It was the 1970s. Inflation, which started at 6.2% in 1970, reached over 13% by the end of 1979. Unemployment hovered around 6%, while borrowing money to pay for a home or a car could easily cost you 20% in interest. Recession, high oil prices, low productivity, and inflation were the new norm in America. The result was a new term in the field of economics, and a fresh challenge in American politics: Stagflation.
With economists and policy analysts arguing over the causes there was little political consensus about what to do. The political void created by these developments would be filled by presidential candidate Ronald Reagan in 1980.
Claiming that excessive regulations and high taxes were the problem, candidate Reagan's message touched a political nerve in America - in spite of the fact that his political prescriptions did nothing to address the economic problems challenging America. In the end, Reagan was able to sell America on a deregulation and tax cut program that would do little more than transfer wealth to America's richest class, while exacerbating the economic problems facing the nation, and the world.
In fact, regulations and taxes were only a small piece of the economic puzzle that challenged policy makers in 1980. The economic instability and new challenges America faced were ultimately rooted in the successes - and subsequent collapse - of the post-war world order that the United States had created, then poorly managed and, finally, helped to undermine with reckless budget deficits.
How we arrived at this point is what makes this story.
THE POST-WAR ENVIRONMENT
After World War II, the uncertainty caused by the destruction of war was heightened by the reality that we were now in a nuclear age. Post-war leaders knew they also wanted to avoid the economic conditions that led to the rise of tyrants like Adolf Hitler (economic collapse) and the Soviet Union's Joseph Stalin (underdevelopment).
With memories of walking away from the global community after World War I, when the United States Senate rejected the League of Nations, America was convinced it would have to lead the world in constructing a world order that would be both politically inclusive and economically disciplined.
By supporting the United Nations, the North Atlantic Treaty Organization, and the International Monetary Fund and the World Bank - economic institutions created at Bretton Woods in 1944 - the United States demonstrated that it was committed to building a new world order. With the hope that the world economy would stabilize and grow, America put the full force of its authority behind these political, military, and economic institutions.
In the process, because the goal was cooperation rather than domination, the United States demonstrated that it had embraced a more sophisticated understanding of power.
The Marshall Plan - which committed about 4% of the U.S. GDP to Europe - showed the world that the U.S. was serious about its commitment to the global institutions it helped build. The costs of the Marshall Plan, however, would pale in comparison to the benefits the U.S. enjoyed from having the dollar enshrined as the world's "anchor currency," which nations sought and coveted. Over the years the privileged position of the dollar would allow the U.S. to effectively print and send dollars around the world, which other nations dutifully held.
But this privileged position would come with a price.
The United States would have to pay the bulk of the costs associated with defending the west. While the western world enjoyed the benefits of global stability (as virtual free riders) and recovered economically, the U.S. experienced bloated budgets. While the post-war world order was at times tense the cold war environment was a stable one. This set the stage for new market competitors to arrive on the global commercial stage.
As well, a flood of U.S. dollars would spread across the globe, as market players found it convenient and profitable to trade in dollars.
POST-WAR SUCCESSES ... AND A WAVE OF U.S. DOLLARS
Because so many countries sought and welcomed dollars the U.S. learned that it could print and send out dollars without the fear of having them sent back to America, where inflation would then become an issue. Colloquially, the United States found that it could write checks that others would not cash.
With the United States taking the lead in the cold war, in Korea, Vietnam, and in every region around the world America learned that paying for the defense of the west was not so difficult. Demand for devalued dollars was maintained because the world was willing to hold dollars.
This condition was facilitated by several developments that the United States did not necessarily anticipate, and may have even encouraged because of how it promoted the dollar abroad.
Beginning in the 1950s the British understood how popular the dollar was around the world. In an effort to benefit from the demand for dollars the British actively began soliciting and then lending dollars on their own terms in 1957. And just like that, a Euro-currency market built around dollars was born. While this would help undermine its long-term stability (because the British effectively began speculating on the dollar), in the short-term the British were promoting and increasing demand for the dollar.
