The Failure of Economic Management

PRESIDENTIAL ECONOMICS by Herbet Stein. Simon and Schuster, $16.95.
FEW THINGS IN life are quite so shattering as the loss of illusion. This has, in part, been the national experience of the past decade. In the early 1970s, Americans had the idea—fed to them by politicians and economists— that once-frequent economic cycles and disturbances had been eradicated. Not only had we stilled the social turmoil caused by downturns in the business cycle but we had harnessed the economic machine for the greater good. We could, we thought, count on an ever-rising stream of national wealth for the continual perfection of our democratic society.
Now we recognize that the celebration was at best premature. Economic fluctuations and disruptions reappeared wdth a vengeance in the 1970s. The expansion of national wealth slowed, then stopped, making us more conscious of choice and scarcity. The common question is: What went wrong? But that is not the right question. And the great virtue of Herbert Stein’s new book is to show that it is not the right question.
As a people, Americans personalize politics and policy: we say that President Carter’s or President Reagan’s policies failed and, having said that, find new hope in a change of administration. But Stein, an economist who was the chairman of the Council of Economic Advisers from 1972 to 1974, shows that our failure has been much deeper and less personal. We have, he indicates, a government as much of moods as of mortals. Certain ideas, tempered by experience and circumstance, have conditioned government policy, and the dominant players—Presidents, their advisers, and Congress—fall captive to these moods. The mood that seized the national spirit in the 1960s—and still maintains a strong grip—was, frankly, utopian. During the Kennedy-Johnson years, the national government assumed an unprecedented responsibility for economic well-being. The Kennedy—Johnson economists argued that we could manage the economy to assure full employment and to maximize output without triggeringinflation.
We are still living with this legacy. It created a political and psychic ideal to which all subsequent politicians have been held and have held themselves. Stein relates the striving, and his story—told lucidly and wittily, if sometimes at excessive length—is one of almost continual failure. Since the early 1960s, we have had more than a dozen major tax bills, starting with the huge Kennedy-Johnson tax cut of 1964 and ending with the large 1982 tax increase. We have also had voluntary wage-price guidelines (1962-1967 and 1978-1979), a wage-price freeze and mandatory controls (1971-1974), a flirtation with credit controls (1980), a devaluation of the dollar (1971), the abandonment of the system of fixed exchange rates (1973), and a major shift in Federal Reserve monetary policy (1979). The ideal remains elusive.
It remains elusive because it is unattainable. The story of the past twenty years is not that we have done a bad job striving for the doable but that by attempting the undoable we have made an imperfect world worse. The relevant question becomes: Why did we buy the promise in the first place? Up until the Depression, hardly anyone believed that economic cycles could be eliminated. They were considered an inevitable part of life’s uncertainty.
Now, as a nation, we find ourselves trapped between experience and expectations. We expect the government to achieve full employment along with little or no inflation. But experience teaches us that efforts to attain this ideal are doomed to failure. We search continually for some new idea that will fulfill the promise rather than questioning whether the original expectation was ever realistic.
A huge void between expectation and reality has opened in American economic and political life. The government is simply too large (federal spending now equals a quarter of national output, up from about 3 percent in 1929) to disengage itself from economic management. And Stein is almost certainly correct in his belief that we know more now than we did fifty years ago and are better equipped to influence the economy. But he is equally correct in arguing that the perfectionist objectives of the 1960s and early 1970s—namely, steady growth at full employment and with stable prices—exceeded the competence of both economists and government. Without a better matching of expectations and possibilities, we risk falling prey to crackpot cures. The potential is already evident from both right and left; the exaggerated claims for “supply-side economics” in 1980 and for “industrial policy” today attest to it.
TO UNDERSTAND OUR present predicament, we have to revisit the late 1950s. By comparison with Depression America—the frame of reference for most adults—America in the fifties was enormously prosperous. People were buying homes, appliances, and cars at an amazing clip. Indeed, there were serious suggestions that Americans were so sated with consumer goods that, without the come-on of advertising, the economy might collapse, because people wouldn’t feel the need to buy anything more. Still, the economy’s performance was far from perfect. By the time of the Kennedy presidency, there had been four postwar recessions: in 1948-1949, 1953-1954, 1957-1958, and 1960-1961. It seemed to many economists that these downturns, although mild by pre-war standards, were especially wasteful, because they were unnecessary.
