C+I+G+T
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 .
“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.”
Or in other words when Reagan did for America what he’d already done for CA. And reversing Reaganism/Friedmanism and the “free-market” fetishism of the elites that control both political parties – and which has become the accepted CW of halp the population – ought to be the first – if not the only – order of business of the rest of us out here in the “reality-based community” if we ever hope to save the sinking ship that our nation/economy has become.
I don’t recall making the theoretical arguments that you claim I make. Can you cite a specific argument of mine that you think is factually wrong? I don’t recall arguing that investment/GDP ratio rose after Reagan became President. Indeed I argued that there were four key neoliberal refroms, all bi-partisan (deregulation, cuts in high MTRs, freer trade, and welfare reform.) Welfare reform increases labor participation. So does tax cuts (compared to Europe.) Deregulation and freer trade make capital work more efficiently, a very different argument from increasing the capital stock. Some tax cuts increase investment, but there are many disincentives to invest in our system as well. Perhaps you confused me with Kudlow. I’m not a Republican.
BTW, I can’t imagine why housing is consumption. I thought everyone agreed it was investment? Don’t houses usually last longer than factories?
And although I never made the investment claim you suggest I made, your graph doesn’t show that investment between 1980-2010 is lower than in the previous 30 years, so it doesn’t even show what you would need to show in order to refute the argument that investment prevented growth in GDP from falling after 1980. You are confusing levels and changes. If investment determines growth rates (which it doesn’t) you would have expected growth to be just as high after 1980, as in the 1950s and 1960s, albeit with a downward trend in the last few years.
Excellent post highlighting a critical juncture in post-war US economic history. An important mechanism sustaining the fiscal break of the early 1980s is the behavior of monetary policy in subsequent years – increasing debt-to-income ratios that resulted from a growth rate of living standards above real income were supported by progressively lower peaks and troughs in the absolute level of target interest rates. In other words, we observe increasing leverage but roughly static debt servicing costs. That’s a strategy that works until you hit the zero-bound (maybe a little further thanks to QE).
The standard argument is that the Reagan tax cuts lead to more investments.
That is just not true.
I have never read your blog until this issue came up, so I have no idea what your long term position is. I will plead guilty of assuming you meant things you did not mean because it is common to conservative/libertarian economists.
But you made the statement that Reagan was responsible for allowing growth to continue.
But about the only long term changes Reagan actually made was to shift the tax burden and create the long term structural deficit. He played a very small role in deregulation and many of the things he is commonly credited with. Carter did the bulk of deregulation and on an effective basis that is also true for ending price controls on energy. The Reagan formal ending of energy price controls had no meaningful impact. The most significant welfare reform was under Clinton. What did Reagan actually do for welfare reform except cut federal aid to states for mental health care? the biggest impact of this was to create a large homeless population that essentially did not exist before 1980.
Yes, in the national accounts housing is though of investments because it provides a long term service. But In this context I am thinking of investment in the sense of creating something that is used to produce more goods. In this context housing is consumption, not investment. The life time of the good plays no role in whether or not it is a capital or a consumption good if you think of capital as a tool. Growth comes from very few things — more labor, more capital and better knowledge. Even though housing in the national accounts is investment I have never seen anyone arguing that housing is responsible for growth in the context of what drives growth. Yes, technically investment does not determine growth, but it sure plays a major role.
I’m sorry but I come out of this with the impression that you are arguing semantics and are really taking a typical conservative/libertarian position until you are called on it and then you try to talk your way out of it.
I wish I’d read Presimetrics. If it doesn’t have a chapter on Presimetrics and NIPA it should. I note some exceptions to the pattern you note. Fixed capital investment went up roughly 1992-2000 and Federal Government spending went down sharply roughly 1993-2000. Hmm wonder what happened then? It wouldn’t happen to have been a partial reversal of Reaganism ?
I haven’t read Sumner’s comment in full.
I find it hard to believe that an actual economist doesn’t understand why housing investment might reasonably be reclassified as consumption. The idea is that the investment which interests us is productive investment, that is investment in productive plant and equipment. Clearly the Clinton Treasury took a strong view that, of these two, investment in equipment was more important. No effect on policy (Congress didn’t agree). People who attempt to understand economic growth in different countries definitely distinguish housing and fixed capital invetment. The logic of causing higher growth by causing higher investment works if investment is used to mean fixed capital investment and not if it is used to mean NIPA investment. Larger houses do not imply higher employment or measured GDP.
