An Anecdotal History of Post-War America
"The political problem of mankind is to combine three things: economic efficiency, social justice and individual liberty."
- John Maynard Keynes
The tendency for economists to discuss issues in the abstract and hypothetically is a major flaw. The simplifying assumptions necessary to make Classical economics functional are precisely the mechanisms that remove it from relevance and deliver it into the convenient world of the imaginary. Economics arises in the context of historical events. This is a point we have belabored. This chapter offers a sketch of that history from the perspective of the presidency.
needs a place
The direct look Galbraith took at the American scene contrasted starkly with the approach taken by the Conservative economic schools (Monetarist, Neoclassical, Neoliberal, Supply Side schools). These began and ended with neat and simple theory and assumed away inconvenient reality, ignoring the power and even the presence of the Corporate Oligarchy. The resulting world did not exist, but at least it was marked by healthy free competition, market discipline and vigorous growth. The popularity of these schools derived from their political convenience, to their appeal to a resurgent conservative bloc, particularly after the Vietnam War and to eager sponsorship from the very corporations whose power they failed to acknowledge.
The Great Depression through World War II
Demand Side theory was formulated originally by John Maynard Keynes, who as we noted prescribed deficit spending to invigorate demand and draw the economy upward. But Keynesianism was applied in the United States before that theory was fully disseminated and certainly before it was validated by the war experience. The New Deal of Franklin Roosevelt was Keynesian almost as a byproduct of being compassionate. The hungry, impoverished and unemployed - not the strength of reason nor the elegance of theory - demanded these programs.
This is not to say that the answers of the New Deal were knee-jerk reactions. They were the considered responses of many of the ablest young minds of the era, talented people who turned spontaneously to the problems of the Depression as the grand challenge of the day, much as space was the great challenge a generation later, or the environment is the vital challenge of today. Many of these young economists assembled in the federal Department of Agriculture under Rexford Tugwell, for example. Others found work in the offices of populist elected officials, such as Senator Richard Wagner of New York. Still others located in universities, such as Harvard and the University of Wisconsin, which had freed themselves to some extent from the hegemony of Classical economics.
The confluence of motivated talent and manifest need resulted in a series of measures, among them the Social Security Act, unemployment insurance, the Work Projects Administration, the Civilian Conservation Corps, which increased spending and were financed by borrowing. These remedies of necessity for an impoverished nation were also the deficit spending of Keynes' prescription.
The Social Security Act began sending retirement checks within two years of its enactment, a feat made possible of the pay-as-you-go financing which has in recent years drawn so much criticism. This was a period of desperate want among many older Americans, a want which echoed through whole families. There was no time to wait for investments to mature. Indeed there were no investments to mature in the black days of the Depression. So the stock-based proposals of the current day were not then serious options. The Social Security Retirement Act thus freed children from the sometimes grim duty of providing for parents and allowed them the opportunity to develop themselves and their prospects. Previous to this Act and in many other nations continuing to this day, old age security depended on the number and loyalty of one's children.
Unemployment Insurance is the archetypal counter-cyclical program. So long as employment tracks economic health, benefits are paid out, with their consequent demand stimulus, when unemployment is a problem and withdrawn when the economy heats up. Unemployment Insurance began as Title III of the Social Security Act of 1935. Title IV of that Act was Aid to Dependent Children, another joint federal state program. This provided direct relief to many families abandoned by husbands and fathers during the Depression. Today it is the central element of what is sometimes pejoratively known as Welfare.
The Works Projects Administration was created by direct presidential order in 1935 and employed millions of people. The WPA was a presence in virtually every locality. The Civilian Conservation Corps was created in Roosevelt's first one hundred days and likewise employed people, predominantly young men, in thousands of communities. These were direct employment programs, and they stimulated demand immensely. Those wages not immediately spent by program participants was invariably remitted to their families. The multiplier was very high.
With the advent of war, the conceptual tools of Keynesianism and the economists who used them in the New Deal moved directly from the problems of Depression to the problems of mobilizing the war effort, controlling prices, financing new plants and balancing output. The war economy was managed with an efficiency that matched or surpassed that of the military machine.
In sum, Keynes in Britain and the New Dealers in the United States provided the economic remedy to the Great Depression. Theory and practice was ratified by the experience of World War II. Keynesianism emerged as the dominant system in the US and Europe following hostilities. It would guide public policy for the next twenty-five years.
John Maynard Keynes, a British economist and diplomat, truly was the savior of market capitalism in the last century. Those who have heard of Keynes may be surprised, or even offended, to hear him described her as the "savior" of capitalism, but it is no exaggeration and not even controversial among most economists. Keynes operated in the context of the Great Depression, the deepest and longest, but by no means the only, economic crisis that afflicted pre-World War II capitalist countries. But as we've seen, it was not primarily Keynes' theory that brought on the New Deal. It was, however, Keynes' theory that provided the means to understand the events of the Depression and the following war. When results followed as predicted, it propelled Keynesianism to the fore.
After the war a period of unprecedented expansion began, anticipated by few, but eventually fathered by many. The world's economy was dominated by the United States. Even five years after the war, in 1950, with little more than six percent of total population, the U.S. economy was greater than the entirety of Europe and Scandinavia. It was five times the size of the Soviet Union. Economically the world was composed of 40 percent United States of America and 60 percent everyone else.
The wholesale destruction of Europe and Japan left U.S. industry largely unburdened by competition from other nations and blessed with enormous need for its product. Confidence in New Deal economists and Keynesianism, or a fear of return to Depression, gave rise to the Employment Act of 1946. The Act codified the responsibility of federal government to intervene and direct the economy under the leadership of the president for the purposes of full employment. The Act, for the first time, recognized the power of the government to affect economic outcomes by its use of fiscal policy - taxing and spending - and monetary policy - interest rates and money supply. The Employment Act gave the president the mandate to use policy to effect "maximum employment, production and purchasing power."
