From the Publisher
“Bruce Bartlett is a rarity in Washington, an honest man. In The New American Economy, Bartlett combines an informed insider's knowledge and an economic historian's perspective to create a compelling explanation of where supply side economics came from and what went wrong with Reaganomics.” David Cay Johnston, Pulitzer Prize-winning author of Free Lunch and Perfectly Legal
“Bruce Bartlett is right. The welfare state isn't disappearing. And if Republicans continue to try to roll it back the by using tax cuts to "starve the beast" or trying to privatize Social Security and Medicare, they're history. Wise thoughts from one of the creators of Reaganomics who has seen the light.” Robert Reich, Former U.S. Secretary of Labor, Professor of Public Policy, University of California at Berkeley
“Among today's conservatives, only Bruce Bartlett would have the courage and unconventionality to embrace John Maynard Keynes, much less to champion a big new tax. But here's the thing: he's right. Anyone seeking a new way forward for conservatism or the economy needs to start here.” Jonathan Rauch, National Journal
“Bruce Bartlett, who took the measure of President Bush in his New York Times bestseller, Impostor, has written another highly useful winner: The New American Economy. In this short, tough-minded and often amusing book, he lays out what the Obama Administration is doing to the economy and tells why it will work.” Richard Whalen, Senior policy adviser to Ronald Reagan and author of The Founding Father: The Story of Joseph P. Kennedy
“Bartlett is the rarest of all creatures: an honest conservative economist. He was one of the original supply-siders in the Reagan administration. However, he pursued it as economic policy, not religion, which meant that he changed his views when things did not turn out exactly as planned. Readers of all political perspectives will find this book valuable. It is a serious account of the economic history of the post-World War II era and provides thoughtful prescriptions on the way forward.” Dean Baker, Co-Director, Center for Economic and Policy Research
“Bruce Bartlett is something rare and admirable: a brave and intellectually honest man. He understands that the truth is rarely pure and never simple. An erstwhile protagonist of supply-side economics, supporter of Ronald Reagan and darling of the conservatives, he explains here why the economics of Keynes is, yet again, relevant and why the US will need extra tax revenue if it is to finance the rapidly growing burden of entitlement spending. Whether US conservatives like it or not, what the American people resolutely defend will have to be financed, . The answer, he argues, is a value added tax. He is right. Every serious analyst must know it.” Martin Wolf, Chief Economics Commentator, Financial Times
“In this remarkable book Bruce Bartlett attempts two daunting, even heroic tasks. The first is to persuade conservatives that John Maynard Keynes was actually one of them - a true conservative who saw that to manage the capitalist system was the price of protecting it, against the socialist challenge. The second is to persuade Republicans that their future lies with finally accepting the welfare state, financed, in keeping with supply- side principles, through a consumption tax. Bartlett here injects fresh thought into Reagan's legacy, and American politics will be much more civilized, and possibly also more competitive, if he succeeds.” James K. Galbraith, professor economics, University of Texas at Austin and author, The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too
“Bartlett offers the valuable perspective of a real inside witness . . . he is, moreover, a good economic historian and provides a well documented summary of the last 80 years of American macroeconomics.” The American Conservative
“Bartlett has had to concede the unpopular view that higher taxes will be inevitable, and makes the case that a value added tax (VAT), something like a national sales tax, may be the only way to generate the revenue that will be required to keep this ship afloat.” Booklist
“Do yourself a favor and read Bruce's new book. And know that Bruce is one of those conservatives who actually put principle over access to power. If you're a liberal looking for a real conservative to debate and read, you won't go far wrong with Bruce.” Andrew Sullivan, The Atlantic
“It is a significant work for any serious student of economics and perhaps the best general reference for anyone wanting a sober retrospective on the Keynesian phenomenon.” Library Journal
Read an Excerpt
The New American Economy
The Failure of Reaganomics and a New Way Forward
By Bruce Bartlett
Palgrave Macmillan Copyright © 2009 Bruce Bartlett
All rights reserved.
THE GREAT DEPRESSION
The economic crisis of 2009 has only one precedent in modern history: the Great Depression of the 1930s. The similarities are not only their depth and breadth, but their origins as well. Both resulted from an excessively easy monetary policy by the Federal Reserve that created economic distortions in both financial markets and the real economy. In each case, when the Fed tried to fix its mistake by tightening monetary policy, it went too far and created deflation—a falling price level, the opposite of inflation—that was most evident in the collapse of stock prices but was also seen in business bankruptcies and widespread unemployment.
