Source: Robert Carson, "What Economists Know: An Economic Policy Primer for the 1990s and Beyond", p.51-90, 1990.

Looking over Our Shoulder, I: Origins of the Modern Economy, 1929-1950

"The success of the General Theory was instantaneous and as we know, sustained. Unfavorable reviews of which there were many, only helped. A Keynesian school formed itself.... Nor is this all. Beyond the pale of orthodox Keynesians there is a broad fringe of sympathizers, and beyond this again there are many who have absorbed, in one form or another, readily or grudgingly, some spirit or some individual items of Keynesian analysis. There are but two analogous cases in the whole history of economics-the Physiocrats and the Marxists" 1 Joseph Schumpeter

Attempting to specify precisely when the modern economic epoch commences is an arbitrary and wearying task. Some might choose to go all the way back to our own revolutionary year of 1776 which also marked the publication of Adam Smith's Wealth of Nations, the first full-blown articulation of the economic and ethical principles of a democratic capitalist society. Others may emphasize the institutional foundations of the economy, perhaps selecting in the case of the United States, the beginning of the factory system in the early decades of the nineteenth century or possibly the post-Civil War maturity of the corporate form of business organization. Still others may select the closing years of the nineteenth century and early years of the twentieth century with the rise of government as an important actor on the economic stage. Certainly powerful arguments can be offered for any of these watershed periods, as well as a great many others, standing out as an historical benchmark noting the beginning of modern economic times.

However, I have a strong predisposition to a fairly recent beginning point, one within the lifetimes of a fair number of living Americans: 1929. There need be little argument that 1929 is one of those years -like 1066, 1492, 1776, 1914, 1941 -that is indelibly printed on human consciousness. To most it is probably remembered as the year of the Great Wall Street Crash, the real beginning of the Great Depression. And the public perception does not differ greatly on these points from ideas held by economists. For more than five decades economists have indexed much of their thinking and their studies in terms of pre-1929 or post-1929 reference points.

But what was it precisely that makes 1929 unique? Nineteen twentynine was neither the first nor the last spasmodic collapse in securities markets, and business slumps were a common occurrence both before and after. On the other hand, no economic downturn, before or since 1929, was to run quite so deeply, and, probably as a result, none was to have so profound an effect in reshaping fundamental economic belief and practice.

The 1920s Boom

To understand how our economic ways were altered, we must briefly sketch the contours, if not quite all the details, of the pre-1929 economic world. First off, we need to dispose of a popular misconception - then, as well as now- that the decade of the 1920s, up to the collapse of the stock market, was one of soaring prosperity. The "Roaring Twenties" had indeed been a period of growth, but in comparison with other decades not especially outstanding. Over the decade~ the average worker enjoyed a 25 percent increase in real wages (the actual buying power of wages after adjustments for price changes) and to many that probably seemed very good considering the dismal performance of the economy in the two decades that bookended the 1920s (1910-1920 and 1930-1940). However, looking backward, it was substantially below real wage increases of the 1880s, and looking ahead it was much smaller than the wage gains of the 1940s, 1950s, and 1960s. In fact, the average American industrial worker was receiving $1400 a year in salary (about $4 a day) in 1927, at the same time that the government calculated that it took $2000 to "bring up a family of five in 'health and decency." Meanwhile, unemployment over the decade averaged 5 percent of the labor force, with only 3 years (1923, 1926, and 1929) reporting figures of 3 percent or less (what was then considered to be an "acceptable' unemployment level).

The 1920s prosperity also was marvelously uneven. Work in construction, autos, steel, the new electrical appliance industry, or the growing retailing and service sector was steady and increasingly rewarding. In agriculture (which still sustained one out of every four Americans as late as 1930) and such "sick" industries as textiles, coal mining, and railroads, poverty, not prosperity, was the common recollection of the 1920s. Meanwhile, easterners; and westerners; had twice as much average income as those living in the old South. And not to be overlooked was another uncomfortable fact: the very well-to-do were doing a whole lot better than everyone else. Between 1922 and 1929, the richest 1 percent of all Americans increased their share of the nation's wealth from 32 to 36 percent.

For the average citizen, however, the 1920s did provide a device that enhanced the illusion of an expanding prosperity: consumer credit. Except for the purchase of farms, homes, and farm equipment, installment purchases had been uncommon before the 1920s. To these items were now added autos, radios, washing machines, baby carriages, clothing, and much more as Americans doubled their installment debt payments between 1920 and 1929.

Despite the now apparent weaknesses of the boom - the shallowness of its employment and real wage gains, its sizable dependence on consumer debt, and the unevenness of its benefits, there can be little denial that a perceptible sense of economic well-being took hold of most citizens' consciousness. In a nation where many could still recall life on a rough frontier - either in rural isolation or in new towns and cities - and where others can still remember the "up-by-your-bootstraps" drive necessary to distance themselves from the stench of immigrant ships, there was a tendency to see the present "prosperity" as the solid achievement of individual hard work. To be sure there were many who were neither prospering nor were assured that hard work would lead to prosperity in their own lifetimes -blacks, poor rural whites, and many urban industrial workers. Yet, even the poor were not without hope, so deep ran the American belief that individual diligence would sooner or later be rewarded- if not in their lifetimes then in their children's.

Insofar as any in the prosperous or would-be prosperous majority of the population needed any intellectual justification for their individualist frame of mind, they could turn to a vulgarized version of traditional laissez faire economics that was readily available in newspapers, magazines, books, Sunday sermons, and, always, at service club luncheons. This simplification of the labors of Adam Smith and his many intellectual progeny stressed the role of the individual economic man (not much thought was given to women in these matters) who was perceived as a rational maximizer competing with others in all manner of markets and ultimately receiving rewards according to his hard work and the impersonal forces of the market. In fact, the simplistic restatement of Smith's view of human psychology, his laws of the market, and his unwavering faith in the material progress of a society organized around the principles of free markets and free individuals remained the touchstone of belief for most economists as well. Indeed, even today, Adam Smith's economic world remains the beginning reference point for most neophytes' introductions to economic reasoning.

Yet this harking back to a simple laissez faire economy is paradoxical: both the practical world and the theoretical world of economics in the 1920s was, as it is today, replete with exceptions to simple market solutions. In general, Americans had always been quite pragmatic in economic matters, preferring always to experiment rather than to hold to doctrinaire theories. In particular, the nation had come to accept a high degree of government intervention in the market, especially since the closing decades of the nineteenth century. These "progressive" efforts to use government to improve the ordinary functioning of certain markets were broadly popular, a fact sometimes overlooked by a later generation that has advocated "deregulation". The creation of the Interstate Commerce Commission (1887) to regulate railroads, the passage of the Sherman Anti-Trust Act (1890) and the Clayton Act (1914) to control monopoly power, the establishment of a Pure Food and Drug Administration (1903) and a Federal Trade Commission (1914) to protect consumers from undesirable business practices, and the erection of the Federal Reserve System (1914) to oversee the nation's banking operations, along with hundreds of other regulatory interventions at the federal and state levels, had, in actual practice, created an economic system quite different from laissez faire mythology. However, and it is evidence that the power of belief is eminently greater than the power of fact, few citizens or economists saw these "interventions" in the market as matters that seriously altered the individualist and free market underpinnings of traditional economic faith.

The paradox in popular thought- free men and free markets operating in an actually more regulated economic world- was complemented by a paradox in pre-1929 professional economic thought. While the ideological bedrock for most American economists had changed little since Smith's writings, the corpus of economic theory and study dealt with a great number of sophisticated economic realities. Imperfect competition, public regulation of monopolies, labor unions, the relation of money and credit institutions to economic activity, fluctuations of international trade and exchange rates, public finance, antitrust economics- virtually every theoretical and applied topic found in the microeconomics half of a present-day introductory text and a good deal of what currently constitutes the macroeconomics half- were the ordinary focal points of professional economic inquiry.

The point is worth remembering, because in the folklore of the economics profession over the next thirty years, a myth grew depicting pre-1929 economic thought as naively disconnected from practical economic concerns. To be sure, the practical tools of the economist were crude. Data collection was poor and the level of quantitative technique rather primitive, with the result that empirical economic studies were, by present standards, unsophisticated. But, economics and economists did address most of the practical economic issues of the day.

There was, however, a fatal flaw, a kind of blind side to the dominant mode of economic thought. It stemmed from the fact that economists and ordinary citizens -irrespective of their largely pragmatic and practical approach to specific problems - still held to an essentially laissez faire private philosophy. That is to say, interventions in the market might be needed from time to time but these were "exceptions". ' Laissez faire was still the "rule".

In particular, the blind side extended to matters of the business cycle. This is not to say that economists were unaware of cyclical downturns in the economy. Indeed, the eight to ten year roller coaster ride of the economy through prosperity, contraction, slump, and revival was a well-known economic feature, and the 1920s had begun with one of the sharpest downturns to that point in time. But if slumps were normal, they were also largely understood as self-correcting. Left alone, they would go away. Such a view was more or less reinforced by the expectations of the citizen on the street, who, apart from charitable undertakings to help those most unfortunate, expected no radical redirection in economic policy to be applied when the economy slipped out of prosperity.

But why did such benign neglect of cyclical movements in the national economy lead to disaster in 1929? The answer is not a simple one, and it has been the source of extensive disagreement among economists for the past sixty years. Indeed, it is this question and the answers given- both theoretical and applied- that mark the beginning of the modern period of economic thought.

