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The End of the Cold War
Led to Global Cuts
In Defense Spending
In late 1975, as the US economy was beginning to recover from the worst recession since the 1930s, we first said that inflation was on the way out, even though prices were still accelerating. Our analysis showed that in this country the history of serious inflation is the history of big government spending, usually in shooting wars but in the Cold War and the War on Poverty as well. We noted that in the 1749-1974 years, wholesale prices rose 1.4% per year on average, but about 12% in the war years while declining 1.3% per year in peacetime.
The Chicago Sun Times in its November 13, 1975 edition used our graph of long-run inflation and added a cartoon--American soldiers, marching through the nation's wars (Chart 1-1)--in an article headlined "Maverick Economist Deflates Inflation." The newspaper went on to quote my reasoning for a smaller share of the economic pie going to government.
Voter attitudes have changed. The long liberal swing that began in 1933 ended with the Vietnam War. People now don't trust the government's ability to run much of anything, whether it's foreign policy after the Vietnam War, the political process after Watergate, or the economy after the two recent recessions.
Furthermore, after near runaway inflation, voters seem willing to live with much higher unemployment if that is the price of lower inflation. We stress the attitudes of voters, not politicians, since the latter do want to be re-elected.
The country is now entering a period of lower inflation rates--we believe 2% or 3% will be the norm--and of stable growth not seen since the early 1960s. Few believe that this is possible, and that's why it probably is. As long as the country is worried about inflation, it is likely to hold down government spending and take other measures that will keep inflationary forces in check.
Why this linkage between wars and inflation? Quite simply, because you and I don't drive tanks. People are paid to build them, but they can't be bought by civilians--although defensive driving advocates may wish they could replace their banged-up cars with M-1 tanks. Unless taxes are raised enough to offset the government spending on the tanks--seldom the case in times of big military outlays--income is created without a comparable new supply of consumer goods and services. So, overall demand exceeds overall supply and prices rise.
The Cold War Is Over
The Cold War, of course, ended in the late 1980s and, as a result, US defense spending is falling in real dollar terms and even more rapidly as a percentage of GDP (Chart 1-3). Furthermore, this is a global phenomenon, as shown in Chart 1-4. In effect, one of the prime causes, if not the cause, of inflation is being removed.
In addition, while military spending cuts after hot wars remove inflationary excess demand, the unwinding of the Cold War goes even further. It's actually deflationary since it reduces demand even more. To see why, contrast the post-World War II and post-Cold War experiences.
In World War II, General Motors stopped making cars in order to use its assembly lines to build tanks and other military vehicles. The workers were paid about the same amount as before, but there were no cars to buy. After the war, those factories were converted back to auto production. In fact, during the war GM said it would be making cars within six months of peace, and it beat that time table. Tanks were no longer being produced when the war ended, but assembly line workers went back to making cars immediately, so incomes were again matched by an equal supply of civilian goods and services.
In contrast, the Cold War spawned whole industries that were not converted from civilian production but built from scratch. Nuclear warheads and the rockets and nuclear-powered submarines needed to deliver them have no civilian counterparts. And they are very expensive since, trade-for-trade, defense industry employees in the Cold War earned about 50% more than their civilian counterparts. When this hardware is no longer built, the production facilities are essentially dismantled and employees terminated. There are no civilian products they switch back to building. Sure, some rockets have civilian uses, but they use a much different technology than those that were aimed at the former Soviet Union. Supersonic jet fighters are a different breed in cost and design from Boeing 777s.
The unwinding of Cold War spending has been gradual enough to prevent big nationwide unemployment problems, much less a recession. Nevertheless, the lack of conversion to civilian goods production by many defense industries means that the end of the East-West confrontation is actually deflationary.
Defense spending is the most volatile component of government spending and the most inflationary, but others are significant. As we'll see in Chapter 2, they, too, are moving in deflationary ways.
Major Country Government
Spending and Deficits
It's easy to over-complicate things, especially inflation. Fundamentally, overall prices rise when demand exceeds supply, and the reverse in deflation. Any sector of the economy could create excess demand by spending more than its revenues, and then use the resulting inflation to shift the economic pie in its favor. In fact, however, government is the only sector that has the financial credibility to outspend its revenue by enough and for long enough to create serious inflation.
