A Supply Side Historiography
I've been reading about the history of the 20th century for the last several weeks and can find very little interpretation with which I can agree. The idea that World War I started because of the assassination of an archduke in the Balkans, or that World War II began because Hitler wanted to conquer the world, are only two of dozens of superficialities being tossed around. I'd hoped that Robert Mundell would satisfy my desire to see the century described in terms of political economics, as he chose the topic for his Nobel lecture in Stockholm this month. As proud as I am of Mundell, the lecture was not as satisfying as I had hoped. Because the prize was directly related to his achievements in monetary policy, he put his heaviest emphasis on the monetary history of the century. As important as money has been, it is still too narrow by itself to carry the burden of the century's political history. In 1977, when I wrote The Way the World Works, I at least tried to weigh the interactions of global politics with monetary and fiscal policies, an analytical framework I still find the most satisfying. On the last day of the century, I'll try to bring us up to date.
* * *
First, a quick review of the 19th century, which was Britain's. It defeated Napoleon in 1815, went back on the gold standard in 1819 at the pre-war parity, and spurred by a populist movement began scaling back its wartime tax rates. Even while cutting tax rates almost every year to 1875, its colossal war debt of 1815, £800 million, had been pared to £600 million on the eve of WWI. It restored the income tax (non-progressive) in 1846, but at a very low level, and then, only to offset the expected loss of revenue as the tariffs on grains (the Corn Laws) were eliminated in order to permit massive imports from the United States to deal with the Irish famine of 1846-47. With a currency as good as gold, interest rates fell to less than 3% in 1900 from 6½% at Waterloo. A modern historian recounts that "Between 1815 and 1875, Britain was to become the world's workshop, the world's banker, and the world's trader." Following London's example, the rest of Europe cut back its protective tariffs. As I noted in TWTWW (p.177):
As long as the world pie was expanding, prosperity fed on itself as protectionist pressures in each nation abated, permitting steady worldwide lowering of tariffs. France began peeling away its skyhigh protective rates in the 1840s. In Prussia, seventeen fragmented states joined together in a tariff union (Zollverein) in 1833, providing for free trade between these German states... Italy and Russia also moderated their rates through the mid-century and Britain, the leader of the free-trade parade, by 1875 had only twenty revenue items on its dutiable list. The constant expansion of world trade meant a diminishing of internal national complaints about an "export of jobs," and thereby a lessening of external frictions. Except for a few minor skirmishes, as in Crimea, and the Civil War in the United States (which itself had deep roots in the conflict over tariff policy between the industrial North and the agrarian South), the world was at peace until the end of the century. In the vital sense of the term, it was a Pax Britannica.
The awesome expansion began to slow in 1875 when the weather turned against Europe and there was no economic theory of how to handle it. The harvest in France was a disaster and the government raised tariffs. Germany, which had become a true believer in free trade via the Zollverein experience, by 1877 had eliminated tariffs on 95% of all imports. That was the first of three terrible harvest years for Britain, though, and in order to import more food, Britain exported more manufactured goods. German industrialists complained of this "dumping" and forced up tariffs. Russian industrialists complained they could not compete against the Germans and in 1893 pushed up tariffs. Germany responded by raising its tariffs against Russian goods and Russia reacted by doubling its rates against German goods. At the same time, Italy became frustrated with France's protectionist tariff and raised rates that did not come down until the Mussolini era.
These economic conflicts were the primary causes of WWI, just as economics is invariably the source of war and civil strife. This is why I am an economic determinist, a la Karl Marx. The idea that culture or religion are more important sources of conflict strikes me as implausible, when one considers the Christian slaughter of Christians over the last two millennia. If there were only Confucian Chinese on the planet, there would be a history of Chinese slaughtering each other, and in fact there is. Calories are primary, for without calories to eat or to heat, life must be extinguished at the margin. Culture adapts to calories, as evidenced by civilization's variable tolerance for abortion.
A reading of Niall Ferguson`s history of the events leading to WWI, The Pity of War, demonstrates the automatic reaction of one nation state after another sensing a contraction of calories on the horizon, by increasing military preparedness. How sad, but there it is and how logical it is. A string of bad harvests in Europe and economic nationalists naturally and logically assume there must be a war just around the corner, so they might as well prepare for it. The fact that defense spending for armies and navies has the added advantage of occupying unemployed youths who might otherwise turn to crime. The monarchs of Europe were essentially powerless to halt the forces pressing toward war. There comes the military-industrial complex of each nation, operating on worst-case security scenarios, then a vicious cycle of higher taxes, lower growth, contraction of calories. An archduke assassinated in Sarajevo is merely the match that lights the war.
