The 1980s
"I regret to say that we are in the worst economic mess since the Great Depression."
"Productivity isn't everything, but in the long run it’s almost everything."

The 1970s were anything but dull. This was the decade where America "lost" a war in Southeast Asia and an ally in the Shah of Iran; wars were fought in the Middle East and Cyprus, while arms accords with the Soviet Union were signed and full relations were opened with China after Mao's death; OSHA, The Energy Department and the EPA were established; the price of gold increased more than 2,000 percent from $35 to over $800 an ounce and the US averted nuclear disaster in the Three Mile Island crisis; BIG oil was discovered in Mexico and US oil imports were shut off twice - in late 1973 after war in the Middle East and in 1979 following the fall of the Shah; an American President resigned and two others failed in their re-election bids - victims of the poorly performing economy.  It was also a decade where we saw the first money market funds, discount stock brokers, and a prolonged bear market as stock prices fell long and far; the US began running trade deficits, while Sony introduced the VCR and Walkman, Volkswagen opened a production plant in Pennsylvania, Miller introduced Lite beer, and Federal Express began shipping; and word processors were beginning to replace typewriters in offices and the VisiCalc spreadsheet first appeared.

On the macro policy side it was also quite a decade.  It began with a conservative Republican imposing a mandatory and comprehensive freeze on wages and prices and abandoning the gold standard.  The headline in the New York Times on August 16, 1971 said it all.  "NIXON ORDERS 90-DAY WAGE-PRICE FREEZE, ASKS TAX CUTS, NEW JOBS IN BROAD PLAN: SEVERS LINK BETWEEN DOLLAR AND GOLD."  As Nixon saw the situation, "Prosperity without war requires action on three fronts.  We must create more and better jobs; we must stop the cost of living; we must protect the dollar from the attacks of international money speculators."  The decade ended with Paul Volcker dramatically altering the Fed's monetary strategy, a move on which a Fed spokesperson commented: "long after the Pope is gone, you'll remember this [policy change]."  During the decade Americans endured long gas-lines and the most severe recession since the Depression with inflation peaking at 18 percent in 1974 and unemployment peaking a year later at nearly 10 percent. Interest rates followed inflation rates higher and by 1980 the rate on short-term government securities was above ten percent, 100 percent higher than the rate at the beginning of the decade.  The stock market showed little sign of life during the decade and ended it substantially below where it began once you adjusted prices for inflation. 

Diagram 1a
Domestic Macroeconomic Performance in the 1970s

It was also a time where the specter of permanent job losses caused by cheap foreign labor appeared on the scene, triggered by the rising inflow of goods and services from abroad. By the end of the decade the dollar was down 20 percent from its peak, while exports and imports continued to rise substantially faster than GDP.   By 1979 the real value of U.S. imports and exports were nearly 150 % higher than their 1965 levels while total output (GDP) was only 50 % higher.  By the second half of the decade the trade deficit exceeded 1 percent of GDP.   This was the beginning of the persistent and large US trade deficits.

Diagram 1b
International Macroeconomic Performance in the 1970s

Americans had also witnessed a substantial increase in the size of the federal government.  Federal outlays, which had averaged about 18 percent of GDP in the 1950s, had grown to nearly 21 percent of GDP in the 1970.  Taxes, however, did not increase as sharply and the budget deficit expanded.  The cycles in the budget deficit, evident in the diagram below,  did not hide the fact there was a definite trend toward larger budget deficits, and by the late 1970s the deficit was averaging nearly 3 percent of GDP.

Diagram 2
Federal Government Finances

In addition to growth, there were also some substantial shifts in the composition of outlays and receipts.  The federal tax burden was increasingly falling on individuals as personal income and social insurance taxes' share of the total tax revenue rose from 60 to 80 percent. These taxes were also rising faster than income, and by 1980 social insurance tax revenues were ten times their 1959 level, while GDP was only six times as large. The American people were ready for a tax revolt, but there was little room for a tax cut given the budget deficit.

