Project Syndicate, September 25th, 2018.
It has been less than a year since US President Donald Trump and congressional Republicans enacted a massive tax cut, following in the footsteps of former President Ronald Reagan during his first term. And, as was true in the 1980s, fiscal stimulus in the US is being felt worldwide, and not in a good way.
Will history repeat itself? When US President Ronald Reagan assumed office in 1981, he lowered the maximum corporate and personal income tax rates, and allowed companies to write off capital expenditure depreciation almost instantly. Reagan described this tax package, combined with a larger effort to deregulate the economy, as a supply-side policy, when it was actually the largest Keynesian stimulus program in history (at the time).
In selling his economic agenda, Reagan invoked the so-called Laffer Curve, according to which tax cuts will finance themselves by spurring growth, and thus revenues. When this theory came into contact with reality, the result was sobering.
Over the course of Reagan’s two terms in office, the US budget deficit as a share of GDP rose to nearly double what it had been under the two preceding administrations, and the national debt increased by hundreds of billions of dollars more than it otherwise would have. Still, the economy gained substantial momentum from the middle of Reagan’s first term, and to American conservatives, he remains an economic hero.
The flip side of the 1980s boom was that interest rates rose dramatically. Real interest rates for ten-year US Treasuries – which in the 1970s had remained largely under 2%, and temporarily even reached negative terrain – suddenly shot up to about 7% in 1982, and during Reagan’s two terms in office they were about three times as high as under the two preceding administrations. Meanwhile, the external value of the dollar appreciated against most other currencies. By 1982, it had risen by half against the Deutsche Mark; and by the end of Reagan’s first term in office, it had actually doubled in value.
For non-US banks, governments, and any other entity that had borrowed in dollars, the strengthening greenback created repayment difficulties. Balance sheets that had to be prepared in the local currency suddenly hemorrhaged equity as their liabilities increased. Mexico declared bankruptcy in 1982; and Brazil, Argentina, and Chile followed soon after. In the 1970s, many Latin American countries had borrowed in dollars with abandon. In the 1980s, those debts became unbearable.
In Europe, the results were less dramatic because debts weren’t denominated in dollars. Even so, European countries could not ward off the interest-rate increase without risking an even greater depreciation of their own currencies. As a result, a construction boom that had been building up in some European countries, particularly Germany, suddenly hit a wall.
This history is worth bearing in mind as we consider the potential global impact of the enormous tax cuts enacted by Trump and congressional Republicans last December. The Tax Cuts and Jobs Act of 2017 lowered the corporate tax rate from 35% to 21%, allowed for near-instant depreciation of equipment investment, and offered a “tax holiday” for US multinationals to repatriate profits that they had long held overseas. All told, the legislation is expected to add $1.9 trillion to the US national debt by 2028.
With respect to the economy’s performance, the parallels between today and the Reagan era are striking. In the second quarter of this year, US GDP growth surpassed 4%, a rate that seems astronomical from a European perspective. Current unemployment is as low as at the peak of the dot-com bubble in 2000. At the same time, interest rates continue to rise. In 2011-2012, there was basically no difference between the yields on US and German government bonds; today, the spread is around three percentage points. The uptick in interest rates has been accelerating since the summer of 2017, when it became clear that the tax package would pass. Exchange rates, too, have been responding. Whereas the euro was rising against the dollar in 2017, it has now been falling since the beginning of 2018.
This downward trend will likely continue, even though the euro is already undervalued. The European Central Bank has decided to keep interest rates at zero, at least at the short end of the curve, even though the US Federal Reserve’s federal funds rate has already increased to 2%. This does not necessarily mean that we will witness exchange-rate fluctuations as dramatic as those of the Reagan era. But many countries that have borrowed heavily in dollars are already under pressure.
The emerging currency crises in Argentina and Turkey are linked to rapid exchange-rate depreciation and loans in foreign currencies that are becoming increasingly difficult to service – just like in 1982, when both countries also encountered serious difficulties. Indonesia, South Africa, and several other emerging economies are also at risk. Southern Europe, which did not borrow in foreign currencies (but has close financial links with Turkey), will likely face difficulties in coping with higher interest rates, which is why the ECB would prefer further euro depreciation to interest increases. Nearly four decades after Reagan’s alleged supply-side revolution, déjà vu is in the air. It’s the scent of an approaching storm.
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