The rise of the Euro-currency market would parallel the surging demand for dollars that was created by U.S. firms that went abroad in search of new markets to conquer. With increased trade by U.S. multinationals came increased demand for financial services. Following lead of the British in 1957, by the early 1960s U.S. banks jumped in to fill the dollar needs of multinational firms around the world.
By the 1960s the U.S. was putting military bases up around the world and paying for the defense of the west. The Euro-currency market was in full swing. Multinational corporations were also paving the way for the increased use of dollars around the world.
One could be pardoned for thinking that increased demand for U.S. dollars meant all was well for the United States. Think again.
THE FRENCH CHALLENGE THE EXORBITANT PRIVILEGE ... AND LOSE
Global markets had become so saturated with dollars that the U.S. promise to pay $35 for every ounce of gold became an unrealistic promise. By the 1960s the French began demanding more dollars for gold, and wanted others to follow their lead. This was the backdrop to a meeting between the French and the Americans in the late 1960s.
It was 1967 and Secretary of State Dean Rusk was engaged in yet another round of frustrating talks with the French over defense issues related to NATO and the creation of multilateral forces. The United States was trying to convince the French that its security needs would be covered by the U.S. “nuclear umbrella” in Europe.
French President Charles de Gaulle was not convinced by the promise. He believed the U.S. wanted to dissuade France from building her own nuclear arsenal because it would undermine America's position as the leader of the free world. The prestige associated with her privileged position, according to de Gaulle, enabled the Americans to avoid being held to account in other areas. And de Gaulle’s evidence was strong.
Charles de Gaulle pointed to the war in Vietnam, which he believed was irresponsibly financed by deficit spending. Coupled with balance of payment deficits and the costs of Lyndon Johnson’s Great Society programs, de Gaulle complained that the U.S. was recklessly printing and issuing more money than it could back with gold. Noted historian, Walter La Faber, explained it this way:
War costs shot upward from $8 billion in 1966 to $21 billion in 1967. Dollars flew out of the United States to pay for both the war and growing American private investments abroad (which rose from $49 billion in 1960 to $101 billion in 1968). The nations export trade could not pull those dollars back.Charles de Gaulle was particularly miffed that the U.S. was the only country that could unilaterally print money and issue credit without having to experience the inflationary effects at home. No other country had the privilege of writing checks that others would hold. According to de Gaulle this was an “exorbitant privilege” that no other nation enjoyed, and he set out to make things right by demanding gold when France’s dollar reserves grew.
If other nations had been receptive the France's complaints the financial position of the U.S. would have suffered a serious setback. As Benjamin J. Cohen pointed out in In Whose Interest? International Banking and American Foreign Policy (1986), by the mid-1960s “almost two-thirds of America’s cumulative deficit was transferred in the form of gold.” This was up from just 10 percent in 1958.
Fortunately for the United States, there was no real effort to collectively demand gold as the French did after 1965. The Americans, to de Gaulle’s chagrin, could not be disciplined.
This was the backdrop to Charles de Gaulle’s tense meeting with American Secretary of State Dean Rusk over NATO in 1967. Events finally came to a head for de Gaulle when he announced that France was pulling its troops out of the military arm of NATO. He went so far as to declare that France’s nuclear forces might even be deployed against the west.
Making matters worse was the bitter and acrimonious tone surrounding France’s break from NATO. When de Gaulle informed U.S. Secretary of State Dean Rusk that the French were pulling out of NATO he bluntly told Rusk that he “wanted every American soldier out of France.” Impatient and angry over de Gaulle’s lack of decorum, Rusk replied, “Does that include the dead Americans in the military cemeteries as well?”
|The Oise-Aisne American Cemetery and Memorial in France, where 6,012 American rest.|
This privilege position would not last. Trouble was around the corner. Continued deficit spending on the part of the U.S. coupled with the demands of the French would help convince President Nixon to quit exchanging dollars for gold on demand. This would be followed by the Nixon shock (price controls), and a flood of petrodollars and debt after 1973.
