A Little Reaganomics Please: Expansionary not Contractionary Policies

In April, news of a municipal fee was announced on residential rents for expatriates. Since the fee is a percentage of rent, this is, by definition, a real estate tax. This comes on top of the value-added and corporate taxes announced earlier. I wonder if there is some confusion between maximising taxes and maximising tax revenue. The difference is important.

The former US president Ronald Reagan oversaw one of the strongest economic growth periods in America. His plans, dubbed Reaganomics, were and remain hotly debated by economists. Understanding them is instructive. But first, let us agree on some terms.

Governments basically have two methods to influence the economy. The first method is monetary policy, which is the control of the money supply in the system, and this is usually effected through the central bank or equivalent. The central bank in turn manages the money supply using two methods.

The first is by setting short-term interest rates. The higher the interest rate, the more people save, and you get a reduction in money supply, which is called a contractionary policy as it slows down the economy. The reverse is what has happened since about the year 2000, when Alan Greenspan brought rates to basically zero, so people were not incentivised to save but instead to spend. This is called expansionary monetary policy.

The second method that the central bank can use to enact monetary policy is by buying or selling financial assets. The Troubled Assets Relief Program in America did this when bad assets were bought by the Fed. The Federal Reserve continued this in its multiple quantitative easing programmes by buying fin­ancial assets, basically bonds, as it could not lower interest rates any lower than zero.

As explained in my previous article on austerity, the UAE cannot control monetary policy because of its dollar peg and internal regulations. That leaves only fiscal policy as a potential tool for managing the economy.

Fiscal policy also has two methods. The first is how much a government spends. In an expansionary fiscal policy the government would increase spending and this would stimulate the economy. The reverse, contractionary fiscal policy, contracts the economy. This is what has happened recently under the aim of austerity, and I argued against this idea in my austerity article.

The other fiscal policy tool that governments have is taxes. Expansionary policy means cutting taxes so people can invest and spend, while contractionary policy means raising, or introducing, taxes, which leads to people having less to invest and spend.

Back to Reaganomics. In 1980, when Reagan took office, the American economy was in trouble. The issues he faced were far more complex than what we face in the UAE today, but there are elements of his economic policies that we can learn from.

Up to that point in time classical Keynesian economics had prevailed, and this included demand-side economics, which looked at creating consumption. Reagan moved towards the idea of supply-side economics, and that is that consumer spending is not the cause of economic expansion, it is a result, and ultimate goal, of economic expansion. One of the pillars of Reaganomics, and a radical change to decades of economic behaviour, is that stimulating production by allowing people to invest in and build businesses was the most effective way to expand the economy. The way to do that was through expansionary monetary and fiscal policies.

Reagan reduced taxes and he slowed the growth of federal spending, but he did allow it to grow. He did this by borrowing. The national debt increased by about 300 per cent over eight years. On a yearly basis, Reagan was borrowing an average of US$237 billion, up from his predecessor’s $57bn.

Contrast the expansionary monetary and fiscal policies of Reaganomics with today’s austerity approach that Germany has imposed on the European Union. Italy is not allowed to save its banking system, whereas the Americans did it and are fine. The destruction of 30 per cent of Greece’s GDP over a four-year period was unnecessary and not wholly Greece’s fault.

America’s GDP is about 25 per cent of global GDP. It chose expansionary policies and is an economic powerhouse. The EU’s collective GDP is slightly less. It is an economic basket case.

So what does that mean with regard to the 3 per cent rental tax? If Reagan was right, it means people will have less to invest in the economy and will lead to a longer contraction. Then again, maybe the German minister of finance Wolfgang Schäuble is right and the light he sees at the end of the tunnel that he steered the EU into is not an oncoming train.

This article was originally published in The National.