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Presidential Performance – Ch1
An Economic Record of Presidential Performance
Chapter 1 Major Events and Timeline 1945-1995
Introduction
The Great Depression · 1929-42
Depression Theories
Errors in Economic Policy Leading to and During the Depression
Table 1.1 Federal Government Receipts and Expenditures, 1929-45
World War II
War Financing
Wartime Changes in the Economy
Major Events 1945-Present
Transformation to A Peace-Time Economy
The Employment Act of 1946
The Post War International Economic Order
The Bretton Woods System – Exchange Rates, the World Bank and IMF 1945-1971
General Agreement on Tariffs and Trade (GATT)
Marshall Plan
Korean War
Tax Cut of 1964
The New Frontier and the Great Society
The Viet Nam War (U.S. involvement and Table 1.2
Wage and Price Controls 1971 – 1974 and the Fall of Bretton Woods
The Oil Crises of 1973 and 1979
Reagan Tax Cut of 1981-83
Tax Reform of 1986
Stock Market Crash of 1987
The Omnibus Budget Reconciliation Act of 1990
Suggestions for Further Reading
Endnotes
Introduction
A president’s control over economic performance is often if not usually tenuous. There are too many variables beyond his control, including the personal economic decisions of 260 million Americans, to be able to influence key economic variables with much certainty. The lack of control is particularly evident when there are major events outside the domestic economy, such as wars, oil embargos and global economic cycles, all of which have profoundly and repeatedly influenced the U.S. economy. However, there are also important aspects of the economy well within the control of the President (and Congress), such as major economic legislation, controls, liberalization and reforms. The President commands the resources of the Treasury Department, the Office of Management and Budget and the Council of Economic Advisors to influence economic policy.
Whether the President has a high degree of responsibility for the economic performance during his reign, or not, he is indeed judged by what is perceived to have transpired “on his watch.” It is important for that reason, for historical accuracy and for a meaningful starting point to have a record of what actually transpired economically, complemented with a background of events which influenced the economic indicators.
To provide context for the economic performance of the presidential administrations, major events after WWII are presented. This discussion includes both economic and non-economic events since both affect the indicators. The intent is to point out coincidance of major events with changes in the indicators and for the reader to explore other sources for an assessment of the impact of these events. Examples of other sources are provided in Suggestions for Further Reading at the end of each chapter. A timeline of events is also presented at the end of this historical summary.
The events of the post-war era, themselves, should be placed in a historical context. A brief overview of the economic policies pursued and the lessons learned during the Depression and World War II provides this context and insights into economic thought in post-war America.
The Great Depression · 1929-42
Because it jolted the U.S. economy so severely, the Great Depression permanently changed economic thinking. Prior to the Depression, economies of the U.S. had rebounded regardless of the business shocks and returned to their full-employment levels of GDP. But the shock of the 1930s was beyond any other in the U.S. experience; real income fell by 18 percent in 1931 alone. Unemployment skyrocketed from 3.2 percent in 1929 to 24.9 percent in 1933. When the economy bottomed out in March, 1933, national income was 36 percent below the 1928 level. As Milton Friedman pointed out in his Monetary History of the United States, per capita income had fallen to 1908 levels, thus erasing a quarter century of improvement in the nation’s standard of living. The U.S. economy did not emerge from its depressed state until well after the start of WWII.
Depression Theories
There are many theories as to how such an unprecedented economic decline came about. A few of the more well-known ones are presented here. The divergence in the explanations of the causes of the Depression parallels the difficulties in establishing an economic policy concensus in the post-war economy.
1. The restrictive fiscal and monetary policies which were pursued primarily out of the fear of increasing budget deficits, precipitated a severe recession and turned a banking crisis into full-scale financial collapse. Persistance with these perverse policies throughout the 1930s deepened and prolonged the depression. This view reflects the “Friedman-Schwartz” or monetarist view.
2. The Federal Reserve intervened too much in not allowing the nominal money supply to fall to its natural level. Therefore, prices did not fall far enough to spark the (demand-driven) recovery that would have occured, ostensibly because demand would have re-ignited due to lower prices. This “Austrian”/Schumpeter view notes that with the radical deflation of 1920-21, prices were allowed to fall completely and a recovery did occur.
3. The increasing concentration of wealth that was allowed to develop during the 1920s resulted in a very high savings rate. The correspondingly low consumption rate was gradually outpaced by rising productivity until industry and industrial employment could no longer be supported by consumer demand. This theory also contends that the surplus saving of the rich was used in stock market speculation, which in turn contributed to the stock market crash in 1929.
4. “Secular Stagnation,” a term coined by Keynesnian economist Alvin Hansen, stated that because the U.S. had reached its geographical frontier, population growth had slowed and because there were fewer investment opportunities and less innovation, the economy was inexorably led into depression.
5. With the consumption binge of the 1920s concluding with the stock market crash in 1929, consumers simply decided to be much more cautious and spend less. Proponents of this view note that consumption declined by 41 percent between 1929 and 1933.