These economists’ ideas—ultimately embraced by Presidents Kennedy and Johnson—were fundamentally conservative. They did not involve abolishing capitalism or even modifying it significantly. They were aimed at making it work better. Economic instability hurt everyone: business, because profits suffered and uncertainty discouraged investment; workers, because they experienced periodic bouts of joblessness; and the hard-core unemployed, because they could rarely get jobs at all. If business cycles were moderated or eliminated, everyone would be better off. Moreover, increased stability and affluence would allow the government to smooth capitalism’s rough edges. If the economic pie expanded, the nation could be more generous. The government could aid those who fared least well under capitalism. Increased social spending would reinforce public support for an economic system that, to these economists, was fundamentally efficient and compatible with American political ideals.
As these economists saw it, the economy could be described in fairly simple terms. At any moment you could estimate its theoretical peak output, which would increase from year to year, because both the labor force and overall efficiency (in the jargon, “productivity”) were growing. Plotted on a chart, the economy’s theoretical capacity would thus be a gently sloping upward line. If actual output (the gross national product) fell below this theoretical peak level, the government could move it closer to the ceiling by spurring overall demand. It could do this by increasing spending or cutting taxes; the effects of various policies could be projected, because different tax or spending changes would affect consumer and business spending. The main technical task for economists was to refine their estimates of these secondary effects, so that the government could be more precise in its fine tuning.
IT SEEMS TOO good to be true—and it was. If we examine how the Kennedy-Johnson economists thought the world operated and then look at how it actually operates, gaps appear. Economists did—and do—debate the theoretical correctness of these ideas. But the main flaws do not involve esoteric matters of theory so much as common sense.
First, economists in the early 1960s assumed, or at least hoped for, a benign politics. Even if their theory was perfect, it required political cooperation. When the economy was below the fullemployment level, the government would provide stimulus. But there was also the possibility that the economy might sometimes exceed its theoretical capacity. For a short time, this could happen relatively painlessly, because workers would work overtime and firms would strain the capacity of existing equipment by, among other things, deferring maintenance. But if it continued, it would simply produce inflation: firms would compete for scarce workers by bidding up wages and would exploit excess consumer demand by raising prices. Logically, then, the government had to prevent this overheating by enacting tax increases or spending cuts. The politicians who had cheerfully voted benefits for their constituents (tax cuts or spending increases) would need to reverse themselves just as cheerfully.
This was not to be. In 1965, Gardner Ackley, chairman of the Council of Economic Advisers, proposed a tax increase to President Johnson to suppress incipient inflation. Johnson rejected the proposal, in part because he didn’t think Congress would pass it. He was, of course, right. He finally advanced a surtax, in 1967, but Congress did not adopt the measure until June of 1968. By that time, the virtual price stability of the 1950s and early 1960s had been lost; between 1960 and 1966, inflation had risen from one to 3 percent, and it kept rising.
The episode revealed an inherent imbalance in the politics of economic management. It is very difficult for politicians to take action—especially unpleasant action—against a problem until the problem seems compelling. By that time, though, action tends to be tardy. The point of economic management is to stabilize the economy, but a political system that requires signs of instability before it can act makes the process self-defeating.
A second flaw lay in the contradiction between price stability and the pledge to maintain full employment. The conventional wisdom of the early 1960s was that any inflation could be quickly cured by a brief, mild recession. If rising prices reflected excess demand, then a period of slack demand would dampen them. Experience proved otherwise. When the Nixon Administration tried this approach in 1969 (the economy had been in a period of continual expansion since 1961, and inflation had risen to more than 5 percent), inflation subsided only slowly and stubbornly. Even in 1971, it was 4 percent; this was not the stability economists had expected.
Why? Firms and workers apparently took the full-employment pledge seriously. Naturally, workers wanted to enhance their living standards, and firms wanted to improve their profits. With the government committed to full employment, wage and price restraint was pointless: if there was a slump, the government would quickly revive demand. Even for employers with non-unionized workers (who now make up about 75 percent of the total work force), wage restraint risked damaging morale and losing good workers, who could find new jobs in an economy of full employment. Economists such as Arthur Okun, a chairman of the Council of Economic Advisers under President Johnson, quickly recognized that lack of wage restraint and other types of inflationary behavior were perfectly sensible.