Crash, 1929

Without at this point making any particular judgments as to which economic explanation fits the circumstances most accurately, we can still come to a generally agreed-upon scenario of what actually happened. Primarily, it appears, practically everyone forgot the rules of the economic game with regard to business cycles.

On the one hand, there was ample evidence that the production base of the economy was contracting as early as 1926 when new housing starts turned downward and the annual increase in consumer purchases of autos, that premier durable good of the 1920s boom, began to slow down. At the same time, most likely reflecting signals business managers were receiving from growing inventories, there was a marked slowdown in investment in new production facilities. By early 1928, economic signals should have led to the anticipation of a normal cyclical bottoming out witb no particular reason for expecting that the slump would be any sharper or prolonged than usual, a matter of a few months as prices, wages, output, and investment "corrected."

The trouble was that by 1928 almost no one was looking at economic indicators anymore. All eyes were on the stock market, which after mid-1928 seemed to be on an unending upward rise. Why this shift of sights? Answers range from the romantic (the post-World War I mood of wishing to put all matters of unhappiness behind ones self), to the psychological (the nation was caught up in rising expectations), to the moralistic (pure greed simply overwhelmed common sense). But certain facts must be considered whichever explanation one chooses. First, the Federal Reserve System, the decentralized American central bank responsible for controlling the growth of money and credit, took actions to expand money growth in 1927, precisely as the economic indicators promised contraction. Led by Josiah Strong, the powerful governor of the New York Federal Reserve Bank, this was the first time in the thirteen-year history of the Fed that an effort had been undertaken to "counter business cycle activity."

Initially, the dose of easy credit (and credit was expanded a number of times after 1927) seemed to do the trick. After mid-1928, production of consumer durables and employment in general picked up- for a time. But the stock market was the chief recipient of any gains, as large amounts of borrowing went into a nearly mindless speculation, one of those periods of "recurrent insanity" (as John Kenneth Galbraith has called them) that periodically seize financial markets. The price of stocks rose swiftly and steadily as buyers believed that prices could only go upwards as more eager buyers would continue to plunge into the market. The demand for securities bore no relation whatsoever to a company's earning potential. RCA, for instance, went from 85 to 420 between 1927 and 1928; yet, never in its history had the company paid a dividend.

Perhaps distracted by the mini-boom in consumer spending spurred by credit expansion or by the growth in world trade also traceable to a world expansion in the supply of credit, economists simply forgot most of what they knew about business cycle behavior. Usually in the past, the stock market had been a bellwether for economic conditions. Now the market boomed and by implication the economy was perceived to be stronger than it was. A later generation would learn that the market has, to a considerable extent, its own dynamic, sometimes turning bullish when the economy is clearly weak and other times remaining sluggish in periods of extraordinary economic expansion. However, such had not been the experience before 1929. Accordingly, the Great Bull Market seduced economists as completely as ordinary speculators.

At Yale University, no less a figure in the economics profession than the great Irving Fisher acted as a cheerleader. Renowned for his work on the quantity theory of money and his studies of the relationship between the money supply and the general level of economic activity, Fisher wrote and lectured for appreciative audiences, right up to and even after the bottom fell out, that the market could and should go still higher. Fisher was still offering this wisdom a month after the market collapsed in October 1929 but by then he had few listeners. A few individuals made both reputations and fortunes by correctly estimating that the bull market was an aberration and by getting out before it ended. Few however were professional economists or politicians. Both the academic scribblers and the "madmen in authority" listening to their voices failed to see where it all was heading. However, a good many of the "old fortunes", Rockefeller and Vanderbilt, for instance, avoided catastrophe by adroitly getting out of the market just before it peaked.

The last ten months of the Bull Market were madness. Some would later call it an obscenity. The flimsiest of corporations- the holding company which was little more than the pyramiding of stocks in other companies- were created and sold to eager speculators. Banks speculated with customers' monies and created their own financial instruments to speculate in, all on credit of course. Brokerage firms indulged in a variety of sordid financial dealings, all of which would presumably be made good and be forgotten in the wake of the market's continued climb. Not everyone was in the market but more people were than is commonly imagined. According to one historian of the debacle, about 600,000 Americans were speculating "on margin" (credit). A million and a half had accounts with brokerage firms, and as many as 30 million families were in one way or another directly involved in the market. 3 Out of a nation of 120 million, this was not an insubstantial number, involving much more than the 1 percent of the population who controlled 36 percent of its wealth.

Great Depression Economics, 1930-1939

The collapse of the stock market in October 1929 revealed, suddenly and completely, what should have been known six months before Black Tuesday (October 29, 1929): The long economic boom of the 1920s had lost its head of steam and contraction had set in. However, the Bull Market and the easy credit policies of the Fed, which had done much to drive both the market and the unwarranted public optimism associated with it, helped transform what might have been an ordinary business downturn into an economic nose dive. It should be remembered that even an "ordinary" downturn was bound to be sharp given the high degree of instability and underproduction that plagued most of the European economies in the decade after World War I. Moreover, the economic slowdown after 1929 was greatly worsened by the high degree of financial instability that the collapse of the Bull Market inflicted on American banking and credit institutions -although it could be argued (and was) that the bankers had brought it all on themselves. Perhaps a more important spin-off from the business slump was the general loss of public confidence in virtually all economic institutions, a characteristic of any contraction now made all the worse by recent memories of the market's boom and dizzying collapse. Indeed, the matter of economic confidence or lack of it was, in one form or another, to haunt economic policymakers for the next decade, figuring mightily among the forces that held the Western world in the throes of a Great Depression.

Among the enduring myths of economic history is the following scenario. After the crisis of 1929, Herbert Hoover- a do-nothing president -sat callously by as factories and banks closed, unemployment queues grew long, and shanty towns sprang up. Then, with the election of Franklin D. Roosevelt in 1932, and the development of a strong presidency and strong federal government, a new direction was undertaken. A flourish of "New Deal" economic legislation aimed at helping farmers, union members, and even business gradually turned the tide of depression, saving both the economy and democratic institutions. Or at least that is the way it was supposed to have happened if many high school history texts are to be believed. That scenario, however, is fundamentally untrue. Hoover was not that inactive and Roosevelt and his New Deal were not that successful.

Hoover did not resort to the laissez faire policies that had been popular before 1929; he, perhaps even more than FDR initially, was committed - to interventionism. just as he had accepted the Fed's stimulative credit policies in early 1929, Hoover now determined to use the economic machinery of government to overcome depression - to counteract the business cycle rather than accept it. Through 1930 and 1931, he cut taxes, increased government spending, and produced the largest peacetime deficits heretofore achieved in American history. Although opposing direct relief to the unemployed as a matter of principle ("It would destroy initiative"), he proposed and pushed through Congress direct aid to farmers (the Agricultural Marketing Act), a loan program for businesses hard pressed to obtain credit (the Reconstruction Finance Corporation), and an emergency public jobs program (the Emergency Relief and Construction Act). Such actions were to lay the foundation for FDR's own New Deal, all historical irony since the same general economic philosophy was to secure Roosevelt's place in history.

The extension of ordinary governmental regulatory activities to general business cycle conditions was to Hoover, as it was to many American economists and citizens, merely the logical continuation of social engineering efforts nearly a half century old. History has been unkind to Herbert Hoover. First he was pilloried by a generation of liberal interventionists who inaccurately attacked him for "doing nothing"; more recently, he has been attacked by conservative free market advocates for "doing too much". At any rate, whatever he did was not enough to arrest the general business downturn. Between 1929 and 1932, the Industrial Production Index fell from 114 to 54, business construction and durable goods manufacture both fell by more than 75 percent, and unemployment jumped from 3.2 to 22 percent of the labor force.

It is hard to say which ebbs first in periods of great social and institutional decay- hope or ideas. In any case the two are inextricably connected, and there was little of either in the 1932 presidential election. Far from being a popular referendum on "the old order," as New Deal propagandists were later to argue, FDR, with scarcely an economic idea or program in his head, campaigned across a nation without hope. The irony of the election, as well as the uncertain economic notions of FDR, were revealed as he whistle-stopped through Sioux City in September. Pointing his finger in the air in typical Rooseveltian fashion, he charged:

"I accuse the present administration of being the greatest spending administration in peacetime in all our history. It is an administration that has piled bureau on bureau, commission on commission, and has failed to anticipate the dire needs and reduced earning power of the people." 4

Three weeks later in Pittsburgh, FDR announced, "I regard reduction in federal spending as one of the most important issues of this campaign." 5

Indeed, if the election was a plebiscite on intervention versus the old laissez faire nostrums, the populace indicated they wanted the latter, as they voted for FDR in a landslide. And briefly, at least, Roosevelt tried to live up to his campaign promises of shrinking the federal government and lowering government spending. Quickly, however, this was abandoned in favor of an activist interventionist policy. For the next seven years the depression dragged on and the economy proved to be only mildly responsive to the interventionist efforts that Roosevelt came to accept and advocate as his "New Deal" for the American people.

Although New Deal legislation tumbled forth in a steady stream, directed at a wide variety of Great Depression problems, these efforts never had a clear economic policyrnaking focus- or rather, it might be argued, they suffered from too many focal points. Direct relief, public works, and social security programs were aimed at either expanding jobs or creating a measure of income security. Specific groups such as farmers or labor unions obtained a high measure of governmental support. Business, on the other hand, was at one point encouraged to price-fix and act as monopolists in efforts to raise profitability (under the National Industrial Recovery Act of 1933) and later were subject to a variety of reformist constraints and a very active antitrust policy.