These and other forces combined to collapse the stability built around the Bretton Woods currency system.
Worse, it would facilitate facilitate a speculative assault on the dollar that has destabilized world markets ever since.
Ronald Reagan’s arrival, as we will see, would help accelerate this development.
MISREADING THE TEA LEAVES
So what happened after Charles de Gaulle called attention to U.S. spending habits? For our purposes, effectively nothing. The United States continued to spend. And when de Gualle’s criticisms failed, America spent even more.
The question for us then is, Why didn’t the U.S. suffer the inflationary consequences from creating more dollars? Very simple: The U.S. and its cold war allies had come to an agreement. As Benjamin J. Cohen explained, in the early 1970s the U.S. agreed to continue paying for the defense of the west. For their part, U.S. allies agreed to continue underwriting American debt and to hold U.S. dollars.
While this was both an economic and geo-strategic coup for the United States its western allies benefited as well.
Instead of spending on tanks and guns they could concentrate on producing a parade of better cars and stereos. The Germans and the Japanese led this economic parade in Europe and Asia. In essence our allies said, “Go ahead, build up your military and spend all that money doing it. Even though you'll be creating more dollars and debt we still won’t won’t send your dollars back (at least not yet).”
In the process the U.S. kept its perch as the undisputed leader of the free world.
There was only one problem. Nothing was being done about the long term political, economic and military issues that continue to affect the U.S. position today:
(1) BLOATED BUDGETS: The costs associated with paying for the defense of the west has been matched today with the costs associated with industry bailouts and the costs of failed wars. These are financial burdens that will last generations.
(2) FINANCIAL INSTABILITY: A wave of dollars has undermined the value of the dollar, fluctuating interest rates, and the economic stability we experienced immediately after World War II. Today we see speculation, gambling and bailouts caused by bets made on increasingly complex financial products.
(3) THE GLOBAL CASINO: The cumulative impact of multinationals and other firms who went from hedging their bets in currency markets to outright speculating and gambling on currencies and other financial products has not been helpful.
(4) VIETNAM SYNDROME RUN AMOK: The penchant for the U.S. to pursue reckless wars and military-spying adventures has undermined America's position, and eroded its prestige around the globe.
(5) ENERGY PLANNING: After OPEC jacked up prices - which supercharged financial instability and global debt - little was done to develop a viable energy policy. Because the OPEC nations made a commitment to continue trading their product in dollars - and to purchase U.S. debt - after 1973, the U.S. has been unable to wean itself and the world from the instability in the Middle East.
(6) NEW COMPETITION: While Europe and Asia were able to recover and develop under the protective institutional umbrellas created after WWII, America was left flat-footed. To date, in an effort to deal with new competition the U.S. has chosen to embrace a race to the bottom strategy that takes jobs overseas and undermines the prospects of labor at home, while castigating other nations for cheating.
(7) THE SYMBOLIC ECONOMY: Finding it easier and more profitable to gamble on currencies and other financial products, market players are increasingly more interested in wealth extraction than with wealth creation.
In the case of #7 above, economist Joseph Schumpeter would have argued that our biggest market players today are now playing monopoly rather than building them.
In any case, it's clear that was was ailing the United States in 1980 was not simply too many taxes or too many regulations. The challenges confronting the nation were a product of too many dollars wrecking the institutional discipline created at the 1944 Bretton Woods conference. As well, new competition from Asia and Europe came about precisely because the post-war world order did what it was supposed to do: nurture market stability and economic development.
The problems that Ronald Reagan saw, and the tax cutting and deregulation policies he sold to America, missed these larger question.
Not only did President Reagan's trickle down policies make matters worse by putting more deficit dollars into the global economy, but they redistributed wealth in America in ways that threatens to undermine the American experience even today.
Worse, contrary to popular opinion, President Reagan's policies didn't actually fix the problems that confronted America in 1980, as we will see in the next section.
