• U.S.

To Set the Economy Right

25 minute read

Nobody is apt to look back on the 1970s as the good old days. The economy’s most disruptive decade since the Great Depression has borne the stagflation contradiction of no growth amid rampaging inflation, the can’t do trauma of receding productivity in the nation that was long the world’s cornucopia, the reality of an energy shortage in the land of supposedly boundless resources, and the debauch of a dollar that once was “as good as gold.”

Economists, proud and powerful in the 1960s, now look like Napoleon’s generals decamping from Moscow. Their past prescriptions —tax tinkering and Government deficit spending to prop up demand, wage and price guidelines to hold down inflation—have been as helpful as snake oil. “Things just do not work now as they used to,” says former Federal Reserve Chairman Arthur Burns, and who can contradict him? The U.S. economy, bloated and immobilized, has been turned topsy-turvy.

Yet a revisionist group of economists, eclectic and unorthodox, is on the rise, and they have provocative views about what has mucked up the economy and how to start fixing it. These academics, still in their 30s or early 40s, admit to many more questions than answers and are sometimes unfairly dismissed by their more traditionalist colleagues as “N.C.s” (Neanderthal Conservatives). Hardly Neanderthal, they are instead moderate, pragmatic economists of the late 1970s who are bringing fresh air, and fresh hope, to the dismal science. Says Rudolph Penner, head of tax-policy studies at the American Enterprise Institute: “The exciting ideas are now coming from the under-40 crowd, and they are saying that Government is not efficient.”

That heresy shakes the almost reverential respect accorded by the profession to Britain’s late John Maynard Keynes, the century’s most influential economist. The belief of Keynes’s disciples that governments often could manage economic affairs as efficiently and effectively as free markets themselves has been rejected by the accumulating research of the new economists.

Still undergraduates when Keynesianism was flourishing in the late 1950s and the 1960s, the new economists are now professors in their own right at universities around the country. Among them: Martin Feldstein, 39, of Harvard, who is the leading thinker in the group; Robert Lucas, 41, of the University of Chicago; Michael Boskin, 33, of Stanford; Rudiger Dornbusch, 37, and Stanley Fischer, 35, both of M.I.T.; as well as many, many others.

The new group represents what might be termed the rubber band school of economics—what the profession itself calls “elasticity.” The sensible notion is that people respond to the specific incentives of price and supply and that, given the right incentives, the market itself is better equipped than the Government to bring about lower prices and more supplies of what people want and need.

The economists argue that instead of providing the right incentives, government policy has been coming up with all the wrong ones. They assert that Government has motivated Americans to spend too much and save too little. They charge that federal tax, budget and monetary policies have promoted immediate consumption instead of investment for the future. Their fundamental warning: America has been living off, and eating into, its capital stock. Many of its factories and machines have become outmoded; its old industrial cities have become rundown; its work force has become less productive; real growth has swung low while demand has remained high. The nation is, in short, losing its economic edge in the world, and the hour is late—very late.

The price that every American pays for these failures is a decade-long inflation that is the most pernicious price spiral since the Korean War, and certainly the most alarming one in the nation’s history. Because competitiveness and efficiency have declined, and productivity growth, that most basic yardstick for measuring a nation’s economic vitality, has slowed, the real cost of producing goods has jumped. Meanwhile, to keep demand up, the Government has created money and credit at far faster rates than businessmen can turn out products and services. The result: too much money chasing too few goods, which is a classic inflation. Largely because of the rapid expansion of money, the average household income is more than twice as much as it was ten years ago, or $16,100. Yet because of inflation, real purchasing power is up only 11%, and for millions of Americans it is now only the second income from a working wife that enables families to make ends meet.

Inflation has spread a financial virus of unwanted dollars to the economies of the nation’s trading partners, turning the once mighty greenback into the sick man of international finance. Since 1970, some $650 billion has piled up in so-called Eurodollar accounts in banks overseas, and the threat is ever present that holders might stampede to sell their dollars. Since 1971, minipanics have led to the collapse of worldwide fixed exchange rates against the dollar, the slide of the dollar against gold and other precious metals, and the progressive disintegration of global confidence in the dollar itself.