The Administration never put forth a single, convincing explanation of why the economy had contracted or why it remained in a slump. This was not, however, for lack of explanations by the "academic scribblers" who came to Washington to work for the New Deal. Among FDR's immediate economic advisers, Robert Lekachman argues at least five theories competed for his attention: (1) the "monopoly power" theorists who maintained that giant corporations must be induced to lower prices and hence expand real purchasing power; (2) the "inflationists" who worried more about prices rising from government spending than about the unemployment such spending was supposed to soak up; (3) the "tax the profits" advocates who believed that undistributed corporate profits should be paid out as dividends to enhance purchasing; (4) the "pump primers" who advocated the view that government spending and/or expansionary money policy would sooner or later generate the purchasing or investment necessary to restore prosperity; and finally (5) the "'Secular stagnationists" who quite simply believed that capitalism as a system no longer worked and that broad social intervention and control offered the only escape. The older, earlier generation of economists who believed that the best anticyclical cure was simply rest and doing nothing were largely unrepresented in Washington and remained generally silent, attracting diminishing media and professional attention.

From across the Atlantic, however, a new message was being sent. In a famous letter to The New York Times in 1933, John Maynard Keynes revealed the essence of a "solution" he would lay out in detail three years later: "I lay overwhelming emphasis on the increase of national purchasing power resulting from government expenditure, which is financed by loans" 6 By 1936, when his The General Theory of Employment, Interest, and Money was published, events had produced a highly receptive audience, although it was not then clear to many that they would in fact be receptive. As Keynes was putting the finishing touches to his work just before Christmas, 1935, American unemployment remained stuck at about 20 percent (having peaked in 1933 at 25 percent) and national output (in constant prices) stood at 17 percent below 1929 output. With unemployment remaining high and output low, an increasing number of economists were of the opinion - as was Keynes - that "insufficient purchasing power," always a characteristic of a cyclical downturn, was also the cause of a slump turned permanent.

The General Theory

The General Theory was a merciless assault on the already circled wagons of the traditional market theorists, or what Keynes was to call almost derisively, classical economics. One by one he picked off their theoretical assumptions: that there could be no long-term overproduction of goods; that over the long run there was no such thing as involuntary unemployment; that prices, wages, and interest rates were both flexible and effective as signals for inducing appropriate market clearing behavior; and most important, that a free and unfettered economy tended by its own natural inclinations toward a full-employment, high-output equilibrium.

Keynes immediately proclaimed what many practicing economists already were coming to believe and what was universally unacceptable to the "straw men" of the classical economic tradition he had set out to destroy: namely, rather than having a natural tendency toward growth and equilibrium, capitalist economies had a built-in propensity toward periodic disequilibrium and chronic bouts of stagnation. At the time, Keynes' views seemed outrageously radical, but they stopped well short of Marx's somewhat similar macroeconomic critique, which foresaw the revolutionary end of capitalism. Keynes did not seek to destroy the production-for-profit system, although he clearly had little respect for businessmen and their individual and collective practices. He sought only to reform it.

Keynes' objective in The General Theory was to lay out the path to a high-employment economy. His approach emphasized aggregate rather than microeconomic aspects, as orthodox analysts did. First, aggregate levels of employment depended on the total demand for goods, including consumer purchase of goods and business investment as well as government spending. Second, the primary culprit in the cyclical downturn of an economy was the activity of investors, since it is through changes in investment outlays that changes in total demand for goods and services are affected most directly. Consumer spending was a fairly constant function of total income, with consumer outlays rising and falling directly as national income fluctuated. Government spending was small, and, in depression conditions, tended to get smaller as governments tried to live within the orthodox doctrine of annually balanced budgets.

Keynes' analysis led inexorably to the conclusion that only through artificiallv induced higher levels of aggregate demand would it be possible to attain full employment and full utilization of plants and equipment. The course was clear: Business investment had to be stimulated, government spending had to be inflated, or, some combination of both had to be tried. Given the state of business confidence in the mid-1930s, it was apparent to Keynes that the whole burden would have to be shouldered by government which must resort to massive deficit spending.

Keynes frankly believed that The General Theory would change the way economists looked at economic matters. He was assured of an audience, even for a densely packed and difficultly argued effort like The General Theory. He possessed considerable international stature, having served as a minor British treasury official at the writing of the Versailles Peace Treaty in 1918, having written a number of important books, and being editor of the influential professional review, The Economic Journal. Indeed, his stature was such that he had been invited to the White House to meet FDR in 1934. Toward the end of The General Theory, Keynes admitted that changing economic ideas would come slowly, observing ". . . in the field of economic and political philosophy, there are not many who are influenced by new theories after they are twenty-five or thirty years of age. . . . " 7 If he meant what he said, then he must not have been upset by the reviews in the academic journals that politely, if somewhat disinterestedly, noted the new book and its arguments but hardly approached it as the epochal work it would become. Why was this so?

Keynes may have been right to some extent about the age factor in accepting new ideas. Paul Samuelson, later to become a Nobel Laureate and author of the best-selling American economics textbook that did much to popularize Keynes' ideas, probably had it right when he said, "To have been born as an economist before 1936 was a boon- yes. But not to have been born too long before." 8 The larger reason for Keynes' slow start in the United States, however, was that the economy began a slight upturn in late 1936 and many economists were holding their breath waiting to see if the worst was really over. The boom did not last long however. FDR, still a believer in balanced budgets, had trimmed government outlays as the economy turned upbeat, and this diminishing of government spending was soon followed by another general economic decline.

In the long run, perhaps the most important result of the 1937 downturn was the sudden credibility gained by John Maynard Keynes. Never timid when public officials erred, Keynes had predicted in 1937 that FDR's economic actions would indeed produce a slump. Keynes' stock went up precisely as the economy went down. Rarely had an economic theorist had his ideas validated by events so quickly. Within the Roosevelt administration, the central feature of Keynesian anticyclical policy- the view that deficits in times of economic contraction are good since they stimulate output and employment- become accepted doctrine. Beyond that, however, there remained a great gulf between the ideas of Keynes and the actual economic practice of the New Deal. Roosevelt tolerated deficits because he plainly had no other choice. As we saw earlier, he had indicated after his first meeting with Keynes in 1934 that he did not understand the British economist. Clearly, it was some other earlier "academic scribbler" that had FDR's ear, if indeed heard any voices at all. More than two decades would pass before any occupant of the White House listened attentively to the ideas of the British economist. Conversions within the American economics profession, however, came much quicker.

Alvin Hansen of Harvard University was perhaps Keynes' most influential and attentive academic convert, although there were, within a couple of years, many in academia who found Keynes' critique of capitalism and recipe for depression's cures irresistible. Hansen had been deeply affected by the crash and depression, yet, as late as 1933, he was still opposed to government deficits resulting from "pump priming" or "compensatory spending" on the grounds that financing such deficits only reduced the pool of private funds that might otherwise finance investment and private spending. However, as the gloom of the depression grew darker, Hansen abandoned his earlier, typical faith in the natural equilibrium of market forces. By 1938, as president of the American Economics Association, Hansen had come over to a "secular stagnation" point of view that held that the combination of population decline, the end of investment opportunity on the western frontier, and the decline of foreign investment produced a chronic slowdown in American economic growth. Searching to offset these secular declines in spending, Hansen found an answer in Keynes, particularly the Keynesian call for using the public debt to halt stagnationist tendencies. Viewing full employment as the only honorable ultimate goal of any economic policy, Hansen finally grasped the Keynesian cure as the only conceivable means to that end. And, he pushed Keynes a step further. Not only could turning on the government spending spigot in slumps erase depression, but turning it off in prosperous times would control both growth and prices, while at the same time providing budget surpluses that would offset earlier deficits over the entire term of the business cycle.

Alvin Hansen did not produce the last word on Keynesian theory but there was little that followed over the next several decades' development of "Keynesian Economics" that he did not anticipate. In one respect, though, Hansen proved Keynes wrong: It was possible for someone over thirty to change his mind. Hansen's individual odyssey from believer in classical economics, to secular stagnation pessimist, to ardent Keynesian optimist, was a fairly good example of what happened to the collective state of mind of the American economics profession during the 1930s. Not everyone in the profession was converted, but as the years passed converts soon outnumbered the unconvinced. By the close of the 1930s, it was practically inconceivable that collective economic belief could ever return to the wisdom of the 1920s with its view that business cycles were natural, essentially unimportant from a theoretical point of view, and at any rate, selfcorrecting.

World War II and Postwar Recovery

Although the strategies implicit in The General Theory had some converts among FDR's advisers and a growing following among academic economists, after 1939 it was the force of events and not ideas that proved the Keynesian case. It was World War II -not Keynes or even the New Deal- that made the depression gloom lift and the nation return to full employment. Some simple statistical information shown in Table 3-1 proves the point.

TABLE 3-1: Selected Economic Data

With the coming of World War II, first slowly, as America, not yet in the conflict, supplied the Allies and then with a rush after December 7, 1941, government outlays for war goods expanded. From $1 billion a year in 1939, national defense spending swelled to $81 billion by 1945, absorbing in that year 82 percent of all federal spending and almost 40 percent of the nation's output for goods and services. Between 1939 and 1945, total military spending exceeded $250 billion. Most of this was financed by government deficits. While these deficits may have been undertaken for good patriotic purposes (virtually no one complained about deficit spending in wartime), they had precisely the effect Keynes argued they would have. Unemployment fell from 19 percent of the labor force in 1938 to 1.9 percent in 1945 (although, of course, 11 million men and women under arms also helped reduce civilian unemployment). Real GNP, after adjusting for price increases, grew by 80 percent.