6. The standard Keynesian scenario for recession or depression as presented in The General Theory (1936) was as follows: For whatever reason, e.g., “animal spirits,” a sudden collapse of the marginal efficiency of capital (or return on capital) occured. As a result, investors’ revised their estimates of future returns of current investment plans downward. Therefore, investment demand dropped and recession followed. The Keynesian solution to the recession was called “compensating fiscal policy” which was designed to smoothe out the peaks and valleys in the business cycle through compensating tax and spending programs.
An additional Keynesian observation of the Great Depression contended that the large cash surplus which some banks held indicated that they were hoarding cash and thus inhibiting demand for securities and investment. This phenomenon later came to be known as the “Liquidity Trap.”
Theories 1. to 3. suggest errors of economic policy, while theories 4. to 6. suggest forces largely beyond control of the policy-makers. Ironically, many of the tools of monetary, fiscal and foreign trade policy were already in place in the 1920s and, in all probability, could have been used to assuage or possibly avoid the depression if they had been correctly understood.
Errors in Economic Policy Leading to and During the Depression
The description of events leading up to and during the Great Depression, here, follows the line of the first theory, i.e., that poor monetary and fiscal policies were to blame. This hypothesis is perhaps the most highly supported theory of the Depression and it focusses on factors within the control of policy-makers. It is also more reflective, among the theories presented, of the type of economic thinking which emerged after WWII. International factors contributing to the Depression are also discussed.
Although both monetary and fiscal policy blunders contributed to the Depression, monetary policy was probably the more culpable. The most serious fiscal policy errors were committed well after the Depression was under way. Faulty monetary policy was central to engineering the financial crises during 1929-33 which precipitated the Depression. From 1929 to 1933, the money supply was substantially reduced, a counter-stimulative policy which was exactly the opposite of what would normally be prescribed for a recession. In 1929, the M1-measured money supply stood at 26.4 billion and by 1933 it had fallen to 19.8 billion,1 a drop of 25 percent in nominal terms.
The tight money policy certainly aggravated and perhaps was the primary cause of the rapid deflation (over 8 percent annually) which was occuring in the economy. Thus, even though the nominal interest rate was only 1 to 2 percent, the real interest rate soared to over 10 percent. This high real interest rate had a strong depressing effect on the economy. In addition, in September 1931, Britain left the gold standard. Other countries which held U.S. dollars feared the U.S. was going to follow Britain. With the low and declining interest rates in the U.S., these foreign countries decided to cash in their dollars for gold. The ensuing run on U.S. gold exacerbated the Depression because the Fed, concerned about the gold drain, actually increased the rediscount rate to member banks. The timing of this move was particularly destructive as it occured during a wave of bank failures. This perverse policy continued as the rediscount rate was also increased in 1933 and 1937, the latter contributing to the major recessionary setback of 1938.
Table 1.1 Federal Government Receipts and Expenditures, 1929-45
(billions of dollars)
Sources: Economic Report of the President, 1994, Survey of Current Business, September, 1993
There was another international policy error which also contributed to the Depression. With economic conditions suddenly declining in other countries as well, there was a clamor for protectionism. Each country, including the U.S., was desperate to maintain a favorable trade balance in order to improve its employment situation. Tariffs were raised and quotas were instituted. In 1930, the Smoot-Hawley Tariff was passed. The collective result of this tariff and the high barriers to imports imposed by other countries was to further curtail what employment relief might have been realized from the expansion of international trade.
On the fiscal side, a tax increase was actually instituted in 1932 in an attempt to eliminate budget deficits. Because of the fear, especially Herbert Hoover’s, of budget deficits, tax rates were increased to a level which effectively doubled full-employment tax yields. As Table 1.1 shows this tax increase was not successful in eliminating budget deficits. Tax increases occured not only at the federal level, but also at the state and local levels. At the time, state and local taxes accounted for substantially more revenue than did federal taxes. Although the tax increases occurred well after the Depression had started and after national income had already fallen by 30 percent, they served to deepen and prolong the Depression and indicated a further lack of understanding of how economic variables in respond to economic policies.
In the 1930s, with the exception of the first year, Government spending increased under both Hoover and Roosevelt policies and budget deficits were run every year (Table 1.1). But Government spending was still insufficient to pull the economy out of the Depression. In 1935 and 1937-38, Government spending actually constricted as a share of GDP. Thus, it was the reduction in revenues and not excessive spending which was primarily the cause of deficits. In fact, spending fell far short of what was needed for recovery. The 9-10 percent or so of GDP accounted for by federal expenditures, a common level in the 1930s, did not come close to the magnitudes of wartime spending of over 40 percent of GDP.
The taxing and spending structure which continued throughout Franklin Roosevelt’s administration in the 1930s was designed more to eliminate the deficits than to nurture the economic recovery. The tax increase of the early 1930s, which, as mentioned, would have doubled revenues at the full employment level of national income, was not rescinded by Roosevelt. Moreover, in 1936, in order to finance the new Social Security programs, additional taxes had to be imposed. Thus, taxes grew faster than expenditures which held down economic recovery long before full employment was attained. This view is supported by the course of unemployment during the remainder of the 1930s. The level of unemployment did improve to 14.3 percent by 1937 from its 1933 high of 24.9 percent, but then shot up to 19.0 percent in 1938, almost 9 years after the Depression began. Unemployment continued at historically high rates of 17.2 and 14.6 percent during 1939-40. What recovery did occur in the 1930s appeared to come more from a struggling private sector than from fiscal (especially tax) policy, the proliferation of government programs notwithstanding.2 In conclusion, the economic policies, both monetary and fiscal, which were pursued in the 1930s not only precipitated the Depression, but also prolonged and deepened it.