The United States could have covered its eyes and ears to the war in Europe, except history does not work that way. The U.S. was destined to stay out of the calorie conflicts of the rest of the world for its first 130 years, but we were old enough in 1917 to begin asserting an adolescent kind of global leadership. My thesis in TWTWW is that civilization's march has been in search of political systems better able to produce effective political leadership. Monarchy was superior to warlordism, imperialism was useful up to a point, parliamentary monarchy advanced political systems a considerable distance, but WWI demonstrated there must be better way to deal with incipient global conflict. Parliaments turned out to be not all that "democratic," much too quick to rubber stamp war if the monarch ran out of more creative diplomatic solutions. The crowned heads of 1914 did not have a clue, except to order millions of young men to serve as cannon fodder; military force would sort out the answers.
We easily could have stayed out of WWI, but I think history had decided we really had to get into it, if we were to move to a position of global leadership. If we can appreciate where we are today, the Global Sovereign of the planet, we have to see that there had to be a point where we increased our willingness to shoulder international responsibilities. The political upshot was a clearing away of monarchy as an efficient system of governance. The balance of the century involved a competition of different forms of democracy, which in the broadest sense means a process by which any citizens can be chosen from the common pool to govern. In the second world war, our form of democratic capitalism joined with the "collective democracy"of the Soviet Union to defeat "state capitalism," with its reliance on a strongman, a "dictator." When that bloody struggle ended in 1945, history arranged for the showdown between democratic capitalism and the Soviet form of collectivism.
Interwoven throughout the last eight decades of the century were the varied trial-and-error experiments in economic policies which the major powers tried as they struggled to keep up with the demands of public finance in a time of almost perpetual war. When the century began, tariffs and excises were the primary forms of taxation everywhere. Rather than compete in the continental tariff wars that led to WWI, Britain introduced the first progressive income tax in 1902, and the other powers followed suit as the demands of military preparedness overwhelmed revenue flows from tariff schedules that had gone beyond the point of diminishing returns.
The 16th Amendment permitting an income tax was passed in the United States in the Republican administration of William Howard Taft, weeks before the inauguration of Democrat Woodrow Wilson in 1913. The first tax had a top marginal rate of 7%, which applied at annual incomes which would be the equivalent today of roughly $20 million; the lowest rate of 1% applied at the current equivalent of $40,000. The tax brought with it the economic recession of 1913-14, which ended when war began in Europe and orders for goods came from across the Atlantic. When the U.S. entered the war in 1917, Wilson pushed the top income-tax rate to 75%, with capital gains taxed as ordinary income. The Republicans won in a 1920 landslide with a promise to cut the tax rates and restore the tariff schedules Wilson had altered in 1913. The other powers left their tax rates at high wartime levels as they attempted to deal with war debt. The Roaring Twenties produced phenomenal economic expansion, mostly in the United States.
The Federal Reserve Act also passed in 1913, providing for an elastic> dollar that could stretch and contract to small degrees, as long as the dollar remained as good as gold, at $20.67 per ounce. Almost all other economists trace some or all of the economic declines of the century to monetary errors by the central bank. I do not, because I view money's most important role in society as being a unit of account, as opposed to a medium of exchange or store of value. As long as the U.S. government maintained its commitment to gold at a fixed price -- $20.67 until 1934, then $35 per ounce until 1971 -- the errors of monetary policy were necessarily small. If the Fed tried to put more dollars into the banking system than the system required, the surplus would pull gold out of Treasury's gold reserves. That automaticity had been built into the gold standard.
The pivotal moment of the 20th century, to my mind, was the Wall Street Crash of October 1929. This was not understood by the economists of the time as being directly related to the Smoot-Hawley Tariff Act, which President Hoover signed into law in June 1930. Not satisfied with having restored the tariff schedules to 1913 levels, which the markets had anticipated, the Republicans pushed them to levels that surprised the markets and at the margin blocked global commerce that was in the works. Inventories built for sale abroad piled up on both sides of the higher tariff wall. Because the U.S. had become a creditor nation, our debtors could not now earn from trade the interest and principal on their debts or their equity investments abroad. It was not until 1977 that the Crash/tariff connection was established, as I did in the process of researching my book. I present the details in Chapter VII.
Not knowing why the market crashed, world political leaders were led to several false conclusions. In Moscow, Joseph Stalin assumed the capitalist bubble had burst as Karl Marx had predicted. In Germany, where the economy was already crippled by the punitive exactions of the Versailles Treaty, the fascist idea took hold. This was especially true when of all the powers, Italy under Mussolini appeared to be the only one still able to thrive, with a "strongman" able to manage the economy where "the marketplace had failed." Tokyo came to a slightly different conclusion, seeing Smoot Hawley not in terms of the 1929 Crash, but in its direct effects of walling off the U.S. market to Japanese exports. Thus imperiled, it embarked on an Asian strategy, hoping to find security within a "Greater East Asia Co-Prosperity Sphere." British imperial interests, which did not relish a Japan interfering in its hegemon, persuaded Washington to help box it in. When Franklin Roosevelt slapped an embargo on oil exports to energy-dependent Japan, it essentially declared war. The status quo being unacceptable, there seemed no option to Tokyo but Pearl Harbor.
