20 Century20 CenturyCreated 2/24/1997
Go to Brad DeLong's Home
Page
J. Bradford DeLong
University of California at Berkeley and NBER
February 1997
- Elections: Margaret Thatcher and Ronald Reagan
- The Supply Side
- The Medium Term Financial Strategy and the Falklands War
- Weak Claims and Weak Claimants
- The Social Insurance State under Seige
The diagnosis of American economic distress that the Republican coalition elected in 1980 carried with it had several parts. The first part was that the U.S. in the late 1970's had a high rate of both infiation and unemployment because earlier governments had been unwilling to accept moderate unemployment. As Herbert Stein wrote in the late 1970's:
the main reason we have such a high rate of infiation difficult to reduce, is that we now have a history of a high rate of infiation and that the announcement of government intentions to curb the infiation has little credibility.I think theemphasis on fiscal and monetary restraint was correct and our mistake was in not realizing how critical it was. We did not recognize how difficult it would be to reverse course once we had gotten on to the infiationary path, and therefore how essential it was not to set foot on that path. This isa reminder of how essential it is to get off that path before we move much further along it
The first principle, therefore, was to fight infiation, and to accept whatever unemployment was necessary no matter how high it might go in order to reduce infiation from nearly 10 percent to a level at which it would once again be so low as not to be a major element in workers', firms', and investors' calculations. Monetary policy was to be turned over to Federal Reserve chairman Paul Volcker-who had already decided that his job was to lower infiation no matter what the cost-and he was to be allowed free rein. Soon, the administration and its supporter believed, the fact that a strong Federal Reserve chairman had been given a blank check to stop infiation would lead people to expect that infiation would be stopped, and so they would no longer be building infiation premia into their demands for wage raises or interest payments.
The second principle was that much of what had gone wrong in the 1970's was the fault of too large a government. Therefore the government needed to shrink. Too many of its policies and programs were destructive. As Martin Feldstein put it:
Expansionary policies were adopted in the hope of lowering the unemployment rate but without anticipating the infiation. High tax rates on investment income were enacted and social security retirement benefits were increased without considering the subsequent impact on investment and saving. Regulations were imposed to protect health and safety without evaluating the reduction in productivity that would result or the effect on an uncertain regulatory future on long-term [activities].[T]he government never considered that [high]unemployment benefits would encourage layoffsthat Medicare and Medicaidmight lead to an explosion in health care costs; that welfare programsto help [the] poormight weaken family structures; or that federal aid through the tax lawsto encourage [suburban] homeownership would have such adverse effects on the cities, precipitating relocation of businesses [to the suburbs] and [creating] poverty and other problems for those left behind...
The perception that there were substantial fiaws in the fabric of the welfare state was not wrong. Why, in Britain, did social democratic education policy turn out to give children of doctors and lawyers the right to go to Oxford without paying for it? The system was fiawed when social democratic industry policy used the nationalized "commanding heights" of the economy not to accelerate technological progress and keep employment high, but rather to retard the shift of labor out of "sunset" industries.
The sociologist T.H. Marshall had looked forward to an extension of the concept of equal rights to equal social and economic rights: the right to work, the right to an education, the right to a fair and equal share of what society can produce. This extension stalled: you had a right not to a share of society's wealth but to opportunity and to social insurance. You can only buy insurance in proportion to your resources. And opportunities can either be seized or missed. Taken all in all, it was possible to argue that late twentieth century social insurance states placed most of the tax burden on the relatively poor, while providing services-subsidized higher education systems, air traffic control systems, subsidized broadcasting systems, unemployment insurance payments that varied proportionately with pre-unemployment wages, and so on-that were at least as much use to the rich as to the poor.
The chosen instrument to use to enforce a reduction in the size of the government was a tax cut. Tax cuts are always popular. A new tax cut enacted by a new president would be very popular and, politicians and strategists calculated, would greatly weaken opposition to subsequent spending cuts: for the alternative proposed by those who wished to maintain spending would then necessarily include large budget deficits as a consequence. This tied into the third principle: tilt the distribution of income in favor of the rich. Industry should be rewarded, and sloth punished. The rich were industrious. Moreover, the rich saved and invested, thus enriching everyone in the future. The third principle, therefore, was to tilt the distribution of income in favor of the rich by cutting their taxes most.
