Myth: Carter ruined the economy; Reagan saved it.
Fact: The Federal Reserve Board was responsible for the events of the late 70s and 80s.
Summary
Carter cannot be blamed for the double-digit inflation that peaked
on his watch, because inflation started growing in 1965 and snowballed
for the next 15 years. To battle inflation, Carter appointed Paul Volcker
as Chairman of the Federal Reserve Board, who defeated it by putting the
nation through an intentional recession. Once the threat of inflation abated
in late 1982, Volcker cut interest rates and flooded the economy with money,
fueling an expansion that lasted seven years. Neither Carter nor Reagan
had much to do with the economic events that occurred during their terms.
Argument
In 1980, the "misery index" -- unemployment plus inflation
-- crested 20 percent for the first time since World War II. Ronald Reagan
blamed this on Jimmy Carter, and went on to win the White House. Reagan
then caught the business cycle on an upswing, for what conservatives call
"the Seven Fat Years" or "the longest economic expansion
in peacetime history."
Were either of these presidents responsible for their fortune with
the economy? No. Carter battled the peak of an inflationary trend that
began in 1965. In the following chart, take special notice of the long,
slow climb in the inflation column:
Year Inflation Unemployment (1)
-------------------------------
1961 1.0% 6.7%
1962 1.0 5.6
1963 1.3 5.6
1964 1.3 5.2
1965 1.6 4.5 < Vietnam war spending increases
1966 2.9 3.8
1967 3.1 3.8
1968 4.2 3.5
1969 5.5 3.5
1970 5.7 5.0
1971 4.4 6.0
1972 3.2 5.6
1973 6.2 4.9
1974 11.0 5.6 < First oil crisis
1975 9.1 8.5
1976 5.8 7.7
1977 6.5 7.1
1978 7.6 6.1
1979 11.3 5.9 < Second oil crisis
1980 13.5 7.2
1981 10.3 7.6
1982 6.2 9.7
1983 3.2 9.6
1984 4.3 7.5
In 1965, President Johnson started increasing deficit spending to fund
the Vietnam war. This fiscal policy (as predicted by Keynesian theory)
increased inflation and reduced unemployment.
Unfortunately, inflation is a self-fulfilling prophecy. If business
owners expect it, and raise their prices by the anticipated amount to compensate
for it, then they have created the very inflation they fear. This process
forms a vicious circle -- inflationary expectations and price increases
feed off each other, with the potential of creating hyper-inflation. Unfortunately,
economic theory at the time was such that economists didn't know how to
stop it, at least safely.
Growing inflation in the 70s received two huge boosts: the first comprised
the late-1973 and 1979 oil shocks from OPEC (the Organization of Petroleum
Exporting Countries). Soaring oil prices compelled most American businesses
to raise their prices as well, with inflationary results. The second boost
to inflation came in the form of food harvest failures around the world,
which created soaring prices on the world food market. Again, U.S. companies
that imported food responded with an inflationary rise in their prices.
All this was accompanied by a growing crisis in monetary policy at
the Federal Reserve. Traditionally, the Fed has fought inflation by contracting
the money supply, and fought unemployment by expanding it. In the 60s,
the Fed conducted an expansionary policy, accepting higher inflation in
return for lower unemployment. It soon became clear, however, that this
strategy was flawed. Expanding the money supply created jobs because it
put more money in the hands of employers and consumers, who spent it. But
eventually businesses learned to expect these monetary increases, and they
simply raised their prices by the anticipated amount (instead of hiring
more workers). The result was that the Fed gradually lost its ability to
keep down unemployment; the more money it pumped into the economy, the
more businesses raised their prices. As a result, both inflation and unemployment
started growing together, forming a twin monster that economist Paul Samuelson
dubbed "stagflation."
Stagflation happened to reach its peak on Carter's watch, spurred on
by the 1979 oil shock. How Carter can be blamed for a trend that began
a decade and a half earlier is a mystery -- and a testimony
as to how presidential candidates often exploit the public's economic ignorance
for their own political gain.
However, Carter did in fact take a tremendously important step in ending
stagflation. He nominated Paul Volcker for the Chairman of the Federal
Reserve Board. Volcker was committed to eradicating stagflation by giving
the nation some bitter medicine: an intentional recession. In 1980, Volcker
tightened the money supply, which stopped job growth in the economy. In
response to hard times, businesses began cutting their prices, and workers
their wage demands, to stay in business. Volcker argued
that eventually this would wring inflationary expectations out of the system.
The recovery of 1981 was unintentional, and with inflation still high,
Volcker tightened the money supply even more severely in 1982. This resulted
in the worst recession since the Great Depression. Unemployment in the
final quarter of 1982 soared to over 10 percent, and Volcker was accused
of the "cold-blooded murder of millions of jobs." Even high-ranking
members of Reagan's staff were vehemently opposed to his actions. Congress
actually considered bringing the independent Fed under the government's
direct control, to avoid such economic pain in the future. Today, economists
calculate that the cost of Volcker's anti-inflation medicine was $1 trillion
-- an astounding sum. But Wall Street demanded that Volcker stay the course,
and that may have been the only thing that saved him.
In the late summer of 1982, inflation looked defeated, so Volcker sharply
expanded the money supply. Once as high as 14 percent in 1981, the Fed's
discount rate fell from 11 to 8.5 percent between August and December 1982.
Within months, the economy roared to life, and took off on an expansion
that would last seven years. Because the recession had been so deep, and
the number of available workers so large (with not only laid-off workers
waiting to return to work, but also a record number of women seeking to
join the workforce), the recovery was guaranteed to be long and healthy.