Policymakers of the 1930s misunderstood the nature of the economic problem and were slow to pinpoint the Federal Reserve's policy as the primary source. By the time they did the economy had declined too much for an expansive monetary policy alone to turn it around. Simply lowering interest rates was not enough to encourage borrowing and spending, as it usually is during moderate economic downturns. Only by coupling an easy monetary policy with an aggressive fiscal expansion through federal spending and deficits was it possible to get the economy off a dead stop, end the deflation, and end the depression.
Unfortunately, it took Franklin D. Roosevelt and his advisers a long time and a lot of trial and error before the proper set of policies were in place. Many mistakes were made and setbacks suffered. Since history's errors often teach us more valuable lessons than its successes, knowledge of the Great Depression is essential if we are to avoid repeating those mistakes and get today's economy moving again.
As the nation coped with its second greatest economic crisis in early 2009, analogies to New Deal policies were common. The Obama administration was explicit in its belief that the mistakes that caused the Great Depression to be so long and so deep would not be repeated. Thus, Barack Obama's first major action in office was to ask for a huge stimulus bill that was enacted less than a month later. The Fed was also extremely aggressive in pursuing unorthodox policies of previously unthinkable magnitude, such as its announcement on March 18, 2009 that it was prepared to add an additional $ 1.2 trillion to the nation's money supply to unlock credit markets.
Throughout the 2008–2009 crisis, echoes of identical debates from the 1930s were common. Did low interest rates indicate a sufficiently easy Fed policy or did one also have to look at the money supply and pursue what the Fed calls "quantitative easing"? Was a stimulative fiscal policy essential to economic recovery or was it only necessary to wait for monetary policy to do its job? Was deflation the central economic problem or something inherent in the nature of financial markets?
I believe that revisiting the experience of the Great Depression—especially the arguments among top economists about its fundamental causes and the reactions of politicians and policymakers to the circumstances they faced as they faced them—can help us more clearly understand the nature of today's problem, avoid the errors that made the Great Depression so severe, and help restore prosperity as quickly as possible.
THE CRASH OF '29
In the popular imagination, the stock market crash that began on October 24, 1929, known as "Black Thursday," was the cause of the Great Depression. It is thought that it mainly resulted from a speculative bubble—excessive buying of stocks, pushing them to prices that were unjustified by economic fundamentals—not unlike those that had led to spectacular market crashes over the centuries.
Some saw it coming. One famous example is banker Paul M. Warburg, a founder of the Federal Reserve, who said in March 1929, "If orgies of unrestrained speculation are permitted to spread too far ... the ultimate collapse is certain not only to affect the speculators themselves, but also to bring about a general depression involving the entire country."
Perhaps even more famous were the comments by Yale University economist Irving Fisher in September 1929 denying the possibility of a stock market collapse. Responding to a prediction by statistician Roger Babson that a sharp decline was imminent, Fisher said, "Stock prices are not too high and Wall Street will not experience anything in the nature of a crash." As late as mid-October, Fisher asserted that the market had reached "a permanently high plateau" and would move higher in coming months. Even after the market started to break, Fisher remained optimistic, citing the economy's underlying strength.
In truth, Fisher's analysis of the stock market was not unreasonable. Many studies have found that only a few stocks making up the Dow Jones Industrial Average had price-to-earnings ratios that appear to have been unsustainable. Most of the stocks were trading at very conservative ratios, and in fact could be considered undervalued based on earnings growth. This suggests that the market collapse was not the result of errors by investors but some change in the economic environment that fundamentally changed the rules of the game. Investors don't all make the same mistake at the same time otherwise.
As soon as the market broke, analysts immediately began searching for deeper causes. As with all major historical events, it was hard for those living through it to see all the pieces and their interrelationships. Even with the benefit of historical perspective, there are many details that remain contentious, and probably always will. That is why events like the Great Depression need to be studied and reexamined by each new generation in light of their own experience and the knowledge gained from subsequent events.
On November 11, 1929, Frank Kent, a director of Bankers Trust, fingered the Smoot-Hawley Tariff, which was then making its way through the Senate, as a prime factor. He declared that growing support for the tariff had created unrest, fear that industry would be injured, prospects for higher unemployment, and general unease in the business community.
