of the table,
standard errors on coefficient estimates are approximately: constant (0.006), lagged
inflation (0.09), expected inflation (0.15) and log unemployment (0.6). The bottom part
of the table shows forecast errors from the equation estimated over 1964Q2-79Q3.
has not ended yet (DRI does not currently predict a recession for the
next three years: the table also reports the DRI forecasts for 1987-89,
and what they would imply for the 1983-89 recovery).
Through 1986 the rate of growth of output has not been higher than
in previous recoveries. The rate of growth of domestic spending has
exceeded the rate of growth of GNP, hence the deterioration in the
trade balance, but it is not particularly high in comparison to previous
recoveries. The comparison with the long expansion of the 1960s must
take into account the fact that trend growth was higher then than now.
The recovery has not been abnormally strong by historical standards.
The other components of spending grew at rates surprisingly similar
to those of previous recoveries. In particular, investment, both
Table 7. Comparing recoveries
% annual change in
State
Non- and

Length Domestic residential Residential Federal Local
Period (quarters) GNP spending Consumption investment investment spending spending
1961Q1-1969Q4 36 4.2 4.3 4.0 6.2 3.1 3.1 4.8

1971Q1-1973Q1 9 5.7 5.8 5.5 7.5 19.2 -3.5 3.1
1975Q2-1978Q4 15 5.1 5.3 4.7 7.6 14.7 1.3 1.6
1983Q1-1986Q3 15 4.2 5.5 4.5 7.2 15.1 3.5 3.4
1986Q4-1989Q4* 13 2.6 1.6 1.7 1.6 0.7 -0.1 1.4
1983Q1-1989Q4* 28 3.5 3.5 3.1 4.4 7.9 1.7 2.4
Sources: Historical Statistics, Department of commerce, peak and trough dates from NBER business cycle dating.
Note: *DRI forecasts, February 1987.
residential and non-residential, has grown at the same rate during this
tight-money loose-fiscal recovery as during previous ones, so that the
effects of higher real interest rates must have been offset by other
factors. One factor is the decrease in corporate taxation, although from
the numbers in the previous section, it is not clear that it has fully offset
the effects of higher interest rates.
Given the fact that GNP growth has not been abnormally strong, one
is tempted to conclude that the recovery would not have been much
weaker had fiscal policy been tighter. Indeed, there is no reason to
doubt that there exists some rate of growth of money which could have
decreased real interest rates sufficiently to achieve the same growth in
output, with the accompanying depreciation producing both a smaller
trade deficit and inflationary pressures. But there are good reasons to
doubt that such a monetary policy would have been adopted. Table 1
earlier showed that growth rates of money have been high. More
expansionary monetary policy would have required even higher growth
rates, and it is far from clear that after a successful disinflation the Fed
would have been ready to accept such rates. The experience of Europe
must be relevant here. After disinflation, European central banks have
been very reluctant to expand monetary aggregates; and in the absence
of fiscal and monetary expansion, European economies have not had
a recovery. The European experience makes a strong case for the
proposition that, without demand expansion, forces which lead to
recovery and a return to full employment are slow or simply non-
existent.
To summarize, disinflation was less costly than would have been
predicted. The recovery, while not exceptionally strong, must be partly
credited to the fiscal expansion. Apart from the excess of spending over
Reaganomics 33
output, the shape of the recovery has not been very different from
previous ones. In particular, investment has not suffered from the
money-fiscal mix.

3.4. T h e political bet
The political bet has not yet been won: the reduction in taxes has not
yet led to drastic cuts in overall spending; thus one must rely on guesses
and forecasts as to what will happen over the next few years.
Table 8 gives DRI forecasts, as of February 1987, for spending and
taxes over the next three fiscal years. DRI does not expect that the
Gramm-Rudman targets will be met and assumes that, under some
guise, they will be revised upwards. This assessment is based on the
fact that the (non-binding) targets for fiscal year 1987 were exceeded
by $45b, and on the assessment that the budget presented by the
administration for fiscal year 1988, which formally satisfies the Gramm-
Rudman target, is politically infeasible. DRI also assumes that, because
of the proximity of the last tax reform and the next presidential election,
there will be no major tax increase. Nevertheless, they forecast a steady
decrease in deficits through reduced spending. Official deficits decrease
from 4.8% of GNP in 1986 to 3.1% in 1989, implying a decrease in
inflation-adjusted deficits from 3.8% in 1986 to 1.8% in 1989. An
inflation-adjusted deficit of 1.8% in 1989, together with a DRI forecast
of GNP growth of 2%, implies that the debt/GNP ratio will still be
growing at approximately 1 % per year by the end of the decade.
How much confidence should we have in these forecasts? Table 9
provides indirect evidence by presenting the evolution of projections
and forecasts over time since mid-1985. One can see how quickly
projections have changed. Congressional Budget Office projections of
the 1990 deficit which were $285b in August 1985, decreased to $97b
by August 1986 and increased again to $134b by January 1987. 9 Private
forecasts have fluctuated, although less widely: DRI has revised upwards
its estimates of future deficits over the last 9 months.
Assuming that by 1989 no further cuts in spending are politically
feasible and the budget is balanced, then or later, by a tax increase,
what will have been the results of the policy on spending? Table 8
suggests two conclusions. First, non-interest government spending as a
share of GNP will be the same in 1989 as it was in 1980. This may not
look like much of an achievement, but it is in fact a change from the
trend of increasing spending in the 1960s and 1970s (see numbers for
9
As explained above, CBO projections are not forecasts of fiscal policy, but rather projections
based on current legislation and CBO's forecasts of economic variables.
Table 8. Forecasts 1987-89: spending, receipts and deficits (% of GNP)
Fiscal year 1986 1987* 1988* 1989*
Spending: 24.6 24.1 23.4 23.1

Interest 3.2 2.9 3.0 2.9
Non-interest purchases 21.3 21.2 20.5 20.3
defense 6.5 6.5 6.4 6.2
non-defense 2.2 2.1 2.1 2.0
Transfers 9.4 9.1 9.0 9.1
Other 3.3 3.5 3.0 3.0
Receipts 19.8 19.9 20.1 20.1
Personal taxes 8.6 8.4 8.0 8.1
Corporate taxes 2.1 2.4 2.7 2.5
Social insurance 7.8 7.8 8.1 8.3
Other 1.3 1.3 1.3 1.2
Budget
Balance -4.8 -4.4 -3.4 -3.1
Inflation adjusted surplus -3.8 -3.6 -2.3 -1.8
Primary surplus -1.6 -1.3 -0.4 -0.2
Source: DRI Economic Review, February 1987.

