Monday, April 05, 2010

The Terrible 1970s, Part II (Econoclasts, Part III)

#4 in an ongoing series on Econoclasts: The Rebels Who Sparked the Supply-Side Revolution and Restored American Prosperity. First post in the series: Econoclasts: The Rebels Who Sparked the Supply-Side Revolution, Intro. Previous post: The Terrible 1970s (Econoclasts, Part II)

--Continued from The Terrible 1970s (Econoclasts, Part II).

. . . With capital investments being taxed at such high rates, people who had money to invest did the only reasonable thing they could do in such circumstances: they invested in tangible assets rather than stocks and bonds. Put another way, the '70s saw . . .

5. A preference for "stuff" over saving.

We could go into more detail but let me quote just one section from Econoclasts:
[C]onsumerism was rampant in the 1970s. Sales of all sorts of things, useful goods and especially novelties such as recreational vehicles, were robust in the Carter years. Given inflation, this was only logical. If one bought immediately on getting paid, one exchanged money for goods. If instead one saved one's pay, that money largely evaporated. Savings could not reasonably be held in bank accounts, whose rates lagged behind inflation. . . . Savings could be put in gold, commodities, and land, and indeed they were. But as always these were tricky investments, with land having an excise tax attached to boot. Saving money became a fine art, an option foreclosed to the masses. So the masses spent.
--pp. 180-181

6. A preference for commodities and "stuff" over capital investment.

Domitrovic provides many examples of this point, but one particularly caught my eye: the story of U.S. Steel. That's partially because of a book I read several years ago that suggested the decline of the U.S. steel industry occurred because the American manufacturers were unwilling to adopt mini-mill technology, a low-cost, efficient technology that their competitors from overseas were using, first to produce pig iron, then rebar, and then, slowly, up the chain of quality until, finally, they could produce even high-end steel. The author of the book I read referred to "low-end disruptive" technology and suggested that the American steel industry was kind of "caught unawares."

Domitrovic suggested something else was at work. The federal government's tax policies made it uneconomical to invest in capital improvements. It made more sense to put one's resources elsewhere.
In the 1970s, U.S. Steel declined to make the big capital investments that technological innovation had made necessary in the race to keep up with its competition, especially foreign competition.

In particular, U.S. Steel chose not to buy the (expensive) basic oxygen process (BOP) furnaces and continuous casting machines for its plants. The storied Homestead Works near Pittsburgh went to its grave in 1987 having never replaced its Carnegie-era open-hearth furnaces with a "BOP shop," nor its ingot molds with a caster. This had easily made Homestead irrelevant in the international steel market by 1980. But by that date, U.S. Steel had found a better use for the capital it could have spent on steelmaking machines. It set aside $6 billion to acquire Marathon Oil, whose petroleum reserves increased in value with inflation. Had U.S. Steel bought capital equipment with that $6 billion, it would have been killed by taxes and inflation. Thus did the company, soon to be called "USX," forsake steel for oil.

After 1982, when the [Marathon Oil] transaction cleared, approximately 160,000 steel workers lost their jobs. This was precisely the future that began to worry workers in the early 1970s in Buffalo and Lackawanna, New York, Lake Erie towns that were home to massive Bethlehem Steel plants, today as shuttered as Homestead.
--pp. 133-134
Domitrovic provides other examples of this shift from capital investments into tangibles. He describes General Electric's temptation to abandon "manufacturing in such areas as power generation, engines, and medical devices" in favor of "the small natural-resources segment of its business portfolio" that was producing "exceptional profits" (p. 152).
In the late 1970s, the commodity play appeared a plausible strategy. In 1978, for example, GE's natural resources business accounted for 5 percent of the total sales of the company, yet 15 percent of its profits.
--p. 218
GE's main competitor, Westinghouse, actually pursued this strategy. "In the 1980s, Westinghouse decided to wind down its core competency, nuclear power, and gobble up land out west, as if it were a time for survivalism" (p. 259). Once inflation was slain--just at the time that Westinghouse was moving into tangible assets--that particular strategy turned out to be counterproductive. GE surged ahead while Westinghouse "edged to the brink of bankruptcy in the late 1980s and 1990s and was forced to reverse-merge into a shell" (ibid.).

Domitrovic tells the story of the experience that convinced Congressman Jack Kemp, during his freshman year in Congress, to seek a major reduction in capital gains taxes. Kemp said he saw a help-wanted sign on a machine shop in his district. It included an unusual requirement of anyone who was to be a successful candidate. He had to be able to "Bring own lathe." Clearly, the machine shop owner didn't want to take the risk--or pay the price--to buy equipment for his employees. He figured it would be a bad investment: "I'm willing to hire you, but I'm not willing to buy the tools you'll need to do your job."

For me, one of the most striking concepts having to do with investment in commodities v. capital equipment arose from the research and thinking of a Northwestern Mutual Life Insurance Company economist. Domitrovic says Harvey Wilmeth "discovered a Federal Reserve publication that detailed the 'balance sheet' of the nation." According to this document, by the late '70s, more than half of all assets in the United States were "tangible assets--hard assets such as real estate, collectibles, commodities, and consumer durables."

