Late last month there was a debate among several bloggers over an article by Scott Sumner over US growth after the Reagan revolution. In the debate it was suggested that it would be
helpful to do the analysis by looking at the various components of GDP–consumption, investment, government and trade . I was sidetracked on other projects, but belatedly decided to do exactly that — look to see if there were breaks in the various GDP accounts around 1981, when the Reagan revolution occurred.
Remember, Sumner was defending the position that because of the Reagan revolution the US was able to sustain the trend in real per capita GDP that prevailed from WW II to around 1980. He argued that without the changes Reagan implemented that US real per capita growth was have slowed sharply.
The real break in the data around the time of the Reagan revolution is clear in the trade balance or the current account. Prior to the late 1970s, early 1980s, the US normally ran a small trade surplus year in and year out. This reflected the basics of the supply and demand for savings and investment that prevailed from WW II to about 1980. What the savings and investment data showed in this era was that roughly personal savings financed the housing sector and business savings financed nonresidential fixed investments. Each ran a small surplus that financed the federal deficit and left a small surplus for a net outflow of foreign investment.
Starting around 1980 two factors changed this. One was the creation of a large structural federal deficit. The second was the peaking of the personal savings rate and a contraction of personal savings. I see no need to go into an explanation of the start of the structural federal deficit. But some Republicans claim it was deliberate and called it the starve the beast strategy.
The weakness in personal savings was a real surprise and caught most economists by surprise. Starting around 1980 the US started creating a series of special saving accounts where individuals could shelter their savings from taxes. Essentially all schools of economic though believed this would lead to greater personal savings because savers would realize greater after tax returns. So virtually everyone was surprised when these policies were miserable failures as the personal savings rate fell irregularly to almost zero over the next 30 years. This has to be one of the greatest failures for the economics profession on record even though we still see the advocates of these polices continuing to push them.
Personally, I see two main reasons this policy failed. One was the stagnation of middle class living standards that lead them to use expanded debt to sustain their anticipated standard of living. The other is within the basic theory of tax breaks generating greater returns. Standard theory says this should lead to greater savings. But there is another theory that savers have a goal they want to achieve, having a million dollar stock portfolio at retirement, for example. Remember, in the national accounts the annual contribution each individual makes to their tax free account is what counts as savings as the returns on this portfolio do not count as savings.
But if the objective is to achieve a savings goal — a million dollar portfolio at retirement — realizing greater returns means that the individual contribution each year can be smaller. If this is the savers objective, providing them a tax break and greater returns actually leads to less savings — the individual’s annual contributions — just the opposite of standard theory. Maybe some behavioral economists should look at this.
But anyway, the theory was that it is OK to run a large trade deficit and import capital from abroad if the foreign capital is invested in productive capital that will generate greater output than can be used to raise standards of livings and easily allow the foreign capital to be repaid.
It is like it is OK for you to run up a large credit card balance if you expect a pay increase that will allow you to easily repay the credit card balance.
That is the basic theory that Scott Sumner and most republicans use to justify claims that the Reagan revolution lead to greater investments that sustained the pre-1980 growth of per capita real GDP.
So maybe we need to look at the other component of GDP to see what happened and if their was a break in the series around 1980.
First, look at nonresidential fixed investments. The justification for the cut in taxes on investment income and upper income individuals income taxes is that it leads to greater investments that lifts the boat for everyone and raises everyone’s living standards.
So here is the data on nonresidential fixed investments. Scott Sumner and other are right that there was a sharp break in the series around 1980. The problem is that the break is in exactly the opposite direction that their theory calls for. All through the 1950s, 1960s and 1970s there was a clear trend of business investment rising as a share of GDP. But since the Reagan revolution of the early 1980s that trend has clearly reversed. Just as with the theory on personal savings the results has been just the opposite of what standard economic theory posits.
So where did the influx of foreign capital go, after all it did not just disappear. The data on personal consumption and housing — a form of consumption — also shows a clear break around 1980 just as the investment data does. But what it shows is that the inflow of foreign capital was used to finance an ever expanding share of consumer spending rather than investments as Sumner and the other advocates of the Reagan revolution claim.
This data clearly shows that what Reagan initiated was an era of the American consumer living beyond their means and borrowing abroad to sustain their living standards. Yes, their was no break in real per capita GDP around 1980. But it was not because the Reagan policies generated greater savings and investments. Rather it was because the Reagan policies lead to middle class Americans and the government borrowing abroad to sustain the living standards they had become accustomed to before the Reagan revolution shifted an increasing share of income to the top few percent of the income stream at the expense of the middle class.
To make the analysis complete I’ll also include a chart of government as a share of GDP. This chart will not look familiar because in the national accounts government spending does not include transfer payment. It only shows government consumption. For example, if the government pays a farmer not to raise crops it does not show up in the data on government consumption. Rather, it depends on where the farmer spends the transfer payment. If he buys tractors, etc., it shows up in the investment account. If he uses it to buy a condo in Miami it shows up in housing. Alternatively, if he uses it to give his daughter a three month trip to Paris as a graduation present it shows up as an import. There are exceptions of course.
For example, the government agricultural subsidies use to take the form of government stockpiles of agricultural products. Much of the drop in the federal governments share of GDP in the early 1970s was Nixon selling these stockpiles to the Soviets.
But the bottom line is that the Reagan revolution has been accompanied or followed by a drop in capital spending and an increase in consumption as a share of the economy. Now I know this is not what Larry Kudlow and others keeps telling you, but what can I say– just don’t let the facts confuse you .