"Purchasing power" in the Employment Act was added late in negotiations, being a euphemism for price stability. The concern for inflation later would grow to overshadow full employment. This conflict between conservative Republican concern for price stability and Keynesian and Democratic concern for employment played out in the maneuvering leading up to passage of the Act, as it would over and over again in the decades to follow and until its provisions were reversed by neglect.
Aside from the new role for government in directing the economy, postwar America was different from prewar America in other respects: the federal government was four times its former size, the United States held geopolitical dominance over the world, Protectionism although not dispelled completely had begun an inexorable turn toward a free trade bias, and expectations of people and business were of a level higher than previously.
Truman
Harry Truman, "the man from Missouri," and later "Give 'Em Hell Harry," rose to prominence as a U.S. Senator leading investigations of wartime waste, fraud and corruption through the Truman Committee. Tapped by Franklin Roosevelt in 1944 to run as vice president in place of Henry Wallace, Truman ascended to the presidency in 1945 on Roosevelt's death. It fell to Truman to traverse the gauntlet of transition from war to peace. First inflation, as industry scrambled to retool capacity for consumer goods and consumers released years of pent-up demand, demand further enabled by the innovation of installment credit. Then employment, as seven million men under arms returned to the work force. Finally, a new geopolitical reality, as the U.S. emerged into a position of global superpower and began the first mapping of the Cold War. Truman and his chief economist Leon Keyserling are not sufficiently appreciated for their courage and insight in this critical time. By the path they chose through these obstacles, no two men are more responsible for setting the foundation for the growth and stability of the next twenty-five years and an unprecedented material prosperity.
Keyserling was the second chairman of the Council of Economic Advisers, an office created by the Employment Act, and probably the most influential of any. Keyserling's approach was more New Deal than Keynesian. He propounded an economic "partnership" between government, labor and business. Targets for development, targets for production and targets for inflation were, in Keyserling's view, to be a shared responsibility under the basic purpose of full employment of labor and capital. Needless to say, this view was not adopted by all, but Keyserling and Truman deserve credit for growing the economy through the postwar inflation, against vigorous opposition, without substantial unemployment.
In particular, when the inevitable inflation began to rise in manufactured goods (but also in commodities, particularly farm commodities), many called for higher interest rates and government action to "cool off" the economy. Truman and Keyserling resisted that notion. Even though their preferred tool of price controls had been taken off the table by the business-dominated Congress, they continued to argue for growth, and their determination won out. The price surge broke. The boom cycle ended in the context of dramatic federal downsizing, and the country appeared headed now in the opposite direction, toward the universally feared return to Depression. Instead the economy stabilized and began to grow again. Truman immediately claimed credit for this by virtue of, among other things, his farm price supports, which as he said, provided a floor of demand.
In the most celebrated political comeback in American history Truman won reelection in 1948 when he ran as an activist president against the "Do Nothing Congress." His subsequent assessment of the threat of the Soviet Union and the strategic capabilities of the United States, developed in large measure by Secretary of State Dean Acheson, defined the era to follow. Anticipating the rise of the Soviet Union, the National Security Council explored the Cold War in advance. A top secret memorandum, NSC-68, outlined the threat and America's ability to respond. The key opposition to a proactive America centered on the contention that U.S. economic strength would be drained by an aggressive build-up. Keyserling's analysis of the nation's economic capacity refuted the contention. The experience of World War II was fresh enough evidence in support, and the Korean War which forced Keyserling's analysis into practice and bore him out.
During the darkest days of the Korean conflict, in one of the most unmarked and unremarked-upon events in American economic history, the Federal Reserve Board ("The Fed," America's central bank) wrested from the President and the Department of the Treasury unilateral control of monetary policy for itself and indirectly for the benefit of lenders. Prior to the so-called "Treasury Accord," the Fed had been independent only in the sense that other oversight boards and commissions (Federal Communications Commission, the Food and Drug Administration, etc.) were independent. That is, although not associated with a particular Executive department, they took policy direction from Congress and the President. During this time the Fed, obviously, worked closely with the Treasury. But as Truman's support sank in a tide of bad news from Korea, and then in the aftermath of his highly unpopular recall of General Douglas MacArthur, closet negotiations produced the agreement which gave the Fed its unilateral power, the Treasury Accord. William McChesney Martin, a key negotiator within the Treasury because of the hospitalization of the Secretary of the Treasury William Simon, earned a long tenure as chairman of the Fed in the conspiracy. (As well as the sobriquet of "traitor" from Truman, delivered personally on a chance meeting between the two some years later.) Monetary policy soon shifted its focus from keeping interest rates low and stable (in part to reduce the burden of the war debt on the federal treasury) to a concern for the interests of the banking community and maintaining price stability. Two decades later, Keyserling estimated the cost in excess interest to be in the hundreds of billions of dollars. That figure was given prior to the great run-up in debt of the Reagan Administration and would be well into the trillions today.
Truman is regarded far more positively today by the public and historians than the day he left office. Economically, he holds the distinction unique among postwar presidents of producing a net federal budget surplus, this in spite of financing the Korean War on budget. The Truman years were splendid in terms of low unemployment, high growth and strong corporate profitability. In the next chapter we explore the economy's performance using statistical measures, by president, and we will find Truman at the top of the scorecard.