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World War II
War Financing
At the onslaught of WWII, the policy decision was made to finance the war through additional borrowing as well as taxes. In 1940, individual income taxes were 20 percent of revenues and in 1945 they were 43 percent. In all, it is estimated that 46 percent of the war expenditures was paid for by current taxation. Thus, most of the incremental war costs were met through borrowing, primarily through bonds sold to the banking system and the public. That the war was heavily financed by borrowing is reflected in the budget deficits in Table 1.1. In 1943 and 1944, government expenditures’ share of GDP reached 44.8 and 45.3 percent, respectively. By 1945, government revenues were less than half of expenditures and the federal deficit reached a quarter of GDP (the deficits of the early 1990s were roughly 5 percent of GDP). The huge increases in government spending profoundly reduced the unemployment rate. In 1940, the unemployment rate stood at 14.6 percent, 0.3 percent higher than the rate three years earlier in 1937. But as the preparations for war began in 1941, the unemployment rate dropped to 9.9 percent and then to 4.7 and 1.9 percent in 1942 and 1943, respectively.
In the final analysis, it was deficit spending that hauled the economy out of the depression. The combination of taxing and spending followed a Keynesian blueprint: Increased government expenditures generated the output needed for war and for civilians. The money or production cost of war goods meant income for civilians, but war goods did not enter the economy, which meant increased income without increased goods on which to spend it. Taxation and war bond sales played the role of absorbing the excess income and, therefore, avoided inflation. In reality, however, pervasive price controls probably had more to do with controlling inflation than the absorption of excess income by war financing needs.
Wartime Changes in the Economy
The exigencies of the war and the need to pay for it ushered in new features to the economy which remain today. For example, changes were made to revenue collection to facilitate the financing of the war. The pay-as-you-earn individual income, or withholding, tax was instituted in accordance with the Revenue Act of 1943. The timing of revenues and expenditures was improved and the costs of collection were avoided as employers would perform the tax collection function for the IRS. Taxpaying also became as an act of patriotism.
Another interesting development in economic policy practiced during WWII and important to future economic policy was the discovery of the revenue side of fiscal policy as a tool for economic stabilization.3 The realization emerged that returning spending power to the economy through lower taxes had advantages over deficit spending. The enhancement of aggregate demand through lower taxes would be more evenly distributed throughout the economy and be less distortive and inflationary than government deficit spending, which would be confined to public works projects. Although war-time tax rates did not return to pre-war, peace-time levels when the war ended, the idea of stimulating aggregate demand through tax cuts gradually gained support and culminated in the Kennedy-Johnson tax cut of 1964, which is discussed below.
At the end of WWII, the Depression experience was still fresh, several new institutions of the Roosevelt administration–the Social Security Administration (1936), the Securities and Exchange Commission and the Federal Deposit Insurance Corporation–were more firmly established, U.S. manufacturing had been built up tremendously and the U.S. was ready to assume the leadership role in the world economy. Thanks to some painful lessons learned in the Depression, U.S. Presidents could pursue macroeconomic policies with a better understanding, which was infused, to a large extent, with Keynesian economics. The economic framework of today has many basic similarities to that of 1945, in spite of the dramatic changes between 1945 and 1993, thus, leaving a basis for presidential comparison during this time period.
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Major Events 1945 to Present
Transformation to a Peace-Time Economy
The United States emerged from WWII with the only intact industrial base in the world, a currency which was preferred to gold and virtually no international competition. Yet, in the transformation to a peace-time economy, many economists predicted a massive recession with high unemployment. The reason for this dire prediction was the inevitable, tremendous reduction in the government’s military expenditures, which could not reasonably be expected to be compensated for by increased government expenditures in other sectors. Government expenditures fell from 93 billion dollars in 1945 to 30 billion dollars in 1948 (nominal terms), a drop in outlays as a share of GDP from 43.7 percent to 12.1 percent. In real terms, government expenditures declined by rates of 43, 50 and 16 percent, respectively, during 1945-48. The newly demobilized military personnel were also not expected to be absorbed by the private economy.4 However, although the fall in government outlays did occur without compensating government outlays elsewhere, the private sector responded and the recession was much milder and shorter than expected.
Some economists attribute the milder than expected recession to the pent-up purchasing power which consumers had accumulated during both the Depression and the war, in all, a period of almost 17 years. Consumer demand could, thus, pave the way for the transition from not only a war- to a peace-time economy, but also from a government-run to a private economy. However, the prospect of inflation due to this demand was strong. In addition to the pent-up domestic demand, there was great demand in Europe and elsewhere, especially for U.S. goods needed to rebuild. Ultimately, both foreign and domestic demand fueled a successful transformation to a peace-time economy. The manufacturing and housing sectors quickly geared up for this demand and created millions of new jobs. In addition, the Serviceman’s Readjustment Act of 1944, better known as the G.I. Bill, facilitated the transition back into civilian life with loans, educational subsidies and other benefits.