As a result, as goes government spending, so goes inflation. This is primarily due to defense spending, as shown in Chapter 1, but nondefense spending is also important. Although not shown in Chart 1-2, state and local government expenditures add to the federal government's share as do government sponsored entities like Fannie Mae, TVA, rural electrification, government guaranteed loans, and many, many others.
Defense spending is highly inflationary since incomes are paid to military personnel and to civilian defense workers but no goods or services are produced that they can buy. Nevertheless, nondefense spending is also inflationary, especially when it produces things that nobody wants or uses, like many pork barrel projects. Building public housing will satisfy political patronage demands, but provides little value if located in areas of such high crime that it is soon abandoned.
Furthermore, there is no bottom line incentive for efficiency in government spending. Quite the opposite, there is every incentive for inefficiency so more resources can be employed and bigger empires built by government managers. Indeed, the term, government efficiency, ranks with airline food, congressional ethics, military intelligence, postal service, tax simplification, vegetarian vampires, beloved mothers-in-law, and other oxymorons. If you don't agree, just take a trip to your local post office. When you observe its workings, you know you're experiencing a technological excursion into the 19th century. Obviously, the more of the economy that is involved in the inefficient government sector, the higher the inflation.
In addition, government spending surges, defense or nondefense, are even more inflationary if they result in big deficits, since government then creates more income than is removed by tax increases, regardless of whether purchasable goods and services result from the outlays. Spending leaps and large deficits almost always go together, of course, since governments seldom raise taxes enough to pay for hot wars, cold wars, wars on poverty, or other costly exercises. Unless the economy is in a deep recession with excess supplies of unemployed but employable people and equipment, demand rises at a time that supply is constrained by capacity. Prices go up.
And inflation works to government's benefit in a reinforcing cycle by inflating taxable inflation incomes. Rising nominal personal incomes move individuals into higher tax brackets. Inflation also creates taxable but artificial profits through increases in the value of inventories and under depreciation of corporate assets. Chart 2-1 shows the clear correlation between federal deficit and inflation.
Furthermore, the bigger the government and the more involvement in the economy, the more likely that there will be inflation by fiat, a term we coined in 1977. This refers to all the ways in which with the stroke of a pen, Congress, the Administration and the regulators can push up prices. Obvious examples include dairy and other farm price supports, sugar tariffs and import quotas, the minimum wage, and Social Security taxes.
Why Was Big Government Tolerated?
Most Americans detest inflation, and the link between government spending and rising prices isn't all that complicated. Why, then, have voters tolerated the rise in the federal government's share of the economy from a few percentage points up until the 1930s (excluding shooting wars) to almost 20% today? To a great extent it's probably inertia carried over from the days when voters saw government as a positive force in their lives, starting with the New Deal in the 1930s.
Whether the New Deal, which touched off this stratospheric climb in government involvement in the economy, can be credited with getting the nation out of the depression is highly debatable. The return to full employment was probably more closely related to the rise in military spending in Europe, the rebuilding of the military structure in this country and finally, World War II. Nevertheless, the inclination then was to give credit to the New Deal for the economic revival because the two moved in parallel.
Then the US entered World War II, a popular war from which she clearly emerged as the leader of the free world. This nation was the only major country not in ashes after the war, and was the last bastion against communism in the Cold War period. After the war, the nation entered decades of substantial economic growth. It was also a period of growing government involvement, and the two continued to be associated with each other in the eyes of many.
Almost any trend that humans create tends to get overdone, however, and confidence in government was no exception. Recall the excesses. By the 1960s, administration economists actually thought they were so adept at controlling the economy by monetary and fiscal means that they could prevent not only major recessions but minor dips as well--the "fine-tuning" philosophy. In fact, those economists were so sure they could eliminate the business cycle that they changed the title of the Commerce Department's monthly, Business Cycle Developments, to Business Conditions Digest. Those clever folks kept the same acronym.