Domitrovic says this is, was, and, from a forward-looking perspective, ought to be, abnormal. "Under ordinary circumstances, financial assets [stocks and bonds should] dwarf tangible assets in value" (pp. 216-217).

"Stuff" is what has already been produced. "Securities" or "financial assets"--stocks and bonds--are claims on what will be produced in the future. The ratio of stuff to securities is a measure, therefore, of confidence in the economic future. If the ratio is getting higher, as it was in the late 1970s, the message is that expectations are declining about the future production of stuff.
--p. 217; emphasis added
Or put the other way around: If a nation is to have a future, if it is to have positive future expectations, then it ought to have--it needs to have--a greater investment in capital stock than commodities.
Wilmeth realized that the taxes and inflation of the 1970s had increased the cost of holding financial but not tangible assets. Because taxes in general were . . . income taxes, and because inflation buoyed the value of things already produced or in the ground, the rise in income-tax rates along with inflation in the 1970s had led to a tremendous move out of stocks and bonds and into the stuff that presently existed. . . .[F]uture stuff . . . cannot be produced without investments in financial assets. The shift into tangibles thus prefigured a decline in production.
--p. 217; emphasis added
Financial assets--stocks, bonds, mortgages--are bets on people being productive in the future. They have nothing to do with the past. . . . For the market for financial assets to improve, there must be a clear reason for businesses and individuals to believe that there will be stable money, low taxes, and beneficial but spare regulations as new economic initiatives are undertaken.
--p. 291
If you want people investing for future productivity, you can't disincentivize them by taxing such behavior so that it makes more sense for them to buy non-productive "stuff" than to pay for productive assets in hopes that they might produce profits in the future. (I hope I'm not sounding like too much of a broken record. Remember my post on March 14th: More on taxes and tax avoidance . . . and prosperity? I quoted a speaker who noted that politicians understand how taxes work as incentives (or disincentives) in other areas of life: "We want to decrease the number of people who smoke. Let's raise taxes on cigarettes." Why don't they understand that the same thinking applies to such issues as income and investment?)

7. Resource shortages or scarcities.

At a conference held in May 1974 by the American Enterprise Institute, Robert Mundell
provided a table showing commodities that had risen in price as much as or more than oil in recent years, among them cotton, rice, and wheat, with sugar beating oil's price increase by a factor of three. . . . Since the United States in particular had given up on mooring the dollar to gold in any credible way in the 1960s, and since the convention up to that point had been for the world's currencies to be priced in relation to the dollar, this was the result: "Confidence in currencies in general declined and a shift out of money and financial assets commenced. . . . [Soon] the prices of metals, foods and minerals more than doubled. Shortages of beef, sugar and grains appeared, but gold and oil led to the most dramatic 'crises' and received the most attention from the public."
--p. 108

What was happening? With inflation running rampant, buyers were seeking to acquire everything they could as soon as possible (while their money still had value) . . . while producers were motivated to slow supply as much as possible to get the best (future) price.

8. Terrible unemployment.

We've already told the story of steel workers being thrown out of work.
Inflation plus a progressive tax code that made it impossible to have two things simultaneously: a job and pay. You can have a job, but if you've militated for real pay, the employer would run out of cash and thus have to look for a less labor-intensive business to go into and make the playoffs. Inflation did not cure unemployment in the 1970s; it caused it.
--p. 152
Before 1979, bracket creep combined with inflation had encouraged vigilance on the part of wage earners. They had to get a COLA-plus in order simply to get a COLA. The inflation that came in 1979 and 1980 intensified this requirement beyond all hope. Workers from across the income spectrum were now at best breaking even against inflation and taxes. After the 26 percent inflation of 1979-80, raises had to be in the 30 percent-50 percent range in order to reach par.

If an employee got such a raise, it was a brilliant coup. But it was devastating to his employer. To grant employees raises that kept up with inflation, employers had to ensure that their revenue gains outpaced inflation rates now in the double digits.
--p. 176
And, of course, that proved impossible.

Just how bad was unemployment in the '70s and early '80s?

Well, "Unemployment, which had held at under 4 percent through . . . the late 1960s, went to 5 percent and then 6 percent in 1970 and 1971" (p. 93). "[I]t surged to 9 percent in 1975, easily the highest level since the Depression, a rate that was one-quarter higher than during any postwar recession" (p. 105). "Unemployment hovered at 6 percent in 1978 and 1979 and went to 7 percent in 1980" (pp. 175-176).

Back in the 1960s, Arthur Okun, chairman of President Johnson's Council of Economic Advisors, had almost jokingly produced what he called the "economic discomfort index" (the sum of the inflation rate and unemployment rate--a play on the weather service's "discomfort index" that totals temperature and humidity). In the '60s, Okun's index ran at 6 or 7. "[I]n 1975 it hit an unthinkable 18." And, as Domitrovic says, "This wasn't merely discomfort, so someone recast the metric as the 'misery index'" (p. 105).

