The 1970s

"I have directed [Treasury] Secretary Connally to suspend temporarily the convertibility of the dollar into gold. "

"In a world organized in accordance with Keynes' specifications, there would be a constant race between the printing press and the business agents of trade unions, with the problem of unemployment largely solved if the printing press could maintain a constant lead…"

The 1960s was a period where America turned to the government for solutions to its problems and Washington became home to a "brotherhood of scholars," "action intellectuals" who would lead the attack on the social, economic, and technological problems of the times.  By the mid 60s the tide had turned in the space race when Gemini 7 orbited the earth 206 times and rendezvoused with Gemini 6 in December of 1965, proving that a manned trip to the Moon was possible.  The cold war with communism also cooled a bit as the Soviet Union backed down during the Cuban missile crisis, slightly more than a year after the disastrous Bay of Pigs invasion of Cuba in April of 1961 and in 1963 the US was selling grain to the Soviet Union and China.  It was also a time where Blacks and women began to assert their rights.  Within a year of the Civil Rights march on Washington, President Johnson, following up on the agenda of Kennedy's New Frontier, gained passage of the Civil Rights Act of 1964.  Three years later Thurgood Marshall became the first justice of the US Supreme Court.  It was also the decade of Roe vs. Wade, the pill, and NOW; heart transplants, valium, and weight-watchers; the Beatles, Woodstock, hippies and Timothy Leary; the first Super Bowl, Roger Maris' 61st home run, and the launching of the QE2 and GI Joe, the Bullet Train, the Boeing 747, and the Mustang, oil discovery in Alaska, formation of OPEC, and publication of Rachel Carson's book Silent Spring; Medicare, the Department of Transportation, and Michael Harrington's book The Other America; cash machines and "Plastic" bank cards; and the opening of Domino's Pizza and Walmart and McDonald's listing on the NYSE.

These were very good times to be an economist - and a liberal. On the macroeconomic front, passage of the Revenue Act of 1964 ushered in what Rukstad appropriately refers to as the "Zenith of Keynesian Economics." By mid decade there was talk that the business cycle, a scourge of capitalist systems, had been tamed and that active government policies could defeat the problem of economic instability. Arthur Okun, president Johnson's economic advisor, was so confident in the successes of the revolution that he claimed recessions "are now generally considered fundamentally preventable, like airplane crashes and hurricanes."  There may have been room for refinement, for fine-tuning the theory of macroeconomic stabilization, but it was firmly in place so there was little surprise when President Nixon, a conservative Republican, announced "Now I am a Keynesian."

The successes of the Keynesian 'experiment,' and the reason for their confidence, seem apparent when we look at the unemployment rate in the 1960s. Throughout the 60s the economy continued to expand as unemployment fell below 4 percent, the generally accepted definition of full employment.

Buoyed by their success and confident that government could right the wrongs of the market system, economists and policy officials turned their attention elsewhere. Michael Harrington's book The Other America had brought poverty to the attention of the American people at a time when they were increasingly insulated from it in their rapidly growing suburban communities.  President Johnson sought to take on the problem by moving beyond the New Frontier in 1964 and declaring war on poverty.  In his inaugural speech he proclaimed "This administration today, here and now, declares unconditional war on poverty in America."  The Economic Opportunity Act that followed pumped money into a number of programs, including the Jobs Corp, designed to help those least able to help themselves.  In the following years he initiated a number of federal government initiatives including the establishment of Medicare in 1965 and two new cabinet posts - Housing and Urban Affairs in 1965 and Transportation in 1966. This was followed by a sharp increase in defense spending from an early 60s level of $50 billion to $70 billion in 1967 and $80 billion the following year.

There were also the problems of the environment, popularized in Rachel Carson's book The Silent Spring, that ultimately led to Earth Day and the formation in 1970 of the Environmental Protection Agency (EPA). And if that were not enough, the science community had delivered on Kennedy's promise to put a man on the moon before the end of the decade.