Eisenhower
General Dwight D. Eisenhower was elected in a landslide in 1952 over Democrat Adlai Stevenson, the first Republican president in twenty years. Eisenhower entered the Oval Office as an administrative genius, a man who had masterfully managed the European Theater during World War II and the one who could bring skill and sanity to civilian government. Ike left eight years later as the man too small for a big job.
Eisenhower saw government as a management problem, and went to the rivate sector looking for good managers. He appointed a long line of corporate officers to government posts, including the notorious Charles E. Wilson from General Motors as Defense Secretary. Wilson produced an uproar with the statement, somewhat apocryphal, "What's good for America is good for General Motors, and vice versa." In this vein, Wilson presided over the National Interstate and Defense Highways Act, a national defense strategy that produced the interstate highway system, the largest government-sponsored construction project in history. None benefitted more than General Motors and the auto industry. One can only speculate as to the different America that might have emerged from investment of similar magnitude in rail transportation.
Virtually all economists at the time - including Eisenhower's own chief economist Arthur Burns - were Democrats, so the Conservative flag was carried forward by Republican political operatives, notably Senator Robert Taft. Eisenhower alienated Taft and the Old Guard when he proposed a budget in 1953 that did not balance and later when he refused to lead the effort to roll back the social programs of the New Deal.
Eisenhower's alternative "New Republicanism" was itself rejected, however, first in 1956. Although he beat Stevenson in a rematch of 1952, Republicans lost thirteen Senate seats and another forty-nine in the House. It ushered in an era of seemingly permanent Democratic majorities on Capitol Hill.
In Eisenhower's farewell address to the country in 1960 he spoke with feeling about the dangers of the "military-industrial complex," the conspiracy of interest between the Defense Department and the industrial suppliers of technology and arms. This was not a late discovery of his. Odd, perhaps, for a former general, and certainly unexpected by many prior to his election, rooting out waste in Defense was nonetheless a strong theme of his presidency.
Kennedy
Of all presidents, John F. Kennedy was the most engaged with his economic advisors. He assembled a brilliant group, with Walter Heller, James Tobin and Arthur Okun in the Council of Economic Advisers and adding John Kenneth Galbraith and Paul Samuelson in unofficial roles.
Of all presidential fiscal policy precedents, none has been more problematic than Kennedy's 1963 income tax cut. Designed by his Keynesian advisors to reinvigorate a slowing economy, it worked. But it was deficit spending, so Conservatives pilloried it mercilessly. Since that time, hearts have changed, to say the least. The Kennedy tax reduction has become a model, or at least a supporting case, for every Republican president since. The extremely modest scope of Kennedy's tax cut has been expanded by a hundredfold into the hundreds of billions of dollars per year now exacted for "stimulus" sake under George W. Bush. Such an ongoing stimulus, of course, is not only counter-intuitive, but counter-productive.
The most dramatic economic action on Kennedy's watch, however, was the 1962 showdown with Steel. Today the management of inflation has been implicitly assigned to the Fed, which manipulates interest rates in anticipation of or reaction to price pressures. Kennedy and all the presidents prior to Reagan met inflation in the field with one or another direct program. Kennedy and his advisors employed the tactic of directly influencing product and labor prices through a program of wage and price "guideposts," not mandatory, but heavily suggested targets. It was an incomes policy similar to that envisioned in Keyserling's partnership between business, government and labor.
Crisis occurred in 1962. After particularly difficult negotiations in the steel industry, steelworkers' unions had grudgingly accepted a contract in line with the Kennedy guideposts. U.S. Steel's president then announced a raise in prices above the guidepost level. Seven of the biggest steel companies followed suit. Kennedy's response to the betrayal of the guidepost policy was volcanic. "My father always told me that businessmen were sons of bitches," he was reported to have said. "But I never believed it until now." Every pressure possible was brought to bear on the offenders. Federal contracts were cancelled with the offended companies and handed to Republic Steel, the one company who had not raised prices. Inspectors and regulators showed up on their doorsteps. Investigations by the Federal Trade Commission and Justice Department (under Robert Kennedy) were launched. Seventy-two hours later Steel backed down.
Kennedy was assassinated in September 1963 in the most traumatic national event prior to 9-11. His programs were taken up by his vice president Lyndon Johnson. Although the psyche of the nation was shaken, its economy continued upward.
Johnson
In Lyndon Johnson rare parliamentary skill was matched with a vision, the vision of the "Great Society," an echo of Franklin Roosevelt's new deal. The Great Society programs ranged across the challenges of urbanization, education, health care, poverty and equal opportunity. These were programs that envisioned a government active in reducing poverty, discrimination, and the financial insecurity of its citizens. Some elements, notably the Medicare program, survive. Others, as well as appreciation of the domestic policy aspect of the Johnson presidency, have been washed away, because at the same time Johnson prosecuted a costly and divisive war in Vietnam.
Johnson continued to wield the wage-price guideposts to address inflation. In 1965 he threatened to dump commodities from the government's stockpiles on the market, which forced producers of aluminum, copper and wheat to moderate price increases.
Ironically, it was Johnson who had coined the phrase "guns or butter" a decade earlier to describe Truman's military build-up and simultaneous "Fair Deal" programs. Ironic because "Guns and Butter" was the phrase condensing the desire to have it both ways, war and domestic programs, that was used to stigmatize Johnson's own economic policies. It applied to the desire to have it both ways, war and domestic programs. A super-employed economy meant high factory utilization and record low unemployment, powerful growth, but also price pressures: the feared inflation. Although inflation in Johnson's tenure was mild by comparison to that of the subsequent two decades, alarm was high. Johnson responded with a 10 percent tax surcharge applied in midyear 1968, designed expressly to reduce demand and price pressure. Johnson was the last president to make a tax increase a central point of his economic policy.