I contest the claim that deregulation was bipartisan. I assert that the Democrats deregulated before 1980. I assert that Reagan deregulated essentially nothing (except S&Ls). I point out that so called “telecoms deregulation” was regulation not deregulation (this is obvious it was an application of the Sherman antitrust act which is a regulation and consisted of saying that ATT couldn’t do what it wanted to do with ATTs property).
I admit that there was bipartisan deregulation of finance in the late 90s. I assume that this not what is being discussed (the timing was wrong). Also it didn’t work out so well. I slipped in an “except S&Ls” above. I agree that totally disasterous deregulation of banking and finance was bipartisan. However, airline deregulation and interstate trucking deregulation were Democratic projects.
Hmm I edited this out but just in case anyone is interested here goes.
One of the most clearly idiotic policy moves of all time was called “accelerated depreciation.” I supported it at the time it was proposed. The policy consisted of defining depreciation according to arbitrary simple numbers (for equipment other than transportation equipment, for transportation equipment and for structures) for the purposes of the corporate income tax. In retrospect it is clear that this amounted to a huge subsidy for construction of structures as the arbitrary depreciation was much higher than true depreciation for structures. IIRC it was assumed that equipment depreciated in 2 years (definitely accelerated) and structures over … well a whole lot longer but still much more accelerated since properly maintained structures gain in dollar value given inflation.
The result of this policy was a whole lot of vacant buildings, and a real estate bubble which burst. A very clear example of missallocation of capital. I note that many cubic feet of empty buildings were commercial real estate (investment according to Spencer). Accelerated depreciation also caused a huge increase in the very classic tax shelter of buying real estate, calculating illusory losses due to depreciation which doesn’t really occur then selling. This converts income to capital gains. One argument for the Reagan tax ccuts is that high tax rates cause increased tax avoidance behavior. In fact, the Kemp-Roth tax cuts caused a huge increase in tax avoidance behavior, because accelerated depreciation made it much more profitable.
This was a gross distortion of the allocation of capital
Oh yes increased labor supply. I think it is clear that labor supply increased in large part due to the expansion of the EITC in 1993. That was not bipartisan at all. All Republicans voted against the bill. Every single one. I think it is very clear that EITC expansion had a larger effect than welfare reform. I will note that employment growth since welfare reform has been, on average, much lower than employment growth during AFDC program
Let me do the sloppier than back of the envelope calculation. AFDC becomes TANF in 1996 there are 4 years of rapid employment growth, then 8 years in which employment grew by 1 million, then 17 months during which employment declined on average. Now one might say it is cheating to measure up until now as we are near the trough of a recession. I agree (the claim was meant to be technically true). However, it is also cheating to measure only the first four years of the new regime which were an extraordinary boom. Yet somehow, it is absolutely obligatory to conclude the assessment of welfare reform in 2000. Obviously there is no justification for this approach which is standard among supporters of welfare reform and therefore standard in the general policy debate as all commentators (including most definitely Barack Obama in “The Audacity of Hope” are supporters of welfare reform).
Spencer, Even if I had made the investment argument that you attribute to me, your counterargument would be completely wrong. I did not argue that economic growth sped up after 1980, so there is no need for investment to have sped up. It would be enough for it to have been as high in the 30 years after 1980 as the 30 years before. Which your graph shows it was.
I never denied being a libertarian, I am a pragmatic libertarian. That’s not the same as being Republican or a conservative (two groups that obviously aren’t libertarian, as we saw from the large growth in the Federal government under Bush.)
I am well aware that deregulation began under Carter and that welfare reform occurred under Clinton. I have argued that all four neoliberal items had wide bi-partisan support. Large numbers of Democrats even voted for cutting the top rate to 28% in 1986.
I had thought those on the left agreed with Krugman’s assertion that deregulation was all a right wing plot under Reagan, and I’m therefore glad to hear that you guys understand what nonsense Krugman is spouting on that issue.
If capital goods that produce a flow of services over time aren’t “investment” then a huge portion of “business investments” are also not investment. Medical offices, college buildings, tax preparer’s offices, fiber optic lines, movie theatres, shopping centers, restaurants, etc, etc. So I still don’t see why people are trying to single out housing among all other capital goods. (Of course that’s not to deny that much of the recent investment in housing was wasteful, but thats another issue.
Ok, I’ll buy your position that housing is investment.
But it does not make any difference to my argument as housing as a share of GDP has been falling throughout the post WW II era except during the recent bubble. If I combined the housing with investment data –as I did with consumption — it would not change the investment trend. It would still peak in 1981 and shows a downward slope every since.
Houing starts were actually higher in the early 1970s cycle than in the 1990’s boom.