The Ultimate Supply-Sider: President Ronald Reagan
"History doesn't repeat itself, but it often rhymes." (attrib. to Mark Twain)
"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." (Mark Twain)
"The very ink with which history is written is merely fluid prejudice." (Mark Twain)
"Suppose you were an idiot, and suppose you were a member of Congress; but I repeat myself." (Mark Twain)
This is the first of a two-part series on the history of supply-side stimulus policies and fiscal consolidation budget plans, and what that history implies about the efficacy of President-elect Trump's proposed plans. Over the last 20 years, federal spending has grown 63% faster than inflation. Annual spending will rise to $5.8 trillion by 2024 if nothing is done to change it, according to the annual budget publication put out by the Heritage Foundation. The federal deficit climbed to $590 billion in 2016, according to the CBO (John B. Taylor, 2016). The excess (deficit) spending shown in Chart 1 will eventually land us in trouble; indeed, just the combined cost of entitlements and interest on the debt will consume all tax revenues by 2031 (Chart 2). Recent attempts to limit the deficits, such as the sequestration agreement of 2012, have had little impact (Chart 3). Our economic situation is weakening as federal and private sector debt climb ever higher (Charts 4, 5), the burden of which may have contributed to the weak recovery from the Great Recession and the associated drag on GDP growth since 2007 (Chart 6).
Chart 1: We Have a Spending Problem, Not a Revenue Problem
Chart 2: Entitlements and Interest Will Consume All Revenues by 2031
Chart 3: The Sequestration Agreement Accomplished Little
Chart 4: Total US Federal Debt Continues to Soar
Chart 5: US Private Sector Credit Growth Also Soars
Chart 6: US GDP Growth Has Been Weak for Years
The federal debt situation has fluctuated significantly in recent years, and some economists believe that there are major differences in policy that have influenced these fluctuations. For example, in the period from 1980 to 2000 (Chart 7), gross (net) debt/GDP rose in a series of waves until it peaked at about 65% (48%) in 1993; it then plummeted all the way back down to about 55% (32%) in 2000. This decline is deemed to have resulted from planned fiscal consolidation policies under the Clinton Administration. The decline then reversed in the recession of 2001, with gross (net) debt/GDP rising gradually until the Great Financial Crisis in 2008 when it dramatically soared to a new post-1950 high of about 100% (75%). Projections of the net debt/GDP ratio by the CBO indicate that it will reach around 100% by 2038 (Chart 8). This huge increase in debt since 2000 is dominated by higher-than-average deficit spending associated with the bailouts and stimulus measures that were passed by Congress in the midst of the Great Financial Crisis. However, the spending projections going forward are driven much more by entitlement spending than anything else (cf. Chart 2 above).
Chart 7: Compare US Debt/GDP Under Two Regimes: (1981-2000) and (2001-2014)
Chart 8: CBO Extended Baseline Projection of US Debt/GDP
It is not just debt, however, that is at issue in the halls of government right now. The incoming Republican Trump Administration and Republican-dominated Congress have big ideas for getting GDP growth back on track. There are plans for Keynesian infrastructure spending programs, and somewhat paradoxically, plans for major tax cuts, deregulation, and other supply-side economic measures. These plans are part of why Mr. Trump and the Republicans won the election, and they are absolutely enthusiastic about initiating a number of legislative moves to further their agenda in 2017. Reducing debt through fiscal consolidation, which has been a major theme for Speaker of the House Paul Ryan and other Republicans for years now (Charts 9, 10), may be forced to take a backseat to the push by Mr. Trump for all of these fiscal stimulus measures. However, it may be a matter of debate as to whether that is really the best choice. At this juncture, it makes sense to ask a few questions: 1) Does supply-side economics actually work as its proponents claim? 2) Do fiscal consolidation plans actually work as their proponents claim? and 3) Which of these policies would work best in combination and prove most effective in boosting GDP growth and/or reducing the federal debt burden?
Chart 9: CBO Projection of Republican Fiscal Consolidation Plan
Chart 10: CBO Projection of Improved GNP Per Person Under the House Budget Resolution (Fiscal Consolidation)
HISTORY OF SUPPLY-SIDE STIMULUS IN THE 1920s
There has long been a pretty boisterous debate about the efficacy of supply-side economics (e.g., Scott A. Hodge, 2011; Rex Nutting, 2012; Mark Thoma, 2012; and Scott Greenberg, 2016). In part, there are significant philosophical and political undercurrents in this debate, but there are hotly debated economic issues as well. My interest here is in the economic evidence, and I will endeavor to avoid the purely political aspects of the debate. Fortunately, we have a great deal of historical evidence that can be brought to bear on the question of whether supply-side economics actually works.