Interestingly, Volcker was transformed from villain to hero after the
victory over inflation. His reputation and integrity were so unquestioned
that when his term as Chairman came up for renewal, Reagan renominated
him with overwhelming popular approval. Another interesting tidbit is that
although Volcker's intentional recession was a classically Keynesian approach
to combating inflation, he did so under the name of "monetarism".
(The policies recommended by the two theories converged at this point.)
Milton Friedman, the creator of monetarist theory, and other conservatives
were pleased that the Fed had finally converted to monetarism. However,
they were outraged in late 1982 when Volcker threw off the cloak of monetarism
and openly returned to Keynesian policies for expanding the economy. Most
economists now accept that the Fed was not monetarist at all during this
period, and that the label was merely political cover for drastic but necessary
action.
Of course, conservatives have a far different interpretation of these
events. Let's review their arguments:
THE CONSERVATIVE VIEW
According to conservatives, increasing taxation and regulation
under Carter stifled the economy. Reagan's 1981 budget (the only one not
to be declared "Dead on Arrival" by House Democrats) contained
across-the-board, supply-side tax cuts that allowed entrepreneurs to invest
and increase productivity. Reagan also slashed regulations, unshackling
the entrepreneurial spirit of American business.
There are several problems with this historical spin. First, total
federal taxation under Carter rose by an insignificant 1.7 percent of the
Gross Domestic Product:
Federal tax receipts and spending (percent of GDP) (2)
Year Receipts Spending
-------------------------
Carter
1978 18.5% 21.3%
1979 19.1 20.7
1980 19.6 22.3
1981 20.2 22.9
Reagan
1982 19.8 23.9
1983 18.1 24.4
1984 18.0 23.1
1985 18.5 23.9
1986 18.2 23.5
1987 19.2 22.5
1988 18.9 22.1
1989 19.2 22.1
To claim that such a minor increase could produce crippling stagflation
is to ascribe to the economy an extraordinary sensitivity to taxation.
Although many conservative laymen would gladly accept such a notion, it
is not one entertained by serious economists. West Germany in the 1980s,
for example, had a total taxation rate of 39 percent of its GDP (compared
to 29 percent of combined government taxes for the U.S.), and during that
decade Germany was an economic powerhouse. If even a few percentage points
are the difference between Carter's stagflation and Reagan's boom years,
then by all rights West Germany should have been dead.
But that's only the general level of taxation -- what about the top
rate? Although the top rate for income taxes was 70 percent under Carter
(where it had always been, since Kennedy), Carter gave the rich the most
sacred tax cut they hold dear: a capital gains tax cut in 1978, from 39
to 28 percent. Thus, Carter gave the rich their first tax cut in 15 years.
According to conservative theory, this should have nudged the economy in
the right direction, not sent it into the worst economic crisis since the
Great Depression.
Conservatives also criticize Carter's promotion of expanded government
regulations. But Carter actually began deregulating during his term; in
1978, he deregulated airlines; by 1980, he was deregulating trucking, railroads
interest rates and oil. All are fundamental to the economy's operations.
Carter also set up the deregulatory machinery that Reagan would later use
to slash regulations almost in half by the end of his second term. Again,
Carter's actions should have nudged the economy in the right direction,
not sent it into the worst economic crisis since the Great Depression.
And yet, there is no evidence that regulation was even the cause of
the period's stagflation. The economies of Western Europe are far more
regulated than the U.S., and their productivity has been growing faster
than ours:
Percent of U.S. individual worker productivity (U.S. = 100%) (3)
1950s 1960s 1970s 1980s 1990
------------------------------------------------
United States 100% 100 100 100 100
Canada 77.1 80.1 84.2 92.8 95.5
Italy 30.8 43.9 66.4 80.9 85.5
France 36.8 46.0 61.7 80.1 85.3
Germany 32.4 49.1 61.8 77.4 81.1
United Kingdom 53.9 54.3 58.0 65.9 71.9
Japan 15.2 23.2 45.7 62.6 70.7
Furthermore, Reagan systematically slashed and burned government regulations,
but individual worker productivity grew no faster in the 80s than it had
during the late 70s (about 1 percent for both periods).
As for the claim that Reagan's 1981 tax cuts were responsible for "the
greatest peacetime expansion in U.S. history," a few grains of salt
are in order here. The timeline better fits the liberal explanation than
the conservative one. Volcker expanded the money supply in late 1982, and
a few months later the economy took off. However, Reagan's tax cuts were
passed in 1981, and were already in effect by 1982 -- but, as we have seen,
1982 was the year of the horrific recession.
Tax cuts were supposed to have spurred economic recovery by liberating
the tax dollars of entrepreneurs and allowing them to invest them in greater
productivity and jobs. However, such greater investment never occurred.
It appears that the rich simply pocketed the savings, because investment
fell during the 80s:
Private investment (4)
1970 - 1979 18.6%
1980 - 1992 17.4
So there is no evidence that the conservative revisionism is true.
Return to Overview
Endnotes:
1. Inflation: U.S. Bureau of Labor Statistics, CPI-U (1982-84=100),
not seasonally adjusted, table CUUR0000SA0. Unemployment: U.S. Bureau
of Labor Statistics, Series ID : lfs21000000.
2. Office of Management and Budget, Budget of the United States
Government, Fiscal Year 1997, Historical Table 1.2
3. Where We Stand, by Michael Wolff, Peter Rutten, Albert Bayers
III, eds., and the World Rank Research Team (New York: Bantam Books, 1992),
p. 143.
4. Paul Krugman, Peddling Prosperity, (New York: W.W. Norton &
Company, 1994), pp. 126-127.