Note: DRI forecasts. The inflation adjusted deficit is computed using DRI forecasts of
inflation.
1964 and 1970 in Table 2). If one assumes that, in the absence of
Reagan, the trend would have remained the same, non-interest spend-
ing will be approximately 1 to 2% lower as a share of GNP. Second,
the composition of spending will have substantially changed as well.
Defense spending, which had decreased by 2.5% per year through the
1970s, has grown by more than 6% per year between 1980 and 1986,
so that its share in GNP has increased from 5.1% to 6.5%. DRI however
expects some of the main spending cuts in the future to come from
defense, and its share to decrease to 6.2% by 1989. Transfers, which
had increased at 6.5% per year through the 1970s, have grown instead
at 3.5% between 1980 and 1986. By 1989, their share in GNP will be
the same as it was in 1981, a clear change in trend. Also, many programs
have been modified in important ways, for example the rules of health
care reimbursement. Other transfer programs have not changed: for
example the administration has been unable or unwilling to implement
major changes in farm policy so that payments to farmers have increased
from $8b in 1980 to $25b in 1986 as a result both of programs put in
place in the late 1970s and of various events of the 1980s (good crops,
bad export markets). Finally, non-defense purchases have decreased.
For example spending on education has decreased from $3lb in 1980
to $28b in 1986, and spending on energy has decreased from $1 lb in
1980 to $5b in 1986.
Reaganomics 35
Table 9. Projections, forecasts and dreams: future deficits (billion US dollars)
Fiscal year 1986 1987 1988 1989 1990
CBO August 1985 Baseline projections 212 229 243 264 285

CBO February 1986 Baseline projections 208 181 165 144 120
CBO August 1986 Baseline projections 224 184 150 127 96
CBO February 1987 Baseline projections 174 169 162 134
DRI forecasts, June 1986 208 150 141
DRI forecasts, November 1986 220 176 161 143
DRI forecasts, February 1987 187 161 154
Gramm-Rudman-Hollings targets 144 108 72 36 0
Source: CBO: Baseline projections (various issues), Congressional Budget Office; DRI
Economic Review, various issues.
Note: Data on a unified budget basis.
There is thus little question that, even if deficits are ultimately elimi-
nated by an increase in taxation, both the level and the composition of
government spending will be different as a result of the actions of the
Reagan administration. In addition to changes in spending, deregula-
tion will also have modified parts of the private economy. In large part,
deregulation was started in the late 1970s before Reagan: deregulation
of the airline industry began in 1978 and was completed in 1985,
deregulation of the trucking industry started in 1980. A few new
programs were started after 1981, such as natural gas deregulation and
limited deregulation of financial institutions. Contrary to European
conservative experiments, there has been little privatization, as there
was little to privatize. The sale of Conrail, in the first Gramm-Rudman
compromise, was at least as much a way of closing the reported deficit
through the sale of assets as a way of improving the efficiency of the
railroad system.
While non-interest spending will be lower than it would have been,
the same is not obviously true for total spending. One of the effects of
the long sequence of deficits will have been to increase the level of debt,
and thus future taxes required to pay the interest on the debt. This is
one of the long-run effects of deficits, to which I now turn.
4. The legacy of deficits

The US economy is now close to full employment. But fiscal and trade
deficits are still high, with implications for both the near and the distant
future. In the near future, the economy faces the transition problem
of maintaining full employment while reducing the twin deficits. If and
when this is done, the effects of the deficits will not disappear; they will
still affect both the US and the rest of the world through higher US
internal and external debts.
4 . 1 . T h e transition problem

The unemployment rate for 1987Q1 is 6.9% which is thought to be
close to the full-employment unemployment rate. (See for example
Summers, 1986). The budget deficit is $200b, the current account deficit
is $131b. Can the budget and current account deficits be reduced
without either inflation or a major recession? The issue is conceptually
simple. At a given exchange rate, a reduction in fiscal deficits leads to
a recession, and through the decrease in activity, reduces imports and
improves the trade balance. Given no change in fiscal policy, a dollar
depreciation improves the trade account and increases activity. The
answer is therefore also conceptually straightforward: what is needed
is a combination of fiscal contraction and dollar depreciation.
If we believe the DRI forecasts, inflation-adjusted fiscal deficits will
decrease by 2% over the next three years. Thus the issue is whether
the trade balance will improve sufficiently to offset the fiscal contraction,
i.e. whether the exchange rate will depreciate sufficiently. The real
dollar exchange rate has already depreciated by close to 30% since early
1985. But there is no reason to think that efficient exchange rate markets
will choose that path of the exchange rate which decreases the trade
deficit at the desired speed. (For a recent discussion, see Dornbusch,
1987). The exchange rate depends, among many things, on the course
of monetary policy through interest rate differentials: whether or not
the transition will be successful depends on whether monetary policy
can induce the appropriate response in exchange rates. At this stage
forecasters believe that the transition can be accomplished smoothly.
Forecasts from DRI for the major macroeconomic variables over the
next three years are given in Table 10. They show a $40b decrease in
the trade deficit, which offsets most of the decrease in the fiscal deficit:
GNP grows at 2.6% over the period with a small reduction in unemploy-
ment. This is accomplished through low real interest rates, and a further
22% real depreciation of the dollar. 10 Whilst GNP is expected to grow
at 2.6% per annum, domestic spending is expected to grow at an annual
rate of 1.6% (see Table 7), hence the improvement of the trade balance.
There are major uncertainties in this scenario. The main one concerns
the relation of the exchange rate to the trade deficit. Despite the 30%
I I
10
There are good reasons for believers in rational expectations to have doubts about some aspects
of the forecast. The forecasts imply similar real interest rates in the US and abroad so that the
expected excess return from holding foreign bonds over the three years is equal to the expected
real depreciation, namely 22%. This appears very large.
Reaganomics 37
Table 10. Forecasts 1986-89
1986 1987 1988 1989
Budget balance ($b) -204 -183 -156 -153

Unemployment (%) 7.0 6.7 6.3 6.3
GNP growth (%) 2.5 2.5 3.1 2.0
Inflation (%) 2.6 2.5 3.4 3.7
Short nominal interest rate (%) 6.0 5.5 5.6 5.1
Short real interest rate (%) 3.3 3.0 2.2 1.4
Long nominal interest rate (%) 7.9 7.3 7.9 7.7
Long real interest rate (%) 3.9 3.3 3.9 3.7
Real exchange rate (% change) -17.0 -10.0 -6.0 -6.0
Trade balance ($b) -105 -102 -86 -68
Current account ($b) -142 -140 -125 -108
Source: DRI February 1987.

Notes: The short real interest rate is constructed using DRI forecasts. The long real
interest rate is constructed using expected inflation equal to 4% throughout.
dollar depreciation, the trade deficit has not yet improved. This has
led some (Baldwin and Krugman, 1986) to argue that the large appreci-
ation has led to the loss of markets for US firms, a loss which, to be
undone, will require a large depreciation. It is traditionally expected
that, when the exchange rate returns to its initial value, the economy
returns to the same trade position; the Baldwin-Krugman analysis
implies that in this case the US would still face a trade deficit. Recent
empirical work by Krugman (1987) fails however to find such effects
in the data (at least until mid-1986) and leads him to conclude that the
lack of improvement is due to the traditional J-curve dynamics and a
secular trend decrease of the real exchange rate needed to balance the
current account. The other related uncertainty concerns the behavior
of the Fed: will it be willing to move real interest rates sufficiently, for
example if a large reduction in interest rates is required to achieve the
required depreciation?
What these forecasts suggest is that both external and internal deficits
will be brought under control slowly, without any drastic effect on the
economy. Some of the worst fears which have been expressed about
deficits and debt are clearly unfounded. There is for example little
likelihood that deficits will require repudiation or even monetization
and inflation. There are two reasons. The first is that the ratio of public
debt to GNP, according to DRI forecasts, will be 41% by 1989, 11 and
will then be increasing at roughly 1% per year; this implies levels of
1
The DRI forecast only gives the ratio of gross debt to GNP. The ratio reported in the text is
that of debt held by the public excluding the Federal Reserve, and assumes that the ratio of
that portion of debt to gross debt is the same, 63%, in 1989 as in 1986.
debt for the 1990s far below those at which such drastic measures as
repudiation or monetization have historically been taken. The second
reason is that, given the current dislike of inflation, the inflation tax is
too small a source of revenue to be an attractive possibility: given a
ratio of monetary base to GNP of 4%, a sharp increase in inflation is

