Reagan Recipe on Fed, Taxes Spells Path From Funk

July 9 (Bloomberg) — Double-digit unemployment looms. The country is in a funk. The federal budget deficit is widening to an extent not seen in decades.

This scenario isn't new. It also describes the U.S. in 1982. Somehow, the 1980s and the 1990s turned out to be pretty good years. So it's worthwhile to compare current policy to the one followed then.

Today, it's hard to say where the U.S. stands when it comes to the strength of the dollar. The country is divided on the question of whether we are confronting inflation or deflation.

In the early 1980s, things were different. For a while our officials wanted a strong dollar and managed to drive the currency up so that it bought more French francs and German marks than it had in a decade. On the home front, voters in both parties had already come to see inflation as an enemy. The Federal Reserve advocated a tight-money policy and pushed interest rates up to prove it meant what it said.

Though the position on the exchange rate didn't hold up — our own Treasury Department came to undermine it — the Fed kept up its vigilance on inflation.

Today, taxes are on their way up. Whether it will be abolishing some of the tax deductibility of health care or increasing taxes on soda, President Barack Obama and Congress are clearly signaling the direction in which they want to move. Most tax increases under discussion would make the rich, or companies, the first to pay. The justification offered for this is that the federal government needs the money and may know how to spend it better than the private sector, anyhow.

Tax Cuts

In the early 1980s, the view on taxes was the opposite: get them down. The Economic Recovery Tax Act of 1981, enacted by Ronald Reagan, pushed tax rates down for wealthy and non-wealthy alike. The capital gains tax rate dropped to 20 percent. When Reagan signed the Tax Reform Act of 1986, the top marginal rate on income taxes fell to 28 percent.

To be sure, this period did see some tax increases when other politicians in Washington pressed Reagan to scale back some of his cuts in the name of budget balancing. One of those increases came in the 1986 law, which pushed the capital gains tax back to 28 percent. But the general direction of tax policy in the 1980s was clear.

Three points are worth underscoring.

The first is that neither the Fed's tightening nor the Reagan tax cutting was an obvious sell. Industrialists blamed then-Fed Chairman Paul Volcker personally for the recessions that came with his rate increases. Newspapers tore Reagan apart for believing in tax cuts. When unemployment jumped after the big tax decrease of 1981, the papers crowed. "Mr. Reagan adamantly resists any suggestion that the third stage of his massive tax cut be killed or delayed," complained Tom Wicker in the New York Times in October 1982.

Contradictory Moves

The second point is that the tax philosophers of the era were putting forward a new idea. Traditional economics holds that raising interest rates and lowering tax rates contradict one another — the former tightening, the latter easing. Reagan's gurus, and economists behind them like Robert Mundell, were saying something else: tight money and low taxes go together and can yield growth without inflation.

The evidence of the ensuing quarter-century suggests Mundell was on to something.

The 1980s, 1990s and early part of this decade were characterized by strong growth and stable prices, even when tax rates stood at levels economists might previously have deemed inflationary. The Mundell formula worked because lower tax rates left the private sector freer to allocate resources where they were most efficient. Instead of hunting for a tax loophole, citizens hunted for an invention to invest in. The extra growth — real, productive growth — ate up the extra money.

Leaning on Keynes

The third point goes to the heart of the Obama agenda so far.

For half a century, presidents have, knowingly or not, leaned on one line from John Maynard Keynes justifying a larger role for government. "Moderate planning," Keynes said, "will be safe if those carrying it out are rightly oriented in their own minds and hearts to the moral issue."

Scholars including Allan Meltzer have persuasively argued that such planning — whether it comes in the first, second, third or nth wave of stimulus — isn't all that efficient. So the planning and spending are bound to disappoint. Meltzer's work anticipated Vice President Joseph Biden's recent acknowledgement that the administration misread how bad the U.S. economy was.

The policy formula that could get us out of trouble today is out there to read. It is worth the attention of all, not just GOP nostalgists.

(Amity Shlaes, senior fellow at the Council on Foreign Relations, is a Bloomberg News columnist. The opinions expressed are her own.)

© Copyright 2009 Bloomberg

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