REAGAN'S DEFICIT SPENDING ORGY, AND KEYNESIAN RECOVERY
By the time Ronald Reagan left office inflation and interest rates were down to single digits, while unemployment hovered around 5%. Because of these developments, conservatives and ill-informed talk show hosts like to claim that a combination of tax cuts, deregulation, bureaucratic reform, and assorted incentives created the environment for investment that energized the economy.
Indeed, according to revisionist historians the Reagan administration was able to get America moving by reducing the size of government, cutting government spending, and getting “government off of our backs.”
This would be an interesting by-line except for one thing. It’s not true.
First, it’s interesting to note that job creation under Ronald Reagan never matched the levels achieved under Jimmy Carter, while the size of the federal government’s workforce grew from 2.8 million employees to 3.1 million under President Reagan.
|Job growth, by president, 1981-2015.|
|Public sector job growth, federal government.|
Note the growth under President Reagan after the recession (1981-89).
Acknowledging this, in 1985 Fortune magazine wrote that the “budget is way out of balance because of a little-known fact: real federal spending, adjusted for inflation, has climbed even faster under President Reagan than it did in the Carter years.” In the end, in spite of what the supply-side supporters promised, the national debt almost tripled from approximately $930 Billion to $2.7 Trillion under Reagan.
So what created the conditions for the American economy to stabilize in the late 1980s, and take off during the 1990s? Primarily three factors: all of which undermine the idea that Reagan fixed America with a good ol' shot of capitalism.
On the inflation front, we find that OPEC – an oligopoly that depends on cooperation to sustain itself – found its solidarity undermined by late 1981. With the beginning of the Iran-Iraq War, which Saddam Hussein initiated in part because the ayatollahs were fomenting fanatic revolution in Iraq, black markets in the oil industry grew as cheating on the part of the two combatants began (to fund their war efforts).
In addition, conservation efforts, alternative energy sources, new oil discoveries, among other developments, helped to stabilize oil prices. But these efforts were initiated by President Ford and, to a larger degree, by President Carter. Still, the reality was OPEC unity – one of the primary catalysts behind price hikes – had unraveled, while government-inspired conservation efforts paid off.
As the price for oil dropped, so did inflationary pressures.
We also need to recognize a second force on the inflation front. Recall the strategy employed to control inflation was taken up by Federal Reserve Chairman Paul Volcker. In spite of pressure from the Reagan administration, who initially wanted to expand the money supply, most economists agree that by sticking to his guns, and maintaining a stringent monetary policy, Mr. Volcker helped to slay the inflation dragon. Critical here is that Mr. Volcker was appointed by Jimmy Carter, and not Ronald Reagan.
Finally, the Reagan administration’s deficit spending broke all previous records. In fact, his administration spent twice as much as the previous 39 presidential administrations combined, in the process using taxpayer funded debt to deposit hundreds of billions of dollars into the national and global economy each year. This government induced “pump priming” was an artificial stimulus – what economists call a “Keynesian stimulus” – and was hardly a vote of confidence for laissez-faire economics.
SUMMING UP ... IT'S ONLY GOING TO GET WORSE
In sum, cracks in OPEC unity, conservation efforts, a tight monetary policy, and a state-led stimulus to our larger economy suggest that the Reagan administration’s policies were, at best, a supporting rather than leading factor in reversing the dismal economic environment of the 1970s. Worse, President Reagan's policies did absolutely nothing to fix the very real problems associated with a flood of dollars, new competition, a crumbling global economic framework, and the rise of the symbolic economy. The events of 2008 were neither unforeseen, nor a product of - as Alan Greenspan comically put it - the product of once in a lifetime event.
What we experienced in 2008 was the product of developments that we have chosen to ignore for the better part of four decades. And, yes, our continued "head-in-the-sand" response to the events of 2008 make it clear that things are only going to get worse before they get better.
UPDATE: For my International Commerce students, below are additional posts on topics we've discussed in class this quarter ...
Derivatives explained, Part II
Developing Afghanistan and Iraq ... It's mindless Modernization Theory, again
Decoupling of Productivity from Labor ... The Rise of the Machines, Part I
Decoupling of Productivity from Labor ... The Rise of the Machines, Part II