Hoover's tariff act probably would not have led to World War II if it had not been followed by a series of other economic errors. When federal revenues fell because of the recession, the New York bankers persuaded Hoover that confidence could only be restored by balancing the budget with higher income-tax rates. As surplus dollar liquidity accompanied the weakening economy, the Fed in 1931 had to raise the discount rate to 3½% from 1½% to prevent a gold outflow. The Dow Jones Industrial Average, which had fallen to 230 from 381 in 1929, now continued its decline, until it hit 41 on the 1932 weekend of Roosevelt's nomination as the Democratic presidential candidate. In his campaign, FDR denounced Hoover and his tariff and was easily elected. But he was in no position to cut tariff rates when unemployment was so high in the U.S. One of the most important political developments of the century occurred at this point when black Americans abandoned the party of Lincoln and switched allegiance to the New Deal Democrats, a realignment that exists to this day.
Roosevelt should have cut back the Hoover income-tax rates, but the New York bankers also persuaded him that balancing the budget was paramount. He pushed the top income tax rate to 81% in 1940 and it went as high as 94% in 1944-45, the last war years. It was only because gold remained the unit of account at $35 that wartime inflation was avoided and the enormous war spending could be financed with 2% bonds. Had the U.S. left gold in 1931 as the British did, it simply would have added monetary inflation to the contraction, which is exactly what happened when FDR devalued the dollar against gold in 1934. It also would have been far more difficult to finance the war.
The post-war economic growth followed small reductions in the wartime tax rates and the spread of tax preferences or "loopholes" that enabled capital to form. Also, the rest of the world had to rebuild and bought from our economy with credit and foreign aid. The Smoot-Hawley tariff schedules also had been riddled with most-favored-nation exceptions via reciprocal trade agreements, followed by international agreements to lower rates. President Eisenhower promised an income-tax cut when he campaigned in 1952, but decided not to pursue one when elected. The GOP returned to "fiscal responsibility" and the voters, after giving Ike two years of a Republican Congress, in 1954 began the practice of divided government that continues to this day -- electing Republican Presidents with Democratic Congresses or Democratic Presidents with Republican Congresses.
By the mid-1950s, classical economics was all but forgotten. Keynesian demand-management was in the saddle and began to displace aging classicists at academic institutions around the world. In 1960, John F. Kennedy defeated Richard Nixon on a theme of getting the economy moving again, although he also committed himself to the gold standard as it existed and to lowering tariff rates in a "Kennedy Round" of cuts. Republicans and Dixiecrats in Congress blocked his tax cut proposal, which had been sold to him by West Germany's Finance Minister, Ludwig Erhard in May 1962. The concept came straight out of classical theory and was as "supply-side" as the justification for the Harding/Coolidge reforms of the 1920s. Only after JFK's assassination in 1963 was there sufficient sympathy for passing the tax-cuts in his honor, directed by President Lyndon Johnson. When the stock market boomed and real wages grew rapidly, the Democrats insisted the tax cuts were based on Keynesian theory of increasing aggregate demand. Republicans, led by Senator Barry Goldwater, had opposed the tax cuts as being fiscally irresponsible, and were in no position to claim credit for the expansion they had ignited. Johnson demolished Goldwater in the 1964 elections and elected to use the enormous surpluses produced by the boom to finance his Great Society programs. This aimed at ending poverty in America, but resulted in the unraveling of the black family, as welfare payments could not be made to families that remained intact.
LBJ also compounded this problem when he raised taxes in 1967, to counter the budget deficit swelled with Vietnam spending. (I argue in TWTWW that the Vietnam War was largely the result of Keynesian economic programs being forced on the South Vietnamese government by the Kennedy administration.) The war tax weakened the U.S. economy, more black fathers became unemployed and had to leave their wives and children so they could become eligible for welfare payments. The Great Society excesses and the Vietnam War cost the Democrats their control of the White House. Richard Nixon won in 1968 and immediately began making enormous economic policy errors on the advice of his conservative Keynesian advisors. He postponed elimination of the Vietnam tax he had promised to end and he approved a doubling of the capital gains tax, which the corporate elites urged him to do. (A low capital gains tax encouraged new enterprise which threatened the status quo of the elites.)