The Federal Reserve Board over the years has jumped back and forth capriciously from tightening the nation’s money supply in an effort to slow inflation, to running the printing presses full blast when the economy seemed in need of a lift. But its new chairman, Paul Volcker, seems committed to a more consistent and tougher policy. Last week the Fed lifted its discount rate, the amount that it charges for loans to commercial banks, from 10% to a record 10½%, suggesting that even in the face of a business slowdown the board is at last determined to halt the excessive expansion of money and credit.

That would be a welcome development because it is reasonable to wonder just how much more inflation the U.S. can safely absorb. A nation that hardly noticed when prices inched up, on average, little more than 1% a year during the 1950s and early 1960s, now endures such rises every month. The jarring discovery that the prudent no longer save for tomorrow but spend their dollars as soon as they get them has shaken not only the American economy but also the American psyche. Since 1970, the U.S. has become a nation of spendthrifts, and the personal-saving rate has slipped from 7.4% to 5.2% of aftertax income, the lowest among all industrial nations. The saving slump, which starves investment and feeds consumption, reflects the inflationary attitude of “buy it now” or, worse, “borrow to buy it now.” Whatever “it” is will probably cost more tomorrow.

The new economists have no monopoly on accurate diagnoses of the inflation malady. Economists everywhere agree that excessive federal spending, too rapid expansion of money, too much costly regulation by Government have been among the primary causes. But many of the experts admit to being puzzled about possible cures. This bafflement is not shared by the new economists. Observes former Treasury Secretary W. Michael Blumenthal: “Economists from the 1940s and 1950s just did not have a decent theory for productivity or inflation. It is only the new generation of Ph.D.s from the end of the 1960s onward who are asking these questions.” On the other hand, the solutions they propose will hardly be easy. Among the recommendations:

> Adopt consistent, year-after-year policies of moderate monetary growth so that inflation will be held back and people can plan ahead intelligently.

> Give long-term tax incentives to encourage saving and investment by individuals, entrepreneurs and companies.

> Avoid quickie tax cuts or fiddling with the federal deficit to stimulate consumer spending, and work instead to balance the budget.

> Reduce Government spending, in particular so-called uncontrollables such as social and pension programs that are committed by previous acts of Congress to rise and rise; by cutting spending, more money, more of the nation’s capital will be made available to job-creating private businesses.

> Soften or scrap wasteful and production-retarding Government regulations that devour capital but produce no wealth.

> Restrict Government’s overall role in the economy in order to enhance personal incentive.

> Above all, stimulate increased supply and production instead of increased demand and consumption.

The case for more consistency and less short-term meddling reflects the spreading awareness that efforts to manage effectively a complex $2.3 trillion economy is hopelessly beyond any government’s power. Admits one of the new economists, Thomas Sargent, 36, of the University of Minnesota: “We just don’t have the kinds of detailed knowledge to fine-tune the economy. We are further from that goal than we were ten years ago.”

Just as forcefully, the new economists argue that the Government can and should come up with specific programs to bring more goods and services to market, letting competition curb the price spiral. Economist Jerry Jasinowski, 40, Assistant Commerce Secretary for Policy, is one of many who believe that boosting supply is the only long-term antidote to rising prices. Says he: “We must admit openly that manipulation of demand via public expenditure, taxes and control over credit does not get to the heart of the problems of the 1970s and 1980s. The source of these problems lies not with the ability to consume but with the capacity to produce.”

The unsettling ideas of the incentive economists are becoming a new orthodoxy in much of Government. Last week the congressional bipartisan Joint Economic Committee issued a grave warning in its midyear report: unless major improvements are made in expanding the “supply side” of the economy by boosting saving and investment in order to lift productivity, the nation will face a drastically declining standard of living in the 1980s. Inflation will push prices up to almost incredible levels—$5.80 for a gallon of gasoline, $2.06 for a loaf of bread—even as unemployment itself stays high. But, wrote Chairman Lloyd Bentsen, the Democratic Senator from Texas, “this committee believes we can and we must produce our way out of our economic problems.”

