CHAPTER FIVE
Orthodox Policies and Strategic Thinking Work
SO WHAT lessons can we draw from all this experimentation in public policy? Above all, the main lesson is that orthodox policies work, and deviating from them can lead to trouble.
President Nixon, it might be said, did us a great favor by demonstrating that wage and price controls do not work. He imposed them on the economy and arranged to have them administered by talented people such as John Connally, John Dunlop, Don Rumsfeld, and Dick Cheney, among others. So he gave the country a lesson that, even with high talent at the helm, this approach doesn’t work.
We also must be careful about the argument, as in the Arthur Burns letter, that the economy is a mess and doesn’t work right anymore, so classical methods won’t work. When you reach that stage of the argument, you almost inevitably reach for something different—in this case, wage and price controls.
As is likely to be the case, the analysis proved to be wrong. The prescription of drastic change proved to be wrong, and Paul Volcker in his role as chairman of the Federal Reserve used classical policies that Burns said would not work.
They did work. It took a while for inflation to come under control, but once it did, the economy took off. By the end of 1982, inflation was substantially reduced and stabilized, and everyone could see it was going to stay that way. The last remnants of the controls were killed off. In 1983, the economy took off like a bird. Economic expansion with stable, low inflation took place through orthodox policies. You deviate from these policies at your peril.
This lesson goes well beyond avoiding wage and price guideposts and controls. The same lessons apply to the other changes that began in the 1980s, including tax and regulatory policies. The marginal rate of taxation, having been reduced by Presidents Kennedy and Johnson from 90 percent to 70 percent, was brought down to 50 percent by Reagan and then, in the 1986 Tax Reform Act, to 28 percent. This change passed in the Senate by a vote of 97 to 3, suggesting that politicians were gradually understanding that lower tax rates were stimulating to the economy. The regulatory burden was also lightened in the Reagan era. Everything changed.
All these changes were recommended in the report to President-elect Reagan from the Coordinating Committee on Economic Policy (see appendix C), which we quote from here:
Sharp change in present economic policy is an absolute necessity. The problems … are severe. But they are not intractable. Having been produced by government policy, they can be redressed by a change in policy.
The essence of good policy is good strategy.
The need for a long-term point of view is essential to allow for the time, the coherence, and the predictability so necessary for success. This long-term view is as important for day-to-day problem solving as for the making of large policy decisions. Most decisions in government are made in the process of responding to problems of the moment. The danger is that this daily fire-fighting can lead the policy maker farther and farther from his goals. A clear sense of guiding strategy makes it possible to move in the desired direction in the unending process of contending with issues of the day. Many failures of government can be traced to an attempt to solve problems piecemeal. The resulting patchwork of ad hoc solutions often makes such fundamental goals as military strength, price stability, and economic growth more difficult to achieve.
Consistency in policy is critical to effectiveness. Individuals and business enterprises plan on a long-range basis. They need to have an environment in which they can conduct their affairs with confidence.
The 1990s
This story of good policy turning bad and then back again to good—as in this report—is a recurring one. When you look at what happened after the 1970s and 1980s as covered in this book, going into the 1990s and all the way to the present, you see similar stories. John Taylor remembers calling Milton Friedman from Washington in 1990 during a stint at the Council of Economic Advisers. Friedman was at Stanford’s Hoover Institution and Taylor had the assigned task of calling him and others to see how much support there was for President George H. W. Bush’s “revenue enhancements,” or tax rate increases, which would begin to reverse the tax reforms of the 1980s. Taylor didn’t even have to say why he was calling, let alone ask the question about support for the tax change, before Friedman realized that the call was not simply to say hello and had a purpose. Friedman then made his views very clear. His words of wisdom were short and sweet. He simply said, “The answer is no!” adding, “You better come back to Stanford right away, John. Washington is corrupting you.”
President George H. W. Bush with (left to right) Chair Michael Boskin and Richard Schmalensee and John Taylor from the Council of Economic Advisers, February 1991. The White House, courtesy John Taylor.
While taxes were raised rather than held down in the Bush administration, most other pressures to move in an interventionist direction in the years immediately after Reagan left town were resisted. Economic policy in the 1990s continued to be more market based, especially in comparison to the interventionist wage and price controls of the 1970s. Regulatory reforms led to more competition and innovation. In his 1996 State of the Union address, President Bill Clinton famously said that “the era of big government is over,” and the federal budget moved into balance by the end of the decade. Fiscal policy relied more on automatic stabilizers rather than discretion. President George H. W. Bush did propose a small economic stimulus, but this failed to pass Congress, as did President Clinton’s proposed stimulus package.
Meanwhile, Clinton, his federalism-minded budget director Alice Rivlin, and the Gingrich-Dole Congress found common ground in the “devolution” of moving authorities for various federal programs such as welfare to the states, where they could be more flexibly administered based upon local conditions. Liberalization also continued on the international side, with trade agreements such as NAFTA (the North American Free Trade Agreement, which led to an integrated North American supply chain) and the World Trade Organization (which opened new export markets while exposing US firms to global competition).