A dilemma arose: the promises of full employment created precisely the sort of inflationary pressures that the government was committed to combating. Moreover, any rise in inflation undermined the whole point of economic management—reducing uncertainty and promoting stability—because rising inflation created uncertainty and instability. Reacting to inflation, firms and workers indexed contracts to past price increases, thus further institutionalizing inflation.
A third basic flaw in the economic vision of the 1960s was its sheer simplicity. To enhance the illusion of mastery, economists assumed away many problems. Perhaps the most important of these was the increasingly international character of economic activity. Economists regarded the American economy as a self-contained whole that would be influenced almost exclusively by American actions. To be sure, they recognized international pressures, but did not consider them very important. If outside influences were negligible, domestic control could be asserted; the assumption was comfortable and, for a traditionally self-sufficient nation, entirely natural.
Unfortunately, it was wrong. In the 1970s, global events decisively affected the American economy. Basic grains had become part of a worldwide market; therefore, large Soviet purchases, combined with a poor U.S. corn harvest in 1974, sent U.S. food prices soaring. Oil and energy prices had also slipped beyond American control, as the price explosions of 1973-1974 and 1979-1980 proved. Unhappily, world markets react to unpredictable political as well as economic forces. And the changes extend beyond these dramatic disturbances. From 1960 to 1981, exports rose from 4 to 8 percent of GNP; imports increased from 3 to 9 percent. For many U.S. firms and workers, success or failure often hinges on exchange-rate fluctuations (which alter import and export prices) and other nations’ wage rates, over which the United States has little, if any, control.
Another self-serving simplification was the assumption that living standards would rise automatically. Economists did not pay much attention to how this improvement actually happened. American business was presumed to perform this job by constantly increasing efficiency through new technologies, products, and methods of organization. Economic policy would maintain overall demand, and business would oblige with annual productivity increases of about 3 percent. Because most economists took the increases as given, they were as stunned as everyone else when the gains suddenly slowed and halted, in the 1970s. Not understanding what had happened, they were relatively powerless to suggest ways to reverse the trend.
IF THE CONCEPT of economic management is so flawed, how did we fall under its spell? An uncharitable answer is that economists oversold their ideas, because it suited their interests to do so. A high government job can be an intoxicating, if also frustrating and exhausting, experience. Top government economists meet with Presidents and congressmen, and their views receive heavy publicity. In short, they attain celebrity status.
Stein is rare among economists for acknowledging these lures. He was one of sixteen officials at Camp David in August of 1971, when President Nixon decided to freeze wages and prices and abandon the gold standard (after that, the U.S. Treasury stopped freely exchanging dollars held by foreign governments for gold). Stein vehemently opposed wage-price controls; so did some other economists. Still, the Camp David experience was exhilarating. The economists were constantly reminded of “their unique value,” Stein writes. “|T]he Navy personnel in attendance were unfailingly helpful and courteous, treating everyone as if he were a full admiral.” Until the Kennedy-Johnson years, economists could not fully partake of the pleasures of power; at best, they had modest public standing. What they learned in the 1960s was how to package their ideas in politically useful and understandable forms. The lesson endures. Any economist, regardless of party or ideology, who now wishes to be taken seriously politically must be part salesman. Many are.
But the triumph of their ideas cannot be attributed simply to shrewd self-promotion. The 1960s marked the completion of a process, begun in the 1930s, of shifting economic authority to government. The economic tacticians of the 1960s may have been self-serving, but their enthusiasm for change was genuine. They reflected the prevailing optimism and impatience with old ways. They deplored an almost willful indifference to sophisticated economic thinking, arguing that the country was, in effect, ignoring a new technology. A more charitable explanation of why they failed is that they knew far less than they thought they knew.
To a large extent, economists in the 1960s remained prisoners of the Depression, which was the decisive influence on postwar economic thinking. What distinguished the Depression from earlier business slumps was its duration. Economists had generally assumed that business downturns automatically generated the seeds of recovery: prices, wages, and interest rates dropped, making business and investment opportunities profitable. But strong recovery and prosperity did not re-emerge in the 1930s. This seemed to throw the existing body of knowledge into disrepute, and required explanation. John Maynard Keynes argued, contrary to dogma, that the economy could settle in a permanent state of underemployment. Wage-and-price declines would not inevitably generate an upturn. Likewise, interest rates might already have dropped so far that further declines would be impossible.
