Economic Viewpoint: The Dangers of “Reaganomics”

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After four years of steady output growth, and with the prospect of even faster growth this year, capacity constraints are emerging and inflation has doubled from the low point of May 1983. But unemployment has not fallen and some commentators are still calling for fiscal expansion. The ranks of the expansionists have been swollen by the signs of economic slowdown in the US, which have prompted the OECD to call for “an international configuration of policy‐settings conducive to a performance that is both sustainable and adequate”. The noted US‐based economist Rudiger Dornbusch has also called for a fiscal expansion worth about £5bn as part of a general plan to expand borrowing in Europe while the US cuts its deficit. The obvious objection to such a policy prescription is that it would be inflationary. However proponents of reflation are now careful to couch their expansionary fiscal policies in an anti‐inflation framework of tight monetary discipline.In this Economic Viewpoint we take issue with this prescription. We show that there are good theoretical reasons why the combination of tight monetary policy and fiscal expansion will always produce high interest rates and an uncompetitive exchange rate, and we show how this happened to Japan in the mid‐1970s as well as to the UK in 1980 and to the US at the present time. Our examination of these earlier episodes suggests that, although this policy mix is generally successful in boosting consumption and containing inflation, its longer‐term effects on investment and net trade are adverse. Even in a large, relatively‐closed economy these adverse consequences mean that the policies have sooner or later to be reversed. In a small open economy this reversal will happen sooner rather than later.