The Depression and World War II served as historical tests for Demand Side. Peace brought more ambiguous economic events - inflations, prosperity, industrial expansion, social programs, supply shocks - and on a scale not before seen. The mild Johnson guns and butter inflation was taken by eager Conservatives as a failure of Demand Side. The analytical tools and biases that had failed in the Depression were dusted off and trotted out to meet the new problems. Fortunately for the country at the time, the problems were not severe enough to embarrass the failure of the Classical tools. Unfortunately for the long term, the absence of embarrassment only gave credence to the convenient tenets and allowed a full resurgence later under Reagan.
Bitter over criticism of the Vietnam debacle, Johnson refused to stand for reelection in 1968. His vice president Hubert Humphrey secured the nomination in a tumultuous and divided convention. The election would be held in the context of seven years of uninterrupted economic expansion during which GDP had risen nearly 40 percent, but in the campaign economics took a back seat to an unpopular war, crime, and a perceived decline in personal morality during the 1960s.
Nixon
Richard Nixon bested Humphrey. Nixon used the much discussed inflation as a backdrop for sermons against the Great Society. He did not offer a remedy, however, believing in private that the peace dividend from the end of the war and high growth seemingly embedded in the economy would ease the problem without sacrifice.
The economy cooled, but inflation remained stubbornly high. Balance of payments deficits (again mild by today's standards) fueled alarm. During a weekend retreat at Camp David the weekend of August 13-15, 1971, Nixon and his economic brain trust produced one of the most dramatic and least successful economic policies of the postwar era - the Wage-Price Freeze. They were very popular initially with the public, but ultimately the ramifications of price controls absent the wartime willingness to personal and communal sacrifice were chaotic. Evasion of controls was rampant, and the explosion of prices after the inevitable lifting of the freeze produced more uncertainty than ever. Disorder returned when against the advice of his advisors Nixon reinstated the freeze in 1973.
Between those two years was the election of 1972 and the first edition of the "political business cycle." When Nixon had first run for president in 1960, most blamed his loss on a weak performance in the televised debates with Kennedy. Nixon himself blamed the sickly economy he had inherited from Eisenhower. So in 1972 Nixon sought to create economic good times in the period leading up to election day. He timed government outlays strategically and elicited interest rate accommodation from the Fed. Nixon's strategy worked well and has been employed by every incumbent president since, with the exception of Jimmy Carter in 1980.
In 1973 the phenomenon that combined high inflation with high unemployment emerged. Stagflation. Although it occurred in the middle of a Republican administration, stagflation was widely used to discredit Keynesian economic analysis. This was done by imputing to Keynes the contention that inflation and economic recession would not coexist, partly because the guns and butter explanation of Johnson's inflation did not fit, and partly in a simplistic response to the relation between inflation and unemployment typified by the so-called Phillips Curve. This notion of a necessary trade-off between inflation and unemployment is not particularly Keynesian. Stagflation's roots likely lie instead in the rise of OPEC and the first oil price shock in 1973. The price of oil rose from $4.11 per barrel in December 1973 to $10.11 the following month and trended upward with inflation in the years to follow. This initially led to long lines at the pumps, as the Nixon freeze prevented supplies from being rationed by the price mechanism (higher prices discouraging demand). Oil prices soon seeped into every nook and cranny of the economy, first by drawing up the prices of other energy sources and then by sifting these prices into production and transport costs.
In another decision reached in the 1971 Camp David retreat, Nixon ended the convertibility of the dollar to gold. This " taking the dollar off the gold standard," or "closing the gold window," effectively ended the world's last stable exchange rate regime, a regime, known as "Bretton Woods" for the New Hampshire town where world finance ministers negotiated it in 1944. Nixon's move allowed the dollar to float against other currencies, a move intended to avoid the need for capital controls as Johnson had used, to keep capital from fleeing to more attractive currencies. It worked for that purpose in 1971. Since then, the resulting instability of exchange rates has proven, to put it mildly, very problematic.
Ford
Nixon resigned under the Watergate cloud in August 1974. His running mate Spiro Agnew had resigned a year earlier under bribery charges. Gerald Ford, an appointed vice president, thus became the only unelected president in American history.
Ford inherited an administration whose lines of governance had been unraveling for more than a year as a result of Nixon's obsession with salvaging his political career and legacy from the Watergate scandal. The economy was struggling with stagflation and the absence of clear policy direction.
Ford appointed Alan Greenspan, later long-time Fed chairman, as chair of his Council of Economic Advisers. Their approach cannot be described as clear or aggressive. Emblematic was the WIN lapel button - "Whip Inflation Now." The button and the Ford policy were minimal in effect. The economy did pick up late in Ford's two-year tenure, but it was too late for his election chances.
Carter
James Earl Carter, "Jimmy" Carter, was elected as an outsider to the Washington political machinery. Impeccable in character and sincere in his efforts to be trustee for the common person, Carter was not sophisticated economically. But he recognized immediately the central importance of oil. Oil prices had doubled between 1973 and the time he took office in 1977, and US dependence on foreign supplies was growing inexorably. Early in his administration, Carter attempted to mobilize public will to address the problem, which he defined as "the moral equivalent of war." The 55 MPH speed limit imposed on the nation's highways saved immense amounts of energy, but the public was more annoyed than motivated. Carter's effort was lampooned by its acronym MEOW and pronounced ineffective.
The Democratic Congress was sympathetic to the efforts to reduce oil consumption, but at the same time frustrated with the administration's obsession with inflation produced the 1978 Humphrey-Hawkins Full Employment Bill, an amendment to the 1946 Full Employment Act. It sought to balance inflation fighting with efforts to spur employment and growth. The bill set out procedures to coordinate actions by the president, Congress and Federal Reserve, and imposed specific goal-setting requirements.