On the negative side, prices did rise and would have risen even more had. not the government imposed stringent price controls and rationing. Only in part did FDR follow Keynes' wartime advice to greatly raise taxes to soak up the sudden increase in purchasing power at a time when few civilian goods were available for consumption. FDR, whose political philosophy earlier led him to seek budget balance against Keynes' advice, now allowed deficits to swell for a different set of political reasons. He frankly doubted the depth of American patriotic support for the war if taxes sopped up the wartime income gains.

More surprising than the wartime boom, however, was the postwar prosperity. As a rule of thumb, supported by the experience of every war in which the nation had been involved, it was understood that all wars were followed by an initial postwar downturn. In fact, little slowdown was observed through 1946-47. With over $250 billion in savings accumulated during the war years and fifteen years of more or less inadequately filled wants - first stifled by depressionary levels of income and then by wartime shortages - Americans undertook a level of personal spending and investment outlay that carried the economy into the mid-1950s. The laws of the business cycle, of course, had not been repealed. There were short sharp downturns in 1949 and in 1953-54, but in contrast to the immediate past these were mere economic hiccups.

Before the pace of postwar expansion cooled in the late 1950s, and a general debate redeveloped along the lines of 1930s concerns about stagnation and growth, America enjoyed a decade of expansion unsurpassed by any similar period in our history. Between 1941 and 1955, GNP grew about 4.7 percent a year. Except during the two recession periods, unemployment remained below 4 percent (even in the bad years, it never reached 6 percent, which was still only a fraction of the unemployment level in the worst depression year, 1933).

Had the war and wartime government spending proven Keynes' analysis to be correct? On the face of the data one could easily conclude so, but in terms of political leaders' or the public's, understanding, this was not viewed to be the case. There is nothing quite so salutary in making people forget bad times as the coming of good times. Policymakers in the immediate postwar decade, although sometimes looking nervously over their shoulders at the 1930s, increasingly took the view that the 1930s were abnormally bad and the 1950s were a return of normally good times. Keynes' economic analysis was viewed, when it was considered by political policyrnakers at all, as "depression economics" useful, if at all, only when the economy slumped downward deeply and abruptly. Not until the slowing of the postwar boom in the late 1950s and the recessions of 1957-58 and 1960 would the economic message of the war years be reread and Keynesian analysis be elevated to levels of political debate. As the 1950s drew to a close, a good many in the economics profession, who had learned or were learning their Keynes, were quietly preparing themselves for a reopening of the debate over economic stagnation, its causes and cures.

The Employment Act of 1946

In January 1945, as World War II was entering its final, victorious stage, a bill was introduced in the U.S. Senate (S. 380) that called for the federal government to accept the responsibility for maintaining "full employment". S.380 not only determined that "full employment" was to be the law of the land, but also laid out in some detail specific machinery by which it was to be achieved. The document was pure Keynesian, relying as it did on Keynes' theories on aggregate demand and application of cyclical fiscal policy.

At the time of its proposal, a debate was raging among most economists and a good many politicians as to what economic conditions peace might bring. S.380 reflected the views of those who believed that once government wartime spending ended there would be a return to the Great Depression levels of unemployment. Among the advocates of the act were practically all of the Keynesians and a good many New Deal liberals who wished to commit the American economy to a higher degree of central planning. On the face of the evidence, a present-day observer might reasonably wonder who in fact opposed the bill and why? Wasn't the evidence really on the Keynesians' side?

The answer to the last questions was probably yes, but that didn't matter. Practically no one made or could make the case that wartime spending had done anything but stimulate the economy. Indeed, it was the prosperity caused by this spending that now reduced support for S.380 or any similar full-employment legislation. Whatever the personal anguish caused by the war, it had produced an economic uplift. Not many in the general public sensed, as the Keynesians thought they did, a return of hard times. Debate on S.380 through 1945 inspired little public interest, and, probably in 1946, any interest generated was likely to be negative as the economy made a pleasant transition from wartime prosperity to peacetime prosperity. Among business groups, however, opposition to S.380 was very solid. Keynes had once cajoled FDR for his habit of publicly attacking business interests, a strategy Roosevelt found to have political benefits in the 1930s when much of the public believed that the depression had been business's fault. Now, from many business leaders' point of view, full employment acts, Keynesian economics, and compensatory fiscal policy were all part of the New Deal paraphernalia that should be abandoned. Perhaps we had spent ourselves out of depression, but once out there was no reason to return to "New Dealism". Had economic collapse rather than prosperity followed the war, the outcome might have been different, but the best Keynesians and political liberals could get out of Congress was the Employment Act of 1946 (notice that "full employment" had been dropped). This legislation proposed no radical program, meekly calling for "the Federal Government" to use all practicable means consistent with ". . . its needs and obligations and other essential considerations of national Policy - . . to coordinate and utilize all its plans, functions and resources for the purpose of creating and maintaining ... conditions under which there will be afforded useful employment opportunities ... and to promote maximum employment, production, and purchasing power. 9

For the next decade and a half, the Employment Act of 1946 was kept from obscurity only by the Keynesians who pretended that it was a victory, a kind of hidden mandate for federal maintenance of "the great trinity" of economic goals: high levels of employment, stable prices, and economic growth. They also reported victory in the act's creation of a President's Council of Economic Advisors and its requirement for presidential submission to Congress of an annual The Economic Report of the President. At least for the time being, Alvin Hansen's enthusiastic endorsement of the Employment Act of 1946 as being the "Magna Carta of government planning for full employment" seemed a bit too expansive.10 Privately, a good many Keynesians believed the political moment had been lost, an event only adding to the grief they felt after April 21, 1946 when John Maynard Keynes died at home in Tilton, Sussex at the age of sixty-two.

The Employment Act of 1946 and Keynes' ideas, however, survived the postwar prosperity decade as more than mere touchstones for the "true believers" in countercyclical policyrnaking. In classrooms and seminar rooms, a generation of economics students were learning of the possibilities of demand management while their mentors were pushing the theoretical possibilities of macroeconomic policyrnaking to new outer limits. All that was needed to project this formidable body of belief onto center stage was the force of economic events.



Looking over Our Shoulder, II: Grace and the Fall, 1950-1988

The maintenance of full employment through government spending financed by loans has been widely discussed in recent years. This discussion, however, has concentrated on the purely economic aspects of the problem without paying due consideration to political realities. The assumption that a Government will maintain full employment in a capitalist economy if it only knew how to do it is fallacious. In this connection the misgivings of big business about maintenance of full employment by Government spending are of paramount importance. This attitude was shown clearly in the great depression in the thirties, when big business opposed consistently experiments for increasing employment by Government spending in all countries, except Nazi Germany. The attitude is not easy to explain. Clearly higher output and employment benefits not only workers, but businessmen as well, because their profits rise. And the policy of full employment based on loan financed Government spending does not encroach upon profits because it does not involve any additional taxation. The businessmen in the slump are longing for a boom; why do not they accept gladly the "synthetic" boom which the Government is able to offer them? 1 Michal Kalecki

Limiting our perspective to the decade and a half roughly bounded by the Great Crash and the end of World War II, it is noteworthy how thoroughly economic thinking and policyrnaking were transformed. By 1945, economic aggregates, not individual markets, held center stage, and interventions by government on behalf of maintaining the national economy had replaced the older individualist faith in a natural, self-balancing economic order. While the Employment Act of 1946 had not embodied all the interventionist machinery its framers sought, even in truncated form it was a statement on behalf of all enlarged economic role for government. However, it is also noteworthy that, over the next sixteen years, the economists and the policymakers wandered off in different directions. The Truman and Eisenhower administrations treated the Employment Act of 1946 indifferently, as the political mood of the country was conservatized by a flamboyant and apparently unsinkable economy. Although the Great Depression memories never completely receded, the good times gave many citizens the opportunity to reconsider if all that had been done in the name of restoring economic order bad been wise. The not always subtle market interventions were now often painted as dangerous shifts toward collectivism, exacting heavy costs in lost individual freedoms. Such interpretations became all the more common and politically attractive as the Cold War heated up and an "us versus them" (freedom versus totalitarianism) mythology seized the publies imagination.

For its own part, much of the American economics profession was outside the mainstream of public opinion, as economists' recollections of Great Depression agonies proved more durable than those of elected officials entrusted with policyrnaking. This imposed two developments or limitations-on professional economics in the United States. First, it drew the profession together in an essentially single-minded identification with Keynesian ideas (except where a few bastions, like the University of Chicago, held out oil behalf of a market-based economics). Second, it encouraged the highest professional vigilance with regard to a "second coming' " the appearance of any signals of the expected return of economic stagnation. By the late 1950s, many Keynesians were sure that they hadsighted a star in the east.

Camelot

The last three years of the Eisenhower Administration showed the unmistakable signs of protracted slump with a deep recession in 1957-58, followed by all uneasy recovery and a further downturn in 1960. Unemployment hit 6.8 percent in 1958 and never got below 5.5 percent over this period. In 1958, real GNP actually fell for only the second time since demobilization in 1945 (there had been a short, sharp downturn in 1953-54).