In part due to success on the macroeconomics front, and in part because of the escalation in the Vietnam War, the economy was a non issue in the 1968 presidential campaign narrowly won by Nixon.  By 1970 the mood was beginning to change as Americans came to realize that many of the promises of the 1960s would not be easily delivered.  The War in Vietnam was heating up after the US initiated bombings of Vietnam in 1965, and before the decade was over students had taken over control of many of the nation's most prestigious universities in a wave of antiwar protests.  There were also no signs of a thaw in the Cold War as Russian troops invaded Czechoslovakia. The war on poverty and inequality was also not going well as a number of the nation's largest cities became engulfed in riot triggered fires similar to those experienced in Los Angeles during the summer of 1965. The nation also mourned the deaths of Martin Luther King and Robert Kennedy, leaders in the civil rights movements who were assassinated in 1968.  And finally, the space program had been dealt a setback with the near disastrous Apollo 13 mission. 

There were also some signs all was not well with the macroeconomy.  The nation was plagued by strikes and the Keynesians were not able to deliver on their promise to 'fine-tune' the economy - or at least without a cost of higher inflation, which by the end of the decade was approaching 7 percent.

There was also the problem of the rising budget deficit.   Kennedy had warned of the power of myths, but the ability to grow a surplus was beginning to look rather like a new myth.  The economic growth to be created by expansionary fiscal policy never produced the tax  revenue increases promised, and by 1968 the deficit was $25 billion, a 200 percent increase from the previous year.

Internationally, there was growing concern over the declines in the US current account balance.  As the decade ended the US current account was moving downward and there were fears that the US would run a trade deficit. 

There was nothing, however, that could prepare one for the decade of the 1970s. The euphoria of the 1960s brought on by falling unemployment and rapid growth ended rather abruptly in the early 1970s as the economy slipped into a severe recession.  As for economic policy, Nixon's response in the early 70s indicated the influence of Keynesian liberals was waning.  There were no tax cuts or spending increases proposed to get the economy moving out of the recession in 1970, the type of proposals we had seen a decade earlier, and we would see a decade in the future.  Nixon found himself caught between a rock and a hard place - unacceptably high inflation rates, a stagnating economy, and a trade deficit that threatened the international financial position of the US, with no easy solution offered by the economics profession.  What he did know was that unemployment was a political liability for a president, something he learned as vice president for Eisenhower in the 1950s. In De Long's "America's Only Peacetime Inflation: The 1970s," we see this in Nixon's discussion of the upcoming 1960 presidential election.

"Two other developments occurred before the convention, however, which were to have far more effect on the election outcome…

early in March [1960], Dr. Arthur Burns…called on me… [he] expressed great concern about the way the economy was then acting…. Burn's conclusion was that unless some decisive government action were taken, and taken soon, we were heading for another economic dip which would hit its low point in October, just before the elections…

The matter was thoroughly discussed by the cabinet….[S]everal of the Administration's economic experts who attended the meeting did not share his bearish prognosis…

In supporting Burn's point of view, I must admit that I was more sensitive politically than some of the others around the cabinet table. I knew from bitter experience how, in both 1954 and 1958, slumps which hit bottom early in October contributed to substantial Republican losses in the House and Senate…" 

The Dr. Burns he is referring to would be the Chair of the Federal Reserve and was a past president of the American Economics Association.  In his presidential speech to the association in 1959, Dr. Burns had expressed his doubts about the ability of the economy to produce low inflation and unemployment simultaneously.  At that time Dr. Burns  noted that:

" during the postwar recessions the average level of prices in wholesale and consumer markets has declined little or not at all. The advances in prices that customarily occur during periods of business expansion have therefore been cumulative…. All these appear to be symptoms of a continuation of inflationary expectations or pressures. "

