It's Reagan's Economy, Stupid.

The roots of America's new prosperity--and how to sustain it

By James K. Glassman
James K. Glassman is the DeWitt Wallace-Reader's Digest Fellow at the American Enterprise Institute. He writes two weekly columns for The Washington Post on finance, economics and politics. He also hosts Capital Gang Sunday on CNN and TechnoPolitics on PBS.

Americans are living in an economic golden age. For the first time in our history, 15 years have passed with only a single shallow recession. The gross domestic product, that grand measure of all our goods and services, is clipping along at 3 percent annually. Unemployment is 4.9 percent. Inflation is 2.2 percent--and probably closer to 1 percent if a more accurate gauge were used than the Consumer Price Index.

While these figures are impressive, even more remarkable is the stability that has descended on the economy. Growth, inflation, interest rates have reached a kind of stasis--a glorious plateau. This lack of volatility has encouraged investors to commit more of their money to long-term investments in the stock of U.S. corporations, and partly as a result, since the recession of 1982, the Dow Jones industrial average has risen from 777 to over 8000-- an unprecedented advance. At the same time, the total number of Americans employed has increased by 30 million, or one-third.

Who gets the credit for this golden age?

First and foremost, individual Americans and the companies they create and work for.

In the past 15 years, we've made things (and provided services) better, cheaper and faster--through risk taking, talent, better education and training, hard work and good management.

But what about government? Is there something government has done to encourage the private sector to boom? And, if so, whose government?

The answer, it seems to me, couldn't be clearer. The golden age began under Ronald Reagan, and policies set during his administration have sustained it. George Bush and Bill Clinton deserve credit mainly for not tampering excessively with the changes Reagan wrought. And then there's the Republican Congress. But for the GOP victory in 1994, Clinton almost certainly would have ended the game prematurely. (In this assessment of the role of Republican majorities on Capitol Hill, the market seems to concur. For the first two years of the Clinton administration, with a Democratic Congress, the market rose 21 percent, or about 10 percent annually. Since November 1994, the market is up 98 percent, or about 30 percent every 12 months.)

Tax cuts, inflation, spending and regulation

The causes of economic growth remain a mystery, but the barriers to growth are clear: high tax rates, high inflation, high government spending and excessive regulation. Reagan's goals, at the start of his administration in 1981, were to reduce all four, writes William Niskanen, a member of his Council of Economic Advisors.

The reason these conditions thwart growth is that they put heavy burdens on businesses and prospective entrepreneurs, restricting their flexibility and their ability to raise capital, hire good workers and plan for the future. The four conditions do something else. They deter experimentation, which is the wellspring of growth--an issue I'll get to a little later.

Reagan was successful on taxes and (with the help of Paul Volcker, who was appointed chairman of the Federal Reserve Board by President Carter in 1979) on inflation. He reallocated government spending to defense, but didn't reduce it overall. In 1980, spending on the military and on domestic discretionary programs was roughly equal. By 1990, spending on the military was 50 percent greater. Today, domestic spending exceeds military.

But, to the disappointment of those who wanted to see a smaller government, total federal outlays as a percentage of GDP rose from 22.3 percent in 1980 to a post-World War II record of 24.4 percent in 1983 before settling back to 22.1 percent in the last year of Reagan's term.

The regulatory record was mixed, and perhaps the single most important accomplishment in this area was the work of a judge: the breakup of AT&T, which led to at least a partial lifting of the restrictions on what communications companies can do. In the July issue of Wired magazine, Peter Schwartz and Peter Leyden argue that what they call "The Long Boom" began with two events that occurred at roughly the time Reagan took office: "One is the introduction of personal computers. The other is the breakup of the Bell System." Both led to wider, cheaper dispersion of information, which, in turn, has meant that individuals and businesses can work more efficiently.

On both spending restraint and regulation, the new Republican Congress has picked up the ball for Reagan. Federal outlays have now fallen to 20.8 percent of GDP; subsidies are, at last, being phased out in farming; and free-market competition is the norm in transportation and telecommunications--with gas and electric utilities next on the agenda.

Meanwhile, another of Reagan's economic victories was the firing of striking air-traffic controllers just seven months into his presidency--a watershed in the history of organized labor. Subsequently, the percentage of union members in the work force fell by one-fourth, from 20 percent to 15 percent.