unlikely to significantly reduce the real burden of servicing the debt
when the average maturity of the public debt is under 5 years, as is
now the case in the US. Even if these worst-case scenarios are unlikely,
this does not imply that the effects of deficits will disappear when the
deficits themselves disappear: deficits have long-run effects.
4.2. T h e long-run effects o f deficits
The mechanism through which deficits have long-run effects is a simple

one. 12 They lead to a build-up of public debt which remains even after
deficits have disappeared, once taxes have been increased to pay for
the interest on the higher debt. Higher public debt leads consumers to
feel wealthier, and thus to save less at any level of income. In an economy
which does not have access to international capital markets, lower savings
lead to lower investment and a lower level of capital and output. But
if the economy has access to such markets, two things happen. First,
lower domestic savings do not necessarily translate into lower domestic
investment. Indeed, if the economy is small, so that it does not affect
the world interest rate, domestic investment is unaffected and the
difference is entirely made up by borrowing from abroad. If the
economy is large, the decrease in savings leads partly to borrowing,
and partly to a decrease in both domestic and foreign investment
through an increase in world interest rates. Borrowing from abroad
leads over time to a steady transfer of wealth abroad which, by increasing
consumption abroad and decreasing it at home, ultimately restores
current account balance.
These effects, hidden by short-run disequilibria, have been at work
in the case of the US deficits. Deficits have led to a build-up of public
and foreign debts. When fiscal and external deficits eventually stop, or
at least when the ratios of internal and external debt to GNP are
stabilized, higher public debt in the US will mean lower US savings at
any level of income, lower world savings and lower world capital
accumulation. Higher US debt vis a vis the rest of the world will require
a trade surplus to finance the interest on the debt.
12
A more formal treatment is given in Blanchard (1985) for the case of one country with or
without access to international capital markets, and by Frenkel and Razin (1986) for the case
of two countries linked by perfect capital markets. The analysis which follows assumes that debt
is partly net wealth, so that Ricardian equivalence does not hold.
Reaganomics 39
4.2.1. The increase in public and foreign debts. H o w large a r e these long run
effects likely to be? The place to start is to ask what will be the ratios
of internal and external debt to GNP as a result of the deficit strategy?
This is another impossible question to answer as, in addition to specify-
ing what fiscal policy would have been, it requires assumptions as to

what would have happened to interest rates and growth through the
1980s and the 1990s; but back-of-the-envelope computations are again
useful. The ratio of government debt (held by the public excluding the
Fed) to GNP was 23.1% in 1980, 37.2% in 1986 and is forecast to be
41% by 1989. What would it have been in the absence of the deficit
strategy? In the 1970s, primary deficits and inflation-adjusted deficits
were on average both equal to zero (the equality between the two reflects
the fact that real rates of interest were close to zero). This suggests two
alternative assumptions, which yield upper and lower bounds on the
increase in debt.
A first assumption is that primary deficits would have been equal to
zero from 1980 on, so that debt to GNP would have increased by the
difference between the real rate of interest and the growth rate of GNP.
Assuming this difference to average 3%, the ratio of debt to GNP would
have been equal to 31% by 1989. Thus, under that assumption, the
ratio of debt to GNP will be 10% higher than it would have been. An
alternative assumption is that inflation-adjusted deficits would have
been equal to zero, so that the debt to GNP ratio would have decreased
at the rate of GNP growth. Assuming a growth rate of 2.5%, the debt
to GNP ratio would have been 12% by 1989, 29% lower than the current
forecast. This suggests that, by 1989, the ratio of debt to GNP will be
between 10 and 30% higher than it would have been. By 1989 however,
it will still be growing: forecasts of 2% growth and inflation-adjusted
deficits of 1.8% imply that the ratio of debt to GNP, which will by then
be equal to 41%, will still be growing at a rate of 1% per year.
Similarly, if we use DRI's current account forecasts, the ratio of
foreign debt to GNP will be 17.5% higher by 1989 than if the current
account had remained balanced through the 1980s, as it was for most
of the 1970s (this number assumes the same 3% difference between the
real rate of interest and the growth rate of GNP). While the level of
net external debt is not known with precision, it is thought that it was
close to zero in 1985; this implies that by 1989, the foreign debt to GNP
ratio will still be growing by between 1% and 2% a year.
4.2.2. The effects of higher debts. The next step is to assess the effects of
the increase in US public debt on capital accumulation. This question
is even more difficult to answer than the previous one, as the answer
depends on the effect of public debt on savings, and the long-run
elasticity of savings with respect to interest rates, about which we know
very little. Because of high capital mobility, I consider the effects on
world accumulation (where 'world' refers to the set of countries with
high capital mobility), without distinguishing between the US and the
rest of the world. Theory suggests that the long-run decrease in the

capital stock is likely to be less than the increase in debt, that displace-
ment is likely to be less than one for one. 13 Taking the upper bound
for the increase in the US public debt to GNP ratio to be 35%, assuming
one-for-one displacement, assuming that the capital-output ratio is equal
to 2, and that the US capital stock is one-third of the world's capital
stock, the upper bound on the decrease in the world's capital stock is
6%.14 This is a large number, but it is only an upper bound, and is
based on too many tenuous assumptions to command much confidence.
How do these changes in the world's capital stock and in the level of
US external debt finally translate into changes in consumption? Lower
asset holdings reduce income proportionately to the net rate of return.
On the other side, less saving is required to maintain a lower asset to
GNP ratio while the economy is growing, the reduction being propor-
tional to the growth rate. All in all, a lower ratio of assets to GNP implies
a decrease in consumption in proportion to the difference between the
real rate of return and the growth rate. At the world level, if we take
the net marginal product of capital to be between 5 and 10% and the
growth rate to be 2.5%, this implies an upper bound on the decrease
in world consumption of 0.15% to 0.45%. The external debt raises
similar questions. The issue is what trade surplus will be required to
service the US debt once it has stabilized. As a trade surplus requires
a reduction in domestic spending (relative to the no-debt situation), the
question then is ultimately one of spending restraint. Here again, we
need to consider the difference between the real interest rate and the
growth rate of GNP. When the real interest rate is lower than the GNP
growth rate, there is no burden of the debt as the debt grows less fast
than GNP and the debt to GNP ratio eventually stabilizes, even with a
trade deficit. DRI forecasts the short real interest rate to average
2% throughout the 1990s. If we assume the US GNP to grow at an
I I
13
In the analyses of Blanchard or Frenkel and Razin, given wage income and the interest rate,
the effect of debt on steady-state capital is equal to minus one if the interest rate is equal to
the subjective discount rate and debt is not neutral. The effect is smaller when the effect of
capital on the interest rate, and the effect of the interest rate on savings are taken into account.
14
It is interesting to note that such a change in the capital stock would, under plausible assumptions,
have little effect on marginal products and thus on steady-state world interest rates (this point
was already made by Blanchard and Summers, 1984). For example, if the technology was
Cobb-Douglas, with share of capital equal to 0.25, a 6% decrease of the capital stock would
increase its marginal product by 4.5% and the real interest rate by 60 basis points if the marginal
product was initially equal to 15%.
Reaganomics 41
annual rate of 2.5%, the US will grow out of its higher debt level at no
cost.
The experience of Latin American countries in the 1970s and 1980s
which, based on the similar computations, borrowed heavily only to see
the real interest rate later exceed their growth rates, warns us that the