Legislative and Administration leaders are pressing new policies to enhance production and supply. New Treasury Secretary G. William Miller, among many others, urges faster depreciation—that is, bigger tax write-offs for business spending on factories and tools—to spur capital investment in expansion, modernization and automation. Last year’s passage of a version of the Steiger Amendment to reduce capital-gains taxes and stimulate investment has boosted venture capital (the money that investors risk on new businesses) by 1,000%. To shift still more money into investments, Senate Finance Chairman Russell Long and House Ways and Means Chairman Al Ullman champion lower taxes on capital, profits and personal income, and correspondingly higher sales taxes.

Support is also building for proposals by Long and many other legislators to reduce income taxes on interest from bank accounts to encourage people to save instead of spend. Dollars put into saving are reinvested by banks in wealth-creating projects, such as home construction and factory expansion. That not only provides jobs but also slows rising prices by stimulating production. On the other hand, money spent on end-use consumer items, such as a car or TV, buys just one thing.

The incentive economists, and even many of their older, more traditional peers urge the scrapping of outmoded and costly Government regulations and programs that amount to little more than self-inflicted wounds on the economy. Not only do they often aggravate inflation and reduce productivity, but they frequently produce results that their well-intentioned authors never envisioned. Some of the programs have been around since the New Deal and have become patent sops for special interest groups. The nation needs more food, and at lower prices, but federal price-propping subsidies last year paid farmers some $2.2 billion in supports; and almost one-third of that was payments not to plant crops at all. The nation desperately requires all the domestic oil and gas it can find, but the Government’s five-year-old mishmash of domestic price controls encourages Americans to burn more oil and U.S. oil companies to do their exploring in other countries.

Some of the more recent regulations make the Government look like a neurotic nanny. Just one example: federal health rules require hospitals to use plastic liners for wastebaskets, but Government safety rules ban their use as fire hazards. Says Charles Schultze, chief White House economic adviser: “We have to regulate with more rationality and sensitivity. The major problem of Government management over the next 20 years will be management of the regulatory process.”

Making economic sense out of Government’s tax policies is a paramount concern of the incentive economists. One of the best known, and certainly most flamboyant, of them is the University of Southern California’s Arthur Laffer, 39, creator of the “Laffer Curve,” which he sketched on a napkin after dinner at the Two Continents restaurant in Washington, D.C.

The curve illustrates that after a certain level is reached, tax increases do not raise Government revenues but actually lower them. Reason: higher taxes discourage people from working or investing to earn more money since the Government simply takes it away. Conversely, lower taxes encourage people to work harder and earn more, leading to higher revenues. Thus the best way to increase Government income—as well as productivity, investment and general wealth—is to hold taxes low.

The incentive economists also urge predictability and stability in Government monetary policy. The University of Minnesota, home of Liberal Walter Heller, and the University of Chicago, where Milton Friedman did pioneering work in monetarist theory, have lately produced one money-oriented branch of the new economists, the “rational expectations” group. Their thesis: if politicians promise to cut inflation but pursue policies that just make prices rise faster, the people eventually will get the message and act on the rational assumption that inflation will keep increasing. Recognizing that savers are suckers, citizens will just spend their money as soon as they get it. Thus, in order to increase savings, the Government’s wisest course would be to keep the growth of money consistently low. People then would rationally expect inflation to diminish and, acting on that belief, would save and invest.

The intellectual leader of the young economists is Harvard’s Feldstein, a soft-spoken family man from The Bronx, whose looks and middle-class background and mannerisms call to mind a benign dentist. While most of his peers remain academically cloistered, concentrating on the higher mathematics and econometric concepts of modern research, Feldstein is at home in both academe and Government. He is equally comfortable pondering a regression equation for a computer program or testifying to a congressional committee, which he often does. Both political parties eagerly seek his counsel. He was an adviser to Jimmy Carter’s ’76 campaign, turned down a bid to join Gerald Ford’s Council of Economic Advisers, and is often spoken of as a future CEA chairman, probably in a Republican Administration.

