Reaganomics

The term Reaganomics, a portmanteau of Reagan and economics, was used to describe, and decry, the economic policies of U.S. President Ronald Reagan during the 1980s. Reagan assumed office during a period of high inflation and unemployment, and his economic theories are claimed by his supporters to have eventually led to a strong recovery.

An Explanation of Reaganomics

Reaganomics or supply-side economics is a highly politicized term, which can be interpreted many different ways. In brief, Reaganomics has two key ideas: lower taxes and smaller government. Or in Reagan's words "government is the problem."

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Classical economists such as Adam Smith stress the importance of specialization and trade. For example, if a farmer trades wheat for horseshoes from a blacksmith, then the farmer is more productive and society is better off than if the farmer had attempted to manufacture horseshoes himself. However, classical economists have struggled mightily to explain and offer solutions to the periodic business cycles of boom and bust.

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During the Great Depression, Keynesian economists saw the vast numbers of unemployed workers and suggested that the government should "prime the pump" through government borrowing for job creation programs. During the New Deal, the WPA and other programs put this theory into action. Keynesian economists justified this government spending, by claiming through the multiplier effect -- one employed worker's salary will benefit 5 other workers etc. Critics argued that government, being a political entity, is an inept distributor of economic resources.

Related Topics:
New Deal - WPA

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One school of critics, the monetarists, argued that government can better stimulate the economy by manipulating the money supply. When the economy is weak, the monetarists argued that the government should lower interests rates and increase the money supply. This additional money will seek businesses and start-ups to invest in, via banks and other non-governmental means. The negative effect of an increased money supply is inflation.

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After the Oil Shocks of the 1970s, a new economic phenomenon took hold: Stagflation. Stagflation combined high unemployment with runaway inflation. Previously, the economy experienced either high unemployment and low inflation, or low unemployment and high inflation. The economy had not experienced both high unemployment and high inflation at the same time. Stagflation meant that if one followed the Keynesian model to stimulate the economy, the government must intervene via new spending programs. The new spending is to be financed either by new taxes or borrowing. On the other hand, if one followed the monetarists, the government had to choose either to raise interest rates to tame inflation and cause further unemployment, or lower interest rates to stimulate the economy and cause further inflation.

Related Topics:
Oil Shocks - Stagflation

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A new school of thought gradually arose. It argued that the competitive nature of free markets (free of government regulation) made markets the best means to distribute economic resources. Businesses have to be innovative and create wealth to survive. This anti-government view saw businesses as the "goose that lays the golden eggs" and government regulation and taxes as "strangling the goose". Reagan partially agreed with this anti-government view and sought to stimulate the economy by lowering taxes, financed by borrowing. He argued that lowering taxes will revive the economy. When the economy revived, the increased tax revenues will be used to pay off the debt. Excluding military spending, he argued for broad cuts in government spending, which he viewed as a drain on the economy. Reagan raised military spending, however, as he saw defense as an integral government function, especially in regards to the Cold War.

Related Topics:
Free markets - Cold War

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The disagreement between "Reaganomics" and New classical economics (a modern economic theory which emphasizes that free markets self-regulate most efficiently and optimally) becomes clear with understanding Reagan's exceptional military spending. While taxes were cut and thus endorsing that element of neoclassical theory, massive military spending in the Reagan era resulted in a massive budget deficit. The 1983 deficit reached $207.8 billion, equivalent to 6 percent of the economy, the highest level since the World War II era. This emphatic deficit spending violates neoclassical economic theory emphasis on a balanced budget. Absent this, private actors will rationally expect, as explained by the Ricardian equivalence, for taxes to increase sometime in the future to offset this deficit, and will end up saving enough to offset any increase in consumption resulting from government spending. Furthermore, deficit spending is problematic under neoclassical theory because even if the Federal Reserve lowers the federal funds rate to keep interest rates low and combat this "crowding out" effect, the rational public will see the lack of credibility with this merely fiscal-policy-reactionary monetary policy.

Related Topics:
New classical economics - Ricardian equivalence - Federal Reserve - Federal funds rate - Crowding out

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Reaganomics ultimately exists in two forms, actual historical experience and theory. The historical experience of Reaganomics is of increased defense spending and large federal deficits. But the theoretical Reaganomic initiative of smaller government and spending restraint was never implemented, due to a lack of political will.

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