Franco Modigliani, Nobel Prize Winning Economist

Landon Lecture
April 21, 1987

What We Have Learned from the Reagan Economic Experience

It is a great pleasure and a great challenge to be here with you at the 75th Landon Lecture. It is an honor that I appreciate, as the name of Landon is one that I have heard since I first came to this country. As you just heard, I arrived in 1939 at the time when the '36 election was still very much in everybody's mind, and so the name was very familiar.

As a topic for today's lecture, I have chosen to speak about the economics of Reagan, or as you might say, the economic consequences of Mr. Reagan. It is a topic which involves a great challenge, speaking in a rather Republican part of the country and speaking in the Landon Series, since my view of the policies of the President and of its consequences are, on the whole, rather negative. So I hope, at least, I will elicit some good questions and some good discussion at the end of what I have to say.

I believe that to understand fully the nature of the Reagan experiment one has to go back to the climate that was prevailing at the end of the Carter administration. Not unlike other Presidents, Carter started fairly well. During his first years, he was able both to reduce inflation, which was quite high when he first arrived on the scene '73, '74, '75 because of the oil crisis, and he was able to produce a fair expansion of output. Output increased nearly five percent the first two years in '76-'77 and '77-'78, then abated somewhat in '79.

But by 1980 the economy was not in such good shape. Inflation had picked up again, and there was a slight decrease in output in 1980. In 1980 output actually fell. At the same time, in several of the years of this administration there had been substantial deficits. They had first been declining, while everything else was improving, but toward the end the deficit became fairly large again. In fact, it got up to two and a half percent of GNP, which is quite a large number.

It is in the midst of these circumstances that President Reagan made an appeal which sounded very promising and really appealing, promising policies which would achieve a number of targets. First, he began by offering the country a diagnosis of what was wrong so as to be able to offer the proper cures. And the diagnosis was sort of surprisingly and enticingly simple. What had happened, what was wrong with the country was that the Democrats had spent, spent, spent they don't know anything else. They spent so much that at some point they had been forced to raise taxes, so they had to tax, tax, tax. At some point they found that was sapping incentives, was counterproductive, so they couldn't tax anymore, and the only thing that was left was to run a deficit. And the deficit created inflation, and the inflation produced disarray, which in turn produced slow growth and unemployment and all the other bad things.

Given this diagnosis, which I shall indicate later is almost entirely false; there is almost nothing valid in this diagnosis, but given this diagnosis, the cure was clear. Step number one was to be a rigorous fiscal policy. There was going to be a cut, expenditures were to be cut, taxes were to be cut even more, but always with a balanced budget. So we were going to have a reduction of taxes based on a reduction of expenditures and balancing the budget.

In addition, he was going to produce a new, vigorous growth of the economy. And the methods by which he was going to do that by the way, he was going to reduce inflation painlessly, that is a very important point to remember later was to increase productivity and output through a high productivity and incentive to work harder, to save, and to invest. All of these things were going to produce this healthy economy.

So this was to be accomplished by the rigorous fiscal policies, which I mentioned before, lower taxes and reforms of taxes to provide incentive to work, save, and invest, and more efficiency in the economy by reducing regulation. Those were the essential features of his program.

Now, as we look at this program I think we will find that there is fundamentally only one thing, one promise, that has been fulfilled, and the methods, the policies, have not had the intended outcome. Which is the promise that was fulfilled? Well, it is the reduction of inflation. Inflation was running quite high in '79 and '80, running in the two-digit area. In some areas like energy, it was much larger, and essentially between 1981 and 1984 the inflation was reduced to about four percent. In the years that followed, inflation remained basically of the same magnitude, a little higher, a little lower, but remained around that level, and only in '86 did it finally come down further to about two and a half percent, but that was connected not with the policy of the administration, but with the fact that there was a collapse of the price of oil.

Now, that was a success. However, one ought to realize the limitations of that success, which are the following: The reduction of inflation was supposed to be painless, by which we mean, it was supposed to occur without increasing unemployment. Previous attempts at reducing inflation, whenever countries have had the guts to do it, had always involved substantial contraction of the economy, substantial unemployment, and unemployment then led to a slowing down of wages, which led to a slowing down of prices.

