Lessons from the Reagan Era on Managing Twin Deficits

Below is a guest post from Norman Mogil and Arthur Donner.

Lessons from the Reagan Era on Managing Twin Deficits

Many in the U.S. are harking back to the Reagan era for guidance on how to implement the pro-growth policies advocated by President Donald Trump and the Republican Congress. When Ronald Reagan took over the leadership of the United States in 1981, he inherited an economy that had endured nearly a decade of stagnant growth combined with accelerating consumer prices.

Tax cuts lay at the heart of the so-called Reagan revolution. Reagan believed that high taxes threatened individual freedom, suppressed overall economic growth, and encouraged wasteful government spending. Thus, the tax laws of 1981 were the single most important piece of legislation to emerge from Reagan’s first term. The sweeping tax cuts slashed federal income tax rates, for taxpayers in every income bracket, by 25% over a three-year period. However, slashing taxes came at high price.

On the fiscal side, Reagan’s failure was his inability to restrain government spending. Reagan ran for office in 1980 as a harsh critic of “tax and spend” liberalism, vowing as President to shrink the size of the government by slashing federal spending. Once in office, however, Reagan found it impossible to deliver on his promises. Simply stated, the Reagan Administration blew up the federal deficit to 6 per cent of GDP in 1985 from just 2 per cent in 1980. (See accompanying table). It was not until the first term of President Clinton that a balanced budget was restored.

First, while still fighting the high inflation created in the 1970s, the Federal Reserve continued with its tight-fisted monetary policy. Long term interest rates remained above 10 per cent for much of the decade and really did not start to make their long decent until the first half of the 1990s. The cost of government debt finance was part of the problem of containing the steep budget deficit. The United States had to fight internal inflationary pressures and at the same attract foreign savings to fund the deficit.The tripling of the American budget deficit was highly stimulating to the economy. In effect, it was the application of a Keynesian strategy that used government to prime the pump of the economy. But the surge in the U.S. budget deficit had unintended consequences.

Second, high interest rates led to a surge in the external value of the U.S. dollar. The U.S. exchange rate index soared by over 40 per cent in the period 1980-85. Because of the fiscal stimulus, the U.S. economy was growing again and savings from abroad contributed to a rapid appreciation of the dollar.

Third, the presence of an expensive dollar and a growing economy took a heavy toll on the U.S. trade account. In 1980 the American trade account was roughly in balance, but it soared into a deficit of 4 per cent of GDP by 1985 and remained so until the end of the decade. There also was a big push in the United States to introduce protectionist policies to deal with the trade deficits. Does this not sound familiar today?

Fourth, a soaring U.S. dollar and a rapidly deteriorating trade deficit obliged the international community to intervene alongside with the U.S. The “Plaza Accord” of 1985 called for the United States to devalue its currency in response to its rising current account deficit. The central banks of United States, West Germany, Japan, France, U.K. agreed to intervene in the exchange markets to bring about an orderly devaluation. By the end of the decade, the U.S. dollar declined by about 50 per cent.

Summing up, the Trump Administration is proposing to cut taxes dramatically and simultaneously spend up to $1 trillion over the next decade towards improving the country’s deteriorating infrastructure. Hence, there is a deep concern that the federal budget will explode. The Trump tax cuts will likely result in higher budget deficits, not lower deficits.

And as a reserve currency in uncertain times, the U.S. dollar will likely remain too strong, and increase even further due to the tax cuts and rising interest rates in the United States. A higher dollar will likely lead to a widening of the trade deficit as imports becomes relatively cheaper than today.

As for a new Plaza Accord agreement, this seems most unlikely. The Trump Administration has adopted a very aggressive stance towards it trading partners, and in all likelihood, it has eliminated the goodwill necessary to reach any new agreement.

Lastly, it is hard to see the Canadian dollar strengthening against the U.S. dollar in the early stages of the Trump Presidency.

More likely, as negotiations on revamping NAFTA begin we can expect the Canadian dollar to come under downward pressure, especially if the United States takes a hard line and unilaterally slaps on a broadly based border tax. Right now, the jury is out on the future price of the Loonie.