Casting about for a theme in the 1960 presidential campaign, John E Kennedy picked up on the matter of "getting the economy going again". JFK's campaign rhetoric dwelt endlessly oil the adverse competitive situation between the United States and the USSR: There was a missile gap to the Soviet Union's advantage. We were losing the space race. And, most important, Russia's rate of economic growth had come to exceed our own. Yet, it was not Kennedy's rhetoric or his economics- which remained largely unclear during the campaign- that won him the election. Nixon's defeat was provided by Eisenhower who, wishing to leave office with a budget surplus after several years of unintended and despised deficits, initiated economic policies that brought a return of recessed economic conditions in the middle of the election year. As a rule, Americans vote their wallets, and the Republican administration had provided enough votes against itself to tilt the election to Kennedy.

Contrary to later myth, Kennedy was not a Keynesian when elected. His economics training at Harvard evidenced little more expertise than FDR had obtained as an undergraduate, nor had the grades in those courses he did take indicate an aptitude in economic matters. However, a marriage ofconvenience was arranged between professional economists and the Kennedy campaign. Kennedy, sensing a new economic and political wind on the rise, had sought the advice of leading economists on a number of campaign issues, especially the advice of Paul Samuelson, Seymour Harris, and Kennedy's tutor at Harvard, John Kenneth Galbraith. All were established Keynesians. While their impact upon Kennedy and the outcome of the election in 1960 is uncertain, Keynesian economic ideas would soon loom large in the new administration.

Undaunted by his narrow election victory, which was hardly a mandate for sweeping political or economic change, Kennedy created a "Task Force on the Economy." Headed by Samuelson, this body made certain policy recommendations, including submission of names of professional economists for the President's Council of Economic Advisors. All of the economists selected for the council were well-known Keynesians. The chairman, Walter Heller, was to have an especially influential role in the construction of Kennedy's "New Frontier" policies and was to enjoy an access to the presidency never before enjoyed in an official capacity by a professional economist. Meanwhile, Keynesians filtered into other key policy positions at the Treasury Department and the Bureau of the Budget. Not since FDR was there such a grand exodus from college economics departments to Washington.

Before proceeding, however, it is worth noting that then, as now, Keynesian economics came in a number of varieties. Two variants are of particular interest. Government efforts to stimulate aggregate demand could follow one of two basic fiscal policy routes, or, of course, a combination of both. First, there could be a simple increase in government spending, following the "compensatory" road of the 1930s and the wartime spending of the 1940s. Second, there could be a tax reduction, which would raise aggregate demand by increasing consumers' disposable (spendable) incomes and firms' supplies of investable funds. The taxcutting approach had been inadvertently followed after World War Il when excess profits taxes and personal income taxes were reduced, with a particularly salutary effect on the general economy.

The spending strategy was especially popular with old New Dealers, of which a few still survived among the ranks of active politicians, and with "left" Keynesians. To this group, the advantage of using government spending to stimulate the economy was that it allowed a high degree of social engineering, permitting resources to be directed toward desirable social objectives such as public works, job training, and the like. John Kenneth Galbraith was the outspoken advocate of this point of view. He had argued eloquently in 1958, in his book The Affluent Society, that America was caught tip in a paradoxical social imbalance: while a rich private sector squandered its wealth on silly creature comforts, an impoverished public sector suffered from inadequate social services and a depleted infrastructure.

Advocates of the tax-cutting position, meanwhile, tended to be a bit more politically conservative. After the tax cut of 1964, in fact, a sizable proportion of American business leaders enlisted in the ranks of this group. Apart from the political attractiveness of applying fiscal stimulus by cutting taxes and allowing spending decisions to remain essentially private in their principal focus, tax cuts had the advantage of affecting demand for goods on their adoption while spending required the time-consuming creation of cumbersome agencies to administer the funds.

Either fiscal strategy, tax cutting or increasing government spending, presumed the purposeful creation of government deficits for effectiveness. On this point, during his first year, Kennedy waffled; but, eventually his Keynesian tutors, most prominently Walter Heller, had their way. In his famous Yale University commencement speech in June 1962, he announced to the nation his Keynesian conversion. JFK attacked the persistent myth "that federal deficits create inflation and budget surpluses prevent it ." Noting that budget surpluses after World War II didn't stop inflationary pressures nor did the accidental Eisenhower deficits of the past two years cause prices to rise, Kennedy went on to justify deficits thoughtfully undertaken and with clear policy objectives in mind. By January 1963, he had determined to take the tax-cutting route, and before the Economic Club of New York, he explained the logic of his approach: Deficits in the recent past had resulted not from excessive spending or insufficient tax revenues but from inadequate economic growth. Pursuit of a balanced budget through higher taxes, the preferred policy of his predecessor, choked off growth, which actually led to growing deficits. A tax cut would stimulate growth, thereby enhancing the revenue collecting possibilities.

Galbraith and the "left" Keynesians had lost in the struggle for Kennedy's economic mind. As Ambassador to India (some suggested he had been packed off to New Delhi because of his excessive badgering of the president), Galbraith could not counter the arguments of Heller and others. At the time it probably was not considered especially important by many economists, the conversion of a president to some version of Keynesian thinking being the really important development. However, in the light of later events, Kennedy's decision to go with a tax cut was momentous. Galbraith had put the issue to Kennedy quite directly: Tax cutting was the wrong strategy because it would start a bad precedent, one that fiscal and political conservatives would quickly embrace and then apply their own balanced budget logic to batter down government social spending. Two decades later, Galbraith was to see his fears justified in the Reagan administration's fiscal strategies.

The remaining months of the Kennedy administration saw a wideranging debate on the heretofore unheard-of idea of purposely creating a peacetime deficit for the purpose of stimulating the economy. Three months after Kennedy's assassination, a bill, providing for $11 billion in tax relief for individuals and $2.6 billion for corporations, passed Congress and was signed into law by President Johnson. Within a year, its effects seemed to be better than predicted. Unemployment, which bad not fallen below 5.2 percent in any Kennedy year, was down to 4.5 percent in 1965 (and under 4 percent the next year). Per capita GNP growth nearly doubled from 1963 levels to 4.5 percent in 1965.

The Kennedy administration was too brief to make a very accurate assessment in terms of its actual economic record. Indeed, the tax cut was probably passed by Congress because of Kennedy's death rather than because of widespread conversions to Keynesian economic reasoning. However, JFK had declared his acceptance of the New Economics. He had elevated economic debate at the presidential level. And he had brought economists into active policyrnaking roles. Camelot may have ended prematurely, tragically, and inconclusively, but it did produce a legacy. When Lyndon B. Johnson won in a landslide over Barry Goldwater in 1964, in a campaign that pitted LBJ's interventionist, big government ideology against Goldwater's traditional laissez faire appeal, Kennedy's conversion to New Economic thinking seemed to be justified. To many, the Kennedy years were now seen as the real beginnings of a new economic era.

The High Tide of the New Economics, 1964-1967

The high-water mark of the "New Economics" was reached early in LBJ's first and only elected term of office. Broadly speaking, the public came to understand the New Economics of Johnson's "Great Society" program to be much more than the practical application of Keynesian theory. The president, who had cut his political teeth under FDR, constructed a wide ranging social and economic program intended to finish all of the old New Deal agenda and then some. Accepting and enlarging upon the tax-cutting gains, Johnson introduced his own expansionist fiscal policy; but, unlike Kennedy, LBJ opted for massive domestic spending programs aimed at "eliminating poverty in our time." Job retraining, higher educational subsidies, urban development, enhanced and enlarged welfare and social entitlement programs, and a variety of public works programs were memorable centerpieces of the Great Society effort. Between 1964 and 1967 (the last year before the Vietnam War spending really kicked in with a vengeance) the federal budget grew by almost 40 percent, from $65.2 billion to $90.9 billion. At the time, the spending seemed to have a useful effect on the economy, sending GNP up by 25 percent and keeping unemployment below 4 percent.

With regard to the general management of the economy, there was by now a widely held belief, in the economics profession as well as among business leaders, the media, and the general citizenry, that the business cycle had been conquered. "Fine tuning" had entered the economics vocabulary. Simply put, the concept held that through adroit actions by fiscal policyrnakers and with appropriate accommodations by the monetary authorities, the Keynesian spigot could be adjusted in its flow of aggregate demand not only to expand output and employment as needed but also to control excessive demand situations that might be inflationary. The latter element of the fine tuning argument, however, remained more a matter of theoretical conjecture than proven fact since almost two decades had passed since a serious inflationary situation had existed. Yet, to a nation, enjoying by early 1967, five years of sustained economic growth, these and other New Economics arguments sounded eminently sensible. Indeed, the New Economists had captured almost everyone's interest, and economists enjoyed a level of respect and attention heretofore unheard of. Feature stories on Keynes and Keynesian economics graced Time, Newsweek, and other publications as the nation celebrated, somewhat prematurely as it developed, victory over the darkness of recession and depression.

Today, the 1960s are best remembered as a time of national travail- political assassinations, an unpopular war, youthful rebellion, racial unrest, agonizing cultural changes; but for most Americans, at least until the latter third of the decade, it still seemed a time of solid social and economic achievement. Only later, in the grim 1970s, did "the Sixties" take on an ominous dimension. We have looked at the sixties in some detail in Chapter 2, but the economic and social values and beliefs of this period remain so important in unraveling present perspectives that going back again is entirely worthwhile.