And by inverting the vicious cycle that had followed the oil crisis, you are getting back to a very low level of inflation. Now the lack of pain in the control of inflation was supposed to come from the fact that the Federal Reserve was going to announce in advance that they would pursue a policy of reduction in the expansion of the money supply and that because this would be believed and accepted by everybody, this was supposed to lead automatically to workers being willing to accept lower wages, not waiting for unemployment, but just on the announcement itself, willing to accept cuts.

This idea of credibility is very much connected with a new school of thought which arose a little before Mr. Reagan, the so called "rational expectations school." So it had the implication of this kind of scenario.

Now what did happen, in fact, is that the contraction, the reduction in inflation, was achieved with a tremendous amount of unemployment. In fact, we had the worst depression in the postwar period with the highest level of unemployment in the postwar period, that being especially in '82 when unemployment went over ten percent, to eleven percent. So it occurred, but it didn't occur in the painless way of the new Reagan and company school of thought.

The other thing to notice is that the main merit for the accomplishment of reducing inflation is really the Federal Reserve, and particularly Mr. Volcker. It was he who helped pursue the kind of tough policy which at the cost of extreme unemployment reduced the inflation. And what is funny about it is that Mr. Volcker, the hero, was an appointee of Mr. Carter.

Now the other thing that the administration usually gets credit for is the deregulation of the economy in general, particularly certain areas like transportation, and the financial area, where there has been deregulation. But what is special about this case is the deregulation was almost entirely preceding Mr. Reagan. It was under Mr. Carter that the basic legislation which deregulated all the areas was either passed or set up in such a way that later deregulation was a consequence of the initial step.

Now let us look at all the other promises and how they were carried out. Well, the one promise was to get great results from cutting taxes. Now taxes were indeed cut. As you well remember, they were cut in several phases: there was an initial cut which drove down the highest tax on unearned income from seventy to fifty percent, so the fifty percent became the highest bracket for everybody. And then there were successive reductions in all brackets at the spread of three years. Now that certainly resulted in a substantial reduction in revenue, especially when it was enforced by very large tax concessions to business for the purpose of stimulating investment. So this reduction in taxes had the effect of reducing the revenue relative to GNP a fraction of GNP quite substantially.

Now at the same time, the cut in taxes was not supposed to reduce revenue. Why? Because the idea was that so-called Laffer Law: that if you reduce taxes then people will evade less, therefore, you won't lose much revenue. People will work more because they can retain more, and there will be strong incentives to do that. So the results of this should be that the cut in taxes does not cut revenue. In fact, the revenue decreased very substantially.

Now, the other thing that this was supposed to do was to lead to more investment and to more saving. Why was it supposed to lead to more investment? Well, very simple and thoroughly wrong reasoning, that I think most economists now, at least, appreciate. The idea was that you increase investment by giving incentives to invest, like reducing taxes, accelerated depreciation and investment credit, other devices which give an incentive to invest. And, it was naively believed that if you give an incentive to invest that people must invest more.

Now what's wrong with this is a very fundamental principle of economics that says: "You cannot invest more unless people save more; you cannot invest unless they are saving." And why should an incentive to invest increase saving? Well, the idea was that perhaps it should increase saving because: reducing the taxes on unearned income, for instance, the taxes on interest you were increasing the return on interest, and the return from property and that might lead to higher saving.

Well, this possibility exists, but many economists know that it is very questionable whether increasing interest rates or reducing taxes on earned income, that is, increasing net-of-tax interest, whether that will or will not increase saving. It is generally assumed by people who are not well informed that obviously it must be so; if I am offering a larger interest, then people must save more. But what you have to understand is that what matters is not whether you will save more. Of course, if you get more income you will save more. The question is, will you consume less? Only if you consume less will you have a net effect in terms of permitting more investment. It must cut consumption.

And if you reflect on this, you will realize that if you get a higher interest rate and you are richer, you are just about as likely to consume more than to consume less, on the ground that if you postpone consumption you will get more. This is what economists call the income and substitution effect.

