There are plenty of things from the early 1980s we’d rather not revive; no one wants to drive around in a Ford Sierra or watch Dynasty. But there is one thing from 25 years ago that is worth resurrecting: Reaganomics.
In the UK, there is a stultifying consensus among economists and pundits that all the lessons we need to learn come from the 1930s. We need massive government spending and money printing, we’re told. But the decade this country should really be learning from is the 1980s.
In the early 1980s, the US faced a global recession. Unemployment was rising fast, as was inflation. Output was falling. The government budget deficit was out of control. Nobody appeared to have a clue how to pull the country out of what looked like a severe economic downturn. The conventional response, pushed by Keynesian economists, was to raise government spending on public works, let taxes rise to keep the deficit under control and get the Federal Reserve to cut interest rates to make money cheaper.
Sound familiar? It’s about the same mix the UK is following today. In response to a global recession, the budget deficit is being allowed to soar. The Bank of England is keeping interest rates at all-time lows and printing money. A cross-party consensus is emerging that taxes will have to rise. All the Conservative Party can promise is that it will raise them a bit less. From next year, the British top rate of tax will rise to 50%, one of the highest in Europe. Many other tax rises are likely to follow.
Ronald Reagan’s genius was his ability to rip up consensus views and try something radically different. That’s precisely what he did on the economy. Ignoring the Keynesian consensus in academia and on Wall Street, he slashed tax rates. The Economic Recovery Tax Act of 1981 pushed down average income-tax rates by a quarter: the top rate fell from 70% to 50%, while the bottom rate fell from 14% to 11%. Allowances were legally tied to inflation and capital-gains taxes slashed. But to make sure all those tax cuts didn’t spark inflation, the then Fed chairman, Paul Volcker, pushed up interest rates. From 11% in 1979, US rates rose all the way to a peak of 21.5% in 1982.
Most of the economic and business establishment thought Reagan was crazy. It was precisely the ‘voodoo economics’ that his vice-president George Bush had complained of on the campaign trail. But he turned out to be right. Within a few years, not only had the US pulled out of recession, it had laid the foundations for what turned out to be a quarter-century of growth, new jobs and rising prosperity.
What Reagan had done was create what supply-side economists call an ‘enterprise recovery’. The tax cuts stimulated entrepreneurs, while higher interest rates encouraged saving, allowing the deficit to be funded, and creating wealth for businesses to draw upon. Over the next decade, the US economy was rebuilt. Sure, there was some pain involved, but the policy was a resounding success. There are plenty of lessons in that for Britain today.
Right now, we have cheap money and rising taxes. Chances are this won’t do much good. There’s already evidence that the tax rises needed to fund Gordon Brown’s so-called ‘stimulus’ will stunt the recovery instead. A report from The Taxpayers’ Alliance this week showed that money would effectively be taxed at 92% before entrepreneurs had a chance to invest it. “Politicians are promoting a huge range of schemes to try and hold down unemployment but they aren’t paying nearly enough attention to how their policies affect entrepreneurs, who create the vast majority of new jobs,” argues research director Matthew Sinclair.
And not only entrepreneurs are deterred; ordinary consumers are nervous of future tax rises. That will dampen both consumer and business confidence, vital ingredients for any recovery. At the same time, interest rates are so low it is almost pointless to save. And any money that is saved will be sucked up immediately by the government’s vast borrowing. If Britain wants to change direction, it should follow Reagan’s example:
1. Cut taxes dramatically: A country with Swedish tax rates and Zimbabwean-style public services won’t be able to compete. With the state consuming 50% of GDP, there is no chance of sustained recovery. In the short-term the deficit will rise even higher. But if tax cuts are part of an enterprise recovery, tax revenues will come along in due course to start paying off debt, as they did for Reagan.
2. Let interest rates rise: Once taxes are cut, monetary policy will have to be tightened to stop inflation running out of control. And the UK needs to restore a savings culture – the only way to do that is to start rewarding thrift again. Tight money and low taxes, contrary to what the Keynesians will tell you, are natural bedfellows, creating sustainable, non-inflationary growth.
For the UK economy to recover, it needs to save more, work harder, and create new industries. Reagan understood that was the only lasting recipe for economic success – and at some point, the British will need to relearn it as well.