It was still a surprise, however, when on August 15, 1971 Richard Nixon emerged from a retreat to announce his New Economic Policy designed to cure the dual macro problems - inflation and unemployment.  What to do with inflation? With the encouragement of Arthur Burns, conservative Chairman of the Federal Reserve Bank, attention turned to incomes policies as the solution to the inflation problem. Although Burns had been a critic of the Kennedy-Johnson guidepost policy, by the early 1970s, he was proposing establishment of a wage-price review board - a position echoed in the press and among Republicans worried about the upcoming election.  These wage and price controls could break the back of inflation, which would quickly translate into lower inflationary expectations, and the controls could be lifted quickly.  At least this was the story line, but the verdict seems to be that the controls did little to slow inflation which returned as soon as the controls were lifted.  One price control that lingered was the control on oil prices, and in 1973 the US saw the impact of a "wrong price."  This was the time when the OPEC nations cut off oil supply to the US, and because the price of oil was fixed, there was an excess demand for oil that showed up as long lines of cars waiting to get gas.  In 2000, when the price of oil rose sharply again, there were no price controls and the impact of another OPEC supply cut was steeply higher prices, but no lines. 

Nixon also had to deal with the problem of international imbalance.  A balance of payments deficit was unsustainable given the existing fixed exchange rate system developed at Bretton Woods, so Nixon set the exchange rate free.  This marked the end of the Bretton Woods era.  It also ushered in a decade where the important policy and theory developments had to do with money - both domestically and internationally.  Where the 1960s was a decade of experimentation with fiscal policy, the 1970s was a decade of experimentation with money.  

The decade opened with Nixon addressing problems in the international monetary system, a system that facilitated the growing volume of international transactions.  Nixon abandoned the Bretton Woods system and effectively ended the US experience with fixed exchange rates.  In the first section of this unit we will examine the rise and fall of the Bretton Woods system.   Here we will also discuss a model of exchange rates that is a "simple" extension of our earlier work with supply and demand.

By the late 1970s our attention will shift to the domestic money supply and a dramatic change in monetary policy that turned out to be a key complement to the Reagan fiscal policies of the early 1980s. This was a time where opposition to the prevailing Keynesian view was beginning to gain credibility - when we began to hear of Milton Friedman's rather simplistic economic theory known as monetarism.  Monetarists moved the debate about money's role in the economy from -  money did not matter - to money mattered - and finally to  - money mattered most.  The simplicity of the idea, which some would suggest was designed to make the idea "marketable," was evident in the 1972 Friedman column in Newsweek.   At that time Friedman specified the "close, regular, predictable relationship between the quantity of money, national income, and prices..." and suggested the Fed adhere to a policy that provides a slow, constant growth in the money supply.  In the extreme we could replace the Fed by a computer programmed to simply increase the money supply by a specified amount each month.  By the end of the 1970s it was certainly true that  "[m]onetarism achieved its moment of apogee with both intellectual and policy triumph in the late 1970s. Its intellectual triumph came as the NAIRU grew very large and the multipliers grew very small in both journals and textbooks. Its policy triumph came as both the Bank of England and the Federal Reserve declared in the late 1970s that henceforth monetary policy would be made not by targeting interest rates but by targeting quantitative measures of the aggregate money stock."₁ 

In the second section of this unit we will begin by filling in some of the details on money.  We will start with a brief history of the evolution of money.   We will then discuss the market for money in today's economy which will help us understand interest rates - the price of money.   Here we will talk about the various components of interest rates.  The goal is an improved understanding of the factors that influence interest rates and why they change over time.  Included here will be a discussion of the effect of risk, time, and inflation on interest rates.  This will be followed by a detailed treatment of the money supply process including a discussion of the Fed, a major player in the money supply process, the banks that "create' money, and the tools the Fed has to increase or decrease the supply of money.  This will provide the backdrop for a discussion of the monetary policy change announced by Fed Chairman Paul Volcker in November of 1979. To understand the significance of the move, the adoption of monetarism as the guiding principle at the Fed, we need to fill in a few more details of the relationship between monetary policy and the performance of the economy which will be the final section in this unit. 

1 De Long, "the Triumph of Monetarism?" JEP Winter 2000