It could be said that Truman’s performance bore the burden of the economic transition, but also had the advantage of the purchasing power which had accumulated during the Depression and the war years and the benefit of international demand in meeting the rebuilding needs of Europe. With the tremendous demand, both foreign and domestic, for U.S. output, it turned out that it was not the greatly feared return to high unemployment which threatened the transition, but rather the control of inflation as Chapters 3 and 4 show.
The Employment Act of 1946
The Employment Act of 1946 represented the philosophical consensus for the post-war economy in terms of redefining, or at least reexamining, the relative economic roles of the Government and the private sector. The Act is also significant for the debate that ensued during and after its drafting. Initially, the Keynesians in Congress wanted the Act to be called the Full Employment Act. Their idea was to emphasize the Government’s committment to achieve full employment, because they felt that the primary objective of economic policy was to avoid a return to the high unemployment of the Great Depression. Central to this view was that it was the Government which had the primary responsibility to achieve full employment. This view maintained, moreover, that if there was unemployment, then the Government could run a budget deficit which would achieve full employment and that this deficit could be estimated by economists.
After debate in Congress, however, the Act was modified to replace the goal of “full employment” with “maximum employment, production and growth,” to delete references to the Government’s deficit as the exclusive tool of economic management and to reaffirm that economic measures must be consistent with the free market system. The Act also created the Council of Economic Advisors to assist the President in formulating economic policy.
From this Congressional debate, it was clear that Keynesianism was strong, but that it did not have full reign over economic policy. The Government’s power, or mandate, to achieve full employment had limits and the goal of full employment had to accommodate policies which encouraged economic growth as well. Thus, the U.S. economy remained essentially a free market system with the intended role of the Government as an enabler rather than a regulator of economic growth.
The Post-War International Economic Order
As the post-war economic framework took shape within the U.S., the U.S. was also working with other nations sculpting the international economic framework. There were three important components to the framework which helped achieve and maintain international economic order. The three components were: the Bretton Woods System, the General Agreement on Tariffs and Trade (GATT) and the Marshall Plan. The new international system departed from the protectionist philosophy of the 1930s and created an environment conducive to a rapid expansion of trade. The expansion of trade, in turn, contributed to the historically high growth rates in the U.S. and the rest of the industrial world from WWII through the 1960s. From the U.S. viewpoint, the emerging Cold War placed particular urgency and political importance on the establishment of an international economic order based on Western principles of free trade and competition.
The Bretton Woods System – Exchange Rates, The World Bank and IMF · 1945-1971
The Bretton Woods Agreement was signed on December 27, 1945, in Washington, D.C. following the United Nations Monetary and Financial Conference at Bretton Woods, New Hampshire, in July 1944. The agreement established the International Bank for Reconstruction and Development, commonly known as the World Bank, and the International Monetary Fund (IMF). The purpose of the World Bank, which began operation on June 25, 1946, was to make loans for development projects, primarily infrastructure, in war-torn countries and in developing countries for the benefit of poor people, while the IMF was to maintain exchange rate stability and facilitate exchange rate adjustment. The Bretton Woods agreement also attempted to establish a stable international environment through: (1) fixed exchange rates; (2) currency convertability; (3) a gold standard which maintained a gold price US$35 per ounce and (4) provision for orderly exchange rate adjustment in the event of “fundamental disequilibrium” between major currencies.
The IMF would oversee the system and provide medium-term loans to countries with temporary balance of payments difficulties which would, therefore, help preserve the system of fixed exchange rates and provide more stability. As mentioned, the IMF would also facilitate adjustments to a country’s exchange rate in the event that the country was in “fundamental disequilibrium,” i.e., the value of its currency had simply changed with respect to the other currencies such that currency transactions would not be able to sustain the current fixed exchange rate. Currency convertablity meant that one major currency could buy or be bought with another at the fixed exchange rate. However, while the fixed exchange rates component of Bretton Woods was implemented from the beginning, currency convertability did not come about until the end of the 1950s. Currency convertibility was a precondition for freedom of capital mobility and ultimately led to the integration of global financial markets, as shown later by, inter alia, the rise of the Eurodollar market. Balance of payments crises were also worked out at the IMF through ad hoc arrangements.
General Agreement on Tariffs and Trade (GATT) 1947
Although the Bretton Woods system did not become fully operational until well into the 1950s, another major feature of international trade was introduced in October, 1947, the General Agreement on Tariffs and Trade (GATT). GATT was important in setting up the rules of trade, especially for industrial countries. GATT consolidated a series of bilateral trade agreements and created a liberal trade regime based on: 1. Non-discrimination in trade in that a priviledge extended to one signatory was extended to all, i.e., “the most-favored nation clause”; 2. Industry protection through tariffs rather than quotas or other non-tariff barriers and 3. A mechanism to work out trade disputes. Much of the rapid growth of international trade following the war has been attributed to the principles on which GATT was based. The rapid trade expansion, in turn, is cited by many economists as the engine of both European recovery and sustained growth in the U.S.