Experience suggests that these two effects largely cancel out and that saving does not depend significantly on the interest rate, except possibly under very special circumstances. So I had expected there would be no change in savings, and in the middle of the '80s I made a pronouncement that said investment will not increase, what will happen is that interest rates will rise.

If you give an incentive and you cannot, in fact, have more funds, all you end up doing is bidding more for what is available. And of course, that forecast has come true. The evidence is that savings have not changed appreciably during this period. If anything, they may have declined. If you read the standard stuff in the newspapers, which quote the national income statistics, then you get the impression of another strong decline in saving. This comes from about six percent down to about four percent in '86. But these figures are wrong, they are not computed properly. If you compute them properly by allowing for corporate retention and allowing for durable goods, then you find that the amount of saving first is much higher, is not as low as it sounds. Six percent, when we compare ourselves with Japan, which is twenty-four, just sounds terrible. Well, if you correct the figures, we save about twelve percent. But the second thing is that the level of twelve hasn't changed significantly at all, and it may have declined, but just very slightly. So there is no effect there.

So the result is essentially that the maneuver could not generate more investment. Actually, what did happen is that because of the lower taxes on the one hand and higher expenditure on the other because the other fixed point in the policy, which was not offered as a policy to increase the effectiveness of the economy but as a policy which was desirable, per se the defense expenditure increased. The defense expenditure went up appreciably and even though there was reduction in all nondefense expenditures, we find that on the whole expenditure did rise. And the main component is precisely the defense expenditure.

Now other expenditures were cut about the same time taxes went down. And what you have left is a situation in which the deficit has increased a good deal from about one and one-half percent of GNP in 1979 up to nearly five percent now, a somewhat over three percent increase. Now this increase has had some rather significant damaging effects on the whole economy. We have seen we were not able to increase saving; if anything, it decreased. If you take some private saving and the government takes a great deal more, all right. And it was, in fact, in the middle of the '80s, taking about five percent of the total. So something like half of the national savings were being absorbed by the deficit. What would happen in these circumstances is that there would be very little left for business to invest, so one would have expected, perhaps, a decline actually in investments. Why didn't they decline?

Well, the reason they didn't decline is that at the same time that the deficit was formed, and that there wasn't enough for investment, interest rates went up, business bid up interest rates, which it could do even better because of the tax concessions it had. And by bidding up interest rates, it was able to attract capital from the rest of the world. The final result was that investment did not decline much: investment some years went a little higher, some a little lower. On the whole investments have not changed appreciably, until 1987 where the situation is a little uncertain. But in general they have been fairly stable. But that has been financed by foreign capital.

Now how did the foreign capital get into the act? Well, the way these things occur is that when interest rates go up in this country relative to the rest of the world, which itself, as I'll indicate later, was trying to keep interest rates not too high. The result is that foreigners find it advantageous to buy dollars to invest in this country. And when they try to buy dollars, they bid up the dollar.

When they bid up the dollar, the foreign goods become cheap, our goods become expensive abroad, and we develop a deficit which is the way in which the foreigners are able to invest in this country. The way they finally can acquire the dollar to invest in this country is because there is a net of input of goods, which is a net export of dollars, which they are able to use to invest.

So with this mechanism, we then developed the situation in the balance of trade, of which I think most people are aware, even though I think few people understand that this is a direct consequence of the domestic deficit. It is not that we have two different things here. One is a deficit which is a nuisance, and there is, by chance, at the same time, a deficit that is coming from somewhere else.

In fact, many people think that the deficit is coming from things such as our mean competitors abroad, who do all kinds of tricks in order to be able to sell us stuff and to prevent us from exporting. They do all kinds of terrible things. And that is why we are unable to export.

The truth of the matter is that the whole thing has very little to do with foreigners, or with our attempts at undoing it. As I have indicated in a recent article in the New York Times, we could not reduce the deficit simply by protectionism or by punishing the people who export to us, like Japan, by forcing them to buy. We cannot do that.

