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Tuesday, June 08, 2004

Economists Say: The Reagan Years

Another installment in the continuing series about the foolish things that follow the words "Economists say" in the NY Times...

Marilyn Berger's obituary for Ronald Reagan contains following, which I imagine is supposed to be a balanced assessment of his economic policies.
After the 1981-82 recession, Mr. Reagan presided over the longest economic expansion in history, one that saw the creation of 16 million jobs. By his seventh year in office the stock market was reaching an all-time high. Inflation had dropped and the prime interest rate was down, partly a result of the collapse of oil prices and partly from the policies of the Federal Reserve.

But Mr. Reagan got the credit, just as he had gotten the blame for the recession and the deficit. Economists noted that foreign capital pouring into the country had shielded the United States from the consequences of the deficit, but warned that it would be only a matter of time before that buffer disappeared.

The very widely accepted view, espoused in economics textbooks from Stiglitz's to Mankiw's, is that deficits raise real interest rates, lowering investment, and reducing national income in the long run. (Of course, during recessions, deficits can raise income in the short run). Berger doesn't mention this fundamental point.

It's hard to be sure what prediction Berger is garbling when she speaks of "economists" noting that foreign investment shields the U.S. from the "consequences of the deficit." I suspect she means that some economists warned of a currency crisis if foreign investors lost confidence in the U.S. and pulled out their funds. Later in the article, Berger says that the deficit was one of the causes of the October 1987 stock market crash (which is hard to believe). Although deficits have caused financial crises in some countries (and Paul Krugman warned a few years ago that it could happen here), this is not the only consequence of the deficit, and certainly not the most obvious or most common consequence.

Berger mentions that the prime rate fell during the Reagan years, but this is the nominal interest rate: economists focus on the "real interest rate" (meaning adjusted for inflation). Real interest rates were very high under Reagan, higher than at any time since at least 1963, and investment fell steadily. We were hardly "shielded from the consequences of the deficit."

The graph below shows that the macroeconomists really are on to something. As deficits soared under Reagan, so too did real interest rates, and the predictable consequence was falling investment.

I don't mean to speak ill of the recently dead, so let me join with Paul Krugman in giving Reagan credit for correcting his errors. Faced with a soaring budget deficit, he quickly rolled back some of his tax cuts, and began reducing the deficit.


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