Marshall Plan · 1948-52
The Marshall Plan for European Reconstruction (officially called the European Recovery Program), was carried out from 1948 to 1952 and was the largest foreign aid program ever launched by the U.S. The plan cost US$13.2 billion over the four-year period. Another US$1 billion went to East and Southeast Asia. The primary recipients of aid were the United Kingdom (US$3.2 billion), France (US$2.7 billion), West Germany (US$1.4 billion), Holland (US$1.1 billion), which were followed by, in order of amount received, Greece, Austria, Belgium, Denmark, Norway, Turkey, Ireland and Sweden. There were four additional recipients which received modest amounts. The plan helped to rebuild these countries by financing raw materials, semi-finished goods, agricultural inputs, machinery, vehicles, fuel, etc.
The Marshall Plan played an important role in the rapid recovery of Europe. Europe’s human capital and know-how were intact after the war, but its physical capital lay in ruin. Thus, the infusion of capital from the Marshall Plan could be effectively absorbed. The economic success of the recipient countries, especially West Germany, is consistent with this view. Economic historians also note that the Marshall Plan supplanted the World Bank in its role as an “International Bank for Reconstruction…”. Rather, the World Bank became a development institution for Third World countries, many of which were still waging battles for independence after the Marshall Plan was implemented.
Korean War · June, 1950 – July, 1953
The Korean war lasted a little over three years. Hostilities broke out in June 1950 when a force of Soviet-supported North Koreans crossed south of the 38th parallel and invaded South Korea. President Truman acted immediately and gained a United Nations Security Council Resolution (the Soviets were boycotting the U.N. at the time) to resist the aggression. The vast majority of fighting occurred during the first year of the war which is reflected in the trend in U.S. Government expenditures. Huge swings in the tide of battle characterized the war with the UN forces driven almost into the sea, followed by General MacArthur’s counterattack, which pushed the North Koreans almost to the Chinese border. When the Chinese entered the war, UN troops were forced back to the 38th parallel. Thereafter, a stalemate ensued and many lengthy rounds of truce talks were conducted, with the war finally concluding on July 27, 1953 as President Eisenhower signed the armistice drawing the border at the 38th parallel. At its peak, U.S. troop strength in Korea was 350,000 There were 33,600 U.S. soldiers killed in action and approximately $18 billion (non-inflated) was spent by the U.S. on the war.
The Korean War, economists argue, had two effects on the economy. The first was the economic boom, especially in 1950 and 1951, which was triggered by a major increase in defense spending, partially restoring the massive defense cuts following WWII. The second was the worsening of inflation, particularly in 1951. In its concern over inflation, the Congress gave Truman broad power over the economy including that of wage and price controls. The end of the war was followed by the brief 1954 recession. An interesting sidelight to the Korean War is that the U.S. ordered thousands of military trucks for the war effort from a relatively unknown Japanese company named Toyota, a transaction which provided an important early boost to the Japanese vehicle manufacturer.
Tax Cut of 1964
The tax cut of 1964 was the largest tax cut in history up to that time and is attributed to Kennedy, but was actually passed and implemented after his assassination. Kennedy had originally promised such a tax cut in June of 1962, but the first stage of the two-stage tax cut was not enacted until February 1964. Congress had delayed in passing the tax cut due to fears of higher budget deficits and some suggest that the tax cut was approved only on a wave of sympathy from Kennedy’s assassination. The second stage occurred the following year. The purpose of the tax cut, according to Kennedy, was to favor temporary increases in budget deficits in order to promote fuller use of resources and more rapid economic growth rates over the slower rate of growth and small, but chronic deficits of previous years.5
The tax-cut entailed across the board reductions of individual tax rates with the top rate reduced from 91 to 77 percent in 1964 and to 70 percent in 1965. It also reduced corporate taxes to 22 percent on the first $25,000 of taxable income and the tax rates on the remainder went from 52 to 50 percent in 1964 and to 48 percent in 1965. Capital depreciation was also enhanced. The estimated total tax reduction effectively represented $11-14 billion transfer from the public to the private sector.
The tax cut was considered a milestone in that it was not only Keynesian since Government expenditures rose relative to revenues, but that it was also a “supply side” measure as resources were shifted from the Government to the private sector. On balance, the tax cut was politically conservative because it relied on tax reduction rather than expenditure increases, gave benefits to wealthier individuals and lowered the tax burden on corporations.
The New Frontier and the Great Society · 1964-69
The Tax Cut of 1964 was followed quickly by the Great Society programs of Johnson. Prior to Johnson’s own programs, he secured passage of several New Frontier bills initiated by Kennedy, the most important of which was the Civil Rights Act of 1964, which survived a 57-day filibuster from Southern senators. In addition to enactment of New Frontier initiatives, Johnson also declared his “War on Poverty” and established the Economic Opportunity Act, the Job Corps and Vista Volunteers (a domestic peace corps), all in 1964.