Finally, in a surprising failure that was remedied in great measure by Bush and Clinton, Reagan "added more trade barriers than any administration since Hoover," as Niskanen puts it. Still, Reagan's successful defense policy, which led to the demise of the Soviet empire and the spread of democracy and capitalism throughout Latin America, helped create vast new markets for American goods. His tax policies were mimicked by Britain, Canada, New Zealand, Japan and much of the rest of Europe and Asia. It's an amazing record, considering that throughout his term the Democrats held majorities of from 51 to 101 seats in the House, where revenue and spending bills originate.

Some critics, including Niskanen, cite large deficits as another failure of Reagan's, but I disagree. As Reagan told David Stockman, his budget director, in 1981: "I did not come here to balance the budget--not at the expense of my tax-cutting program and defense program. If we can't do it in 1984, we'll have to do it later."

Reagan took a courageous position, pushing tax cuts and national security while ignoring deficits in the short term--and his prediction about the budget will turn out to be right. We'll end fiscal 1997 with a deficit of only $34 billion, the lowest since 1974, and, next year, I'll lay even money that we'll have a surplus. The zero deficit, some 17 years after Reagan took office, is his legacy as well. Let me explain . . .

The myth of the Reagan deficits

The Reagan deficits have been widely misunderstood. They were created not by a shortfall in revenues, but by a surfeit of spending. Roughly half the spending increase came from defense, which rose from 5.1 percent of GDP in 1980 to a peak of 6.3 percent in 1987. In my opinion, that was money well spent.

But revisionists have attacked Reagan mainly on the revenue side, and they're dead wrong. Reagan and his supporters in Congress didn't cut tax revenues in 1981 and 1986. He cut tax rates. The view of his advisers was that rate cuts would generate more economic activity because, at the margin, Americans would have more incentive to work and invest. And that's just what happened.

It's not a difficult concept. Before Reagan took office, the top rate on "unearned" (that is, investment) income was 70 percent; the top rate on earned income was 50 percent; on capital gains, 35 percent. All of these rates fell to 28 percent in the 1980s. In addition, Reagan took the important step of indexing tax brackets so that Americans no longer encountered higher rates simply because of inflation.

Consider a woman, pre-Reagan, who is offered the chance to work longer hours and earn an extra $10,000. That sounds tempting-- until she realizes that the U.S. Treasury will take $5,000 of that additional income in taxes. She decides the extra work is not worth the $5,000 she'll keep, so she chooses leisure.

But, under Reagan, the bite at the margin drops to 28 percent, so she'll keep $7,200. The differences in marginal rates are even more dramatic for interest and dividend income. Instead of keeping just $3,000 out of every additional $10,000 in "unearned income," an investor in the top bracket keeps the same $7,200.

By cutting marginal rates in this way, Reagan and his advisers believed they could boost economic growth, and they were right. Between 1981 and 1989, GDP advanced at a 3.1 percent annual clip-- including the recession year of 1982--and 18 million net jobs were created as new businesses were launched. The 1980s became "the great heyday of the venture capital industry," wrote Robert Bartley, editorial page editor of The Wall Street Journal in his book on the Reagan boom, The Seven Fat Years. After the 1982 recession--the result of action by Volcker, with Reagan's encouragement, to stop virulent inflation created in the Carter years--the recovery would last nearly eight years, second in the modern era only to the 1961D1969 boom during the Vietnam War (which lasted an extra year). But net fixed investment--a good measure of how much new capital was pouring into the economy--grew at a record 3.5 percent annually.

It's tax cuts, stupid

But back to the tax cuts. Alan Reynolds, who was present at the creation and now directs economic research at the Hudson Institute, makes the interesting point that, "since revenues are constant at 19 percent of GDP, the only way for an administration to raise more money is to increase GDP." Why are revenues constant--or roughly so--at 19 percent? "That's all you can collect," he says. "The American public won't put up with anything higher."

Indeed, between 1958 and 1980 tax revenues averaged 18.5 percent of GDP annually, ranging from a low of 17.4 percent to a high of 20.2 percent. During the Reagan years (1981D89), revenues averaged 18.9 percent of GDP--actually, higher than in the preceding three decades--with a low of 18.0 percent and a high of 20.2 percent. They've stayed in that range since.

So the key was constructing a tax system (and making other policy changes) that would make government less obtrusive and encourage growth. That policy worked, without a doubt. The proof is in the tax revenues that were generated. In 1980, Jimmy Carter's last year as president, the Treasury raised $517 billion; in 1989, at the end of Reagan's term, it raised $991 billion. That's a 92 percent increase during a period when consumer prices rose just 46 percent.