Along with the other incentive economists, Feldstein argues that the Government is trying to do too many things that it either cannot do efficiently or that people can do better for themselves. That, of course, is a direct affront to Keynesian doctrine. Beginning in the mid-1930s, Establishment pillars of the dismal science have propagated Keynes’ captivating notion that governments could tame beastly economies, making them stand up and jump through hoops. His prescription succeeded in lifting Western countries out of the 1930s Depression that had been triggered by an almost complete collapse in demand both in the U.S. and in Europe. Keynes’ idea was simple enough: if people were so fearful of the future that they simply would not spend, government would have to prime the pump by doing much of the spending itself.

For almost 40 years the formula worked. Increased Government spending stimulated demand; companies hired more workers to meet the demand; then employees spent, bringing forth more demand and more production, and the virtuous cycle continued. But, says Economist Arthur Okun, long a Keynesian Counsellor to Democratic Presidents: “We were victims of our own success and a good press.”

There were shortcomings and pitfalls, little recognized when Keynesianism was flourishing a decade and more ago. One shortcoming was the Keynesian assumption that supply would simply take care of itself once demand was stimulated. So long as inflation stayed low, that is in fact what happened. Even modest increases in consumer demand would bring quick jumps in output. So productive were U .S. plants and factories that they not only filled the needs of the nation’s domestic market but also deluged the world with material abundance.

Between 1889 and 1970, the nation ran a trade deficit only once, in the midst of the Depression, in 1935. Yet since 1971, the combination of low productivity and high inflation has reduced both the supply and the competitiveness of U.S. products. Consequently, export growth has been sluggish, and foreign goods have poured into the U.S. at an ever increasing rate. Coupled with the nation’s increasing dependence on foreign oil, this has meant that the U.S. has managed to eke out a trade surplus only twice since 1971, running up a cumulative deficit of $59 billion in those years.

Meanwhile, shortages have begun turning up everywhere. Aluminum is in short supply, and such companies as Boeing and McDonnell Douglas must place their orders far in advance to have enough on hand to meet aircraft delivery schedules. Metalworking machinery is also scarce, as are the steel forgings needed by automakers. That, in turn, has helped create shortages of small, fuel-efficient cars, and boosts imports of competing foreign models. There is even a squeeze on fans for people who want to save money by turning off air conditioners, and shortages of insulation for homeowners who are eager to cut winter fuel bills.

True, Keynes argued that excessive demand and price rises could be countered by reversing the cycle—that is, by reducing government spending. But that required a degree of wisdom seldom seen in the spend-and-spend, elect-and-elect politicians of a democracy. Apostles of Keynes contended that to maintain the proper level of demand, the Government regularly had to “fine-tune” the economy with just the right amount of stimulus, either tax cuts or spending increases, or maybe both at once. As Feldstein puts it, the nonstop jiggling and juggling amounted to “an embellishment of Keynes beyond anything that he had claimed.”

The reckoning came with Viet Nam. Lyndon Johnson’s Keynesian economic advisers warned him not to finance both the war and his cherished Great Society programs without asking for a tax increase, but he refused to take the unpopular step until much too late. From 1965 to 1969, more than $42.5 billion in Government deficit spending flooded into the economy, which was already surging ahead at nearly full capacity. Result: inflation leaped from 2.1% in 1965 to 6% in 1969.

No quick fixes have lastingly slowed the spiral. Temporary cuts in Government spending, coupled with a tight rein on monetary growth, as Richard Nixon tried in 1969, brought on recession and aggravated unemployment, but inflation stayed strong. Freezing wages and prices, as Nixon did in 1971, merely built up pressure for huge price increases later on.