Things did not work out well. Two other considerations got added to the political stew at the beginning of the 1980's. The first was the the partisan claim that the Carter administration had dangerously weakened the U.S.'s defenses vis-a-vis the Soviet Union. Ironically, the decade to follow would see the weakness of the Soviet Union become obvious as the process of reform began. Steps would be taken by Republican administrations to gradually cut the defense budget as a share of total national product far below what the Carter administration had planned. And the rapid restoration of the emir to Kuwait would show that the technology gap between NATO and Warsaw Pact equipment had always been immense, and thus that NATO forces in Europe had always been far, far stronger than necessary to stand off a Soviet offensive.
In the short run of the early 1980's, however, the Reagan administration planned a massive buildup of the armed forces, and thus an expansion-not a contraction-of the size of the government.
The second consideration was the unwillingness of the administration to be to identify in advance which programs and subsidies would be cut in the shrinking of the government that the administration to be had planned. To reduce anxiety, politicians looked benignly on and encouraged the growth of the story that no spending cuts at all would be required: the tax cut alone and the lifting of the hand of regulation from the economy would create such a spur of economic growth that even domestic programs could be expanded, not contracted.
No one with a quantitative grasp of the government's budget and its pattern of change ever meant this story to be taken seriously. But administration makers welcomed its dissemination. Policy elites assured each other that their candidate would say a lot of silly things before the election, but that the candidate and his principal advisors understood the important issue. Tax cuts were to be followed by a ruthless attack against "weak claims" on the federal budget: programs like farm subsidies, subsidized student loans for the relatively rich, the exemption from taxation of social security income, the subsidization of the southwest's water projects, and so forth would themselves be slashed in order to balance the budget after the tax cut. "Weak claimants"-people for whom government subsidies and assistance truly served as a "safety net"-would be protected, while "weak claims" would be reduced.
But too many of the Reagan administration's allies and supporters claimed, after the election, that they had taken this story seriously. They would not support spending cuts, for they were the "weak claimants" whose subsidies and programs were to be targeted for reduction. These two factors-the expansion of the military budget and the claim by key legislators and infiuence peddlers that the Republican trip they had purchased was not for a tax cut and spending cut, but just for a tax cut-left the United States with large and only gradually controlled budget deficits throughout the 1980's. Previous decades had seen one or perhaps two years of large budget deficits in recessions. Previously, large budget deficits had been seen only in years of deep recession. But the 1980's saw budget deficits, very large by the standards of the post-World War II era, persist throughout years of prosperity and low unemployment as well.
Large budget deficits threatened to become a drag on the American economy. Funds saved might not now be invested-they might be borrowed by the government and used for current spending. The large budget deficits of the 1980's thus threatened to seriously reduce the rate at which the United States' capital stock grew. This would have had extraordinarily destructive effects on economic growth.
This was especially bitter for those who had worked very hard to elect a Republican administration because they thought that Democratic administrations were pursuing policies that reduced investment in and thus impoverished America's future because"the long-run benefits" of investment "apparently lie beyond the political horizon"-beyond, that is, the Democrats' political horizon. They had hoped to elect an administration committed to increasing savings and investment-to lowering taxes on those who did save and invest-in order to empower America's future. Yet the large budget deficits of the 1980's created by Reagan's administration threatened to be an order of magnitude more destructive of America's economic future than any of the infiationary, redistributive, or regulatory policies pushed by Democrats had been.