A few of the prevailing beliefs that acted as a social compass during the first part of the 1960s are especially worth noting since they- reveal an optimism that was soon to be transformed into cynicism at the political level and into uncertainty in economic matters. First, there was a new view toward the old problem of economic insecurity. For the growing middle class that knew only of an improving material well-being since the end of World War II, economic security for themselves and their children was taken for granted, a situation not many of their parents knew in the 1930s or before. Moreover, the Great Society programs and the Civil Rights Acts of 1964 and 1965 how promised to extend the possibilities of economic security to groups that had largely been excluded before: blacks, Hispanics, ghetto dwellers, rural Americans, the aged, and others. Second, the experience of the depression years, despite the prospect and reality of enhanced individual prosperity, was still a vital memory for many citizens. Insofar as government intervention was seen as a factor in rolling back the depression and in improving general economic conditions, a good many Americans perceived the mixed economy of limited, and not-so-limited, government economic management as essentially desirable. They had showed their preference by rejecting the free market philosophy of Barry Goldwater in the 1964 presidential election.

Another constant in the national mind-set of the mid-1960s, and paralleling the nation's faith in maintaining domestic economic security, was the expectation that the United States was and would remain dominant in the international economy. The other side of this belief was the view that American political and military power might have to be used around the world when vital American interests were threatened. Contrary to some later interpretations, Americans were not dragged into the Vietnam conflict rather, at the outset at least, they enthusiastically supported LBJ's decision to widen that conflict. It was, of course, on this shoal, seemingly unconnected at the time to domestic economic concerns and policymaking objectives, that the New Economics was to flounder. And as it sank, it dragged under both the hopes and the realities of the Great Society.

American involvement in World Wars I and II and the Korean War had commenced when the domestic economy was less than robust. As a result, a fair amount of unused industrial capacity and underutilized workers were available to take up (initially at least) the task of providing war goods, without shifting resources from peacetime production. As these conflicts expanded, especially in the cases of the two world wars, "guns" did indeed displace "butter." However, in the case of Vietnam, America's military involvement began near the peak of a long economic expansion. The nation was fully employed producing butter. Increased war spending- with no offsetting reductions in other government spending, no increase in taxes to soak up private sector demand for civilian goods, no restraining monetary policy to slow down civilian demand- could only have the effect of driving prices upward as guns suppliers competed with butter producers for scarce resources. This was not an unknown economic fact. How then can we account for the economic disaster that the Vietnam War visited on the American economy? For his own part, Johnson, the consummate politician, believed that Congress would not have undertaken the tight fiscal policy needed to make a guns and butter strategy possible. It is of course entirely possible that Johnson was correct in this estimate; but that relieves neither Johnson nor the Congress of the burden of a horrendous economic error, an error that made possible an equally disastrous political error. Had LBJ faced up to the guns or butter choice he was confronted with, Congress and the American people would have had to face up to the costs of the Vietnam conflict much sooner, and national resolve with regard to the war would have been immediately tested rather than later when both the economy and the political structure were in tatters.

But where were Johnson's economic advisers in all this? Economists, of all people, should have known that the opportunity cost of more guns in a fully employed economy must be less butter. Years later, and rather lamely, Walter Heller, Johnson's first chairman of the Council of Economic Advisors, maintained that he and others had not been forceful enough with the president because they "had not been informed" about the scale of the military build-up Johnsor's military advisers saw as essential to winning in Vietnam. Heller's explanation was, of course, only an excuse, offered for himself and for a profession that stood by, mostly silent, as the guns and butter fiasco got underway. All things considered, however, the muteness of most mainstream American economists was better explained as the result of inexperience than a matter of insufficient information. For almost forty years, the preoccupying concerns had been economic growth and unemployment. Except for brief episodes, such as during the extensive wartime mobilization of the economy after 1942 and the postwar demobilization, inflation had rarely been a matter of much practical interest. Neither economists nor policymakers were very well prepared for what was to follow in the wake of LBJ's escalation of the war in Vietnam.

The Great Ungluing, 1968-1980

When LBJ threw in the towel in 1968, his refusal to run for reelection, contrary to political mythology of the time, was not based solely on the increasingly unpopular war in Vietnam but also on the accumulation of grim economic evidence. Two of the three principal measures of macroeconomic policy still looked solid enough in 1968- unemployment held at 3.6 percent and real GNP expanded at a 4.4 percent annual rate, only slightly below the average of the Kennedy-Johnson years. But, prices, on the other hand, were moving up at a 4.2 percent clip. By this time, of course, economists had regained their composure and were generally advocating a restrictive fiscal policy (less social spending and more taxes) to produce a modest trade-off of growth and levels of employment for reduced inflationary pressures. Such a strategy for turning down the spigot controlling the total demand for goods was, theoretically speaking, merely an exercise in "fine tuning.' As a matter of practical politics, however, Johnson correctly perceived that the extent of necessary restrictive actions meant effectively ending his Great Society dreams, since, as he never tired of saying, he could find "no honorable way" to disengage in Vietnam. Under such conditions, turning down the spigot was not a minor and inconsequential policy action. Although a 4.2 percent inflation rate may seem acceptable to a later generation that has experienced double-digit inflation, this was the most significant jump in the price index since 1950. Worse still, it came after the administration had actually undertaken modest steps to cool the economy in 1967- a 10 percent surcharge on personal and corporate income taxes and a moderately restrictive monetary policy aimed at discouraging borrowing.

For those watching both policy and events closely in 1968, the failure of price pressures to subside in the face of contractionary policy actions suggested a terrible thought: The fine tuning thesis so central to New Economic thinking might just be without merit, and if that were true, all of the celebrations of victory over the business cycle had been in vain. This fear was soon realized.

What became apparent through the late 1960s and early 1970s was that the New Economists' strategy for managing an economy through the manipulation of aggregate demand was asymmetrical. To be sure, in deep recessions and depressions, increases in aggregate demand led to increases in output and employment (and falling rates of unemployment). Similarly, reductions in total demand lowered output and employment. It was on the basis of such observable behavior that fine tuning had been advanced in the first place. The asymmetry developed, however, around the behavior of prices. No one of significant economic intellect had any doubts that rising demand at a time when resources were fully employed would produce serious inflationary consequences. The result of "too many dollars chasing too few goods" was widely understood. Some had also noticed that prices might also edge upward before an economy was fully employed, such as during the early months of World War II, when bottlenecks and shortages in certain resource markets led to rising resource costs that were then passed on by producers to consumers of their products. Ultimately these costs appeared as higher consumer prices. The real point at issue though was under what conditions prices might fall, or at least price pressures might diminish. Despite the fact that Keynes, in his original attack upon classical economic orthodoxy, had argued against the classicals' market-clearing argument of flexible prices and asserted that prices were not flexible downward, fine tuning advocates had assumed that managed reductions of aggregate demand would at least halt price pressures. Alas, they were to discover that under reasonable restraints on demand (or at least what was considered at the time to be politically reasonable restraints), prices exhibited a stubborn unresponsiveness. The case can be argued that the restraints actually applied did not cut deeply enough into the demand pressures. And there may be much truth to this argument since LBJ and, later, Richard Nixon exhibited genuine fear of the political consequences of applying the economic brakes too firmly. Surely a numbing recession would have halted the inflationary push. it did so in 1981. But that would not have amounted to a vindication of fine tuning arguments. Fine tuning was, after all, an effort to avoid the agonies of economic fluctuations. To use recession to kill inflation, as a matter of policy, was certainly not a quantum leap beyond the whipsawing economic corrections of the old, "natural" business cycle.

Events were soon to widen this crack in the fine tuners' dike to the point where the economy seemed about to be overwhelmed by a steady torrent of disastrous economic news. The new Nixon administration was greeted by a recession as it took office in 1969. Real GNP growth turned negative for the first time in eleven years, and for the first time since 1961, unemployment went over 6 percent. Worse still, there was no respite on the inflationary front, an unheard of turn of events since heretofore one of the "good" things about recessions had been price downturns. Prices went up 5 percent in 1969 and 6 percent in 1970. "Stagflation:'as Paul Samuelson was later to dub it, had taken hold -high rates of unemployment and slow or nonexistent growth along with high rates of inflation.

The slump of 1969-70 was an awful blow to American confidence. The stock market went into one of its worst nose dives since 1929. The media, only a few months earlier celebrating the victory of the New Economics, now announced its demise. Ardent defenses of fine tuning in particular and Keynesian economics in general still appeared from time to time but less frequently and with less effect. The Nixon administration, meanwhile, pursued various confused policies, only adding to the misery and uncertainty: an ill-conceived effort at direct price controls, continued Vietnam War spending, and the highest "peacetime" deficits thus far recorded in American history.

The still-dominant Keynesian majority in the economics profession now found itself under siege, with its own ranks steadily decimated as once "true-believers" slipped away in the night. in fact the Keynesian orthodoxy was under attack from both flanks. On the right, there was a noticeable reinvigoration of free market economics. Although appearing in sundry forms, these heirs to the classical faith shared a common disposition to oppose "Big Government", and their attack featured the charge that not only had the New Economics failed to work, it was in fact the cause of current problems. On the left flank, a largely homegrown radicalism, nourished on Marx's critique of capitalism and their own, often personal, opposition to the war in Vietnam, to racism, and to the existing distribution of income and power in the society, assaulted the Keynesian tradition as an ineffective effort to paper over the fundamental flaws of any production-for-profit society. If one didn't listen too closely in the early 1970s, the raw rhetoric of both the right and the left sometimes seemed to be identical. In fact, they shared only one common point of view: that a capitalist economy with a high order of government intervention and regulation did not work.