We cannot reduce the foreign deficit unless we reduce the domestic fiscal deficit, because we do not have enough resources to pay for the additional exports and for the import substitution unless we give out something else. To find resources to do that, we need to reduce something else, specifically either consumption or investment, and if we do not want to reduce investment, then it is consumption, and that means we must consume less as individuals, which means higher taxes, or the government must consume less. So we need a reduction in the use of resources of this kind.

Now the huge net deficit of hundreds of billions is, of course, a very serious problem. We have seen that, in the sense that all this commotion about protection comes from the fact that the deficit creates a large shuffling, and costly shuffling of resources.

As the deficit opened up and people lost jobs in the export industries, they did not become unemployed, because they actually lost their jobs precisely because we had so much demand in the rest of the economy that we were forced to import. So people simply moved from doing whatever they were doing to something else, be it government or other service industries and the like consumption industries which were funneled by the large government deficit.

However, this distribution, even though you get no unemployment, is a very costly operation because it means that people lose jobs and have to find new jobs. It means that businesses have to close, and you get states which are in disarray, all kinds of terrible consequences. So that is one of the worst aspects of the administration policy. And one has to add here one other note about saving and its relation to the deficit. One other school that influenced the administration it is hard to pinpoint precisely who influences whom, in the sense that administration policy comes from many sources but certainly one of the influences on the administration was the very novel notion that the deficit does not reduce national saving, because even though the government takes away some, people will just save enough more to make up for that reduction.

This view is associated with a good student of mine, Robert Barrow, very ingenious and I certainly grant him great qualities and I gave him an A, and I am glad I did but it is, of course, faulty, basically, to have this belief. It is based on the following kind of sophisticated thinking, and I want you to think whether you reason that way. There are two parts.

There is a view that says that people base their saving and their consumption on their life resources. Okay. Even within this theory, it is true that the government expenditure might increase saving a little bit. Why? Because when your taxes are cut you know that you will have to pay them later because at some point somebody has to pay. So you find that your taxes are cut, but you know now that in the coming years you are going to pay more tax to pay the interest on that debt.

Now if you take the present value of those future taxes then you get a loss of resources, and that much, that portion of the tax cut, you might save. So if I get a tax cut of a hundred, I might save thirty, because that is the present value of future taxes. Of course, it depends on how old you are and so on, and how rational you are. That is also very important.

Now what Barrow says is that what you will save out of a hundred dollars tomorrow is the full hundred dollars. Why? Because the taxes that you are not going to pay because you fortunately die if you are lucky enough to die before you pay a lot of taxes those taxes will be paid by your children, and obviously, you must think of your children as being yourself, and so you make provision for them to be able to pay the higher taxes later, and so you must leave them a large inheritance.

Now I do not know anyone who would behave that way, but I believe perhaps Mr. Barrow does. I have never been able to ascertain that. I think most people do not dream of looking at the budget the state of the budget when they decide how much to consume and how much to save this year. And, of course, among the objections to the Barrow argument is the fact that even if you and your heirs have the same thing, and you decide on its location between yourself and your heirs, the optimal location may be that the heirs should have somewhat less and you should have somewhat more. So it is the movement forward.

In that case, the only way to do it is by deficit. That is exactly the way to achieve that result.

Now, in any event, if Barrow were correct, we should have observed a large increase in saving, very substantial, and because of the deficit being about three percent, we should have observed saving going up from, say, twelve to fifteen percent, or sixteen percent. The truth of the matter is that saving, as I already indicated, did not rise, and that again sort of proved disastrous for the deficit policy.

If, in fact, the cut in taxes would have lead to that result, then there would have been no deficit. But if you are sophisticated, you will say, "But then, why cut taxes, since if you cut my taxes, I'd behave exactly as before; then why go through these complicated measures?" In other words, the very same thing that says that cutting taxes might not reduce national deficit, national saving, would also say there is no point in cutting taxes.

Now the next thing to consider is the record of whether the incentives from taxes have worked other ways. The main other way you would expect that to work would be that people might be willing to work more, because an extra hour of labor produces more net effect than before. But again, you have got this terrible economic problem of the increment substitution effect.