relevant rate is not necessarily the expected rate. 15 However this does
not tell us what rate we should use. Assuming, for example as above
that the difference between the real interest rate and the growth rate
is between 2.5% and 7.5%, a 20% increase in the ratio of foreign debt
to GNP implies the need for a permanent trade surplus, and thus a
permanent decrease in US consumption, of 0.5% to 2.5% of GNP. The
lower end seems the more plausible. To the extent that this trade surplus
requires real depreciation, the decrease in the terms of trade will further
affect welfare.
To summarize, higher US public debt will decrease capital accumula-
tion and consumption not only in the US but in the world. Higher US
foreign debt will imply lower US consumption. Putting numbers on
those effects is a perilous exercise; the numbers I have derived suggest
that the effects may not be negligible. This analysis has assumed that
the taxes needed to service the interest on debt do not create distortions.
To the extent however that they do, higher US public debt will have
one additional effect. An increase of 35% in public debt, and a 5%
difference between the real interest rate and the growth rate imply an
increase in the ratio of taxes to GNP of 1.7%. Given the analysis of
non-interest spending trends in the previous section, this implies that
the level of taxation will not be very different after Reagan from what
it would have been in the absence of Reagan. If taxes were non-
distortionary, there would be no further effects beyond those we have
just studied. But to the extent that taxes are distortionary, the higher
level of debt will imply higher taxes and higher distortions. This pro-
vides the transition to the last section, which deals with the supply-side
effects of the policy.
5. The supply-side effects

Freeing the forces of the supply side was the ultimate goal of the Reagan
program. Behind short-term developments and the adverse effects of
I I
15
Comparisons of real interest rates and GNP growth rates arise in many contexts in
macroeconomics: dynamic inefficiency, burden of the debt, bubbles. It is a vexing problem that
the sign of their difference often depends empirically on what interest rate we use, on whether
for example we use the rate of return on equities or on bonds, or on short versus long bonds.
As these rates presumably differ because of uncertainty and risk, the question of what rate to
use must be analysed treating uncertainty explicitly. For a recent paper on that subject, see
Abel, Mankiw, Summers and Zeckhauser (1986).
deficits on capital accumulation, can one discern signs of shifts in savings,
labor supply, investment and productivity growth in response to those
changes? This last section reviews both what has happened and what
is likely to happen. In assessing the future, one should take into account

the fact that taxes may eventually have to be raised to balance the
budget. Not knowing what form this increase in taxation will take, I
simply ignore that issue here; it is nevertheless relevant.
5.1. Changes i n i n c o m e distribution
As Solow points out elsewhere in this volume, the first-order effect of

changes in taxes and transfers is to redistribute income. These income
redistribution effects are there, whether or not they lead to supply-side
effects. Thus, a natural starting point is to ask how Reagan policies have
affected income distribution. Pechman (1986a, b) and Browning (1986)
have studied the change in effective tax rates by income level from 1966
to 1985. (These effective tax rates reflect Federal, state and local taxes,
and personal taxes as well as indirect and corporate taxes). They reach
different conclusions about the degree of progressivity of the tax system
and the tax rate for low-income families. They agree that the trend
towards lower tax rates for the highest income group has continued
under the Reagan administration. Pechman finds for example that the
effective tax rate for families in the upper decile of the income distribu-
tion, which had declined from 30.7% in 1970 to 27.1% in 1980, further
declined to 25.3% in 1985. This is a definite decrease, although hardly
a dramatic one, which comes on top of an apparent trend increase in
income inequality, which started long before 1980 and is largely unre-
lated to the Reagan policies.
Focusing on the effects of the Reagan policies on the income of the
poor, a relevant measure is the proportion of persons below the poverty
level, the poverty index. 16 It has the advantage of taking both transfers
and taxes into account; it has the disadvantage of being strongly affected
by economic conditions such as the 1981-82 recession, quite apart from
changes in policy. The poverty index stood at 13.0% in 1980; it increased
steadily from 1980 to 1983, to reach 15.2% in 1983 but has decreased
since. The value of the index for 1985, which is the last available, was
14%. As unemployment rates were roughly equal in 1980 and in 1985,
these numbers suggest some deterioration, although again not a dra-
matic one, in the standard of living at the lower end of the income
scale. Weicher (1986), looking at the changes in the specific programs
16
This measure is reported in the Census Population Report, series P60. The nominal amount
defining the poverty level has increased with the CPI since 1980.
Reaganomics 43
for the poor, reaches a similar conclusion. These numbers suggest that,
overall, the Reagan policies have increased income inequality, although
not by very much. I now turn to their incentive effects.

5.2. Savings and labor supply
The 1981 and 1986 tax changes changed the incentives to save and to
supply labor. By decreasing tax rates across the board in 1981, and by
reducing top marginal tax rates in 1986, they increased the after-tax
return to both savings and labor supply. The 1981 tax changes further
increased the return to retirement savings; these initial tax breaks have
been partly but not fully offset by the 1986 tax reform.
Starting with savings, the evidence is that retirement plans for which
contributions were partly tax deductible have been very successful. The
amount contributed to these plans in 1985 was equal to half of personal
saving (Hausman and Poterba, 1987. This includes contributions to IRAs
and '40IK' plans, which are profit-sharing plans operated by
employers). But those contributions could well have come initially from
portfolio reallocations, and even from inframarginal savings contribu-
tions later. A study by Venti and Wise (1986) concludes that 20% of
the IRA contributions have come from portfolio reallocation, 30% from
amounts which would have been saved anyway, and 50% from reduced
consumption. One would expect the first effect to disappear after a few
years, so that these numbers are suggestive of some effect on savings.
The aggregate evidence on savings is however much less impressive.
Table 11 gives for 1980 to 1985 the net national and private savings
rates, with and without inflation adjustment. Because the adjustment
for depreciation has been criticized, the table also presents the gross
private savings rate. Finally, it gives the sum of private inflation-adjusted
net savings and purchases of durables, which are in part savings. The
results reported in Table 11 assume that corporate and property taxes
are borne by capital, payroll taxes by labor, consumption taxes by
consumers and personal taxes by those who pay them. Many other
factors, probably more important quantitatively than tax changes, have
affected savings during that period; we would expect most of these
factors to have increased the private savings rate. Unless taxpayers
either refused to consider the possibility that taxes would eventually be
increased, or assumed that deficits would be reduced entirely by lower
spending, private saving should have increased somewhat in response
to public dissaving. Higher real interest rates during the period should
also have led to higher saving. The evidence from the table however is
simply that the savings rate, no matter how defined, has not increased
in the eighties.
Table 11. Savings rates (% of GNP)
Year 1970 1980 1981 1982 1983 1984 1985
Net national savings 6.5 5.2 5.7 2.0 2.0 4.2 2.9