If the 1960s are largely remembered for the "victory" of the New Economics, the 1970s are remembered for their largely aimless economic drift and for the high order of political opportunism that was interjected into economic policyrnaking. Nixon's New Economic Policy of first freezing wages, prices, and rents for ninety days after August 15, 1971 and then, over the next fourteen months using three new federal agencies (a cost-ofliving council, a price commission, and a pay board) to administer price and wage controls illustrates this holiday from economic reason. Although most economists have serious reservations about the peacetime employment of wage and price controls, finding them highly inefficient, some will make a case on their behalf. Among the latter is John Kenneth Galbraith, who has long argued that price controls are the only really useful tool against inflation. But even Galbraith could find few kind words for the New Economic Policy (NEP). Administratively, it lacked the staff and power to be truly effective and its emergency nature suggested to all affected parties that the controls would sooner or later be lifted and that a massive effort of catching up on foregone increases would quickly follow. Conservative economic thinkers attacked the policy as a betrayal by a conservative president of free market principle. (They, of course, had been enraged by a Nixon remark in the 1968 campaign that "we are all Keynesians, now.") Liberals saw the NEP as a matter of political grandstanding and attacked Nixon for exercising excessive presidential power. Some also correctly pointed out that the control agencies were heavily loaded in favor of business interests. Meanwhile, radicals largely cheered from the sidelines since the NEP was living proof of capitalism's inability to function properly.

Nevertheless, by mid-1972, a measure of recovery from recession had been achieved and inflationary pressures had relaxed a bit. The miniboom of 1972-73 was probably the result of Federal Reserve actions to greatly increase the money supply. Meanwhile, the NEP, in the short run at least, had provided some downward pressure on prices. The Fed's action drew criticism from many economists as a mere gilding of Nixon with economic good times just before the 1972 presidential election. Keynesians and non-Keynesians alike expected the longterm effects of this action, coupled with the delayed price pressures resulting from the NEP, to bring on n new inflationarv wave. They were not to be disappointed in their inflationary expectations, but, in fairness, it should be pointed out that 1973 was the last vear the American economy enjoyed less than 5 percent unemployment (4.9 percent).

Those who the gods would destroy, they first drive mad. So it was to be for the rest of the 1970s.

Nowhere in the Keynesian toolbox, nor really for that matter among the theories of contemporary free market advocates, was there anything to prepare the nation for the next sequence of events. Despite the fact that the early proponents of a capitalist economic system- Thomas Malthus and David Ricardo- had always agonized over the prospects of a world running out of essential resources, modern economics thinking accorded such views no prominent place. By 1973, deficiencies in the supply of certain critical commodities, heretofore simply taken for granted, exposed these shortcomings in contemporary reasoning and policymaking.

First, there was the self-inflicted problem caused by the Russian Grain Deal of 1972. Nineteen million metric tons of grain, virtually the entire U.S. reserve, was sold to the Soviet Union, who, like most of the rest of the world, was suffering from a cycle of severe crop failures. With supplies of grain for domestic consumption sharply reduced, the prices of grocery store items from bread, to beer, to meat began to edge upward in 1973. Second, the OPEC (Oil Producing and Exporting Countries) cartel briefly shut off the oil tap in the winter of 1973-74, forcing within a year a 50 percent increase in all energy prices. The 1973 oil embargo, ostensibly a reaction to U.S. support of Israel against the Arabs in the Yom Kippur War of 1973, was to be repeated again in 1977. Oil prices would eventually go from $2.59 a barrel in 1973, to $12 in 1976, to over $35 by 1980. Dependent as the United States had become for almost half of its oil from abroad, the result of the oil cartel's imposed price increase was to push upward the production costs of virtually every commodity and service. Third, through 1973 and 1974, worldwide shortages in other crucial metals and minerals produced the widespread feeling, if not quite the reality, that "we were running out of everything."

These so-called supply shocks along with the persistent stagflationary pressures dumped the economy into recession again in 1974 (Nixon's NEP efforts were abandoned in 1974 after a second ineffective price freeze in 1973). Heightening this economic madness was the apparent disintegration of any political will to deal with either the supply shocks or the deepening stagflation. In October 1973, after pleading " no-contest" to charges of tax evasion, Vice President Spiro Agnew resigned. Within a year, Nixon would have to resign in the wake of the Watergate scandal. During this period, effective executive branch leadership virtually ceased, precisely as Congress was preoccupied with the problems of the executive. Attention to economic matters, despite the downward spiraling of the general economy (11 percent inflation and 5.6 percent unemployment in 1974 followed by 9.1 percent inflation and 8.5 percent unemployment in 1975), was distracted and confused.

A measure of the level of confusion was evident in the short-lived Ford administration which, after first asking Congress for a tax increase to fight inflation (a "reasonable" policy course at the time), reversed itself and asked for and received from Congress a major tax cut (also a "reasonable" policy course at the tinie). Predictably, this tax-cutting stimulus encouraged some recovery in 1976; but recoveries just weren't what they used to be. Unemployment only fell to 7 percent while prices kept increasing at an annual rate of nearly 6 percent. The tax cut, to no ones very great surprise, kicked in during a presidential election year, but it failed to deliver enough of the goods to elect Gerald Ford, who had risen to the presidency as a result of the Agnew and Nixon resignations.

The return of the Democrats to the White House with Jimmy Carter in 1977 might have been expected to be a return to some kind of New Deal- New Frontier- Great Society style of economic policymaking. It did not become so. Instead, economic strategy, insofar as it can be alleged that any economic plans actually existed, worked in the shadow of a number of restricting realities. Prices kept edging upward, with annual CPI (Consumer Price Index) increases running to 6.5 percent in 1977, 7.5 percent in 1978, and 11 percent in 1979. After the second oil embargo in 1977, the Carter Administration became preoccupied with the development of an energy policy, an effort that produced unremarkable results. The last year of the administration saw no new economic policy initiatives as the White House was virtually immobilized by the Iran hostage crisis. By 1980, there were signals everywhere that the chronic stagflation situation was about to degenerate into a major recession. Investment spending went flat. Unemployment remained stuck at between 6 and 7.5 percent. Nevertheless, no collapse developed before the end of 1980, largely because consumer spending remained high, probably, most economists observed, because inflation rewarded spenders and penalized savers.American recollection of the Great Depression and commitment to a managed, fully employed economy, however, had not yet completely ebbed. In 1978, Congress passed the Full Employment and Balanced Growth Act (better known as the Humphrey-Hawkins Act). The enactment (effective in 1983) specified the attainment of 4 percent unemployment (3 percent rates for those over 20 years of age) and a 3 percent rate of inflation. Moreover, it specified unemployment as the primary goal in any policy action involving a trade-off with inflation. The act went on to acknowledge the failures of monetary and fiscal policy efforts in providing full employment by calling for a variety of direct actions (job training, price controls, and so on) to fight unemployment and inflation and to promote growth. Presuming the need for greater centralized economic planning to obtain these ends, the act also called for better data collection and the coordination of long-range policy planning between the president, the Federal Reserve System, and the Congress.

Humphrey-Hawkins scarcely merits a footnote in economics texts today. Within a year of its passage, its employment-price stability targets were postponed until 1988. In fact, by the mid-1980s, the targets had been forgotten altogether. Humphrey-Hawkins was the last skirmish in a battle already lost. The full-employment era of public policyrnaking had come to an end and the dominance of high Keynesian orthodoxy in the economics profession was over by 1980.

Conservative Revival-The Reaganomic Revolution, 1980-1988

The election of Ronald Reagan in 1980 marked the end of a 360-degree swing in American economic thinking that had begun almost a half century earlier. Advancing an economic philosophy that was more akin to Calvin Coolidge and Herbert Hoover than the economic wisdom of recent decades, Reagan offered an uncompromising defense of free market economic principles. His specific economic proposals brought together two major themes in contemporary conservative thought- the older monetarist tradition and the comparatively recent supply-side analysis. The former harked back to the classical faith in minimal government, balanced budgets, and the presumption that economic rules rather than discretion were the best guide to economic policymaking. The latter advanced a more controversial doctrine, namely that the economy might be stimulated by various government actions that were aimed at te production (or supply) side of economic activity.

Splicing these two views together, the Reagan economic program called for balanced budgets, tax cuts (matched by spending cuts), shrinkage of government's general economic management activities, and deregulation. This return to. the discipline of the market would presumably end inflation, create jobs, and stimulate growth. Moreover, both supply-siders and monetarists announced that their concerns were not narrowly domestic. By promising to bring inflation under control, they also promised to improve America's deteriorating trade position. Lower priced American goods would sell more easily overseas and would effectively slow the penetration of American markets by low priced foreign competition.

The election, although not a landslide, was not, as many hard-core liberals maintained at the time, a fluke. Orthodox liberal economics was in trouble. Impaled on the horns of the stagfiationary crisis of high unemployment and sagging growth accompanied by high inflation rates, Keynesian theory seemed to practically everyone to be unequal to the task it faced. To make matters worse, Carter, the expected champion of liberal social engineering and interventionism proved to be intellectually unequipped, first, to comprehend the economic crises confronting the economy, and second, even failing comprehension, to rise to the pretension of decisiveness.