"The misery index, at 21 in 1980 thanks to inflation at 14 and unemployment at 7, was 16 in 1982. Eight points of inflation had been traded for three of unemployment." Unemployment actually hit 9.7 percent in 1982 (p. 231). [Let me note--as Domitrovic does--that 1982 was the second year of Reagan's presidency. Not to make excuses for him (Domitrovic, ever the historian, points out several strategic and tactical mistakes Reagan and his advisors--not to mention Congress--made), but it is worth noting here that, following the screaming inflation of the late '70s and 1980 (immediately prior to Reagan's taking office),
The consumer price index rose [only] 3.4 percent (annualized) in the last quarter of 1981, a remarkable achievement. (The full-year 1981 figure was still 10.3 percent.) In 1982, prices in the first quarter rose at an annual rate of only 2.1 percent before yielding to a full-year rate of 6.2 percent. Thus did 1982 end a three-year run of double-digit inflation.
--p. 231
We will return to the issues of inflation and unemployment--the misery index--at a future date, when we consider the results (or lack thereof) of the so-called "supply-side revolution."

Let us "merely" agree, here, that unemployment in the '70s and early '80s was a major problem--worse than at any point in United States' history except for the Great Depression (when, admittedly, it was much worse).

Let us admit, however, one additional point that Domitrovic wants us to acknowledge: when modern pundits claim that the present economic turmoil is unprecedented except for the Great Depression, they are, most definitely, talking without knowledge. The United States' unemployment rate in 2008 to 2010 is not so different from what it was in 1975 and 1982 . . . though those periods of high unemployment were accompanied by far worse inflation. The misery index was far worse than it is today or has been in the last two years or so since the economy started to falter.

9. Property taxes through the roof--and a tax revolt.

Despite all the talk about income taxes, Domitrovic says,
The tax that threatened to turn the '70s funk to the Great Depression was the property tax. In inflationary times, commodities, limited in supply by the earth, increase in price at a rate greater than inflation. . . . Commodities take on the monetary function surrendered by money . . . , that of the "storehouse of value." The one thing that is most limited in supply by the Earth is the earth itself--land. Land values can race far ahead of the price level in inflationary times. The effect is especially acute when the land in question is generally desirable: California land, for example.

In the 1970s, California land prices spiked enormously, just as gold, oil, gas, and other commodities did, but there was a difference in owning land as opposed to a commodity. There was no excise tax on gold, tungsten, copper, and so on, even if there came to be equivalents of such things on oil. There certainly was an excise on California land, namely the local property tax, which averaged about 2.7 percent through early 1978.

Ten years before, in 1968, if you had been a brave California home buyer who stretched your budget to take out a mortgage on a $50,000 home, the tax component of the monthly mortgage payment would've been about $110. Over the next ten years, as the assessors reacted to a fivefold increase in the value of the property, that component would have risen to $550 per month. Inflation had been about 100 percent, but tax inflation had been 500 percent. True, the mortgage would've been reduced in real size by inflation, but that implies that one actually keeps one's COLAs. Given bracket creep, one does not. The bottom line: by 1978, many Californians who had lived in their homes for years realized that they might soon face foreclosure.

Had nothing happened, it would've made for curious history. . . . But . . . California voters . . . passed Proposition 13 in June 1978. Prop 13 collapsed the property tax to 1 percent and underindexed it for future inflation. Henceforth the only time the tax code would treat a house according to its market value would be upon its sale.
--pp. 153-154

10. Government consuming an ever-increasing share of the nation's productive capacity and wealth.

Domitrovic speaks of this issue many times throughout the book, but this section expresses it very well.
[Treasury Secretary William] Simon's last act as treasury secretary, in January 1977, had been to issue a report calling for unconditional tax cuts, including a cut in the top rate of almost half. . . .

In early 1978, . . . Simon's [book] Time for Truth . . . reported . . . [that] government at all levels have benefited from greatly increased revenues in the 1970s because of inflation and bracket creep. Indeed, "the share of gross national product eaten up the government has been inflating feverishly," Simon reported. "In 1930, spending . . . accounted for 12 percent of the GNP. By 1976, as was 36 percent."

Simon marveled that, despite the transfer of wealth from the private sector to government, government was having an ever harder time making ends meet. One of the reasons the Carter deficits were unintelligible to Simon was that they persisted, then increased, in the face of rising tax revenues as a percentage of GDP--not to mention falling military spending. When deficits go up with increasing revenues, and do so consistently, the only expectation can be for further displacement of the real economy by government. Reflecting on this "cannibalistic pattern," Simon wrote that quote no economy can survive a structural war conducted against it by the state."
Finally, one last major problem from the 1970s.

11. Ever-increasing government intrusions into [formerly] private decisions.

A quick summary statement of the problem:
Throughout the long 1970s, the federal government of the United States preoccupied itself with such things as fixing prices, ushering labor unions not to take wage increases, begging shoppers to rein in their spending, mistaking nominal for real income in the tax code, adding regulations, . . . and . . .
We'll stop here with our summary of the worst economic problems of the 1970s in the United States.


Next time: What is supply-side economics?
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