Senator Reed Smoot of Utah and Representative Willis Hawley of Oregon, both Republicans, had initiated their tariff legislation in April. It proposed higher duties on a wide variety of industrial and agricultural products, and many products would have tariffs assessed on them for the first time. In those days, most Republicans were strong supporters of trade protection and believed that high tariffs were needed to insulate American farms and factories from cheap foreign imports. In May, Smoot-Hawley passed the House of Representatives, where Republicans had a large majority, by a wide margin. But free-traders held out hope that the legislation could be derailed or modified in the Senate, where a coalition of Democrats and liberal Republicans threatened passage. By October, however, it was clear from test votes that there was very little likelihood that Smoot-Hawley would fail to get majority support. This led Kent and other analysts to conclude that it was a central factor in triggering the Great Depression.
Rather than respond to the substance of Kent's assessment, tariff supporters instead attacked Kent for lying about the cause of the market crash. Senators William E. Borah, Republican of Idaho, and Harry Hawes, Democrat of Missouri, demanded a congressional investigation of Kent and other tariff opponents. Senator Thaddeus Caraway, Democrat of Arkansas, called Kent's statement "propaganda" and said it was caused by "arrested mental development." But Kent refused to back down.
On November 19, Babson added his voice to those blaming the tariff for the market's malaise. He pointed out that if Congress was in effect going to prohibit nations heavily indebted to the United States from selling their goods here, then they would have no way of servicing their debts. Moreover, they would have no earnings with which to buy American goods, leading to reduced output and employment in exporting industries. Babson suggested that the best thing Congress could do to restore confidence would be to adjourn indefinitely.
Some analysts maintain that Smoot-Hawley couldn't have been a factor in the stock market crash because it wasn't enacted into law until June 1930. However, financial markets routinely discount the impact of future actions, incorporating their effects into prices well before an action becomes effective. Economist Alan Reynolds carefully tracked movement of the tariff bill through Congress and observed that every time there was a legislative setback the market rallied, and whenever the prospects improved it fell.
As to the tariff's economic effects, it has been argued that trade protection was already quite severe owing to the Fordney-McCumber Tariff enacted in 1922. Therefore, the additional Smoot-Hawley duties were not quantitatively significant. However, studies have shown that the marginal impact of Smoot-Hawley was in fact quite considerable and sharply reduced trade. It also led to a large decline in investment and a rise in trade protection among our trading partners, which further reduced exports.
By itself, the Smoot-Hawley Tariff probably wouldn't have had that much impact on either the stock market or the economy. But monetary forces had already made the economic and financial environment very vulnerable to any shock. The tariff may have been the last straw, a trigger that pushed the stock market and the economy into a major downturn.
ROLE OF THE FED
The Federal Reserve, our nation's central bank, had long been concerned about the outsized gains in the stock market in the 1920s that appeared to be potentially destabilizing. But it had to contend with the fact that its policy levers, mainly changes in short-term interest rates, were incapable of targeting just that one sector of the economy without spillover effects elsewhere. In other words, the price for bringing the stock market down to earth was that healthy sectors would also be brought down, creating unnecessary suffering for those not even involved in the market. As Yale University economist Robert Shiller explains:
One thing we do know about interest rate policy is that it affects the entire economy in fundamental ways, and that it is not focused exclusively on the speculative bubble it might be used to correct. It is whole-body irradiation, not a surgical laser. Moreover, the genesis of a speculative bubble ... is a long, slow process, involving gradual changes in people's thinking. Small changes in interest rates will not have any predictable effect on such thinking; big changes might, but only because they have the potential to exert a devastating impact on the economy as a whole.
Benjamin Strong, president of the Federal Reserve Bank of New York and the Fed's dominant figure through most of the 1920s, was deeply concerned about what he viewed as a stock market bubble but didn't know how to deal with it without bringing the whole economy down. As he put it in a 1927 letter, "I think the conclusion is inescapable that any policy directed solely to forcing liquidation in the stock loan account and concurrently in the prices of securities will be found to have a widespread and somewhat similar effect in other directions, mostly to the detriment of the healthy prosperity of this country."
By 1928, however, the Fed felt that it had to take some action to prick the stock market bubble and let some air out before it burst and brought the whole economy down. It began tightening monetary policy by raising the discount rate—the interest rate at which private banks borrow directly from the Fed. In February, it raised the rate from 3.5 percent to 4 percent. In May the rate was raised again to 4.5 percent and to 5 percent in July. There were concerns within the Fed that its monetary policy was endangering the economy as a whole—a cure worse than the disease. But the feeling seems to have been that the Fed could reverse course quickly if necessary.