Meanwhile, conservative economic thinkers had been working hard for some time to nudge the American public toward acceptance of an economic outlook they had turned away from nearly five decades earlier and had soundly rejected only sixteen years previously in the LBJ-Goldwater election. Through 1979 and 1980, the OpEd and editorial pages of The Wall Street Journal and The New York Times began to carry pieces by Jude Wanniski, Paul Craig Roberts, and others laboring on behalf of a variety of programs associated with the new supply-side theories. The publication of Milton Friedman's extremely popular Free to Choose in late 1979, released in conjunction with an equally popular television series of the same name, exemplified a successful strategy of "going public" with economic ideas and analyses that had previously been reserved for textbook and classroom discussion. Whereas the Keynesians of two or three decades earlier made their conversions in economics courses, the new classical economists took their case directly to the public. incidentally, Friedman's folksy arguments on behalf of a simple, market-based economics should not be underestimated in the number of converts they delivered among the more thoughtful of the general population, including a fair number of university economists. But, even apart from such successful proselytizing efforts as these, Americans were turning away in large numbers from the economic mainstream of the past twenty years. Always pragmatic, they could see that the prevailing wisdom was not working. Nor were they much moved by liberal arguments that the ideas put forth by candidate Ronald Reagan had been tried and found wanting nearly a half century earlier.

At the level of macroeconomic policy, Reagan determined to eliminate the stagflationary drift by attacking the problems of growth and inflation simultaneously. (Unemployment, within a classical economic context, did not play the central role that it did for Keynesians and, at any rate, was viewed as a nonproblem if the economy could be stimulated.) According to Reaganomic strategy, output (supply) problems were to be attacked via fiscal policy while inflation was dealt with through monetary policy- a little bit of supply-side economics and a little bit of monetarism. The Tax Reform Act of 1981, the central supply-side tool for stimulating savings and investment, mandated 25 percent, across-the-board personal income tax reductions, spread over the next three tax years. Galbraith's warning to Kennedy that tax-cutting stimulation would have an immense appeal to conservatives now reverberated back over the years. However, while prevailing rhetoric called for deep spending cuts to coincide with the tax cuts, government spending increased rather than declined. Although some social spending programs on the Reagan "hit list" took a pummeling, these reductions were more. than offset by the president's increases in military spending. Quite irrespective of economic considerations, "restoring America's defense capabilities" had been a major theme in the Reagan campaign and was a matter of great personal concern to Ronald Reagan.

The combination of tax cuts and increases in military outlays produced a major hemorrhage of red ink. As any good Keynesian would have expected, such a combination of reduced taxes (T) and rising government spending (G) had to be expansionary. Such a decline in T and rise in G would certainly have generated enormous inflationary pressures (the CPI was already rising at a 10 percent clip) had not the administration applied its monetary cure for inflation. The cure was a tight money, high interest rate policy that stopped borrowing in its tracks and produced a bonechilling recession. Unemployment shot to Great Depression levels of 10 percent in 1982 and 1983. But, price increases did level off, to under 4 percent a year by 1983.

The Reaganomic strategy of tax cuts and tight money has been likened by critics to driving a car by pushing to the floor, simultaneously, the accelerator and the brake. In this case at least, the brake of monetary policy seemed to be the more effective. However, in 1983 the tax cut seemed to kick in, and a long recovery commenced. The administration took credit, of course, pointing to its "victory" over inflation as the key.

Annual price increases fell from 10.4 percent in 1981 to 3.2 percent in 1983 and then held steady at about this rate through the remaining years of the administration. Unemployment was more stubborn, falling only to 7 percent by 1986 before dipping below 5.5 percent in 1988, a figure not obtained since Nixon's last year in the White House. Economic growth was certainly not as impressive as was hoped for only 1984's 5.6 percent increase in real GNP per capita was noteworthy.

Those of a Keynesian inclination were not impressed with "the Reagan boom". From their point of view, the post-1983 recoverv resulted from a good old dose of government fiscal stimulation. The "supply-side" tax cut was really indistinguishable from a "demand-side" cut and government spending for war goods had always proved to be economically exhilarating. That the recession of 1981-82 had slowed prices was also, from a Keynesian point of view, unremarkable. Truly deep recessions on the order of 10 percent unemployment could always be expected to cool price pressures. And, of course, the lower prices after 1982 also reflected the benefits of falling oil prices as the OPEC cartel disintegrated, at least temporarily. However, whatever the Keynesian overtones of Reagan's use of fiscal and monetary policies, few liberal Keynesians were about to embrace Ronald Reagan. And, at any rate, they could not dispute the basic argument: Regardless of strategy, Reagan had done what Keynesians had failed to do.

There were, however, liabilities to consider in the overall macroeconomic balance sheet of the Reagan years. Of foremost importance was the federal deficit which quickly escalated from major hemorrhage to full flood, as Table 4-1 indicates. Over Reagan's term of office, the outstanding federal debt grew from about $1 trillion to $2.6 trillion. Then, there was the second of the terrible "twin deficits" the growing gap between U.S. exports and U.S. imports- the trade deficit. Partly the result of structural conditions over which Reagan had little control and partly a problem inherited from the years of high inflation, the trade imbalance sharply worsened as the federal deficit grew. To attract funds- a large proportion of which were from abroad- to finance the growing deficits, interest rates remained high on U.S. securities. High interest rates, especially between 1983 and 1987, increased the overseas demand for American dollars to invest in the United States. The effect was to bid up the price of dollars relative to other currencies. As the American dollar "strengthened" the price of American-made goods rose relative to foreign goods, opening U.S. markets to foreign sellers and effectively closing foreign markets to American products. By 1986, the foreign trade deficit was about the same size as the federal deficit, and the United States had become the world's largest net debtor nation.

The trade and budget deficits were scarcely secrets, but, for most of the 1980s, except for a few outspoken conservatives who felt Reagan bad abandoned sound economic principles and a small (but growing) number of "doomsday" devotees who saw nothing but disaster at the end of the road of debt, reactions to the deficit were comparatively restrained. The general public, when asked by pollsters, have long agreed that chronic federal deficits are the single most troublesome aspect of the contemporary economy. However, when given a chance to elect a liberal Democrat who agreed with this view and promised to close the deficit with a tax increase, the public again chose Ronald Reagan in 1984. Reagan also frequently expressed his own reservations about the federal deficit, laying it at the doorstep of a Congress he accused of not enacting his requested budget cuts. But, before 1987, his concern did not seem to be exceptional. For its part, Congress yielded to public anxiety and the prospects of political haymaking with its own budget balancing legislation. just before Christmas, 1985, the Gramm-Rudman-Hollings Act was passed. Setting a target of 1991 for balancing revenues and expenditures, this enactment laid out "automatic" budget-cutting machinery to keep deficits within prescribed targets. However, until the stock market, which had itself risen to new and unanticipated heights during the deficit explosion, sent out distress signals in October 1987, the deficit debate lacked urgency.

The Reagan program, of course, had not been limited to tax cutting, and on other matters, for a time at least, be received better economic marks. Deregulation drew considerable praise~ and not simply from free market advocates. His opposition to trade protectionist legislation was similarly viewed as a positive step. Relaxation of antitrust enforcement, along with moving back from the earlier mandated requirements of environmental, consumer, and job-safety protection, while lamented by most liberals, was viewed as sensible by many economists, especially given the worsening "competitiveness" of American business in world markets.

Final examination of the Reagan years awaits the passage of time; however, in the remaining chapters, as we attempt to piece together a picture of the contemporary state of economic reasoning and policyrnaking, we will hold up many of the Reagan era policies to closer scrutiny than we have offered here. Yet, irrespective of the evaluations we finally reach, this period remains notable for its reopening of economic debate on many matters once considered solved and its posing of policy solutions once considered unworkable.

********************************************************************************************************************************************* TABLE 4-1: Federal Government Deficits 1978-1988

Year ;       1978 1979 1980 1981 1 982 1983 1984 1985 1986 1987 1988 1989 (est.) 1990 (est.)

Deficit    - 59.2 - 40.2 - 73.8 - 78.9 -127.9 -207.8 -185.3 -212.2 -221.2 -149.7 -155.1 -161.5 - 92.5
(in bill. $)

Source: Report of the President's Council of Economic Advisors, 1989.
**********************************************************************************************************************************************

Chapter 3

1. Joseph Schumpeter, in Seymour Harris, ed., The New Economics The Influence of Keynes on Theory and Public Policy (New York: Alfred Knopf, 1952),97.

2. John Kenneth Galbraith, The Great Crash (Boston: Houghton Mifflin,

3. ibid., 82-83.

1954),83.

4. Lekachman, The Age of Keynes, 114.

5. Ibid.

6. The New York Times, December 31, 1933, as cited in Roy Harrod, The Life ofjohn Maynard Keynes (New York: W. W. Norton, 1951), 447.

7. Keynes, The General Theory, 383-384.

8. Paul Samuelson, in William Breit and Roger L. Ransom, The Academic Scribblers (Chicago: Dryden Press, 1982), 113.

9. Stat. 24, 838.

10. Alvin Hansen, The American Economy (New York: McGraw-Hill, 1957), 89.

Chapter 4

1, Michal Kalecki, The Last Phase in the Development of Capitalism (New York: Monthly Review Press, 1972), 75.

2. As quoted in Lekachman, The Age of Keynes, 272.

*********************************************************************************************************************************************