In his 1965 State-of-the-Union address, Johnson presented his plan for “The Great Society.” It expanded federal programs to cover the poor and elderly, the rural and urban areas and the middle class as well. Benefits to the middle class were viewed as a means to gain support for the Great Society program as a whole. The main components of The Great Society passed in 1965 and 1966 included the Housing and Urban Development Act, creating a cabinet level department to coordinate federal housing programs, Medicare to provide health care for the elderly, the Appalachian Regional Development Act which provided aid to that area, the Elementary and Secondary Education Act and the Higher Education Act, which provided funds and scholarships, the National Teachers Corps, the Immigration Act, the Voting Rights Act, the Demonstration Cities and Metropolitan Area Redevelopment Act and a general expansion and increase of other programs such as social security and minimum wages. The budgetary implications of these programs are dealt with in Part II.
The Viet Nam War · March, 1965 – January, 1973 (U.S. involvement)
While the groundwork for U.S. involvement in Viet Nam was laid in the Eisenhower and Kennedy administrations, it was under President Johnson that sustained, large-scale war was waged. When Johnson assumed office in November, 1963, there were 17,000 U.S. troops in Viet Nam, mainly serving as advisors to South Vietnamese army units. In August 1964, the North Vietnamese attacked U.S. ships in the Gulf of Tonkin, after which the Gulf of Tonkin Resolution was passed by Congress, paving the way for greater military involvement. After several other escalations, Johnson sent the first combat troops to Viet Nam in March, 1965. The table below charts the yearly course of the war.
Table 1.2 shows that the war had two distinct phases which corresponded exactly with the tenures of the two presidents in charge, Johnson and Nixon. Under Johnson, what started as a few skirmishes and tens of millions of dollars, by 1968 had turned into a full-fledged war with troop strength at 540,000 and tens of billions of dollars spent annually. The peak troop level was reached in March, 1968 at 541,500. Government expenditures on the war reached 13-14 percent of the total U.S. budget for fiscal 1969 and 1970.
Table 1.2 Viet Nam War: Cost, Troop Strength and Fatalities
Troops Deployed
Troops Killed
Source: Figures from A Short History of the Vietnam War, 1978.
In 1969, newly elected President Nixon changed the character of the war by undertaking a policy of “Vietnamization” whereby the burden of ground combat would be shifted from U.S. forces to those of South Viet Nam. U.S. troop levels were steadily reduced along with U.S. casualties, although the policy proved unsuccessful in winning the war. While there was a steady downward trend in the number of U.S. military personnel, Nixon waged a vigorous bombing campaign in Viet Nam as well as an “incursion” into Cambodia. In January, 1973, a peace agreement was signed and the remaining U.S. troops and P.O.W.s returned. In the final tally, the Viet Nam war had cost almost 58,000 lives and over $100 billion,6 not including the costs to the other participants in the war. Through both the Johnson and the Nixon phases, the waging of the war coincided with sustained economic growth and low unemployment on one hand, and larger budget deficits and increasing inflation on the other. Additional details of the affects of the war on the government budget are found in Part II.
Wage and Price Controls · August 15, 1971 – April 10, 1974
and the Fall of Bretton Woods
Wage and Price Controls and changes in the rules of international economic exchange were instituted by President Nixon beginning in August 1971 in response to persistent and relatively high inflation along with the concern, which had been brewing since the 1960s, of a run on the U.S. dollar in the foreign exchange markets. In addition to freezing wages and prices, the measures rescinded dollar-gold convertability and fixed exchange rates, thus removing two pillars of the Bretton Woods system. Also as part of the program, Nixon levied a surcharge on imports as a means to force other major countries to revalue their currencies with respect to the dollar, created an investment tax credit, deferred certain government expenditure increases and eliminated the excise tax on automobiles. A new cabinet committee, the Cost of Living Council, was also created to manage the program which lasted almost three years.
The Nixon wage-price controls were enthusiastically received by the public with the Dow-Jones Industrials Average rising 32.9 points the day after the program’s unveiling, the largest one day increase in history up to that point. This response is interesting in that it suggests rather shallow public support (as represented by the stock market), in principle, for the basic characteristics of a free market economy. The public’s acceptance of the controls did not change for the nearly three years that the controls were in effect. The actual price and wage freezes lasted only about 90 days and the program as a whole lost the battle with inflation.
Key features of Bretton Woods were eliminated by President Nixon because they did not reflect economic reality of the time. For example, Bretton Woods was a fixed exchange rate system in a world where economic forces required exchange rates to change constantly. This phenomenon, as mentioned, was known as “fundamental disequilbrium” because “real” exchange rates differed from the fixed exchange rate. Different inflation rates between countries, as well as other factors, made it impossible to maintain the value of some currencies with respect to others. Fixed exchange rates could not be maintained even with substantial interventions from major central banks. Furthermore, on average, countries felt more pressure to devalue than to revalue their currencies with respect to gold and therefore the dollar. Without the other currencies revaluing, the U.S. could only support the exchange rate of the dollar by selling gold. U.S. Gold reserves were depleted from $17.8 billion in 1960 to $11 billion in 1971, a decline of 38 percent. The result was a deterioration of the balance of payments and a dollar crisis in the U.S. giving rise to a liquidity problem that thwarted the ability of the system to adjust.