Net private savings 7.4 6.4 6.6 5.5 5.7 6.9 6.3
Gross private savings 16.1 17.4 18.0 17.6 17.6 18.3 17.5
Net private savings
inflation-adjusted 6.3 4.4 4.9 4.4 4.9 6.0 5.3
Net private savings
inflation-adjusted+purchases
of durables 14.8 12.4 12.8 12.4 13.4 14.7 14.3
Source: Economic Report of the President (1987).
This is not good news for believers in an impending savings boom.

Can the view that tax incentives will eventually increase savings be
rescued? The best defense, and not an absurd one, is that tax incentives
may take a long time before they lead to a higher supply of capital. (If
for example, consumers have a very low intertemporal elasticity of
substitution, they may in response to a higher rate of return initially
increase consumption and decrease savings). But wealth will accumulate
at a higher rate of return, so that wealth may end up larger than before
the change in rates. In this case, an increase in the rate of return initially
decreases the savings rate, only to increase it eventually. While this is
a possibility, there is no hard evidence of a change in saving behavior.
Effects on labor supply have been studied both by looking at the
actual effects of the 1981 changes, and by predicting the effects of these
changes using estimated models of labor supply. Lindsey (1986), com-
paring tax returns for 1982-84 to a baseline projection based on pre-
1981 tax return data, has found taxable income to have been roughly
2% higher than would have been predicted in the absence of tax changes.
His results may however partly capture changes in reporting. Using
estimates of labor supply from Hausman (1981), Hausman and Poterba
(1987) conclude that labor supply by married men has increased by
0.4% as a result of the 1981 tax changes, and will increase another 0.9%
as a result of 1986 tax reform. They also estimate that the labor supply
of married women will increase by 2.6% as a result of the 1986 tax bill,
largely as a result of increased participation. These are positive, but
not very large effects. Hausman and Poterba find however that the
changes in taxation will have substantially decreased the inefficiency
(deadweight) losses associated with taxation: for example, if the
inefficiency losses are measured in units of income, the ratio of these
losses to taxes on income from married women will have decreased
from 0.58 before 1981 to 0.25 after the 1986 reform.
Reaganomics 45
5.3. Investment and productivity
Taxation of business investment was sharply reduced in 1981 and

investment has been strong during the recovery despite the higher rates
of interest. This suggests that tax cuts have indeed stimulated investment

since 1982. Bosworth (1985), looking at disaggregated evidence,
confirms the strength of investment given interest rates but finds
however that most of the investment has taken place in sectors not
particularly affected by tax reductions. The 1986 tax reform has
increased taxation again, so that effective corporate tax rates, at given
real required rates of return and inflation, are close to what they were
before 1981. Thus, whatever effect the lower levels of taxation implied
by the 1981 changes may have had on capital accumulation will disap-
pear in the future.
The tax reform of 1986 however does more than increase tax rates.
It reduces differences across effective tax rates on business investment.
Different effective tax rates across sectors imply that the allocation of
the total capital stock among industries is not optimal. As a result, the
aggregate stock of capital is larger than optimally needed to produce
the aggregate output. How large a gain in efficiency and output has
the tax reform achieved? Auerbach (1983) computed the decrease in
corporate capital which would be achieved by equalizing tax rates across
types of capital and reallocating capital optimally. His answer was that
the capital stock could be decreased by 3%; the tax reform has not gone
as far as equalizing all tax rates and thus the efficiency gain must be
smaller. Furthermore, as Summers (1987) has argued, the tax reform,
which has not removed the preferential treatment of owner-occupied
housing, in fact increases distortions between corporate and residential
capital.
Any effect of policy on the level of productivity growth would even-
tually dwarf both the effects of debt computed in the previous section
and the effects on savings and investment reviewed above. It is not clear
how and why policies would have affected productivity but we under-
stand productivity growth so poorly that this possibility should not be
discarded a priori. Table 12 gives both labor and multifactor productivity
growth numbers for the period 1960-85. 17 Labor productivity growth
in the non-farm business sector, which had decreased from an average
2.3% in the 1960s to 1.3% in the 1970s, has remained at a low 1.2%
17
Multifactor productivity growth is that part of productivity growth which is not due to increases
in either labor or capital. Equivalently, it is equal to labor productivity growth, adjusted for
changes in the capital-labor ratio. The number reported in the table is computed by the Bureau
of Labor Statistics as the difference between output growth rate and the average growth rate
of capital and labor weighted by their respective shares in value added.
Table 12. Productivity growth (%)
Labor productivity Multifactor productivity
Non-farm Manufacturing Services Non-farm Manufacturing

1960-69 2.3 2.7 1.2 3.8 4.0
1970-79 1.0 2.4 0.8 2.8 2.7
1980 -0.3 -0.1 0.5 -1.2 -4.6
1981 1.5 1.9 1.0 1.6 1.5
1982 -0.4 2.3 -3.8 -3.3 -6.3
1983 2.6 6.0 -0.1 4.8 6.2
1984 2.1 4.2 1.4 7.7 10.2
1985 0.3 4.1 -0.7 2.9 3.7
1980-85 1.2 3.6 0.3 1.4 1.5
1986 0.5
1987* 1.0
1988* 1.9
1989* 0.9
Source: DRI Database and Monthly Labor Review, April 1987

Note: *DRI forecasts, February 1987. Labor productivity growth: rate of growth of
GDP per person-hour. Multifactor productivity growth: rate of growth of output per
person-hour, adjusted for changes in the capital labor ratio, computed by the Bureau
of Labor Statistics.
over the period 1980-85. This poor performance comes largely from
poor productivity growth in the service sector, which has experienced
little labor productivity improvement since 1980. Even in manufactur-
ing, which has experienced 3.6% labor productivity growth since 1980,
numbers for multifactor productivity growth suggest that much of this
growth has been the result of capital deepening, with multifactor pro-
ductivity growth in the 1980s contributing only 1.5%, compared to 2.7%
in the 1970s and 4.0% in the 1960s. DRI forecasts do not predict much
change in the near future: they predict an average labor productivity
growth rate of only 1.3% over the next three years.
This would therefore lead one to be pessimistic about strong supply-
side effects on investment and growth. Yet, investment has been stronger
than would have been predicted on the basis of past investment
behavior, even taking into account the effects of the reduction in
effective tax rates. As shown in Table 6, the stock market has also been
very strong. While real interest rates on bonds first increased, and then
decreased over the last year, dividend-price ratios have consistently
decreased over the last five years. Under the assumption that it rep-
resents fundamentals rather than bubbles, the price of stocks is the
present value of future dividends discounted at a rate including the
risk premium on equities over bonds. This in turn implies the following
Reaganomics 47
relation:
dividend-price ratio = (long real rate) + (risk premium)
— (expected growth rate of dividends)