If you are able to earn more per hour, you may react two ways. One is, that because you get more per hour, you work an extra hour, or that because you are richer, you buy yourself more leisure and you work less. So we don't know the priority, what the effect might be here. And I think again the evidence suggests that it may not be very strong. In any event, studies which have been made for this period indicate that there might have been a very small positive effect of inducing a little bit more work. Mostly in terms of women's participation, that is, that may have been incentive, an extra incentive for women to work more, little for men.

Now the next question then is what about their achievements in terms of what was the final target, increased rate of growth of output. Has output risen rapidly and has productivity increased? Now in terms of output, the interesting thing seems to be that even now a large portion of the American population believes that the target was achieved. They believe we have achieved fairly rapid growth of output and we have achieved a low level of unemployment. The reason they believe that is because somehow because they like Reagan they forget what happened between 1980 and 1982, where we went down like mad and then picked up again.

If you start at the bottom, then the record doesn't look so bad. But if you start where you should start, I mean, before the deflation, the rest of inflation produced a contraction, then you will find that the growth of output has been very small, because we started out with negative numbers in 1982. And then the highest we have had is about six percent in one year. But the average of this period comes to something like two percent.

That is lower than any previous administration, including Carter. If you remember the numbers they gave for Carter, something like three. And, of course, Kennedy was infinitely larger, I mean, the Kennedy record for the same period of time, in every direction is far better than Reagan's. I think the real growth of output was three times larger in the six years from Kennedy to the beginning of the Viet Nam War. So it was a very slow, very slow expansion.

What about unemployment? Again, people remember that we went through eleven to about seven and six-tenths a quarter, something like that. What they forget is that before the eleven was seven, that is, the last number of Carter was seven percent. So all we are now back to is the worst point of Carter. The average of Carter was well below that. So in unemployment terms, we have really done very little.

What we have done, that is true, is a lot of expansion of employment. Employment has expanded quite a bit. That is due in a large part to the continuous influx of women in the labor force. But now, how is it possible that we have a large expansion of employment and not an expansion of output? Well, the reason is that productivity did miserably. During this time productivity grew very little. In some years the productivity growth was negative, but in general it was very poor.

Now part of the perception of success of the Reagan administration is the fact that the Europeans did even worse, because the Europeans did have more productivity, true, but they had such a slow growth of output that in the process their employment grew very little. In fact, their unemployment grew to an incredible level. So, at least, we had that advantage, that unemployment stayed relatively stable, and part of that was achieved through the stimulating effect of the great deficit. It is a paradox, but that is the immediate effect.

Now the question that remains to be examined is what is the implication of all this, what is the legacy for the future? And it seems to me that the one urgent thing that we must do is to terminate the twin deficits, the external deficit and the internal deficit.

Now as I have indicated before, it is very important to understand that to terminate the external deficit requires two conditions that must hold simultaneously. On the one hand, you must induce the rest of the world to buy more of your goods and to send you less of their goods. This is a necessary thing. But on the other, you must create the room in our economy to be able to supply these additional goods.

To be able to close the gap, we have to sell that much more, sell and not buy that much more, we have to make that corresponding room. To make that corresponding room essentially means that we have to reduce the domestic absorption; we have to reduce consumption or investment. Now presumably we don't want to reduce investment, because investment is the source of growth, and is necessary for expanding employment and also for increasing productivity.

So we don't want to be in that situation [reducing investment]. Now that means that we have on the other hand then to reduce the consumption, which means, as I have indicated, reducing personal consumption, which means higher taxes, and reducing government purchases, which just means that. It means just not spending as much as we now are. Of course, these two things are the same thing as reducing the deficit, because the deficit is the difference between taxes and expenditures. And this has to go at the same time with an action to induce foreigners to buy more.

Now that action I think has to consist primarily of finding the right level for the dollar in international exchange, the right exchange rate for a dollar. There has been a very large devaluation of the dollar after even larger appreciation, which produced the problem. That devaluation is not yet producing the hoped for results, and some people get discouraged and think that maybe there is something wrong with us, we just will never be able again to sell. I am personally a firm believer in the price mechanism, and I firmly believe that if our things are cheap and theirs are expensive, then we will eventually go back to selling more and buying less. But we know that this process takes time. And it takes time, because when you have had a long time in which we were such a wonderful market, and the other markets were so poor, when this happens, then foreign firms get established here. They develop channels for trading here, and we close our channels there. It is not worthwhile to have a representative inside.