Humphrey-Hawkins passed into law, but was sabotaged early on when he Fed under Paul Volcker adopted a completely independent tight money policy. After the election of Ronald Reagan in 1980, the procedures and principles prescribed in Humphrey-Hawkins were largely ignored. What was intended to resurrect the Keynesian energy of the Employment Act became little more than a reason to footnote official memoranda.
Under Carter another tack was taken against the winds of inflation. Deregulation. The concept of deregulation was to reduce regulatory obstacles to free prices and let competition bring them down. Deregulation appealed to many on both sides of the aisle, and was later a precept of Republican policy. Its initial impetus came from Carter's chief inflation fighter Alfred Kahn, who brought it in from his experience in utility economics. The idea appealed to Carter, and to many on both sides of the aisle. Its effectiveness against inflation disappointed, but in freeing corporations from government oversight, it excelled.
Carter's last year in office was heavily burdened by the Iran hostage crisis. His economy was burdened by the consequent embargo of that country's oil. This second oil shock, seeing prices rise from $15 per barrel in January 1979 to $32.50 at the end created an inflation by the same dynamic as the 1973 OPEC oil shock. Believing inflation to be more important than economic expansion, even in an election year, Carter did a poor job managing the political business cycle. Unemployment rose, frustrating and enervating traditional Democratic constituencies. Taken over his full term, economic growth was moderately strong. But the last year was the second of only two years of negative growth under Democrats in the postwar period. Carter was defeated by Ronald Reagan.
Reagan
Twenty minutes after the completion of Ronald Reagan's inaugural address on January 20, 1981, the 66 American hostages held in Iran were released. The most egregious scandal of Reagan's administration, by possible coincidence, also involved Iran, being the sale of missiles to that country to finance terrorist guerilla bands in Nicaragua.
A chapter in Herb Stein's book Presidential Economics is entitled, "The Reagan Campaign: The Economics of Joy." It is followed by a chapter, "The Reagan Presidency: Encounter with Reality." As we have noted, Stein was chief economist to Richard Nixon. Stein claimed to have authored the phrase "supply side" himself in 1976, but disavowed support for the official Reagan economic theory. Few economists in 1981, in fact, viewed Supply Side as a serious economic position. Supply Side promised higher growth with lower taxes and no sacrifice to fiscal integrity. It was intoxicating as a political program, and was a direct precursor to the Bush tax cuts twenty years later. Both presidents promised prosperity they did not deliver and delivered bonus sized benefits to wealthy Americans financed by federal deficits.
The Reagan Recession of 1982 was the deepest economic slowdown in postwar history. Double digit inflation was nearly matched by double digit unemployment. Poverty skyrocketed. Businesses and banks failed at record rates. "The homeless" became a descriptor for a large tribe of Americans. The manufacturing sector began its demoralizing decline. Corporate profitability entered a decade of anemia. Reaganomics led directly to the biggest federal deficit in the postwar - 6.0 percent of GDP - in 1983.
It was under Reagan that fiscal policy was permanently divorced from the inflation battle. Fiscal policy - taxing and spending - was given over to the Supply Side charade that tax cuts would actually lead to more tax revenue and to a vigorous peacetime military build-up. Neither tax cuts nor increased spending were good news for inflation, so inflation became strictly an economic issue and was shunted to the Fed and its chairman Paul Volcker. The Fed's chosen tools of monetary policy. Monetary policy consisted of interest rates and - most importantly in the Monetarist Era - the supply of money. Volcker had imposed money supply restrictions in the context of the oil shocks of the Carter years. He continued it through the first years of Reagan.
Monetarism promised that by reducing the amount of money in circulation, prices would painlessly and immediately fall. It was, unfortunately, not prices, but economic activity and employment that fell. Monetarism as espoused by its chief promoter Milton Friedman was a direct descendent of the fallacy called the "quantity theory of money." The Monetarist reasoned that prices could be kept down if the amount of money available were kept down. At first glance there is merit in this thought. If inflation is too many dollars chasing too few goods, then simply reducing the number of dollars should bring back a match with goods. (FN: The Truman alternative, as we have seen, was to increase the number of goods. The algebra for this is MV = PY, where M is the supply of money, V is its velocity, P is the price level, and Y is the level of output. eFN)
A little thought, perhaps stimulated by hard experience, demonstrates some of the difficulties with this idea. Another response to fewer dollars might be fewer goods, not lower prices, and this is what occurred in the Reagan Recession. Fewer goods, of course, meant lower employment, lower demand, and as the economy contracted, yes, eventually lower prices. Reducing the number of dollars also made dollars themselves more valuable and increased their price - the interest rate. Higher interest rates, of course, only further increased prices overall, since like energy, credit is integral to virtually all economic activity. A final major response to reducing the number of dollars was the creation of near-money, e.g., credit cards. This and other "credit money" eventually made the quantity of dollars a meaningless measure.
Thus the quantity theory of money was defeated again, if not in the classrooms at the University of Chicago, at least on the playing field. Although inflation did eventually come down, it was the grim task of lines of unemployed to bring it down. Reduced demand and stagnant economic activity broke the rise in the price of oil, and thus inflation. At the same time, the Fed permanently turned from money supply to interest rates as a means of combating inflation. (Interest rates are simultaneously the favored tool for stimulus, which created an awkward double duty that continues to this day.
The Volcker Monetarist experiment and the Reagan years contributed to a sea change in economic policy and economic reality. Reagan's first term marked the beginning of the de-industrialization of America. Manufacturing employment continued to decline even after the deep recession of 1982. With that decline, wages stagnated. In the ensuing quarter century there has been no increase in the real wage of Americans ("real" meaning inflation-adjusted).