Keynes’s thinking justified government intervention to break out of the underemployment equilibrium. By contrast, the previous assumption of a natural full-employment equilibrium (from which the economy might deviate but to which it would tend to return) implied—or at least rationalized—passivity. But Keynes’s ideas (he died in 1946) took several decades to achieve popular acceptance. Contrary to popular impression, President Roosevelt did not energetically embrace them, and the ideas he did embrace did not end the Depression. Unemployment in 1939 was 17.2 percent, lower than in 1933 (24.9 percent) but higher than in 1931 (15.9 percent). War ended the Depression. In 1944, unemployment was 1.2 percent.
What the Depression actually changed was popular attitudes toward business, government, and individual responsibility. It savaged the authority business leaders had enjoyed in the 1920s and weakened the common faith in self-reliance. Bank failures, personal bankruptcies, and overoptimistic recovery predictions made business leaders seem as confused and helpless as everyone else. And no one could argue that people in the 1930s suffered because they were irresponsible or would not work. Greater forces were involved. Then the war provided confirmation that government’s economic powers were huge.
And so, as Stein relates, a postwar social consensus amalgamated these experiences, while also muting the struggles of the 1930s between business and the New Deal. Congress passed the highminded Employment Act of 1946. Government (not business) assumed responsibility for the economy and was to ensure “maximum” employment. But “full employment” was deleted from the bill, and the law left vague how the government would fulfill its responsibility. This was not a popular embrace of Keynesianism. In fact, government policies probably did not contribute much to early-postwar prosperity. Economic performance in the 1950s was no better, and arguably worse, than that in the 1920s. Neither President Truman nor President Eisenhower sought to steer the economy by manipulating spending or tax decisions.
THE KENNEDY-JOHNSON economists saw themselves as completing the political acceptance of Keynes’s ideas. But, ironically, intellectual support weakened just as political support strengthened. The more economists examine the Depression, the more uncertain they become about its causes. Milton Friedman, for example, has argued that the Federal Reserve Board lengthened the Depression by allowing the money supply to decline one third between 1929 and 1933. Lacking sufficient loan funds, banks called in loans, and firms went bankrupt. Unemployment increased; wages and prices declined. As they did, it became more difficult for debtors to repay loans. But, in Friedman’s view, the Fed kept driving this process by permitting the continual fall in the money supply. Friedman, not surprisingly, sees government action (not inaction, as for Keynes) as the key. Nor is his the only alternative explanation of the collapse; contrary, perhaps, to widespread impression, there is no consensus.
This puts us back to square one. Keynesianism argued that government had to run the economy—that is, manage overall demand—because the economy could not run itself. Government would minimize economic swings. But the choice is more ambiguous. It no longer suffices to argue that the private economy fluctuates; it always has. Left alone, it will have its ups and downs. But neither is government intervention necessarily stabilizing; it may inject new sources of instability and uncertainty— for example, rising inflation. The critical question is whether this active intervention makes the economy more or less stable.
Stein favors a relatively passive policy, because he believes the alternatives are worse. This does not mean a donothing policy, which is impossible. The government has a budget, and the Federal Reserve regulates credit conditions and the money supply. The issue is whether these tools should be actively committed to full employment and maximum growth, or whether (as in the 1950s) they should be set to allow the best growth the private economy can produce. Even the latter choice, of course, requires technical judgments on budget and Federal Reserve policies, which would always involve disagreement. For example, it does not mean continually balanced budgets—deficits and surpluses might occur over different parts of the cycle.
But this approach would substitute an inflation range—probably 0 to 2 or 3 percent—for economic growth and unemployment goals. As Stein writes: “Enough [is] known to permit avoidance of long-continued cumulative inflation, even if not enough [is] known to keep the price level stable from year to year.” The presumption is that, over time, growth and unemployment will fare better if left alone than if the government consciously pursues high-growth and low-unemployment targets that risk a debilitating inflation. The experience of the past three decades provides strong circumstantial support for this approach. The early success of the 1960s (high growth with low inflation) derived in part from the price stability of the 1950s. But by the 1970s, the economy had to deal with the inflationary side effects of those policies. Almost all the comparisons favor the 1950s.