The deficits did, however, do substantial indirect harm: for more than half of the 1980's the U.S. dollar was substantially overvalued as the U.S. budget deficit sucked in capital from outside and raised the exchange rate. When a domestic industry's costs are greater than the prices at which foreign firms can sell, the market is sending the domestic industry a signal that it should shrink: foreigners are producing with more relative efficiently, and the resources used in the domestic industry should be transferred to some sector where domestic producers have more of a comparative advantage. This was the signal that the market system sent to all U.S. manufacturing industries in the 1980's: that they should cut back on investment and shrink. In this case, it was a false signal, sent not by the market's interpretation of the logic of comparative advantage but by the extraordinary short-run demand of cash to borrow from the U.S. government. But firms responded to this signal even so. The U.S. sectors producing tradeable goods shrank. And some of the ground lost would never be recovered.
Given the high cost of capital seen in the U.S. in the 1980's, the uncertainty about whether investments in the U.S. were worth making because of the unstable exchange rate-all due to false steps of economic policy-and also other, outside factors like the rapid growth of the labor force as the baby boom generation became adults, it is not surprising that productivity growth in the United States lagged during the Reagan years. Figure 3 shows that the upward pace of productivity growth in the United States, which had averaged two percent per year for a century and came to an end in 1973, did not resume in the 1980's. Compared to what might have been reasonably anticipated from the 19481973 or the 18801973 pace of productivity growth, the U.S. in 1991 fell more than thirty percent low.
Other countries did not see such stagnation in productivity over the 1980's. At the end of the 1980's the U.S. still had the highest standard of living among the industrial nations of the world because of its immense spaces: people in the United States live in large houses and have ample lawns. But the U.S.'s edge in living standards over the rest of the industrial west comes from of the luck of its location rather than, as it came before, from of the skill and industry of its people. At current exchange rates, the United States ranks not first but ninth among industrial nations in total economic productivity: behind Switzerland, Japan, Iceland, Sweden, Norway, Finland, Denmark, and West Germany.
Around 1970, at least, the two income gaps were of about the same magnitude. Skilled workers earned about thirty percent more than unskilled workers, and young college graduates then earned about thirty percent more than high school graduates.
Around 1980 the income differential takes a substantial leap upward. In no more than five years, by far the larger part of the 19291950 equalization of the U.S. income distribution is reversed among young workers. This shift toward greater inequality should not be overstated. So far the shift to inequality is much greater among workers with less than ten years' employment experience than among older, more experienced workers. Perhaps the gap will narrow as the present group of young workers ages. Moreover, while class and education-based income differentials have widened, status and race-based differentials have continued to fall at least through the end of the 1970's.
Moreover, this shift should be viewed with some skepticism: it is not certain that the college-high school wage differential plays the same role in the American economy today as the skilled-unskilled wage differential had at the beginning of this century. And it is not certain that the shift will be permanent. It is, however, clear that there is no longer any reason to believe that the wage distribution will narrow in the future. In the first two thirds of the twentieth century, both market forces-a shift to more balanced technological change and a declining ratio of less-skilled to more-skilled workers-and wage setting institutions-minimum wage laws and a strong union movement-worked to reduce income differentials. This allowed the relatively poor and unskilled would share fully in modern economic growth.
The determinants of the sudden upward leap in income inequality, especially among the young, in the 1980's are also somewhat uncertain. There are three possible causes: a rise in the relative numbers of the unskilled, the near-collapse of the private sector union movement under the pressure of the 1982 recession and of governmental hostility, and the large shift in the U.S. pattern of trade that came about in the 1970's and 1980's and led to the transfer to overseas of jobs for the less-skilled (and the transfer to the United States of jobs for the more skilled). Whichever of these factors is most important, there is no reason to expect the near future to see any reversal of the leap in inequality. International trade is likely to continue to increase, further reducing the employment of the less-skilled in high-wage sectors. The union movement is unlikely to recover. And the labor force is likely to continue to see a disproportionate growth in the numbers of the less skilled.