Now once this has been done, it is going to take time before a firm which has invested in creating a share of the market will withdraw. Initially, they will be willing to sell at the lower price, at the price lower for them. That is, they will be willing to absorb losses, hoping that the situation will reverse itself. Now once they become convinced that it will not reverse itself and there is nothing they can do about it, they necessarily will eventually retrench, and I think gradually we will find this effect will show up. That is, incidentally, what economists call the J effect. The effect is spread in time; it takes awhile.

Of course, we don't know that the level of the dollar now is the right one in the long run. Suppose all the accommodations, all the adjustments have been made, would we be back to a balanced situation? Well, we know at least one reason why the answer is no. And that one reason is that we no longer need just to balance trade. We also have to have a surplus which is large enough to service all the interest of the debt which we have been acquiring during this interval.

All of this time we were borrowing from abroad, all right, and financing our investment by borrowing from abroad.

Now we have to pay the interest on that. So we know that, at least we have to go down enough to create that surplus, and we may even have to go down further because I would think that in the long run, the United States should be exporting capital, and not importing capital, because I think we are a rich country, and we should be providing the rest of the world with part of our capital.

Now these, I think, are the two measures which are immediately needed, and at least one side of it is very painful: namely, learning the notion that we will have fewer services, fewer government expenditures, and more taxes. And I think that part of a change of the budget must simply come from taxes as well as from the defense expenditure. Those are the things that have been changed, and I think those are the things that have to be changed in reverse.

Actually, I think there is a fair amount of consensus that we should spend less on defense, although I understand that you recently had a dissent from this view [George Will]. But I think public opinion polls suggest that the majority of people think this. That's the only thing they can indicate that should be cut. They all agree on that. On the other points they don't. Old people are against cutting social security, and young people are against cutting help to education, and so forth. So it is a point of agreement.

But I think we should remember not to believe the propaganda that was fed at the time of the Kemp-Roth, that our taxes are so high. Not true. Our taxes are by far the lowest in the world among the developed countries. There just is no comparison how much less we pay in taxes, especially as we go into the new tax law.

So the long run legacy is that of the need to rebalance things. And, of course, to have learned from the experience. For instance, I think what we should all learn is never to believe that there exists such a thing as a free lunch. There is no such thing as a free lunch. There is no such thing as reducing taxes and collecting more money. Those are just figments of the imagination, which are usually pushed out with a purpose. What was the purpose, by the way? Did Mr. Laffer really believe the Laffer Curve? Did the administration really believe they will get nothing? I don't believe so. I believe very much that what they thought is that once they created a huge deficit, then it would be easier to cut other expenditures. Okay. And that was simply the entering wedge to cut other expenditures. And, of course, they have been shown to be quite wrong. There have been some cuts, but a very limited amount of cuts, and it is questionable how much more one can make.

Now in the short run we think that we have an additional complication that comes out of the fact that the trick of selling more abroad by the proper techniques, and at the same time making room at home with a proper fiscal policy, and timing it so that things come together, is not an easy trick. If they don't come together, then depending on which comes first, you may either get inflation or a contraction. If you begin by exporting more before we have reduced the deficit, there would be an additional demand on labor, and we don't have much labor left to use. We are down too close to what most economists regard the minimum, before you face an inflationary danger. On the other hand, if the common deficit should come down quickly, before we are exporting more, then this would be contractual, and although it could be offset by the central bank by appropriate monetary policy, it is a very delicate maneuver.

So we are facing, I think, a period of uncertainty, which is the period of undoing the other maneuver, the maneuver that was done four or five years ago of large deficits creating a deficit abroad.

But I would like to indicate that for all these problems, my personal feeling is that the American economy is pretty healthy. It is so healthy that it can stand experiments like the Reagan experiment, and that is saying something.

Thank you.

Franco Modigliani
Landon Lecture
April 21, 1987