Reaganomics redux
Sep 18th 2003
From The Economist print edition
Why the world cannot count on a repeat of the 1980s
PARALLELS abound between Ronald Reagan and George Bush,Like the Gipper,Dubya is a sun-
belt conservative with a fondness for his ranch,In all,Mr Reagan spent about one year of his
eight-year presidency at his California retreat,Mr Bush has turned his patch of Texan scrub
near Crawford into the hottest destination for world leaders,
In economic policy,the script,so far,seems eerily similar,Both presidents introduced huge tax
cuts and big increases in defence spending,Mr Bush has already cut taxes by as much as Mr
Reagan ever did,though he has not,as yet,matched the 1980s defence build-up,Both men
spilled huge quantities of federal red ink,During Mr Reagan's first three years the budget deficit
rose by 3% of GDP,Mr Bush has doubled that figure,presiding over a deterioration of 6% of
GDP in the federal finances since 2000,And under both presidents external imbalances
spiralled,During Mr Reagan's first four-year term,America went from a balanced current
account to a deficit of almost 3% of GDP,Mr Bush inherited a current-account deficit of 4% of
GDP,It is now over 5% and rising fast,
Critics of the current president make much of these Reagan-Bush parallels,They point out that
it took a decade of painful budget discipline in the 1990s to work off the budget deficits built up
in the profligate Reagan era,How comforting,then,that the Reagan-era story has a happy
ending,at least as far as America's external accounts are concerned,Having soared in the early
1980s,the dollar started to fall from 1985,A couple of years later the current-account deficit
began to reverse,By 1991 it had disappeared,Though there were nasty scares,notably the
1987 stockmarket crash,there was no global financial meltdown and no global recession,
However,today's world is very different,A brief detour back to the 1980s will show why,
Morning in America
The Reagan era,like the current Bush presidency,began with an economy in recession,But
unlike the mild downturn of 2001,the 1981 version was severe,with soaring unemployment
and plummeting output,The recovery,however,was quicker and more dramatic,Helped by big
tax cuts,America boomed,In 1982-84,American domestic demand grew almost 15%,against
less than 3% in Europe and 5% in Japan,
Unlike today,interest rates were high,so in 1980-84 the dollar rose by more than 80% against
the currencies of its trading partners,The combination of a strong dollar and a strong economy
sent America's trade deficit soaring,During Mr Reagan's first term,officials cared little about
the strong dollar or the rising external imbalances,Like the current Bush team,they argued
that a bigger external deficit simply reflected the attractiveness to outsiders of investing in
America,The tone was defiant,even boastful.,In Europe they're calling it the American
miracle,” Mr Reagan said in early 1985.,Day by day we are shattering accepted notions of what
is possible.”
Within months,however,the mood in Washington had changed sharply,By the summer of
1985,the domestic political pressures from a strong dollar and rising trade deficit were
becoming hard to contain,Congress was in a militant,protectionist mood,Japan was the
scapegoat,blamed for hollowing out American manufacturing industry,Almost 100 trade bills
were drawn up in 1985,each one of them protectionist,
James Baker,Mr Reagan's new Treasury secretary,realised that something had to be done to
stem the protectionist tide,Over months of secret diplomacy,he put together a plan to secure
international economic co-operation and currency intervention to push the dollar down,On
September 22nd 1985,finance ministers from the world's five biggest economies—America,
Japan,West Germany,France and Britain—announced the Plaza Accord at the eponymous New
York hotel,
Each country made specific promises on economic policy,
America pledged to cut the federal deficit,Japan
promised a looser monetary policy and a range of
financial-sector reforms,and Germany proposed tax
cuts,All countries agreed to intervene in currency
markets as necessary to get the dollar down,Perhaps
not surprisingly,not all the promises were kept (least of
all America's on deficit-cutting),but even so the plan
turned out to be spectacularly successful,By the end of
1987,the dollar had fallen by 54% against both the D-
mark and the yen from its peak in February 1985 (see
chart 8),
Keep it up
This sharp drop led to a new fear,of an uncontrolled dollar plunge,So in 1987 another big
international plan,the Louvre Accord,was hatched to stabilise the dollar,Again specific policy
pledges were made (America to tighten fiscal policy,Japan to loosen monetary policy),Again
the participants promised currency intervention if major currencies moved outside an agreed,
but unpublished,set of ranges,
Heavy foreign-exchange market intervention in 1987 did stabilise the dollar,Meanwhile,
America's external deficit began to shrink sharply,helped by the big depreciation but even