Diagram 3
Federal Government Receipts

On the outlay side of the ledger there were also some substantial changes taking place.  The share of outlays for Human Resources', what most people think of as transfer payments, more than doubled from the early 1950s to the late 1970s.  Defense's share of federal outlays, meanwhile, had fallen from a peak of 69 percent in 1953 (Korean War) to 46 percent in 1968 (Vietnam spending) and bottomed out in 1979 at 23 percent.

Diagram 4

There is one graph, however, that is better than most at capturing the anxiety of the American people and their disillusionment with the economy in the late 1970s. For the Great Depression of the 1930s it was the unemployment rate graph that told the story, for the stagflation of the 1970s it was the graph of real wages. After a virtually uninterrupted climb beginning after World War II, real (inflation-adjusted) wages for American workers stopped rising in the recession of 1973-75 and continued to fall for the remainder of the decade. By 1980 nearly one-third of all the gains in earnings made since 1948 had disappeared and real wages stood at the same level they had been in 1962.  Taxes were up, buying power was down: Americans were ripe for a change.

Diagram 5

As real wages fell, so too did confidence in the prevailing theories / policies to turn things around. Liberal Keynesian economists were unable to produce a set of policies to help lift the economy out of the economic doldrums. President Ford in 1975 tried to utilize traditional expansionary fiscal policy to get the economy moving out of the 1973-75 recession with the Tax Reduction Act of 1975, but it was not enough to restore confidence.  As for inflation, Ford appealed to the American people to wear WIN buttons, a piece of his "Whip Inflation Now" program, but needless to say, the program was a nonstarter.  

In 1976 Ford faced stiff competition in the presidential primary from a former actor and governor of California who was pushing for massive expenditure cuts and a voluntary social security system.  Gerald Ford did manage to defeat Ronald Reagan and capture the Republican nomination, but he was defeated in the November election by a relatively obscure Georgian named Jimmy Carter who had emerged from a crowded field of ten Democrats.  Carter, like Kennedy before him, had successfully exploited the weaknesses of the economy's performance under a Republican president, although some credit should go to the Fed that had slowed substantially the growth in the money supply in the second half of 1974.  As Carter stated in his Labor Day speech in 1976: 

"This year, as in 1932, our country is divided, our people are out of work, and our national leaders do not lead.   Roosevelt's opponent in that year was also an incumbent president, a decent and well-intentioned man who sincerely believed our government could and should not with bold action try to correct the economic ills of our nation. "

Once in office, Carter set about the task of dealing with the unemployment rate that was still above 7 percent.  Carter's goal was to see the economy achieve full employment - what he accepted as a 4.7 percent unemployment rate.  This is what he had "promised" in the election and it was also consistent with the thrust of the Humphrey-Hawkins Bill moving through Congress, even though there was general recognition of the limitations of a Bill designed to set policies with the goal of achieving a 4 percent rate of unemployment.  On the fiscal policy side, beginning in 1977 Carter was pushing an expansionary policy including a temporary tax cut.  The tax cut was never enacted, but the budget deficit did grow.  In an effort to keep monetary and fiscal policy on the same expansionary page, Carter replaced Arthur Burns with G. William Miller as Chair of the Fed in January of 1978.  It is not clear from the money supply data the change was necessary since money supply growth was quite high in the entire 1977-1979 period.  Monetary policy was doing its share of shouldering the burden of reaching full employment.

At the outset there was little concern for a return of inflation.  Based on the "traditional" Phillips Curve there should be little inflationary pressure with these high unemployment rates.  In the first two years of Carter's term the economy performed rather "traditionally" with unemployment and inflation moving in opposite directions - inflation rising and unemployment falling.  As inflation began to rise, however, the president turned to wage and price guidelines for a solution to inflation without having to pay a high cost in terms of additional unemployment.  In October of 1978 Carter announced an anti-inflation policy including fiscal restraint, an immediate hiring freeze for the federal government and employment reductions in 1979, and wage and price guidelines.  It was time for decisive action and President Carter, after a retreat at camp David at which over 100 leaders were consulted, delivered his "malaise speech" in August of 1979.  As Carter saw things, "All of the legislation in the world can't fix what's wrong with America.  It is a crisis in confidence.  It is a crisis that strikes at the very heart, soul, and spirit of a national will ... and it is threatening to destroy the social and political fabric of America."  To restore confidence Carter announced a purge of nearly half the Cabinet plus the Chair of the Fed.  By November, Carter's guidelines had been gutted by Congress and the dollar was in a free-fall prompting a sharp increase in the discount rate.  And to make matters worse, the Iranian revolution had pushed oil prices up forty percent in the first seven months of 1979.