Between 1947 and 1978, From Truman to Carter, real hourly wages rose 72 percent. Weekly earnings, which factor in the number of hours worked per week, rose 53 percent. Between 1978 and the start of the Volcker Monetarist experiment and 2006 (Reagan to Bush II), real hourly wages fell 5 percent and weekly earnings fell 10 percent.
Abetted by the Supply Side rationale, the federal debt exploded. By the end of his two terms, Reagan had tripled the debt to $3 trillion. Reagan's vice president and successor George H.W. Bush added more than another trillion by momentum. After a respite under Clinton, who added barely $400 billion in his eight-year term, the debt explosion continued under George W. Bush, who tacked on almost $2 trillion in his first seven years.
In the next chapter we offer some measures of economic well-being. "Net GDP" is one. Gross Domestic Product (GDP) measures the monetary value of all goods and services produced by the economy. Net GDP takes this figure and subtracts the federal deficit, the public borrowing which is used to maintain or inflate GDP. Just as it would not be proper to count a family's borrowing as earnings, so it is not proper to count the federal government's borrowing in a measure of its product. The Reagan years are in negative territory in Net GDP.
A connection between the federal deficit and the decline in manufacturing is direct. A high deficit means the government is bidding up the interest rate, the price of money, with its borrowing. The dollar climbs with the interest rate. A "strong" dollar means weak manufacturing, because goods are higher priced for no other reason than the currency in which they are denominated is higher in price. That is, an automobile made in the U.S. is more expensive than one made in Japan for no other reason than when the Japanese model is imported, the currencies that are the media of exchange give a discount to the yen. Thus the arrival of Toyota, Nissan and Honda and the departure of Chrysler, GM and Ford.
The Reagan Era witnessed a burgeoning of committees on "competitiveness," which became (depending on the bias of committee members) an opportunity for blaming unions or production management. Finally blame gave way to the understanding of the cost of the strong dollar. Reagan's Secretary of the Treasury James Baker orchestrated the "Plaza Accords" of 1985. Baker convened the finance ministers and central bankers of Germany, France, the United Kingdom and Japan at the Plaza Hotel in New York City to negotiate a reduction in the exchange rate for the dollar. Initial reaction from attendees was dismay that the U.S. demanded concessions from others without reducing its own enormous deficits, which most viewed as the cause of its problem. But they agreed to a process which brought the dollar down by 30 percent against major currencies over the next two years. This gave some relief to American manufacturing, but it was left to Clinton to address the root of the high dollar/high interest problem - the federal deficit.
Reaganomics proved that deficits do matter ... eventually. High interest rates and a ballooning debt in Reagan's first term brought on debt service (interest payments) that sapped the economy's strength in the second term and beyond. Debt service as a proportion of tax receipts has historically been a function of the interest rate, as Leon Keyserling observed in his critiques of the Fed. During the 1950s and 1960s the percentage of tax revenue going to interest payments hovered around 10 percent. Under Nixon and Ford it rose to 15 percent. AS the Volcker Monetarist experiment unfolded it ballooned from 15.8 percent in 1978 to 35 percent in 1984, where it remained through the high interest years of Reagan and Bush I, peaking at 39.4 percent in 1991. That is nearly four of every ten dollars in receipts going to service the debt. Fiscal responsibility during Clinton's two terms and then an aggressive low interest policy by the Fed which began in 2000 have reduced this figure to near 20 percent today. Undoubtedly taxes expended for interest payments produce less economic benefit than taxes expended for goods or services.
Bush II
Reagan's vice president George Herbert Walker Bush followed him to power on the same anti-tax platform. "Read my lips. No new taxes." It was an echo of the "No new taxes," pledge Reagan had made during his debates with Walter Mondale four years earlier. Although both won their elections, and both men raised taxes subsequently, Bush's tax increases did not slide by unpunished as Reagan's had. Bush was lampooned by the press and made out to be the betrayer of the Gipper's legacy.
Reagan and Bush colored taxes with a shade of evil. Taxation became bad for the economy, in and of itself. This clearly disprovable contention rested on vestiges of Supply Side misconceptions and perhaps on a memory of the stimulus enacted during the Kennedy-Johnson years. The evil of taxation was asserted loudly in revival-like meetings and by Right Wing think tanks such as the Heritage Foundation. At its base, it was an assault on government. The hidden message to Conservatives was that taxation was necessary only if the liberal welfare state was necessary. This message was little different than that of Taft and the Old Guard in the 1950s. But this was not the message issued for general consumption, which left off any mention of cuts in government programs. Cuts were effected, however, by undermining revenues. And the cuts had the fingerprints of fiscally moderate liberals on them as a bonus.
Smaller government, the key objective of the Right, was not achieved by this indirect attack on financing, but only because Republican presidents expanded government spending themselves. Key social programs were squeezed, however, and others - notably health care for all - were kept in the can.
Another legacy from Reagan for George H.W. Bush was the need to bail out the savings and loan industry. High interest rates had been deadly to the "Thrifts," which had focused on long-term lending (mortgages) and depended on short-term borrowing. When short-term interest rates rose dramatically, they were caught in a vise. Deregulation began under Carter, but accelerated rapidly under Reagan. Accounting rules were reduce, and capital requirements adjusted. Fraud moved into the opening, and soon indictments and trials began to festoon the daily papers. Charles Keating, Michael Milkin and Herman Beebe were the most famous names to be indicted. Neil Bush, son of the president, was himself director of a Thrift when it collapsed. By 1990 nearly 400 major convictions had been obtained by the Justice Department in Thrift abuse. Bush and Congress closed ranks to bail out the investors. Although each account was insured up to $100,000, the promise of higher interest had drawn flocks of eager investors whose accounts exceeded this figure. The bailout continued a practice of de facto government insurance, employed earlier for Chrysler and Continental Illinois, and later for Long Term Capital. Estimates for the cost to the public of this de facto insurance in the case of the Thrifts ranged from $130 to $500 billion.