Furthermore, many in and out of the Administration in the mid-1960s believed that with just a little more government spending, all the social problems of the nation could be solved. Hence the Great Society programs. Finally, many saw the government as so omnipotent that it could afford to fight a land war in Asia and pursue massive domestic spending programs simultaneously--the "guns and butter" concept.
We can easily look back now at how absurd this confidence in government was--confidence that had all the earmarks of a trend peak. And a peak it was, soon to be followed by the aftermath, an era when everything seemed to go wrong. Frustration over Vietnam and the disappointment in Great Society programs that failed to live up to expectations. Tremendous excess demand created by spending on both that sired serious inflation here and abroad, and eventually, the massive global inventory-building spree that resulted in the 1973-1975 recession--the most severe in this country since the 1930s and the first of global significance since World War II.
Even the CIA and Watergate problems were probably part of this reaction phase. They marked, perhaps, the end of the feeling that Washington was omnipotent and above the law. The net result of the "morning after" was a rapid swing of the pendulum away from the extreme of idealistic trust in government solutions to virtually all problems and toward disillusionment and serious questioning of the government's basic role.
Changed Attitudes about Unemployment
And Government Programs
Voters also turned on the government because their attitudes about unemployment and inflation changed markedly, beginning in the late 1960s. Earlier, a majority of the population had vivid memories of the depression and its peak 25% unemployment rate, while few people had seen significant inflation. Consequently, unemployment was consistently ranked as the country's number one economic problem in the polls. By the late 1960s, however, the depression-scarred constituted a much smaller percentage of the population and everyone had begun to witness inflation of frightening proportions. Not surprisingly, the polls began to show inflation as the top-rated national economic concern. Furthermore, people started to relate inflation to government spending and deficits.
The Voters Speak
Politicians, as usual, were slow to realize the depth and extent of the electorate's changed mood that began in the late 1960s. Constituents' grumbling over government deficits and inflation after the late 1960s did not seem nearly as loud or clear to most politicians as the distinct melodic tones of the many well-organized special-interest groups. Moreover, increasing government spending and proliferating programs and agencies proved to be an excellent way to build power bases in Washington while maintaining a compassionate concern for the poor and the unemployed.
But finally, the politicians began to see the footprints on the voter ceiling. One early manifestation was the Steiger amendment reducing taxes on capital gains in 1978. President Carter had proposed a capital gains tax increase but wound up signing and, of course, taking credit for, a cut. The first big voter revolt against big government size and taxes, however, was Proposition 13 in California in June 1978, which put a ceiling on property taxes at 1% of market value. Similar measures soon followed in other states.
The final proof, of course, was the 1980 election. Not only was a conservative president elected, but on the basis of voting records as opposed to party affiliation, so were conservative majorities in both houses of Congress as well. Seen in this light, the conservative sweep in 1980 was not a fluke or a reaction to Carter's ineptness, but the culmination of a shift that had begun over a decade before. And, as of 1994, Republicans are in control of both Houses of Congress, and that body came very close to passing a balanced budget amendment to the Constitution.
It seems clear, then, that the long liberal swing that began in 1932 in reaction to the Great Depression has ended. Even President Clinton, with all of his liberal instincts, says that the era of big government is over. My liberal friends no longer call themselves liberals, but moderates, and those new moderates may be putting the final nail in the liberal coffin by joining in the trashing of their former idol, John F. Kennedy. His philandering has been known for years. I remember my wife's reading about it a decade ago in a book by Jackie's former maid. But now even normally liberal public television is trotting out his sexual exploits and questioning their effects on his performance as President.
If history is any guide, this shift in attitude toward more reliance on markets and the private sector to allocate the nation's resources and away from government involvement which is so inflationary will last for some time.
On balance, then, it's not surprising that Washington has become zealous about reducing the federal deficit and curtailing spending and employment, and there have been results. Nondefense spending's share of GDP is falling (Chart 2-2). Congress and the Administration stumbled all over each other in the summer of 1997 to pass a bi-partisan balanced budget bill. Of course, they had to act fast before the deficit died of natural causes--declining military spending and soaring taxes spawned by the booming economy, the roaring stock market and capital gains explosion, and two tax hikes in the early 1990s. Washington climbed aboard the speeding freight train but naturally took credit for getting it moving.
