Reagan Offers a History Lesson for the Dollar when it Comes to Tax Cuts
As Donald Trump announces his intention to deliver substantial tax cuts foreign exchange analysts are left wondering what their impact might be on financial markets going forward.
We find a history lesson from the 1980's highly instructive on how the Dollar might react to the intended cuts.
Currently, tax cuts are seen as positive for the Dollar as they are likely to stimulate growth and lead to higher interest rates, but historically this has not been the case.
“The thinking that tax cuts would be USD-positive is because some economists argue that such cuts can be self-financing. Indeed, supply-side economist Arthur Laffer proposed that the new US administration’s policies will lead to economic 'nirvana'. This type of thinking is prevalent in the current administration,” says Bloom in a note to clients.
Reagan's Lesson
Bloom finds a historical template for the current administration’s approach to economic policy in the form of Ronald Reagan’s policies in the 80’s.
Reagan, like Trump, also followed a policy of cutting taxes based on the same theory that they would boost growth and therefore be self-financing, however, he had to concede in the end that this was not the case.
The HSBC analyst notes:
“During Reagan’s two terms in office, tax rates were lowered, including the maximum income tax from 70% to 28%. While there are vagaries surrounding Laffer’s optimal tax rate, one might have thought that this large fall from such a high tax rate would lead to greater tax revenue.
“Instead, the Treasury estimated that the Economic Recovery Tax Act of 1981 resulted in a reduction of taxation revenue by USD143.7bn over a four-year period (1992 dollars). The tax cuts under Reagan were not self-financing, a conclusion that does not bode well for the new US administration.
The failure of his policies slowly became apparent in the form of “twin deficits”, firstly that of the country’s rising debt pile – caused by borrowing to fill the hole left in tax revenue – and its rising trade deficit caused by the strengthening Dollar.
As the twin deficits grew to greater proportions that began to impact negatively on the Dollar which reversed and began to lose ground.
“What is remarkable is how long and how far the USD rallied under the belief that Reagan’s policies would succeed. Even as the budget deficit increased sharply towards 6% GDP in 1983, the USD continued to rally significantly,” says Bloom.
The nail in the coffin for the Dollar was the plaza accords, which was an agreement between western governments to intervene to weaken the Dollar in FX markets so as to help improve trade.
“The Plaza accord – an agreement between western governments to intervene in the FX market and weaken the USD – likely accelerated such a move lower. Yet it is worth noting that the USD had already fallen by around 15% during 1985 before the accords were signed. A weaker USD was a component that helped the US begin to rebalance from its structural challenges. Indeed, today, as we will discuss in the last section, the US administration wants a weaker USD,” says Bloom.
The parallels are clearly very compelling, and have led Bloom to his conclusion that the Dollar is probably close to peaking.
From here on in the policies which led to the rise in the currency are likely to lead to a widening of structural deficits which are negative for the currency.
HSBC forecasts EUR/USD to rise to 1.20 by the end of 2017, and GBP/USD to end the year at 1.20 due to Sterling’s underperformance.