As 1980 approached, the situation was beginning to resemble the early 1930s - an economic problem too large to ignore, yet beyond the abilities of the prevailing theories to explain. Following the lead of Kennedy, Ronald Reagan moved the economy to center stage in his presidential campaign.  He may not have been too far off the mark when he told the American people," we are in the worst economic mess since the great Depression."  As evidence of the sorry state of the economy, Reagan pushed the Misery Index defined to be the sum of inflation and unemployment rates.  By 1980 the misery index stood at approximately 20, twice the level of a decade earlier and its highest level since the Depression [Diagram 6].   And to make matters worse, on November 4, 1979 a mob of Iranians, angered by the decision to allow the Shah to enter the US for medical treatment, stormed the US embassy and took fifty-two US hostages.  This became the top story for much of the next year, including the botched military attempt at freeing the hostages.

Diagram 6

In hindsight, what is clear is that traditional aggregate demand management policies could not be relied upon to solve the problem of stagflation. The problem can be demonstrated with the AS - AD model.  In 1973 inflationary pressures were building as the US dollar declined sharply and el nino helped send agricultural prices sharply higher.  The real shock, though, came towards the end of the year when the OPEC countries imposed an oil embargo.   These "price shocks" reduced the nation's productive capacity which is reflected in an inward shift in the AS [Diagram 7].

Diagram 7
Adverse Supply Shock

The result was higher unemployment and inflation stagflation  - certainly not what the Phillips Curve would suggest.  In fact, the Phillips Curve, long thought to represent a menu of choices open to policy makers, disappeared as you can see in Diagram 8.  The inflation and unemployment rate data from the 1960s and 1970s provides little support for the inflation - unemployment tradeoff.

Diagram 8

The problem, in retrospect, is stagflation could not be treated with traditional aggregate demand oriented monetary and fiscal policies. An increase in aggregate demand - an outward shift in the AD curve - would move the intersection of the AS and AD lines up and to the right. Expansionary fiscal and / or monetary polices could offset the decline in output, but not without causing higher prices. Similarly, contractionary polices designed to reign in inflation - an inward shift in the AD curve - would succeed at lowering prices, but only at the expense of even large declines in output and employment.  Keynesian fine-tuning policies that seemed to have worked so marvelously in the 1960s, failed to work in the 1970s, and offered government policy makers little guidance in dealing with the nation's economic problems.

It was once again time for the pendulum to shift, time for embracing a "new" perspective on the economy and on macroeconomic policy. Into the policy void stepped Ronald Reagan with his plan to restore growth and get the economy moving; reduce inflation which was at double-digit rates; reduce the role of government and get it off the backs of the people; and strengthen national security.  "The opportunity was right and seized by Ronald Reagan who led a team that possessed a feeling of confidence and mission ... They came to correct the errors not only of the past administrations but of the past fifty years.  In the field of economics their program was articulated with unusual clarity..., and embracing the program had been a loyalty test for membership on the economics team."  It was time for supply-side economics.

With the revival of interest in the supply side of the economy, it should be no surprise that there was a revival of interest in the long-run growth of the economy.  One of the important questions at this time was: Can economic growth be speeded up? The early growth theory work of the 1950s was expanded in the 1960s as the government, guided by the theory of economic growth, set about the task of implementing policies designed to get the economy moving again. In the second section of this unit we will examine more closely the issue of economic growth.  We will focus our attention on the importance of growth differentials and explanations of the pattern of world economic growth which tends to center on the concepts of productivity growth and technological change.  The unit will close with a discussion of the problem known as the cost disease of the service sector - the slowdown in measured economic growth that is a by-product of the shift from a manufacturing to a service economy.