Monetary policy focused on inflation, a big change from the 1970s. The 1990 Economic Report of the President38 complimented the Fed under Alan Greenspan, who succeeded Paul Volcker as chair, for attempting “to develop a more systematic longer-run approach.” Greenspan maintained this commitment to price stability through the 1990s. The Fed focused more on transparency in its decisions. For example, in the 1970s, decisions about interest rates were hidden within the Fed’s statements about the money supply. But in the 1990s, the Fed announced its interest- rate decisions immediately after making them.
The 2000s
As the twenty-first century began, one may have hoped that these same policies would continue and be applied to other government programs such as Social Security and even health care. But that’s not what happened. Pressures for intervention continued to mount. People seemed to forget that good economic policy was responsible for economic success.
Public officials from both parties apparently found the orthodox approach of the 1980s and 1990s to be a disadvantage. Some wanted to do more, perhaps to better deal with the business cycle or stimulate home ownership. The good economic performance of the 1980s and 1990s was taken for granted, people became complacent about the successes, and they failed to resist political pressures that can lead to bad economic policy. Policy shifted in a more interventionist direction.
Policy change did not occur overnight. Federal interventions to promote the housing market, for example, grew gradually at first. A temporary tax rebate was passed in 2001 while Taylor was back in government as under secretary of the Treasury, despite his objections and those of Glenn Hubbard, chair of the Council of Economic Advisers. It did not stimulate the economy, and perhaps it was an early warning sign of a shift in policy. Though one could claim that the rebate was a first installment on the more permanent 2001 tax cuts that passed Congress and were signed by President George W. Bush, the decision led Friedman to pronounce with regret that “Keynesianism has risen from the dead.” Given what has happened since then, he was certainly right.
President George W. Bush with John Taylor in the White House, shortly after Taylor assumed duties as under secretary of the Treasury for international affairs, June 7, 2001. The White House, courtesy John Taylor.
Other signs of activism were seen in monetary policy. Between 2003 and 2005, the Federal Reserve held interest rates far below the levels that would have been suggested by monetary policy rules that had guided the Fed’s actions in the previous two decades. As measured against the Taylor rule and other metrics of monetary policy, the deviation was nearly as large as it had been during the poorly performing decade of the 1970s. The Fed added statements that interest rates would be low for a “prolonged period” and would rise at a “measured pace,” an intentional departure from the policies of the 1980s and 1990s.
That departure was intended to help ward off a perceived risk of deflation, but the extremely low interest rates during these years contributed to the development of the housing bubble. The deviation, it seems to us, helped bring on the great recession and global financial crisis of 2007–09. Housing played the central role in the financial crisis that flared up in 2007 and turned into a panic in the fall of 2008. Another temporary stimulus package of $152 billion was passed, and interventionism reached a peak with the massive government bailouts of Wall Street firms in 2008.
Following the panic, the government could have returned to the less interventionist policies that had worked in the 1980s and 1990s. Testifying before the US Senate in November 2008, Taylor strongly recommended such policies rather than temporary tax reductions, including a pledge to stop the tax rate increases that were then scheduled to occur in the near future.
Instead Washington doubled down on its interventionist policies. On the monetary side, the Fed engaged in an unconventional monetary policy, including massive quantitative easing, which involved large-scale purchases of mortgage-backed securities and Treasury bonds to increase the money supply. The administration under President Obama did not reverse this trend. Rather, “it accelerated it,” as Taylor later wrote in First Principles: Five Keys to Restoring America’s Prosperity. There were more interventions—from an even larger $862 billion fiscal stimulus in 2009, which included temporary rebates and credits as well as grants to state and local governments, and many targeted programs including “cash-for-clunkers” vehicle trade-ins and tax credits for first-time home buyers.
Today
There are always pressures to change policy. Frequently the pressures are rationalized by arguments that economic principles have changed in fundamental ways. Avoiding costly deviations from good economic policy making requires vigilance on the part of policy makers and an insistence on a robust, open analytical approach, such as in listening to civil society and those outside of government as the above example of Milton Friedman illustrates.
What do we learn from all this? Point number one is to recognize that there is a constant debate in the United States and elsewhere about various ways of intervening in the marketplace to achieve some desirable results. The political process can easily create a demand to “do something” about important problems. The ability to stay the course on a strategic policy comes under great pressure.
Tried-and-true policies work and get results if given a chance. This leads to point number two, which is that the importance of thinking strategically cannot be overstated. Short-sighted thinking leads to bad results. Long-run thinking, even though it may mean a short-term hit, is much more productive. Orthodox, commonsense policies that are known to have worked need support. For the Fed, that means, it seems to us, a public statement of strategy (call it a rule—even a Taylor rule) from which it deviates only after a full explanation of why. The burden of proof should be on the deviation.
We make these points because today the air is filled with ideas for massive changes in the economy. Maybe some of these changes are needed, but be careful. Remember the mess of the economy caused by intervention in the 1970s and the way that President Reagan’s policies put the economy back on a steady course of growth and expansion.
So remember, orthodox policies work, and excessive interventions by government in the market-based operations of the economy cause problems, sometimes severe. Watch out for charges that the economy has changed, so economic policies must change too. Stay with a long-term strategy and keep tax rates and the regulatory burden under firm control. These are the principles that the lessons of the 1970s and the 1980s have proven.
NOTE
38. White House, Economic Report of the President, Council of Economic Advisers (1990): 84.