Will history repeat itself? When former 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 would finance themselves by spurring growth, and therefore 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 US 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 10-year US Treasuries — which in the 1970s had remained largely under 2 percent, and temporarily even reached negative terrain — suddenly shot up to about 7 percent 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 US dollar appreciated against most other currencies.
By 1982, it had risen by half against the West German 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 US 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 nations had borrowed in US dollars with abandon. In the 1980s, those debts became unbearable.
In Europe, the results were less dramatic because debts were not denominated in US dollars. Even so, European nations 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 nations, 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 US President Donald Trump and congressional Republicans in December last year.
The Tax Cuts and Jobs Act of 2017 lowered the corporate tax rate from 35 percent to 21 percent, 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 US$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 percent, a rate that seems astronomical from a European perspective.
Current unemployment is as low as at the peak of the dotcom bubble in 2000. At the same time, interest rates continue to rise.
In 2011 and 2012, there was basically no difference between the yields on US and German government bonds; today, the spread is about 3 percentage points.
The uptick in interest rates has been accelerating since the summer of last year, when it became clear that the tax package would pass. Exchange rates, too, have been responding.
Whereas the euro was rising against the US dollar last year, it has now been falling since the beginning of this year.
This downward trend is likely to continue, even though the euro is already undervalued. The European Central Bank (ECB) 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 percent.
This does not necessarily mean that we will witness exchange-rate fluctuations as dramatic as those of the Reagan era, but many nations that have borrowed heavily in US 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 nations 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), is likely to face difficulties in coping with higher interest rates, which is why the ECB would prefer further euro depreciation to interest rate increases.
Nearly four decades after Reagan’s alleged supply-side revolution, deja vu is in the air. It is the scent of an approaching storm.
Hans-Werner Sinn, professor of economics at the University of Munich, is a former president of the Ifo Institute for Economic Research and serves on the German Ministry for Economy Affairs and Energy’s advisory council.
Copyright: Project Syndicate
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