The difference between the dividend price ratio and the long real rate,
which was equal to 5% on average in the 1970s, decreased to become
negative in 1982-83 and is now approximately equal to zero. Three,
not mutually exclusive, explanations are possible: the first is that the
market is subject to a speculative bubble or is simply irrational; the
second is that the risk premium on equities has decreased; the third is
that the market expects more growth and thus higher growth of
dividends. The first explanation may well have some relevance. 18 In
Blanchard and Summers (1984) we found no evidence that risk factors,
the second possible explanation, had changed and concluded that the
third explanation was probably partly responsible for the rise in the
stock market. The conclusion today is still the same: the stock market
appears to have expectations of growth higher than those embodied in
current forecasts.
6. Conclusions
The Reagan conservative policy and its deficit strategy will have shaped
the macroeconomic events of the 1980s. When the dust settles however,
the lasting effects may not match the intensity of the action. Inflation
will be lower. The role of government will have been questioned and
partly redefined. Non-interest government spending will end up lower
by a few percentage points than it would have been in the absence of
the policy. But because of interest payments on the increased debt, this
relative decrease in non-interest spending will not translate into a
decrease in overall spending or taxation.
The deficit strategy will have led to a steady recovery in the 1980s
at the cost of a decrease in world capital accumulation in the long run
and a higher US foreign debt. But despite lower inflation, less govern-
ment intervention and less distortionary taxation, there are few signs
that the 1990s will be a decade of supply-side renaissance.
Thus, lacking the supply-side explosion which would have comman-
ded wide support, whether one judges the outcome as a lot of action
and commotion for a meagre result, or instead as a successful attempt
I I
18
In particular, the Modigliani-Cohn (1979) explanation - which was offered before the increase
in the stock market - that the market mistakenly compares nominal rates on bonds to dividend
price ratios, does a surprisingly good job of explaining the movement in the stock market since
1981.
to redefine the role of government while maintaining high employment
and steady growth, must ultimately depend on one's values: The results
certainly look good compared to those of European conservative policies
and this raises two sets of questions. As both are discussed at length at
various points in this volume, I shall limit myself to a few remarks.

Did the Reagan tight-money loose-fiscal mix work because it was used
only by the US? Put another way, did the US performance imply as a
counterpart the prolonged European recession? There is very little
support for this argument. What we know about transmission mechan-
isms of policies across countries suggests that the net effect of the US
mix, at unchanged European fiscal and monetary policies, was probably
not contractionary; even if it was, it could have been offset by a change
in the European policy mix: if this had been done, the US recovery
would have been stronger, not weaker. At the same time, it is worth
noting that the US disinflation (and the European one for that matter)
has contributed to the debt crisis, by simultaneously increasing real
interest rates, decreasing the demand for LDC exports and turning the
terms of trade against LDCs. This is surely a cost of the disinflation
which has to be taken into account. But there is no sense in which the
poor performance of the debtor countries is the mirror image of the
US performance.
Should Europe have adopted a Reagan strategy? Should it have shed
fiscal austerity in favor of a more expansionary fiscal policy? Surely,
wholesale imitation would have been unwise. Fiscal deficits were much
higher in Europe than in the US to start with. The political bet that
deficits would lead to decreases in spending was tailored to American
political institutions, not necessarily to European ones. But the question
remains whether European conservative policies would have worked
better, had they relied both on supply-side incentives and demand
expansion. My opinion is that they would (see Blanchard and Summers,
1987).
Discussion
William Branson
Princeton University
Olivier Blanchard presents a clear and balanced assessment of the
performance of the American economy in the Reagan years, and of
the connection of this performance to the policies of the Reagan
Administration. I agree with most of Blanchard's economic analysis,
but disagree on the political analysis. Blanchard characterizes the
Reagan policy as a 'political bet'. He argues that by cutting taxes the
Reaganomics 49
Administration 'bet' that it could force Congress to cut spending,
thereby shrinking the economic size of the Federal government. The
tax cuts would create a deficit that would force Congress to act on
spending. On this interpretation, one could argue that the Reagan fiscal
policy was a clever attempt to shrink the size of the government,

thwarted by a recalcitrant Congress that refused to play its role. This
is Blanchard's interpretation.
I disagree. The political bet is revisionism that rationalizes the biggest
fiscal policy mistake in the United States since World War II. The
Reagan policy was based on the theory that cutting tax rates would
increase tax revenue thereby creating a budget surplus. The Reagan
budget projections of 1981 - the rosy scenario - showed rapid growth
and rising revenues. The deficit that expanded until 1983 was blamed
on the recession and the Federal Reserve. It was not until the deficit
refused to shrink as the recovery began in 1983 that the Administration
had to recognize the emergence of a 'structural deficit'. Then the
political bet interpretation was developed to rationalize the policy mis-
take of 1981. The Reagan fiscal program has created major structural
problems for the US and the world economies. This program was not
based on a clever political ploy; its foundation was incorrect economic
analysis.
Reagan's fiscal program has changed and will further change the
composition of Federal expenditure in ways that have considerable
social significance. The main items of expenditure to suffer are the
entire array of programs that were expanded in the 1960s and 1970s-
urban and regional development, housing, research, etc (many of which
originate in Lyndon Johnson's 'Great Society' program). Indeed, Char-
les Schultze of Brookings points out that this category of spending
increased from 6.2 to 9.5% of GNP from 1964 to 1980, but fell back
to 7.9% by 1985, and, on present policies, will be down to 6.6% by 1990.
The effects of the Reagan fiscal program on the US macro economy
are summarized in Blanchard's Table 5. There we see the rise in the
real long-term interest rate from 1.5% in 1980 to 6.0% in 1982. This
is extremely unusual for the US economy. Normally the long rate falls
in a recession. The real exchange rate in Blanchard's data shows a real
dollar appreciation at irregular rates from 1980 to 1985, with an initial
jump of 19% from 1980 to 1981. This rise in real interest rates and
the dollar was needed to 'crowd out' investment and the current account
to make room in full-employment output for the emerging structural
deficit.
The increase in interest rates and the dollar contributed to the
recession that is shown in the first two rows of Blanchard's Table 5.
There we see unemployment rising from 1980 to 1983, with negative
real GNP growth in 1982. The recession was due in part to the financial
markets; anticipation of the effects of the budget change in 1981 (see
Branson, Fraga, and Johnson, 1986 for details).
Here the timing of the fiscal package and the movements in real
interest rates and the dollar is important. The fiscal program was

