Taxes and Inflation

Newsweek and Washington Post columnist Robert Samuelson is the best economics writer in the mainstream media today. He nearly always gets things right, and has the numbers to back it up. His column this week on Reagan and inflation is right to draw our attention to an aspect of the Reagan story that has tended to be overlooked during Reaganpalooza, namely that Reagan’s steadfast backing of Paul Volcker’s campaign to wring inflation out of our economy as a crucial accomplishment, and one that few if any other presidents would have had the stomach to see through:

No other possible president at the time, Democrat or Republican, would have so steadfastly supported Volcker. Reagan faced enormous pressure from both Republicans and Democrats to push the Fed to relent. He was vilified in the press; his approval rating fell to 35 percent. Reagan and Volcker, though lacking a close personal relationship, did share a common conviction: America could not thrive with high inflation. “Unlike some of his predecessors,” Volcker later remarked, “he had a strong visceral aversion to inflation.”
Without Reagan, Volcker would have failed. But this story confounds the preferred narratives of both liberals and conservatives. The lesson liberals draw (and urge Obama to imitate) is that Reagan’s political success reflected his optimistic presidential stagecraft. It wasn’t policy, it was presentation. Wrong. Reagan earned his success the hard way — by backing policies that, though initially unpopular, served the nation’s long-term interests. That’s called leadership, a quality Obama has yet to demonstrate.

In my own account of this in The Age of Reagan, I cite Milton Friedman and others on this point:

Milton Friedman, the godfather of monetarism, admired Reagan’s principled restraint: “No other president would have stood by and let Volcker push the economy into recession by restricting the money supply so sharply.” Economist Michael Mussa (a member of the President’s Council of Economic Advisers during Reagan’s second term) wrote: “[T]here can be little doubt that, had Ronald Reagan pulled on his cowboy boots and led a lynch mob from the south lawn of the White House down to Federal Reserve headquarters on Constitution Avenue, he would have been joined not only by members of his administration but also by majorities from both houses of Congress, by the Washington representatives of a vast array of American businesses, and by a fair number of foreign diplomats, particularly from heavily indebted countries.”

But I think Samuelson goes too far in suggesting that breaking inflation was much more important that tax cuts: “As for conservatives, they argue that Reagan’s tax cuts explain the 1980s’ economic revival, when the more important cause was controlling the inflation that had bred four previous recessions.”
There’s no denying that breaking inflation was crucial, but I think Samuelson underappreciates the negative effect the previously high income and capital gains tax rates had on capital formation and productive investment in the 1970s, a problem made worse, to be sure, by high inflation, which made many investments yield negative real returns, even though Uncle Sam taxed you on the phantom gains anyway. Moreover, the Reagan economic plan always had four parts–not just one–tax cuts, monetary restraint, regulatory reform, and fiscal restraint. (The last item, of course, was the least successful.) People can argue about which of these deserves the most credit for the economic turnaround of the 1980s, but they should always be kept in mind as a whole. Take any one of them out (especially regulatory reform in areas such as anti-trust), and I doubt the story would have been the same.
UPDATE: Samuelson wrote in to me to offer some productive arguments and observations, and also reminds me about his very fine book that treats these issues in great (but always accessible) detail: The Great Inflation and Its Aftermath: The Past and Future of American Affluence. While I’m at it, I’ll also recommend Samuelson’s related book, The Good Life and Its Discontents: The American Dream in the Age of Entitlements. I keep both on a close by shelf in my office.


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