Thus, Nixon was forced to sever the dollar-gold link and, later, to cast off the system of fixed exchange rates in 1973. Although Bretton Woods essentially ended as an operational system of international exchange with the de-linking of the dollar from gold and the abandonment of fixed exchange rates, its legacy lives on in the two institutions it created, IMF and the World Bank.
The Oil Crises of 1973 and 1979
The energy crisis of 1973-4 was many years in the making. In the 1950s and 60s, most of the industrialized countries had become dependent on oil imports for sizeable portions of their energy consumption. The immediate crisis in 1973 was precipitated by the Organization of Petroleum Exporting Countries (OPEC) Oil Embargo of countries supporting Israel in the Arab-Israeli war of that year. The embargo was in effect against the U.S. from October 1973 to March 1974 and led to a tripling of the U.S. price of oil. A number of measures were taken by the U.S. to manage the scarcity, including voluntary lowering of thermostats, restrictions on gasoline purchases and a stand-by authority for rationing.
The second oil shock of the 1970s occurred as a result of the overthrow of the Shah of Iran. During the turmoil leading up to the Shah’s flight from his country in January, 1979, Iranian oil workers went on strike. Iranian oil exports, which accounted for 12 percent of the non-communist world’s oil supply, were severely disrupted. Taking advantage of this situation, OPEC raised the price of crude oil by almost 15 percent during 1979. Increases in production from such countries as Saudi Arabia probably prevented an even greater crisis.
Within the U.S., a series of gasoline shortages swept the nation, beginning in May in California and extending to the east coast by summer. Interestingly, some observers laid the blame for this gasoline shortage on the U.S. Department of Energy’s allocation methods citing several supporting facts: (1) supplies of crude oil in the U.S. were actually higher in 1979 than in 1978, (2) some regions of the country never experienced any shortages and (3) regional shortages often disappeared quickly.
Reagan Tax Cut of 1981-83
One of the major issues in Ronald Reagan’s 1980 campaign was general tax reduction, following the premise that such a tax reduction would increase resources and incentives for production. After surviving an assassination attempt in March 1981, President Reagan pursued his major policy initiatives which included substantial income tax reduction, cuts in social programs and accelerated defense spending. The plan was codified in the Economic Recovery Act of 1981.
One important, and often thought to be the most important, element of this act was an across-the-board reduction in individual income tax rates phased in over three years. The income tax rate reductions amounted to 5 percent in 1982, 10 percent in 1983 and 10 percent in 1984, for an overall rate reduction cut of 25 percent over the three years, although, due to technicalities in the process, the total cut worked out to only 23 percent over the three years.
Perhaps an even more important aspect of the tax package was the indexing of income tax rates. For years leading into the Reagan administration, individuals’ income rose rapidly in money terms, largely due to inflation. While individuals’ real income and purchasing power had not risen nearly as rapidly, they, nevertheless, found themselves in ever higher tax-brackets, paying higher percentages of their income to the Government. In effect, this phenomenon, known as “bracket creep,” gave the Government automatic tax increases which were geared to the rate of inflation. Moreover, the Congress was not forced to pay the political price for enacting these tax increases. However, starting in 1985, the Economic Recovery Act required the IRS to increase the income tax-bracket levels by the increase in the consumer price index, thus ending years of progressively higher tax rates on inflation-induced increases in income. Consequently, the hidden benefit to the government of inflation-induced tax increases was ended.
There were also benefits to businesses in the new laws. These benefits included cuts in tax rates at the lower levels of corporate income and a new system of depreciation, known as the Accelerated Cost Recovery System (ACRS). This system provided for much faster write-offs of capital expenditures and consequently lower taxes to companies making such investments.
Tax Reform of 1986
Some observers termed the 1986 Tax Reform Act the most important piece of financial legislation since 1913, when the 16th amendment to the Constitution, authorizing modern-day income taxes, was ratified. It took two years to enact, and was signed into law by President Reagan in October, 1986.
Perhaps the important aspect of the 1986 tax reform was that it largely eliminated, or at least greatly dulled, the progressive tax system for individuals. It also eradicated many long-cherished tax breaks. Prior to 1987, there were 15 tax-brackets for single taxpayers and 14 for married taxpayers. Maximum tax rates were 50 percent in both categories. This system was replaced by a five-bracket system in 1987 (considered a transitional year) and a two-bracket system thereafter. Under the two-bracket system, married and single individuals were taxed at 15 percent up to a certain level of income and 28 percent thereafter. At higher levels of income, the benefits associated with the 15 percent rate were phased out. Among the significantly curtailed or eliminated tax deductions were for interest on consumer loans, medical expenses, sales tax, political and charitable contributions and unreimbursed business expenses (sometimes referred to as the “three martini lunch”).