announced in 1981, but we see in Blanchard's Table 2 that its effect
only began to appear in the budget data in 1982. But the announcement
drove up interest rates and the dollar in 1981 in anticipation of the
impending budget shifts. These movements depressed demand before
the expansionary effect of the actual fiscal expansion was felt. So while
I agree completely with Blanchard's view that the tax cuts and spending
increases contributed in standard Keynesian fashion to the recovery
beginning in 1983, the markets' anticipation of this program con-
tributed to the recession. The Reagan fiscal-led recovery was from a
recession of its own creation.
There are several reasons for believing that the performance of the
US economy under Reagan has been dismal. Note, for example, that
in nominal terms total corporate profits in 1986 were at the same level
as 1979, with a major slump in between these years. Unemployment
rates never fell below 6.5% from 1981 to 1986. Real before-tax average
weekly and hourly earnings have fallen during the Reagan Administra-
tion; in 1986 they were below the 1980 level. This is also true of real
net farm income, which is still below its 1979-81 level. Real long-term
interest rates have remained at record high levels throughout the period
since 1981. National and private saving rates have fallen since 1981.
The ratio of personal saving to disposable personal income, which
fluctuated in the range of 5-7% during most of the post-World War II
period was down to 3.8% in 1986. The only major macroeconomic
indicator that has shown substantial improvement during the conserva-
tive Reagan years is inflation. Even here, it is arguable that this gain is
the result of credibly tight monetary policy that had to fight against
expansionary fiscal policy. Credit for inflation reduction goes to the
Fed and Mr Volcker, not to the Administration.
The shift to a policy mix of fiscal ease and tight money generated
the real appreciation of the dollar from 1981 to 1985. Econometric
estimates reported by Branson and Love (1987) show that the dollar
appreciation reduced manufacturing employment by 5%, or about 1
million jobs. Further, the period of appreciation was long enough to
make it possible that new foreign competitors would remain competi-
tive even after the dollar had depreciated back to its 1980 levels,
making recovery in these industries difficult. So the policy mix of the
Reagan years has undermined US strength in major manufacturing
sectors.
Reaganomics 51
The Reagan fiscal program required a substantial current account
deficit to finance it. This was achieved by the dollar appreciation. The
accumulation of deficits has shifted the US from a position of inter-
national creditor to debtor. By 1987 the US net foreign debt was over
$250 billion, and growing by $100-150 billion a year. As Blanchard

notes at the end of his Section 2, this access to foreign borrowing
insulated domestic investment from a major crowding-out effect up to
1985. The fall of the dollar since 1985 and the upward movement of
real interest rates in the US since 1986 are now shifting the burden of
financing the deficit away from the current account and foreign borrow-
ing toward reduced domestic investment, which doesn't bode well for
future productivity growth.
To summarize, the macroeconomic record of Reaganomics is not
good. Inflation is down. There has been a recovery since 1983, but it
was from a recession partly due to the fiscal program. Almost all major
macroeconomic indicators other than inflation have shown a deterior-
ation. Manufacturing has lost a million jobs and the US is now an
international debtor. Not a good record!
What is the outlook for the dollar and the US economy as the Reagan
term comes to an end? As of April 1987, the real depreciation of the
dollar had reversed much of the 1981-85 appreciation, but the dollar
was still above its 1980 level. To see where the dollar's equilibrium
might be, we can ask what is the trade balance going to be relative to
1980 when the US finally reaches current account balance sometime in
the 1990s?
In 1980 the US had a trade deficit of about 1% of GNP, financed by
an inflow of income on foreign investment. When the US again reaches
current account balance, it will have to run a trade surplus to service
the debt accumulated during the 1980s. At the end of Section 4,
Blanchard calculates that this surplus would be about 0.5% of GNP. So
from 1980 to the new equilibrium in the 1990s, the trade balance will
have to swing from deficit to surplus by about 1.5% of GNP.
How much of a real dollar depreciation relative to 1980 will achieve
this 1.5% of GNP swing? Dornbusch and Frankel (1987) present
econometric estimates that show a 13.5% real depreciation would yield
a gain in the trade balance of 1% of GNP. This elasticity estimate is
close to current conventional wisdom in the US. The implication is that
the dollar must in the end depreciate in real terms by about 20% relative
to 1980 to obtain the necessary swing in the trade balance. Since we
are now (April 1987) above the 1980 level, this means that at least 20%
further depreciation is yet to come.
The dollar depreciation can come in two different scenarios. In the
one that is now being played out, the budget deficit remains high, and
world investors begin to resist further dollar accumulation. This reduc-
tion in the world supply of capital to the US raises US interest rates
relative to world rates (via a dollar risk premium) as the dollar depreci-
ates. In this scenario US investment falls and growth slows. Future US
taxpayers will have to service the foreign debt from a slower-growing

capital base.
In the second scenario, the budget deficit is reduced, and interest
rates fall as the dollar depreciates. This reverses the action of 1981,
and recovery of the current account is facilitated by a shrinking deficit
instead of falling investment. In this more pleasant, but also more
remote, scenario, the US economy is left with a debt to service, and
adjustment costs to pay as new manufacturing sectors expand to replace
those that shrunk in 1981-85. But no reduction in the long-run growth
rate would be needed. This seems to be the best available scenario at
the end of the experiment with Reaganomics.
David Currie
Queen Mary College, London
Having read Olivier Blanchard's lucid review of Reaganomics, it is
only natural to pose the question as to whether the strategy of a
tight-money loose-fiscal policy can or should be adopted by European
countries.
One reason why a Reagan strategy might have different effects in
Europe is because of the possibility that expansionary fiscal policy (for
a given monetary policy) can lead to a depreciation of the exchange
rate. Indeed, the OECD model suggests that, for the UK, it does lead
to a depreciation. This considerably reduces the attractiveness of a
Reagan policy mix, for it no longer improves the inflation-output
tradeoff.
It is also worth noting that even if the Reagan policy mix had the
same effects in Europe as in the US, we cannot, of course, all succeed
in securing exchange rate appreciation. Further, since debt-income
ratios have been on a rising trend in some European countries, it is not
obvious that we should encourage a move towards looser fiscal policy.
In addition, one should not ignore the harm that Reaganomics has
inflicted on the less developed countries (LDCs hereafter) by inducing
a combination of high real interest rates and an appreciating dollar.
Were Europe to also adopt similar policies, it might only exacerbate
the problems of the LDCs. While on the theme of the international
dimensions of Reaganomics, one might also question whether a situation
where the US has become a major borrower on international capital
markets, while Latin American countries are net exporters of capital,
Reaganomics 53
is consistent with either an efficient or an equitable allocation of
capital.
Blanchard argues that, even if the net effect of the US policy mix on
Europe was contractionary, it could have been offset by an appropriate
change in European policies - specifically, Europe could either have