It's true that most of the tax rate cuts accrued to higher-income Americans--but, because those cuts encouraged them to work and invest more, these higher earners became the source of much of the tax revenue growth. "In effect," wrote James D. Gwartney of Florida State University in the Fortune Encyclopedia of Economics, "lower rates soaked the rich."

There were, however, deficits. Big ones. But, despite dire warnings, those deficits did not cause inflation to accelerate, nor did they boost interest rates. Doomsayers like Lester Thurow-- who in 1985 wrote, "American were enjoying the thrill of a cyclical recovery in 1984, but ahead lie more sickening bouts with inflation and unemployment"--were dead wrong.

While consumer prices doubled in the 1970s, they rose by less than half in the 1980s. Rates on 30-year Treasury bonds were 12 percent when Reagan took office and less than 9 percent when he left. One big reason that inflation and rates were relatively low was that the supply-side revolution actually did increase supply. Inflation is too much money chasing too few goods; Volcker (and later Alan Greenspan) took care of the money part, and the tax cuts and deregulation encouraged the production of goods.

The Reagan legacy

The Reagan Boom continues today. In July, Investor's Business Daily commissioned a survey of 200 CEOs and chief financial officers from the nation's largest publicly traded corporations. They were asked, "What triggered recent economic growth?"

Leading the list was productivity, followed by Federal Reserve monetary policies, information technology, restructuring and globalization. Following these, in sixth place, came "Reagan policies" (which, I'd argue, ignited four of the preceding factors as well). They were credited by 26 percent of the executives. Farther down the list, at 14 percent, were "Bush policies," and nearly at the bottom, at 8 percent, "Clinton policies."

At a press conference on August 6 touting what he considered his own economic achievements, Clinton could not resist taking a swipe at Reagan. "In 1993," he said, "we abandoned supply-side trickle- down economics."

Oh, really?

In fact, while Clinton (and, alas, Bush) chipped away at Reagan's economic edifice, it still stands. It's performed as advertised. Tax rates are higher now than they were under Reagan, and that's a shame--but they are still far below the levels that existed before he took office. The top rate on ordinary income is 39.6 percent instead of 70 percent (and 50 percent for earned income). The capital gains rate held steady at 28 percent, and, thanks to the Republican Congress, will be lowered next year to 20 percent.

Just as important, the principle that government usually does more harm than good to the economy is well entrenched. While spending has not fallen, it's risen at a relatively moderate pace. The result, as Reagan predicted, is an imminently balanced budget.

People, things and recipes

It's a mistake, however, to give too much credit to any politician. Economic growth is strictly a private-sector phenomenon. Government can hurt a lot but help not much.

In a famous formulation, Paul M. Romer, a Stanford economist (whose father, by the way, is Democratic National Committee General Chairman and Colorado Gov. Roy Romer), wrote, "Economic growth occurs whenever people take resources and rearrange them in ways that are more valuable." He says that three things show up in every economy: people, things and recipes (or arrangements). For example, "we used to use iron oxide to make cave paintings, and now we put it on floppy disks. The point here is, the raw material we have to work with has been the same for all of human history . . . So when you think about growth, the only place it can come from is finding better recipes for rearranging the amount of stuff we have."

The function of government in this growth equation is to help these rearrangements occur more quickly and more often by liberating people to pursue their imaginations. One way to do that is by keeping tax rates low--that is, minimizing the penalties applied to the rewards of finding better recipes. As Romer puts it, "If the government confiscated most of the oil from major discoveries and gave it to consumers, oil companies would do much less exploration."

Some Americans worry that, if we let government stand aside and let the market operate, unknown things will happen. That's true, and, as far as I'm concerned an unknown future, as long as it's created by the intelligence and imagination of free people, is the good part of the economic story. A certain faith is required, and Ronald Reagan had it.

Lawrence Kudlow, a former Reagan budget official who is now chief economist for American Skandia, the insurance firm, noted last April that the Dow Jones industrial average was 777 in 1982, and, at the time, "not a living soul would have believed it would be 6500 in 1997." (Later, of course, the Dow would pass 8000.)

Not a living soul would have believed that a high-technology revolution would account for 40 percent of the annual increase in GDP or that a company called Intel, started by a Hungarian immigrant, would have a market value of $156 billion--20 percent more than General Motors, Ford, Chrysler and U.S. Steel combined. Or that a place called Silicon Valley (along with its outposts in Washington state and Oregon) would be more vital to the economy than Detroit or New York.

And more vital, for that matter, than Washington, D.C.--which may be the most important development of the Reagan Boom. The declining relevance of government to our lives is something for which Reagan devoutly wished -- and brilliantly accomplished.