1950s 1960s 1970s
Average Annual
Unemployment 4.5% 4.7% 6.4%
Average Annual
Inflation 2.1% 2.8% 7.9%
Average Annual
Productivity Gain 2.6% 2.8% 1.4%
DESPITE THE EXAMPLE of the fifties, the prejudice persists that government must run the economy or it won’t run. Unfortunately, Stein makes no effort to convince the unconvinced. Possibly, he thinks the history of failed government policies is enough. Probably, it isn’t. Reviewing the 1970s, some economists attribute the economy’s poor performance to “special factors”—mainly, foodand oil-price explosions. But this argument, which leaves the case for active government economic management undisturbed, is either disingenuous or shortsighted. Almost every decade has special factors; the 1950s had the Korean War and virulent national strikes. Any theory that requires a tranquil world for it to work is of little practical use. Fundamentally, what can be held against the vision of the 1960s is that it implicitly promised that government could achieve such tranquillity—shifting to government much of the responsibility for eliminating all unpleasant economic change that threatened this ideal state.
The individual discipline that firms and workers impose on themselves when faced with uncertainty was weakened. Inflationary behavior was almost inevitable. Constant change is the essence of economic life. By becoming responsible for what was unpleasant, the government Inexorably made the economy less flexible. People expected full employment and steadily rising living standards. When outside events (such as higher oil or food prices) frustrated their expectations, they did not accept temporary setbacks. They wanted higher wage increases (which ultimately meant higher price increases, not higher living standards) or government controls (on oil). Many industries facing more-intense foreign competition did not become more competitive but instead demanded more government protection. No government can accommodate the accumulation of unrealistic (even if understandable) expectations. But the 1960s mood, perpetuated into the 1970s, encouraged this flight from reality.
Many economists still proclaim that the blissful state of constant full employment plus low inflation can be brought about by “incomes policy.” This refers to either voluntary or mandatory wage-price controls. Neither the acknowledged difficulty of implementing such schemes (“The subject is still wide open,” says one respected advocate, even though it has been studied for two decades) nor widespread disappointment with their results dampens their popularity.
There is something socially destructive and self-serving about this sort of economic advocacy. By telling politicians what they want to hear, economists maintain their political relevance. But, in the end, their proposals tend to be counterproductive. As ideas, they divert attention from the fundamental limits of government’s economic competence. As policies, they tempt government to overstimulate the economy, aggravating scarcity and inflation; this undermines wage discipline or requires formal controls. Meanwhile, firms and workers are distracted from the necessity of maintaining self-restraint. Ultimately, brutal reaction against excessive inflation brings the high unemployment that everyone initially sought to avoid.
What’s needed is a new political compact, comparable in purpose—but different in direction—from its Kennedy-Johnson predecessor. No sensible person ought to want (and Stein clearly does not want) radical political changes. Private firms would continue to conduct most economic activity, and government would exercise welfare functions—that is, blunt the social arbitrariness of free markets. But Stein would have welfare focus more directly on the poor, and would explicitly retreat from the full-employment promise. If business cycles are inevitable, this need not mean permanently high unemployment. The history of cycles shows them to be self-correcting. Typically started by economic excesses—too much investment, too much speculation, overbuying of one sort or another—they tend to be halted by liquidations and price declines. For whatever reasons, the Depression was exceptional; the private economy tends to grow on its own.
Moreover, the prospect for mild fluctuations (as in the 1950s) is probably better now than before the Depression. Government now has greater control over the money supply and credit conditions. Before the Depression, the gold standard—that is, the government’s commitment to exchange gold for a fixed number of dollars—automatically changed these conditions. The Federal Reserve can now prevent abrupt and deflationary declines in money; this added discretion, while creating a potential in the other direction for inflation, may also explain why the recessions up to the 1960s were comparatively mild. The severity of the past two recessions reflects the severity of the previous inflations.
Nothing is more difficult for a political system than to admit its own limitations. Even with three recessions in the past decade, we have not yet arrived at a new consensus. There is still no deep understanding of inflation’s disruptive effects, nor of the self-defeating nature of the conscious pursuit of full employment. Although his policies differed from those of his predecessors, President Reagan’s 1980-1981 utopian promises belonged to a long tradition of overblown rhetoric. His Democratic critics still peddle battered versions of the vision of the 1960s. Government that constantly inflicts failure on itself—by creating expectations of impossible success—risks undermining public support and inducing increasingly unstable and desperate policies. Ideas hold enormous sway in politics. Keynes was right when he wrote that practical men are often prisoners of some long-dead economist. The ideas and strivings of the 1960s were understandable in their time. But they have more than outlived their usefulness.