more by relatively faster growth abroad,In the late 1980s,domestic demand slowed in America
but remained strong in Germany and boomed in bubble-era Japan,By 1990 America's current-
account deficit was down to 1% of GDP,A year later,after America's modest 1991 recession,it
was in surplus,
The story of the Reagan era helps explain why the current Bush team is keeping so calm about
America's external imbalances,Serious as they seemed at the time,the excesses of the mid-
1980s were purged with relative ease,But behind the superficial similarities,America's situation
now is quite different from that in the mid-1980s,The imbalances are bigger; the international
economic environment is more complex; and America's trading partners are weaker,All these
factors suggest that the adjustment will be riskier and more painful,
Start with the size of the problem,When Mr Reagan took office,America was still the world's
biggest creditor,The current-account deficit at its peak in 1987 reached 3.4% of GDP,Mr Bush,
in contrast,inherited an economy that was already the world's biggest debtor,and a current-
account deficit that was already bigger than at its peak under Mr Reagan,
Besides,in the 1980s the current-account deficit had been rising for only four years before the
Reagan team took action,It also had a clear cause,an investment boom after the 1981
recession,coupled with a collapse in saving as the budget deficit ballooned,which together
pushed the dollar sky-high,
Today's deficit,in contrast,has been rising for over a decade,It was started by an investment
boom in the mid-1990s; then fuelled by a dramatic drop in private savings as Americans
splurged in the late 1990s; and is now being sustained by a drop in public saving,An external
imbalance that has gone on for so long,with so many disparate causes,is likely to be much
harder to turn around,
Moreover,today's larger problem must be resolved in a global economic environment that is far
more fragile than that of the mid-1980s,The world economy is still working through the
aftermath of a huge asset-price and investment bubble,Inflation is much lower than it was in
the mid-1980s,Deflation is already a reality in several countries,and hovers threateningly over
many others,A drop in the dollar will put extra deflationary pressure on those countries whose
currencies appreciate against it,
No appetite for action
Despite the world economy's greater fragility,global policymakers are showing much less
appetite for 1980s-style international policy co-ordination,Not everyone views the Plaza and
Louvre accords as a great success,Japan,in particular,blames the monetary easing agreed on
at the time for the development of its bubble economy in the late 1980s,and hence as the root
cause of today's problems,Europeans tend to see both accords as clever American tricks in
which the Reagan officials pushed the burden of dealing with their past profligacy on to others,
Even if the Japanese and the Europeans could be persuaded to overcome their suspicions of a
repeat,it is not clear that the 1980s remedies would work this time,Co-ordination is much
harder these days because of the way policy is made,particularly given the rise of independent
central banks,Back in the 1980s,the governments of Germany and Japan could tell their
central banks what to do,Now both the Bank of Japan and the European Central Bank jealously
guard their independence,Both in Japan and in the euro zone,central bankers see themselves
as guardians of discipline against spendthrift politicians,That makes domestic fiscal and
monetary co-ordination difficult enough,never mind any international efforts,
Moreover,the huge growth in capital markets has rendered currency intervention much less
effective,With over $1 trillion in foreign exchange crossing borders every day,up from less
than $200 billion in 1985,most economists now think that official currency intervention works
at best at the margin,and then only if it is used to reinforce existing economic trends,
Lastly,big changes in the structure of America's trade patterns mean that more countries would
have to be involved in any adjustment process,In 1985,Japan accounted for 16% of America's
trade; now that share is down to 9%,Meanwhile Mexico,China and some other Asian countries
have become much more important partners,A round of financial diplomacy involving
policymakers in only five countries would no longer do the trick,
But the main difference between today and the mid-1980s is that the adjustment paths used
last time round—a big shift in demand away from America towards Japan and Germany,
together with a substantial but orderly drop in the dollar—are blocked,As the next two sections
will argue,both Japan and Germany face big hurdles and wrenching economic reforms before
either can become an engine of global growth in demand; and Asian countries,which account
for a third of America's trade,are refusing to let their currencies appreciate,ruling out an
orderly depreciation of the dollar,That makes the prospects a lot grimmer than before,
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