The 1970's and 1980's also saw rapid growth in the number of Americans whose households did not have access to the labor market. Divorce reduced the number of adults per household and multiplied the number of households. People choose to get divorced, and would most likely not appreciate being forced to stay together. But two households cost more to maintain than one; divorce is usually followed by a substantial drop in living standards for women and children (and a rise in living standards for men); and one parent living as the sole adult in a household trying to raise children has a very difficult time taking advantage of whatever opportunities can be found in the labor market. The declining economic position of lesser-skilled males, coupled with the rise in female-headed households with no access to the labor market and with reductions in public sector support together caused something extraordinary to happen in the 1970's and 1980's: the proportion of the population living in poverty increased.
The "poverty" line, as calculated by the U.S. government, does not shift upward as time passes and as expectations of what is needed to maintain a minimum decent standard of living rise. The poverty line is that amount of money required to purchase a fixed basket of commodities: the proportion living in poverty is the proportion of the population that do not attain a fixed absolute level of material well being. The proportion of the U.S. population falling below the poverty line in 1990 was about 13 1/2 percent-as large a proportion as it had been in 1966. The two decades from 1949 to 1969 saw the poverty rate using the official definition fall from about 32 percent to about 12 percent; the two decades of the 1970's and 1980's saw the poverty rate remain stagnant or rise.
This was the first two decade period in United States history in which anything at all similar had happened: previous decades that saw poverty rise, like the disastrous Great Depression-ridden 1930's, were followed by decades like the 1940's which saw tremendous economic growth and poverty reduction. The 1970's and 1980's marked the first time when, over the span of a generation, the rising tide of economic and productivity growth had failed the lift the boats of America's poor.
The 1980's also saw the halting of Black Americans' progress toward economic equality with white Americans. This did not seem to be due to a resurgence of official, open racism and discrimination. Instead, Black Americans were caught up in the widening of the income distribution. Since more of them were poor, a larger proportion of Black Americans than whites lost ground in the 1980's because the poor lost ground. Because more Black Americans lived in female-headed households, a larger proportion of Black Americans than whies lost ground in the 1980's because female-headed households lost ground. Because more Black Americans lived on the edge of poverty, a larger proportion of Black Americans fell into poverty in the 1980's because those on the edge of poverty did badly during the decade.
From the perspective of many Black political leaders, the fact that the relative decline in the economic status of Blacks was not the result of official, open racism was cold comfort. Official, open racism in the past had put Blacks on the bottom of the American income pyramid. White society owed them redress. And for white society to adopt policies that moved the distribution of wealth and opportunity against those at the bottom-and then to claim that such policies were no racist-appeared a sick joke: analogous to first firing you and then foreclosing on your house because you don't have a job, all along claiming that the foreclosure is not aimed at you and is nothing personal.
IdeologiesThe fist is the "so what?" school made up of thinkers like Friedrich Hayek. They argued that the market's distribution of income and wealth is the just distribution: it is the distribution that arises if everyone uses their own powers and capacities to produce and then to voluntarily exchange commodities with one another. Each gets to keep the work of his own hands or to freely dispose of his wealth to his heirs or whoever else he wishes to bless, and each exchanges his goods for others only when it seems advantageous to do so. What could be fairer than this?
According to this school, concern over the distribution of income is motivated by ideological envy of the smart and productive. According to Kristol, economists study the income distribution not because it is or ought to be a matter of public concern, but because they have been distracted from their proper tasks by ideological "quasi-socialist conceptions of justice" that are "destructive of economics as a scientific discipline." Attempts to shift the distribution of income, by incentives or taxes, away from what the free market produces is unjust, leading inevitably to totalitarianism, according to Hayek. Even if market capitalism did produce a grotesquely inegalitarian distribution of wealth, according to this school, it would still be the right system for producing and allocating goods. Levelling policies have no economic justification and have only a shaky political or moral one as well, for it is not clear whether equality is "an ideal or a nonideal for a good society."
This school is such as to make refutation difficult: their universe of values and assumptions has so little in common with the one that the rest of us take for granted that it is hard to determine what arguments will have purchase.
20
CenturyCreated 2/24/1997
Go to Brad DeLong's Home
Page
Associate Professor of Economics
Brad DeLong, 601 Evans