George H. W. Bush did become as a byproduct of the Gulf War the only president after Carter to preside over a year of trade surplus. The U.S. fought the war to evict Saddam Hussein from Kuwait, but it was the American allies - principally Germany, Japan, Saudi Arabia and Kuwait - who financed the war. Success put Bush's public approval ratings into the seventy percent range. But an oil price shock from the war contributed to a decline in the economy approaching election day.
Clinton
"It's the Economy, Stupid." It was a short, rude phrase to narrow the focus of staff, and it was posted over the doorways of staff offices along the campaign trail of William Jefferson Clinton's presidential bid. GDP growth under the elder Bush ranked dead last for all postwar presidents at 2.0 percent. Unemployment had increased during every year. Business was suffering. Clinton rode the issue of the economy into the White House.
In his first year, he packed his political capital into a program of deficit reduction. He sold it, barely, to a divided Congress. The 1993 Budget Bill increased revenue, reduced expenditures, trimmed the deficit, and required a tie-breaking vote by vice president Al Gore in the Senate to pass into law. Fed Chairman Alan Greenspan responded to the fiscal responsibility by easing off on short-term rates, and long-term rates began to fall. Millions refinanced their homes over the next few years at the lower rates, producing hundreds of dollars per month in new discretionary spending ability for millions of families. Stimulus impossible from further tax cuts was released into the economy, billions of dollars worth. This was the domestic side of "Rubinomics." Robert Rubin, head of Clinton's National Economic Council and later Treasury Secretary advocated fiscal discipline and open markets. This combination was to be the economic theme of the Clinton presidency.
Republicans lost no time in exploiting the tax increases of the Budget Bill in their "Contract with America." Of the ten points of the Contract, five called for tax reductions and limitations. The most specific advocated halving the capital gains tax and indexing it for inflation. Other points preyed on the notion of a runaway government, conflating taxes and profligacy, and ignoring the irony of preaching responsibility while not paying one's bills. The GOP took control of the House of Representatives in 1994 using the Contract as their principal campaign instrument. In the next budget cycle new Speaker of the House Newt Gingritch presented Clinton with Draconian program cuts. Clinton vetoed the cuts and set up an historic standoff during which the government twice shut down. Default was avoided only by creative use of trust funds to pay debt service. The episode narrowed the focus of the nation, however, from the general talking points of the Contract to the specific program cuts. The shutdowns proved to be a PR fiasco for the GOP, who were widely seen as reckless in their brinkmanship. Clinton's stiff resistance sparked his comeback to reelection in 1996.
The fiscal responsibility part of Rubinomics worked better than the push for open markets. The free flow of capital internationally, encouraged under Rubinomics, spurred a series of currency devaluation catastrophes. The largest occurred during a period spanning the last half of 1997 and the first half of 1998. The Asian currency crisis began with the meltdown of the Thai bhat and the "contagion" spread to Indonesia, South Korea, the Philippines and elsewhere. Capital had been flooding into the so-called Asian Tigers; it fled as quickly, since debt tended to be short-term and callable. Since debt was also typically denominated in dollars, the reduction in the value of the currencies against the dollar doubled or tripled the weight of the debt. Default and bankruptcies ensued. IMF relief schemes bailed out the lenders, not the borrowers. Debts were shifted to their governments. Bailout conditions required government budget austerities which further exacerbated the damage.
Financial crisis also visited Russia in the aftermath of free-market "shock therapy." Shock therapy was another Western treatment (from the Washington Consensus prescription book - see Chapter 6) that proved less than therapeutic. Russia under Mikhail Gorbachev and Boris Yeltsin was a nation emerging from the controlled economy of Communism. The remedy advised by the West was wholesale privatization and decontrol of prices. Before the shock was over, Russia had defaulted on its bonds. The default brought down the American hedge fund Long-Term Capital and nearly brought down the international financial system. The principals of Long-Term Capital had won Nobel Prizes in economics, but their mathematical models which counted on historical interest rate behavior to continue were contradicted by real world politics. Only luck and a consortium of financial houses brought together by the New York Fed averted a collapse of international bond markets.
These crises were little more than speed bumps in the inexorable expansion of the American economy, an expansion amplified in the rise of its stock markets. Ever advancing stock prices brought in more investors, and more investors pushed prices up. Nobody wanted to be left behind. Seasoned analysts' warnings did not prevent millions of people poured hundreds of billions of dollars into stocks and mutual funds. Each dip was a buying opportunity and each rise another reproach to the timid and contradiction to the naysayers. The "dot.com bubble," as it would later be called, increased paper wealth, which increased spending, which sent off a new round of growth. By 2000 the economic rise, without tax increases, had lifted the federal budget from record deficit to record surplus. Weakness in Social Security and Medicare trust funds was replaced by strength. A record number of consecutive quarters of growth seemed to have confirmed the arrival of a "New Economy" freed from the strictures of the business cycle.
Bush II
George W. Bush took office in January 2001. The longest peacetime expansion in postwar history ended in March. In September a terrorist attack on New York and Washington shattered the confidence of the nation. In its shadow Bush raised a new and bellicose foreign policy, and insisted on tax cuts and enormous budget deficits to replace the fiscal responsibility of the Clinton era. Hidden by 9-11 were other events more important in understanding the trajectory of the economy.