Somewhat surprisingly, there is evidence of supply-side economics at work in the 1920s. The US Secretary of the Treasury in the 1920s was Andrew Mellon, and he felt that the best way to pay off the country's debts from World War I was to lower taxes, which he thought would actually boost revenues, and might also boost economic growth (Veronique de Rugy, 2003). After getting tax-cutting measures passed in 1921, 1924, and 1926, his ideas were shown to be correct (Charts 11, 12). The so-called Mellon tax cuts sharply increased revenues and supported a general surge in economic growth, with GNP rising by a whopping 59% between 1921 and 1929 (Daniel J. Mitchell, 1996). This may be a significant part of the explanation for why we refer to the period as the Roaring Twenties.
Chart 11: Mellon's Tax Cuts Actually Boosted Revenues
Chart 12: Real GNP Per Capita Soared in the 1920s
HISTORY OF SUPPLY-SIDE STIMULUS IN THE 1960s
The next historical example of supply-side economics in action comes from the 1960s. This episode was initiated by a Democrat, believe it or not: President John F. Kennedy (James Pethokoukis, 2013). Kennedy became a supply-sider when he decided against purely Keynesian stimulus because he was worried about a large deficit ($7 billion!?!). His tax cuts, passed after he was assassinated, behaved in much the same way as the Mellon tax cuts of forty years before (Charts 13, 14, 15). Tax revenues climbed by 41% within a year, and real GDP growth increased by over 42% between 1961 and 1968, in one of the longest booms in American history (Peter Ferrara, 2009).
Another Early Supply-Sider: JFK
Chart 13: Kennedy Supply-Side Tax Cuts Worked
Chart 14: Economic Growth Was Supported by 1964 Tax Cuts
Chart 15: Employment Improved Under 1964 Supply-Side Tax Cuts
The reason we can say that Kennedy's tax cuts were supply-side in nature instead of Keynesian, is that Kennedy didn't seek a temporary boost; indeed, his large (i.e., about 30%) tax cuts were made on a permanent basis. This is one of the defining characteristics of supply-side tax cuts, i.e., they must be perceived as permanent or they tend not to work. Another defining characteristic is that supply-side tax cuts need to be progressive, meaning that the rich cannot benefit more than others from the cuts. Finally, for maximum effectiveness, supply-side tax cuts should be accompanied by spending discipline so that the tax cuts are perceived as real rather than simply a deferral of taxes to a later time (Matthew Mitchell & Andrea Castillo, 2012).
The team that advised Kennedy was led by Treasury Secretary Douglas Dillon, who in turn was aided by the work of a young economist (who later became a Nobel Laureate) named Robert A. Mundell. They were the ones who convinced Kennedy to try the supply-side approach after years of failure with more conventional methods like Keynesian stimulus. Mundell later influenced President Ronald Reagan and his Republican colleague Jack Kemp to try supply-side economics in the 1980s. Mundell favored large, permanent tax cuts, relatively tight monetary policy focused on price stability, a stable dollar, a relatively neutral trade balance, and substantial regulatory relief (Robert A. Mundell, Nobel Prize Lecture, 1999). Mundell, along with his former colleague at the University of Chicago, Arthur B. Laffer, has provided much of the theoretical argument for why supply-side economics should work, and under which conditions it would do best.
Nobel Laureate in Economics Robert A. Mundell
HISTORY OF SUPPLY-SIDE STIMULUS IN THE 1980s
Laffer later produced his famous "Laffer Curve," predicting increased revenues when taxes were cut from high levels (Chart 16), which helped carry the day with the Reagan Administration. Subsequent history indicates that Laffer was right, and this predicted increase in tax revenues is what actually happened. Another big player was Congressman Jack Kemp, who worked with Laffer and ended up helping to lead the legislative battle to get supply-side policies passed by Congress.
Economist Arthur B. Laffer
Chart 16: Laffer Curve Predicts Higher Revenues from Lower Taxes
Republican Supply-Side Thinker Jack Kemp
The Reagan Administration proposed and passed two major pieces of legislation that promoted a supply-side fiscal stimulus. The tax cut legislation was passed in two waves: 1) an initial cut in 1981 that involved a 20% reduction for the rich (from 70% to 50%) and a 25% reduction for everyone else, phased in over three years; and 2) a more massive cut in 1986 (Tax Reform Act of 1986), which cut the top rate to 28%, with taxes cut to only 15% for everyone else. Taxpayers had been subject to bracket creep caused by the high inflation of the time, but after the reforms, tax brackets were indexed to inflation. Income tax revenues from the top 1% and top 10% rose substantially (Chart 17), and total tax receipts rose (Chart 18) by about 43% over eight years (Arthur B. Laffer, 2015).