Unfortunately, Strong took ill and died in October 1928. This created a massive power vacuum at the Fed and left it effectively leaderless at a critical moment in time. Lacking anyone with the ability to change its direction, the Fed basically continued on automatic pilot. Seeing the stock market continue to rise in 1929, despite a tighter monetary policy, the Fed concluded that stronger action was needed. In February, it issued a statement warning against stock market speculation. Frustrated by the lack of impact from its jawboning, the Fed raised the discount rate to 6 percent in August. This proved to be one rate hike too many. Instead of cooling the stock market's speculative fever, the Fed induced a case of pneumonia that became evident a few months later on Black Thursday.
Almost immediately some economists pointed their fingers at the Federal Reserve for causing the stock market collapse. Fisher said that the Fed had created the stock market bubble in the first place by running a monetary policy that was too easy during the mid-1920s. Columbia University economist H. Parker Willis, who had been deeply involved in creation of the Federal Reserve, said this was caused by two factors: first, an overreaction to the brief deflation resulting from the recession of 1920–1921; and second, a desire to help Great Britain get back on the gold standard by encouraging the outflow of gold from the United States. The Fed also hoped to shed what it viewed as excessive gold stocks, which had flowed into the country in search of a safe haven during and after the First World War. Ironically, the Fed viewed the excess gold as dangerously inflationary.
In a classical gold standard, such as that which existed before the First World War, the money supply is tied directly to the quantity of gold reserves. Money in circulation automatically rose or fell as gold moved in or out of the country in response to changes in interest rates and inflationary expectations. If there were signs of inflation, gold flowed out, automatically shrinking the money supply and stopping the inflation. Deflation would draw gold inward, expanding the money supply and easing that problem. But after the war, this largely automatic mechanism was replaced by one that was more managed, giving central banks additional latitude to expand or contract the money supply while maintaining a linkage to gold. This is usually called a gold-exchange standard. While the gold-exchange standard did not provide as much monetary flexibility as exists today, there was much more central bank maneuvering room than is commonly believed.
As a result of the sharp decline in stock prices and the growing slowdown in economic activity that was exacerbated by increased tariffs on imports, the demand for money fell and the supply of money contracted as banks folded, causing bank deposits to evaporate. (There was no deposit insurance in those days.) But the Fed allowed the money supply to shrink too much, bringing on a general deflation. Economists have long believed that there is a relationship between the quantity of money times its turnover, on the one hand, and the general level of prices times the quantity of goods and services, on the other. Thus, a shrinkage in the money supply necessarily requires either a decline in prices or a cutback in the production of goods and services.
Another important factor was a decline in the speed at which people were spending their money, which economists call velocity. When velocity increases, less money is needed for economic transactions; when it falls, more money may be needed. Indeed, because velocity is the ratio of the money supply to the gross domestic product, changes in velocity affect the economy exactly the same way changes in the money supply do. Since velocity also fell during this period, as families and businesses hoarded cash and held off making purchases or investments, it exacerbated the deflationary impact of the shrinking money supply.
The impact of the money supply shrinkage was almost instantaneous. Dun and Bradstreet's commodity price index peaked in October 1929 at a level of 192.204 and fell almost continuously thereafter. By April 1930 the index was down to 179.294 and by December had fallen to 163.20—a decline of 15 percent in a little over a year. Changes in the general price level always show up first in sensitive commodity prices. Therefore, such a sharp decline in a broad range of commodities should have been a signal to the Fed that downward price pressure would soon be felt among industrial goods, real estate, and other sectors of the economy. However, the Fed took no action to add liquidity to the economy.
Economist Virgil Jordan of McGraw-Hill condemned the Fed for standing by passively while the money supply fell, thus bringing on a deflation that was paralyzing economic activity. Consumers were holding off making purchases while they waited for prices to drop further, he said, and businesses were incurring huge losses as they were forced to sell products for less than they cost to produce, which brought investment to a standstill. Jordan urged the Fed to immediately inject $ 250 million into the economy by buying Treasury securities. This would be about $ 34 billion in today's economy.
One problem is that the Fed was a relatively new institution in 1930, having only been created in 1913. The idea of using openmarket operations, as Jordan suggested, to expand money and credit was not yet well developed and was resisted by key members of the Fed's leadership. In such an operation, the Fed buys and sells U.S. Treasury securities. When they are bought, the Fed creates the money itself, thus expanding the money supply. When it sells securities, money flows into the Fed and the money supply contracts. In this way, the Fed can offset changes in the money supply resulting from changing economic and financial conditions. The Fed can also influence the money supply by changing the amount of reserves banks must hold as backing for deposits and by changing the discount rate.
Excerpted from The New American Economy by Bruce Bartlett. Copyright © 2009 Bruce Bartlett. Excerpted by permission of Palgrave Macmillan.
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