The period from 1975 to the spring of 1979, when the third recession of the decade probably began, is often called “the longest peacetime expansion in U.S. history.” Some expansion! Unemployment stands at almost 6%, and to keep the rate from climbing even higher than its 1975 recession peak of nearly 9%, both the Ford and Carter Administrations have had to stuff the people’s pockets with almost as much inflationary funny-money, in the form of Government deficit spending, as was generated in all of World War II.

Inflation has, of course, been seriously aggravated by a host of outside or “exogenous” factors that lie beyond the power of economists to control. They cannot be held accountable for poor grain harvests, such as occurred in 1972, for the harsh winters of 1977 and 1978, or for the weather of last year that cut into harvests in the citrus belt. Government economists also argue that price gouging by foreign oil producers is exogenous. True, but only partly so. Not only did inflation in the industrial countries encourage the 13-nation OPEC cartel to quintuple its prices in 1973-74, but the accelerating U.S. price spiral provides the cartel with its only excuse for raising its prices still higher.

When demand turns slack and unemployment shoots up, Keynesianism can still play an important role. But now the economic pendulum has swung from underutilization of capacity to overstraining of productive resources, and policies aimed at further firing consumer demand without simultaneously increasing investment and supply have become about as useful as Gerald Ford WIN buttons. Says Feldstein: “It is a much more complex world than Keynes or anyone else admits, and it is constantly changing. We know enough to move the economy out of a trough but not to control the business cycle.”

Observes Bruce MacLaury, president of the Brookings Institution, which is no longer quite the hotbed of Keynesianism that it once was: “It has been hard for the Keynesians to contend that their prescriptions are the way out of stagflation. Ultimately, they are forced to admit that Keynesian techniques just bring forth inflation and not real growth. They answer that the solution is wage-price guidelines or another form of an incomes policy, but that is a very weak reed to lean on.”

Not only in the U.S., but in countries as disparate as Sri Lanka, Canada and Algeria, there is an attraction to the new, incentive economics. Among developing nations, those that have prospered most have had the freest, most market-oriented economies: Singapore, Taiwan and South Korea, among others. In industrial Europe, incentive economics is making particularly rapid progress:

> In France, Premier Raymond Barre is scrapping much of the policy, which dates back to Louis XIV, that the government should determine the amount of investment and fix prices. Controls on goods from bread to books, from steel to cars, have been freed. State-owned companies, which control more than 25% of France’s economy, have been instructed to operate as if they were private enterprises by relying less on subsidies and making a determined effort to turn a profit.

> In Britain, Margaret Thatcher’s Tory government was swept into Office in May on a tide of popular fury at the dismal results of Labor rule and is now rapidly unwinding much of the high-tax, nationalized welfare state. Income tax rates have been reduced from a top of 83%, to 60%; a third of Britain’s nationalized North Sea oil industry has been put up for private sale; and the government now has plans to sell off its shares of other state industries, including British Airways.

> In West Germany, Chancellor Helmut Schmidt’s Social Democratic government, supported by powerful but reasonable trade unions, has largely held a noninterventionist course and ignored demands that the government cut taxes or raise spending every time a troubling economic forecast is issued. Result: West Germany’s inflation rate is one-third as steep as the U.S.’s, its unemployment rate is only slightly over half as high, and the country’s living standards are rising.

The economies of Europe and Japan already benefit from government programs that encourage saving. While Americans save little more than a nickel of every dollar of take-home pay, the Japanese save 20% or more, inpart because they have no well-developed system of social welfare and must provide for their old age themselves. Citizens of major Western European countries, which have more substantial social welfare programs, save from 13% to 17% of their disposable income anyway.

A big stimulus to saving in Europe and in Japan is government tax policy, which exempts at least some interest income from taxation or offers premiums to savers. In the U.S., interest is sometimes considered “unearned” and taxed at higher than normal rates. Yet in France, savers can deposit up to $9,600 and receive the maximum 6.5% interest taxfree. In West Germany, couples earning up to $26,300 can put up to $900 in a six-year term account and earn not only 4.5% but also receive a tax-free government bonus payment amounting to 14% of the deposit. In Japan, savers do not have to pay taxes on interest from deposits of up to $65,000.