First, oil prices had favored Bill Clinton. High during the Gulf War, prices had fallen by the time Clinton took office in 1993 and fell even further four years later in the disruption around the Asian currency crisis. Only near the end of his second term did oil begin to rise. At $12 per barrel in February 1999, prices were $25 in November, and $34 in November 2000. In keeping with the political business cycle, Clinton tapped the Strategic Petroleum Reserve to keep prices down and assist Al Gore's presidential campaign. The move was muted, however, because Gore chose not to run on the strong economy. Oil moderated after the election and throughout 2001, but prices began to rise again at the outset of 2002 and did not stop until they reached $74.1 in July of 2006.
Second, long before 9-11 Alan Greenspan saw inflationary pressures in his statistical tea leaves and began ratcheting up short-term rates. The Fed raised its federal funds rate from 4.76 percent in June of 1999 to 6.53 percent a year later. The combination of high energy prices and high interest rates had its way. Inflation never arrived, but a stall in the economy did. Greenspan reversed course. The federal funds rate went into free fall and lost three full points to 3.77 percent over the next year. It halved again over the following twelve months, and kept dropping until the rate broke below 1 percent at .98 in December 2003. But it was too late Since that time the federal funds rate has risen again to 5.25 percent. This is still very low for times of such enormous fiscal deficits.
Third, the Bush tax cuts were not needed by the economy, but the weakness an national uncertainty following 9-11 provided an opening for their passage. During the campaign in 2000, tax cuts were a continual theme of the Bush camp, but using the slogan, "After all, its your money." With the economic downturn, the program did not change, but the rationale shifted. "For the sake of the economy." As under Reagan, hope for stimulus secured reluctant Democratic votes in Congress.
The economy had already begun to stall when the jets hit the Twin Towers, but 9-11 was employed as explanation for many ills, including the subsequent dramatic failure of the tax cuts to do what Bush promised. The cuts were Supply Side revisited, targeted to corporations and the rich, and so were ill-suited as economic stimulus. (See the discussion of the multiplier in the previous chapter.) It is not too simplistic to suggest that the Treasury received funding from the same sources before and after the tax cuts, but that afterward it was obliged to pay interest. Taxes from the wealthy were replaced by purchases of bonds by the wealthy.
A remarkable surge of incompetence and corruption also entered the federal government with George W. Bush, not restricted to the much-documented ineptitude surrounding the Iraq War, but evidenced as well in the aftermath to the natural disasters of hurricanes on the Gulf Coast, in the deregulation of energy traders that led to the Enron fiasco, and in dozens of other government mistakes of policy and practice.
Perhaps the most destructive example came in the area of energy and environment. Early in his tenure, Bush dismissed overwhelming world opinion and scientific evidence about global warming and withdrew from the multilateral Kyoto Accords. Later, as the tide of evidence and opinion overwhelmed doubt, there came no turn in policy direction, but as with tax cuts, only a change in rationale. It became not the weakness of the science, but the weakness of the economy which prevented anything from being done. The United States, the wealthiest society in the history of the world, could not afford its own survival.
The Future
The ability of the U.S. to borrow seemingly endless amounts of money at low rates has kept the economy from sinking, but basic economic weakness lies under this debt and crisis has only been delayed. As with global warming, shunting the weakness to the future will only complicate the solution.
Borrowing leads to an overpriced dollar and a trade deficit, as we've seen. This sets up conditions for a run on the dollar, a dramatic devaluation by market forces. The prospect for weakness in the dollar is extremely worrisome, for its implications on inflation and the potential for overreaction by the Fed. Most U.S. debts are denominated in dollars, so the effect of a devaluation would be to reduce the value of this debt. At first glance this might seem like a painless resolution, but resistance will be severe and depending on which way the pressure is released, damaging in any of a number of ways.
A second major crisis is in the queue hidden by the fiction of the unified budget," which has allowed the pass-through of Social Security and Medicare contributions into the operating budget. This politically expedient phonying up of the balance sheet undermines the financial health of these entitlements. As Baby Boomers retire, the trust funds will be asking for remittence on the bonds they have been given by the operating budget. At the same time the debt service will be growing from the current immense federal deficits. The debt-based financing which has replaced revenue-based financing comes with the price tag of interest payments.
A third, slower-unfolding crisis will arrive with the slow expiration of the housing bubble. Spurred on by low interest rates and speculative forces moving in from the stock market, housing sales and construction ballooned in the early 2000's. American households have incurred massive private debt. The inevitable peak will be followed by a long, possibly rugged decline. Demand strength from the wealth effect of housing has paralleled the experience of the stock market bubble of the 1990s, and has led to demand strength. This strength will leave and be followed by weakness, a reverse wealth effect as homeowners watch the values decline.
The Iraq War will, however damaging it may be to U.S. interests across the board may well mark a shift in the popular paradigm for economic action. World War II, the Korean War and the Vietnam War crystallized such changes. This change will likely be, as have the others before it, a reversal of direction, and may enable a return to social democracy from the Corporate Oligarchy practiced today. Such a turn would release immense productive capacity, because a social democracy has a higher demand function and can focus the energy of the economy more precisely and productively. The Corporate Oligarchy, on the other hand, is essentially set in its direction. Its dynamics allow little more than simple resistance to change for a steering mechanism.
Rationalizing health care insurance and delivery, reining in profligate consumption in favor of new forms of transportation and energy, a renewed commitment to education, and the retooling of the society to meet the challenges of the planet's survival are essential. They will bring growth. But they will have to be implemented quickly to be successful. Can the society can extricate itself from the current entrenched political powers in time? The answer to this question is the verdict on the society's survival.
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