Chart 17: Reagan Tax Cuts Were Progressive
Chart 18: Reagan Tax Cuts Raised Revenues
Deregulation was also a major theme for the Reagan Administration, as was a smaller government in general. The cuts in spending that would go with smaller government don't appear to have occurred though (Chart 19). Arguments that the tax cuts caused the deficits do not appear to fit the facts (Chart 20). Congress and the Reagan Administration boosted defense spending dramatically, as well as spending on many other budget items. This issue of spending vs. revenues has been the cause of a fair amount of the disagreement over the efficacy of supply-side economics. However, in spite of the increased deficit in the 1980s, other aspects of the economy were so strengthened by the Reagan supply-side stimulus that GDP growth soared after the recession of 1982, and employment improved dramatically. These post-recession growth trends are in sharp contrast to the recovery after 2008 under President Obama's Administration (Charts 21, 22). This is not meant to be a political argument - it is an argument based on the actual economic results of policies applied under different theories of how to promote growth. Finally, with respect to the 1980s supply-side stimulus, the Reagan revolution ushered in a wave of corporate tax cuts around the world, and these too seem to have boosted government tax revenues (Chart 23).
Chart 19: Reagan Deficits Were Driven by Spending
Chart 20: Reagan Deficits Not Caused by Tax Cuts
Chart 21: Reagan Recovery vs. Obama Recovery
Chart 22: Reagan vs. Obama Employment Trends
Chart 23: Reagan Revolution Led to Global Corporate Tax Cuts
SUMMARY OF PART I
So far, we have chronicled what appears to be compelling evidence for the efficacy of supply-side economics as applied by Andrew Mellon in the 1920s, John F. Kennedy in the 1960s, and Ronald Reagan in the 1980s. In all three cases tax revenues actually climbed after tax rates were cut, GDP growth soared, and employment improved dramatically. Critically in the current debate, all three of these supply-side episodes were marked by substantial increases in the deficit (see Chart 1 above). Does this matter? Liberals say it doesn't when they are in power, and conservatives say it does when they are out of power. These roles reverse when power changes hands. Separate from the politics, though, there must be a practical answer to this question. President-elect Trump says he's the "master of debt" and he will be able to engineer growth in spite of the deficits. Since this has been done three out the four times it's been tried, perhaps he will pull it off. But others (e.g., Van R. Hoisington & Lacy H. Hunt, 2014) have long argued that our declining productivity and lackluster rate of GDP growth in recent decades is symptomatic of large debt overhangs (Chart 24 below; Chart 4 above).
Chart 24: Steep Decline in Decadal GDP Growth Since 1990
It is also important to note that long-term interest rate trends can affect GDP growth as well. For example, Hoisington & Hunt (Op. Cit.) have charted the decline in GDP growth that has occurred as a result of corporate bond yields rising above nominal GDP growth rates and staying there since the mid-1980s (Chart 25). High relative interest rates tend to pull GDP growth down over time. Now that interest rates are rising sharply again under the post-election reflation trade, will GDP growth be cut back even further, or will Trump's supply-side stimulus push us back into the benign economic growth situation that prevailed before 1983?
I believe that we are at risk of a mild form of stagflation as rates rise under weak economic conditions, but that if supply-side stimulus is properly applied, it is possible that we can rejuvenate growth and avoid damaging levels of inflation at the same time.
Chart 25: Relative Corporate Yields Are a Factor in GDP Growth
In Part II, we will discuss the widely acknowledged failure of tax cutting policies under the George W. Bush Administration in the early 2000s. Then, we will examine reasons why this failure is unique, understandable, and avoidable in future. Lastly, in Part II, we will evaluate the contradictions and similarities in the goals and theory behind recent efforts by Republicans to produce a fiscal consolidation plan within the budget process. We will ask (and attempt to answer) the question, "What should the Congress and the new administration do - should they support fiscal consolidation, supply-side policies, or some combination of the two in 2017?
Investors who believe that the Trump Administration will be able to pull off improved growth and stable inflation under a range of supply-side policies should buy the dips in equities over the coming months. Expect these dips to be significant, however, as the market appears to have already priced in strong earnings from Trump's first year, in spite of the fact that he has not even taken office yet.
Those in a more defensive frame of mind because of the expected dips should hold some intermediate to long Treasuries: the iShares 20+ Yr. Treasury Bond ETF (NYSEARCA:TLT), the Vanguard Intermediate-Term Bond Fund (NYSEARCA:BIV), the PIMCO Total Return Active ETF (NYSEARCA:BOND), and the DoubleLine SPDR Total Return Tactical Bond Fund (NYSEARCA:TOTL); also some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (MUTF:OTCRX), the AQR Long/Short Equity Fund (MUTF:QLENX), the AQR Managed Futures Fund (MUTF:AQMNX), and even some sophisticated hedge-like Closed-End Fund strategies like the Nuveen S&P 500 Buy-Write Fund (NYSE:BXMX).
Disclosure: I am/we are long TLT, BIV, BOND, OTCRX, QLENX, AQMNX.
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