This detail is extremely important in the history of the century because it led to Nixon`s decision -- out of frustration -- to break the dollar's link to gold and allow it to float freely. In its way, this was as momentous a decision as Hoover's with Smoot-Hawley in 1929-30. Indeed, the stock market crashed as much as it did in 1929, but because the value of the dollar plummeted as a sign of the inflation underway, the DJIA fell by only a fraction of its loss in real terms. That is, a DJIA at 1000 and $35 gold is the same as a DJIA at 10,000 and $350 gold. By resisting this monetary inflation, Japan kept its currency almost as good as gold. As a result, it became the strongest economy in the world, through the 1970s and 1980s creating capital that flooded the world. Keynesian economic theory finally burst that bubble when in 1990 Tokyo was persuaded the raise the effective capital gains tax on real property, the primary store of wealth in the island nation. To this day, Tokyo remains in Keynesian confusion, struggling to find its way back on a growth path.
Both Presidents Gerald Ford and Jimmy Carter also remained under the spell of the Keynesians, who believed that just a little more inflation (devaluation) would bring prosperity. It was Ronald Reagan who finally broke the spell. Reagan may not have been a brilliant student at Eureka College, Ill., in the four years he spent there (1928-32), but he did have classical economics -- his major -- drilled into him. In 1980, for a sick national economy, he was just what the doctor ordered, a political leader willing to go against all conventional wisdom in arguing for a Kennedy-type tax cut.
Ronald Reagan's election in 1980 came in the nick of time. He aimed to get the economy moving again in a non-inflationary environment and to wind up the Cold War. There was a rocky start because the tax cuts caused a dramatic increase in the demand for dollar liquidity, but the Federal Reserve was still fighting the inflationary impulses generated by the Carter administration. With dollars scarce, the price of gold fell from $600 at the end of 1980 to $300 in 1982, pulling commodity prices down and driving the economy into recession. Only after the Fed was forced to "print" $3 billion to buy Mexican peso bonds, to avoid the bankruptcies of some of our biggest banks, did gold jump above $400, ending the deflation, and joining the tax cuts to produce a non-inflationary expansion. It was not supposed to be possible in the demand model. Spending increased across-the-board, with major increases in defense outlays, the budget deficit expanded, yet interest rates declined steadily. The Soviet leadership, awed by this economic magic, could plainly see it was useless trying to stay in an arms race with the U.S. It essentially threw in the towel in the Reagan years, but the Cold War did not officially end until the Berlin Wall came down during George Bush's administration.
In retrospect, it seemed one good thing did come out of Nixon's floating dollar and the inflation it produced. The free markets of the U.S. and the west could manage commerce with a floating unit of account, especially as computing power grew at exponential rates. The USSR's planning system depended upon a reliable gold/dollar accounting unit in order to allocate and set prices. When the dollar/gold price began its swings and swoops in 1971, with the ruble officially pegged to the dollar, the planning and pricing system within the Soviet economy went haywire. Had the Soviets left the dollar peg for a stable gold peg, the history of the last 30 years might have been dramatically different. Karl Marx, a great admirer of gold as a monetary accounting unit, could have told the Soviets they were making a great blunder, but the idea never occurred to the millions of communists who had studied Marx in school.
The last 20 years of the century have been Ronald Reagan`s legacy, with his successors in the Oval Office, George Bush and Bill Clinton, doing only a little damage to the national economy while they moved the furniture around. Both Presidents raised tax rates after promising tax cuts. It cost Bush a second term when recession followed, with U.S. Federal Reserve Board Chairman Alan Greenspan refusing to ease monetary policy. The Clinton tax hike cost the Democrats control of Congress for the first time in 40 years, although Greenspan this time accommodated the tax increase.
The gold price, which had been steadied at around $350, rose to a $380 plateau. Much of the rest of the world, keying off the dollar, allowed their national currencies to inflate as well. The mini-inflation went into reverse after the 1996 elections, when the markets correctly foresaw the bipartisan supply-side tax cuts of 1997. As in 1981, when the Reagan tax cuts increased the demand for dollar liquidity and it was not supplied, the gold price also fell with the tax cuts of 1997. Foreign central banks that had inflated now had to deflate if they wished to maintain their dollar pegs. Beginning with Thailand, the Asian crisis unfolded and commodity prices fell like dominoes. Oil prices fell so far that the global oil industry stopped investing in infrastructure. When the deflation ended and gold began its rise in 1999, demand for oil far outstripped effective supply and the oil price climbed to its present high levels. We must await the damage reports of the Y2K computer bug in the next several days to get an early bead on the next century. How the world's political leaders handle any distress may give us early clues.
The Internet, though, will act to offset any tendencies to error by our political systems. As important as the invention of the wheel, the Internet not only increases the efficiency of the world economy by matching surplus capital with capital scarcity. It also permits much more rapid interchange of ideas on how to avoid incipient conflict. It makes it less likely that there will be major wars in the century ahead. In addition, having experienced the trial-and-errors of economic theories over the last century, we are less likely to make the same mistakes, at least to the same degree. My best guess, in fact, is that the view of the century's history presented here will before too many decades become the settled historiography -- and that the 21st century will be a much more peaceful and prosperous time as a result.