increased real interest rates, or accepted lower exchange rates. However,
even higher real interest rates would have further reduced investment
in Europe, while lower exchange rates would only have worsened the
inflation-output tradeoff.
I am also unconvinced by Blanchard's assertion that the eventual
effect of the policy of high budget deficits will be to reduce the capital
stock. This claim is based on some long-run model where full employ-
ment prevails. However, in the short run, if the US had not run a
budget deficit, both US and world economic growth would have been
lower, which, through standard 'accelerator-type' effects would have
implied lower investment. Now, if one allows the short-run performance
of the economy to permanently affect the eventual long-run equilibrium,
(through, for example, 'learning by doing', embodied technical progress
or hysteresis in the unemployment rate) then one may argue that the
overall effect of the policy of budget deficits will be to have increased
the capital stock.
Finally, I must confess that I am less sanguine than Blanchard about
the possibility of a smooth transition to a situation where the budget
and current account deficits are eliminated. Given the prospect of
deficits for a long time, foreign exchange operators may, rightly or
wrongly, begin to fear that monetary policy might be relaxed. We might
then be in for a bumpy ride!
General discussion
Georges de Menil and Patrick Minford felt that Olivier Blanchard had
underestimated the adverse effects that the current account deficits
induced by Reaganomics might have. It was, for example, possible that
we would see the US Congress approving protectionist measures, which
could, eventually, lead to a very damaging trade war. In that sense, the
fiscal experiment that had been pursued was a dangerous one, and the
next few years may be considerably more turbulent than the author
appeared to envisage.
Robert Solow sought to question various aspects of the 'political bet'
thesis. In the first place, he felt that when reviewing a historical episode,
there was always a temptation to impose a semblance of order even
though it really wasn't there. It is unlikely that, amidst the chaos, the
Administration was actually operating in the clear and sophisticated
way that the 'political bet' thesis entailed. It isn't even obviously true
that the Administration approved of the tight-money component of the
policy mix - for, in 1981, attacks by members of the Administration on
the Fed were commonplace. Solow agreed, though, that the Reagan

Administration had won half of its supposed 'political bet', in that it
was very difficult to envisage any significant tax increases in the future.
Blanchard's attempt to judge the outcome of the 'political bet' by
comparing the ratio of spending to GNP in 1980 not with its level in
1980, but instead with the level implied by its pre-1986 trend growth
was highly misleading. It was likely that a Democratic government would
also have reined back government spending and, indeed, this was
explicitly stated during the Carter election campaign in 1980. Staying
with the 'political bet' theme, Roland Vaubel pointed out that it was by
no means unique to the US. The present government in Germany also
appeared to be following a similar strategy, in that they had agreed on
major tax cuts, and were using them to create pressure to cut spending.
William Branson expressed some surprise at the discussion in the

paper regarding why the level of share prices was now 'so high'. One
could equally legitimately puzzle over the poor performance of the
stock market in the last 20 years - specifically, why was the general level
of share prices still lower (in real terms) than it had been in the 1960s?
In his response to his critics, Olivier Blanchard disagreed with David
Currie regarding the effects of US policies in Europe. After all, the
standard Mundell-Flemming model implied that the effects of US
policies were beneficial to Europe. Even if this model were misleading,
and the overall effect was to reduce European output, it was difficult
to believe that it was other than minor. Moreover, European govern-
ments always had the option of taking offsetting actions. However,
Blanchard agreed with Currie that the computations of the effects of
fiscal expansion on the capital stock could be misleading once one
allowed for hysteresis in the unemployment rate. On the 'political bet'
hypothesis, Blanchard stuck to his guns, arguing that it was scarcely
credible that anyone in the Administration seriously believed that the
tax cuts would not lead to deficits.
Appendix. The arithmetic of the user cost of capital

Following Auerbach (1983), the user cost c is:
c = (r + d)(l + t-uz)/(l-u) (Al)
where r is the required after-tax rate of return, d the depreciation rate,
Reaganomics 55
t the investment tax credit, u the corporate income tax rate and z the
present value of depreciation deductions. The rate r depends in turn
on the real rates which have to be paid on equity and debt, according
to:

r = (l-b)(l-u)i + be-p (A2)
where b is the proportion of investment financed by debt, i the nominal
interest rate on debt, e the nominal rate of return on equity and p the
rate of inflation. Nominal interest payments are deductible from profit
for tax purposes so that equal increases in i, e and p decrease r.
Tight money increases real rates of return on debt and equity,
increasing r. See for example Auerbach (1983). There is another effect
which works through z. As depreciation deductions are in nominal
terms, a decrease in inflation increases z; an increase in the rate of
return decreases z. The two effects partly cancel here. If they are small
and z is close to 1, the effect on c of changes in r is roughly one-for-one.
The numbers for real interest rates in Table 1 suggest that tight money
led to an increase in user cost of the order of 3-5%. To go from the
numbers in Table 1 to r, one needs to make assumptions about e. One
assumption is that the premium on equity remains constant, so that e
and i increase by the same amount. Another assumption, which has
some plausibility given the decrease in dividend/price ratios during the
period, is that the premium on equity has decreased. This assumption
leads to a smaller increase in r than the first.
Tax reform shortened write-off periods, which increases the present
value of depreciation deductions, z. The effect of z on c is (r + d), if u
is close to 0.5. Thus assuming r + d to be equal to 15% for example, an
increase in z of 10 to 20%, which is what was implied by changes in
taxation for different types of assets, implies a decrease in user cost of
1.5 to 3%. This suggests that the tax changes only partly cancelled the
effects of monetary policy.
The effective tax rate T shown in Table 4 is the rate which, if applied
to corporate income, would lead to the same user cost when there is
no investment tax credit (t = 0) and when depreciation is computed at
its true economic value, i.e. with a present value d/(r + d), then:
c = (r + d ) ( l - T ^ ) / ( l - T ) (A3)
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Economic Policy October 1987 Printed in Great Britain

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President Reagan came to the White House promising a major shift

Reprinted from 77i« Washington Post, Nov. 15, 1983

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2. Monetary and fiscal policy

2.1. Fighting inflation: monetary contraction

The decision to fight inflation through monetary contraction had been

1979 1980 1981 1982 1983 1984 1985 1986

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Source: DRI Database.

2.2. Putting on the pressure: the tax cuts of 1981-83

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Source: Historical Tables, Office of Management and Budget, Washington.

and 1980-86.' Deficits rose because of all three components: non-

Average tax rates

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Source: Hulten and O'Neill (1982).

Assets were grouped in four categories and given write-off periods of

1980 legislation 1981 legislation 1986 legislation

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Source: Author's computations following a program adapted from Auerbach (1987).

assumptions about inflation and the required rate of return. The

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2.3. O v e r h a u l i n g the tax system: the 1986 tax reform

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Political pressure on spending from the large deficits led in August

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3. Policy and the macroeconomy: 1981-86

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3.1. T h e effects of the tight-money loose-fiscal m i x

1980 1981 1982 1983 1984 1985 1986

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Source: DRI Database.

Rt = I-(l-a'-:)/(l-a) £ o-'£(ft +i |t-l)

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3.2. T h e cost o f disinflation

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3.3. Deficits and the recovery

Quarterly equation for wage inflation (Phillips curve)

Estimated coefficient on:

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1964Q2-79Q3 0.05 0.05 0.79 -1.9

Source: Author's estimates using DRI Database.

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1961Q1-1969Q4 36 4.2 4.3 4.0 6.2 3.1 3.1 4.8

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Fiscal year 1986 1987* 1988* 1989*

Spending: 24.6 24.1 23.4 23.1

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Source: DRI Economic Review, February 1987.

Fiscal year 1986 1987 1988 1989 1990

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4. The legacy of deficits

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1986 1987 1988 1989