The federal deficit, much to the amazement of many, is now moving into surplus. This really isn't amazing, however. It simply demonstrates the tremendous revenue generating power of the federal government. All that has ever been needed to eliminate the budget deficit in the postwar era is to restrain federal spending while letting revenues run.
The Federal Government Was the Last to Know
Although Washington finally got the clue from voters, it was the last American political body to know. After the federal government was thoroughly discredited by Vietnam, Watergate, and Great Society programs that didn't work, government initiatives quite naturally shifted to state and local governments. As noted, Proposition 13 in California in 1978 started the ball rolling. Then followed state and local reforms that have since moved to the federal level, such as requiring able-bodied welfare recipients to work in return for benefits, limitations on welfare payments to unmarried women who continue to produce children, term limits for elected officials, and pressure for a balanced budget amendment.
America Is Not Alone
At the same time that America's attitude toward government was changing in the 1980s, Britain, under Prime Minister Margaret Thatcher, made an even more radical shift from near socialism to capitalism. The labor unions were brought under control, many government programs dismantled, and scores of state-owned companies were sold. These actions led to a substantial fall in nominal government spending growth in the 1990s (Chart 2-3). Recognizing the change in voter attitudes, the British Labor Party, under Tony Blair, realized that it had to shift to the right to get elected, and the new Labor government is out conservativing the conservatives. Prime Minister Blair recently proposed tax cuts for business profits and capital gains and measures to encourage the unemployed to leave welfare and enter the workforce.
Canada considers herself a kinder and gentler US--a combination of Anglo-Saxon capitalism and Continental European social concern. Yet Canada has joined the parade recently as fiscal responsibility spreads from the western provinces east to Ontario, where the People's Republic of Ontario government was replaced by the free enterprise, privatization-oriented Harris provincial administration. Federal budget outlays are falling (Chart 2-4) and the government's budget calls for balance or even surpluses in fiscal 1998, 1999, and 2000. New Zealand and Australia, too far away and too small economically to receive proper attention, have done bang-up jobs in eliminating government subsidies and spending.
[Chapter One Continues ...]
|About the Author||xxiii|
|Introduction: Why I'm Writing This Book||1|
|1||The End of the Cold War Led to Global Cuts in Defense|
|2||Major Country Government Spending and Deficits Are|
|3. Central Banks Continue to Fight the Last War--Inflation||29|
|4||G-7 Retirements Will Lead to Reduced Benefits and Slower|
|Growth in Incomes and Spending||36|
|5||Restructuring Continues in English-Speaking Lands and Will|
|6. Technology Cuts Costs and Promotes Productivity||62|
|7. Information via the Internet Increases Competition||72|
|8. Mass Distribution to Consumers Reduces Costs and Prices||79|
|9. Ongoing Deregulation Cuts Prices||83|
|10. Global Sourcing of Goods and Services Curtails Costs||92|
|11. The Spreading of Market Economies Increases Global Supply||98|
|12. The Dollar Will Continue to Strengthen||103|
|13||Asian Financial andEconomic Problems Will Intensify|
|Global Glut and Reduce Worldwide Prices||121|
|14. China May Well Devalue||152|
|15. Japan Is Still Part of the Asian Problem, Not the Solution||160|
|16. The Asian Flu Spreads||175|
|17||US Consumers Will Switch from Borrowing and Spending to|
|18||A Bear Market in US Stocks Will Trigger A Consumer Saving|
|Spree and Ensure Global Deflation||216|
|19. Deflation Is Self-Feeding||237|
|20. Deflation Is Normal at This Stage of the Kondratieff Wave||247|
|21. Deflation Can Be Good As Well As Bad||255|
|22||Financial Collapses Are Unlikely in the US and Other|
|23. The Industrial Revolution Has Been Exported||283|
|24||Productivity Growth Will Be Robust and Consistent with|
|25. Trade Wars Are a Risk||298|
|26. Interest Rates Down, Profits So-So in Deflation||307|
|27. Investment Strategy for Deflation--13 Elements||318|
|28. Business Strategy for Deflation--18 Elements||358|
|29. Personal Strategy for Deflation--5 Elements||367|