Another important component of the of the 1986 Act was the curtailment of tax shelters. For many years, tax shelters had gained notoriety as unfair tax dodges available only to the very rich. The 1986 Act significantly reduced the attractiveness of tax shelters through the following changes in the code: First, the investment tax credit was repealed; second, the generous depreciation schedules of the 1981 Economic Recovery Act were scaled back and third, losses from tax shelters would no longer be deductible against otherwise regular taxable income. Businesses did receive some benefits in the 1986 Act including reduced tax rates on the top corporate tax brackets.
Stock Market Crash of 1987
The Stock Market Crash of 1987 occured on October 19, “Black Monday,” in which the Dow Jones Industrials Average (DJIA) dropped 508 points, losing 22.6 percent of total market value, the largest one-day loss ever. An overlooked aspect of this crash is that the market had already fallen over 250 points in the previous week. Over the weekend prior to “Black Monday” investors apparently became increasingly nervous about the rapid decline and by Monday the stock market was reeling. The many possible explanations for the Crash range from international causes such as Treasury Secretary Baker’s announcement that the U.S. would not to prop up the dollar and indications that foreign holders of U.S. debt were becoming uneasy with financing U.S. deficits, to technical causes such as think-alike MBAs engaged in programmed trading. The market did recover partially in the following days and by mid-July, 1990 had regained its pre-Crash level.
The Omnibus Budget Reconciliation Act of 1990
The desire to avoid Gramm-Rudman automatic spending cuts in 1990 forced President Bush and Congress into dealing more seriously with the budget deficits than they had in the previous year, Bush’s first year in office. With the economy slowing down and the estimates of the budget deficit rising, the automatic spending cuts would have to be enormous in order to meet the Gramm-Rudman targets. Thus, there was a great deal of pressure on Bush to reach a major compromise with Congress that would attack the deficit on both the expenditure and revenue sides. Democrats, not wanting again to be tarred as “big tax and spenders” would not initiate proposals for increased revenues without the president signing on. On the other hand, for Bush to increase tax revenue meant going back on his central campaign pledge of “No new taxes.”
During 1990, two major budget agreements were drafted. The first budget agreement, the result of a budget summit between the president and Congress, was based on excise tax increases on gasoline and home heating oil and spending cuts, largely on Medicare, but was devoid of both the much-discussed capital gains tax cut and upper income tax increases. When this first agreement was resoundingly defeated in the House by a vote of 179-254, with many Republicans voting against the summit agreement, a second budget agreement had to be drafted.
Obviously, the second budget agreement needed more votes than the first and the question became whether votes should be sought from the left or the right of the political spectrum. House Democrats who felt that Bush had already inoculated them against the big-taxers label, put together their own plan which included higher taxes on the wealthy and eliminated the regressive gas tax. The Senate Democrats found the House version desirable, but created their own budget plan which was modified to get the needed Republican support. The choice was shifted considerably to the left compared to the earlier budget agreement as, in the end, greater Democrat support was sought. The agreement which finally passed included: an increase in the tax rate in the high income bracket (strongly fought against by Bush) and other indirect tax increases on the better-off (i.e., elimination of some deductions), no capital gains tax cut, a smaller increase in gas taxes and smaller cuts in Medicare compared to the summit agreement. On October 28, 1990, the final agreement which purported to decrease budget deficits by $490 billion over a 5-year period was passed in the House and Senate and was later signed by the President under the name of the Omnibus Budget Reconciliation Act of 1990, more commonly known as the Budget Enforcement Act (BEA).
Also noteworthy are the provisions of the BEA which made it more difficult for the president and Congress to dodge the budget deficit targets set by its predecessor in budget legislation, Gramm-Rudman-Hollings (GRH). GRH had required the administration to estimate budget deficits at the start of the fiscal year to see whether the estimate complied with the GRH deficit target. However, it was possible to pass legislation to increase the deficit later in the year as well as in subsequent years, since GRH only applied to the current year. The BEA closed off both of these circumventions by requiring that the administration reveal whether the legislation it signed increased or decreased the deficit. If BEA targets were exceeded, then across-the-board spending cuts would be invoked until the targets were met.
Suggestions for Further Reading
Bernstein, Michael A., The Great Depression, Cambridge University Press, New York, 1987. Surveys short- and long-run theories of the Depression and offers explanations for the delayed recovery.
Friedman, Milton and Schwartz, Anna, A Monetary History of the United States – 1867-1960, Princeton University Press, 1963. Provides an in-depth portrayal, but with readable narrative, of monetary developments during the entitled period, including good background on the Federal Reserve the Great Depression.
Graham, Andrew and Seldon, Anthony, eds., Government and Economies in the Postwar World – Economic policies and comparative performance, 1945-85, Routledge, 1990.
Hughes, Jonathan, American Economic History, 1980.
Millet, Allan R., ed., A Short History of the Vietnam War, 1978.
Niemi, Albert W. Jr., U.S. Economic History: A Survey of the Major Issues, Rand McNally, 1975.
Price, Harry Bayard, The Marshall Plan and Its Meaning, Cornell University Press under the auspices of the Governmental Affairs Institute, 1955.
Stein, Herbert Presidential Economics, 1984. Covers presidents from Roosevelt to early Reagan with in-depth, interpretive historical treatment of economic events and policy.