More than 50 bills have already been introduced in Congress to give Americans similar inducements. Most proposals focus on exempting income hi varying amounts up to $4,000, though the greatest support seems to be building behind a Republican-backed bill by Missouri Senator John Danforth to exempt up to a more modest $400 in interest income if the money is reinvested in either stocks or saving. In the U.S., it will take years to reduce inflation’s bloat, revive productivity and restore real growth. More and more evidence is accumulating that a slow and persistent effort is the best hope for turning the economy around.

It would be tempting to try to fight unemployment by temporarily increasing federal deficit spending and hoping that merely shoveling more money out to consumers would encourage companies to hire workers and expand production. But the 1970s proved that such erratic pumping-up policies only inflate the economy without significantly reducing unemployment.

A basic reason, say Feldstein and other incentive economists, is that much of the unemployment problem has become structural, that is, deeply imbedded and immune to quick fixes. More than half of the nation’s 6 million unemployed—many of them blacks, Hispanics, teen-agers or poorly educated rural people—are out of work not because of a lack of jobs but because they need marketable skills. Warns Feldstein: “If we do not attack the structural causes of our high unemployment, we will face growing pressure to deny firms the right to lay off workers without Government approval, and deny those workers who lose their jobs the right to decide where and when they will return to work.”

Feldstein’s solution is to train these work seekers, with the help of private companies, for particular jobs without inflating the whole economy. Initially, Feldstein concedes, unemployment might rise from the present 5.7% to about 8% and stay there for perhaps as long as five years. But society in general would benefit because this period of slack would reduce pressure on prices. Meanwhile, the unemployed would be taken care of through existing unemployment programs.

High unemployment, of course, would complicate the Government’s budget problem by retarding tax revenues and raising outlays for unemployment compensation and other social programs. The new economists would counter this by reducing spending, or at least the growth of spending, in other areas. Their targets are notably the large number of subsidies to the employed middle class and prosperous industry, handouts as varied as farm price props, generous Civil Service retirement benefits, and subsidies for shipping lines.

In the view of the incentive economists, and an increasing number of Keynesians, long-term progress against inflation can be achieved only at the cost of short-term pain. Gains will require a long period of slow but steady growth of the money supply and a shrinking of total Government spending as a share of the nation’s output of goods and services. Economist Robert Lucas, for example, calls for limiting the growth of money to around 4% a year, less than half the average of the 1970s, for at least three to four uninterrupted years and preferably for as long as seven. That would purge the public of its assumption that the Government has no stomach for holding to a steady anti-inflationary course that would encourage saving instead of spending. But keeping money tight would push up interest rates and aggravate the economic slowdown that politicians instinctively fear.

Fitfully, the Government appears to be moving toward the incentive prescription. Asserts Treasury Secretary G. William Miller: “For too long we have focused on consumption and have not invested enough in productive capacity.” Not only is the Federal Reserve now tightening money but federal spending as a share of gross national product has declined from 22.6% in 1976 to 21.1% currently, and President Carter aims to get it even lower in fiscal 1981.

Feldstein foresees that these developments, if they continue, would enable growth to be spurred on not by inflationary Government spending but by productive private investment. While consumer buying would slow, saving and business investment would rise. In brief, the total demand in the economy would be no lower, but the mix would be different.

Ultimately, the challenge is whether the nation has the will and the determination to take the necessary hard steps. Observes a humbled Lester Thurow, onetime economic adviser to George McGovern during his 1972 presidential campaign: “When there are economic gains to be allocated, our political process can allocate them. But when there are large economic losses to be divided up, the process is paralyzed. Unfortunately, with political paralysis comes economic paralysis.”

The U.S. is by no means paralyzed, but it is at a significant turning point. From Congress to the statehouses, the tax-reforming, investment-boosting, regulation-cutting, supply-expanding recommendations of incentive economics are gaining more support every day and are being increasingly translated into policies. If those beneficial trends continue, the 1980s may yet become the beginning of the good new days.

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