The Great Deformation (25 page)

So as blistering US demand ignited production booms around the world, factory operating rates rose and supply chain backlogs surged everywhere on the planet. Moreover, there was another entirely new, even more potent force at work. In response to the Fed's flood of money and credit, other central banks around the world reciprocated with their own fulsome monetary expansion.

They bought dollars and sold their own currencies in foreign exchange markets in order to forestall the upward pressure on exchange rates that
was inherent in the brave new world of floating currencies. In other words, the heretofore circumspect central bankers of the world became furious money printers in self-defense as they faced the flood tide of dollars being issued by Arthur F. Burns.

In fact, with exchange rates no longer fixed and visible, a more subtle process of competitive devaluation became the daily modus operandi of the system. In this manner, the Fed propagated its inflationary monetary policies outward to the balance of the world economy.

So it was a storm of money and credit expansion which generated the first commodity bubble after 1971, not the OPEC cartel alone or even primarily. For if the problem had been just the putative rigging of prices by the oil cartel, there is no way to explain the dozens of parallel commodity booms during the same two- to three-year time frame.

Quite obviously, there was no evidence of cartel arrangements in the markets for rice, copper, pork bellies, or industrial tallow, for example. Yet between 1971 and 1974, rice rose from $10 to $30 per hundredweight, while pork bellies climbed from $0.30 per pound to $1.

Likewise, the cost of a ton of scrap steel soared from $40 to $140; tin jumped from $2 to $5 per pound; and the price of coffee rocketed up nearly eightfold, from 42 cents to $3.20 per pound. Even industrial tallow caught a tailwind, rising from $0.06 to $.0.20 per pound, and pretty much the same pattern was reflected in the price of corn, copper, cotton, lead, lumber, and soybeans.

Needless to say, the first inflationary cycle of floating money came as a shock to policy officials, especially the Federal Reserve and its chairman. While Chairman Burns was a pusillanimous accommodator when it came to the game of hardball politics in Washington, as a matter of belief he had remained an anti-inflation hawk.

So when Nixon went into his terminal Watergate descent, Burns got his nerve back and threw on the monetary brakes. Accordingly, double-digit bank credit expansion came to a screeching halt, rising by only 1.2 percent in 1975.

THE 1974 RECESSION: INVENTORY LIQUIDATION AND OUTPUT COLLAPSE CAUSED BY THE CENTRAL BANK

The resulting recession was described at the time as the deepest since the 1930s, but there were really not many parallels. Housing construction did suffer a sharp retrenchment and business investment spending also declined moderately.

Yet on the core component of the US economy—consumer spending, which even then accounted for two-thirds of GDP—there was virtually no
reduction. The peak-to-trough decline in real terms was just 0.7 percent. This was hardly the stuff of a near depression and not even in the same ballpark as the 20 percent decline in real household consumption which had occurred during the Great Depression.

Instead, the heart of the 1974–1975 downturn was a sweeping liquidation of industrial and commercial inventories, which accounted for fully two-thirds of the drop in real GDP. Moreover, that generally underappreciated fact followed exactly from the type of inflationary boom that had now been made possible by the destruction of Bretton Woods.

During 1972–1973 the drastic escalation of global commodity prices led to a scramble by businesses to buy forward and accumulate buffer stocks of raw materials, components, and finished goods before prices escalated even higher. This forward buying and accumulation of inventories was at the heart of the post–Camp David boom and bust.

When the monetary expansion was finally halted and pricing pressures subsided, businesses then violently disgorged these same inventories during the subsequent correction phase. Accordingly, what is reported as a deep 3 percent peak-to-trough decline in real GDP during the 1973–1975 recession cycle was only a 1 percent decline based on final sales. All the rest of the deep recession reflected the destocking of what had been excess inventories in the first place.

This rather persuasive evidence that inflationary monetary policy does not enhance long-term growth but only destabilizes the inventory cycle never sunk in among policy makers. In fact, when the downturn did temporarily break the commodity speculation cycle and cause the rate of CPI increase to temporarily dip under 5 percent, Burns and the Ford White House did exactly the wrong thing: they launched a new round of stimulus and soon rekindled an even more virulent inflation.

After assuming the presidency in August 1974, Gerald Ford had started off on the right foot. As a fiscally orthodox Midwestern Republican, he had been frightened by the recent runaway inflation and repulsed by the insanity of the Nixon freeze and the ever-changing wage and price control rules and phases which followed. Ford had also been just plain embarrassed by Nixon's five straight years of large budget deficits.

So for a brief moment in the fall of 1974, he launched a campaign to get back to the basics. Ford proposed to jettison the notion that the budget was an economic policy tool, and demanded that Washington return to the sober business of responsibly managing the spending and revenue accounts of the federal government.

To this end, he called for drastic spending cuts to keep the current-year budget under $300 billion. He also requested a 5 percent surtax on the
incomes of corporations and more affluent households to staunch the flow of budget red ink. At that point in history Ford's proposed tax increase was applauded by fiscal conservatives, and there was no supply-side chorus around to denounce it. In fact, Art Laffer had just vacated his position as an underling at OMB.

BILL SIMON'S CRUSADE AGAINST THE FULL-EMPLOYMENT BUDGET ILLUSION

In attempting to get Washington off the fiscal stimulus drug, Ford was aided immeasurably by the fact that Shultz had vacated the Treasury Department and had been replaced by Bill Simon. The latter was from a wholly different kettle of fish.

In fact, Simon was an inflation-hating bond trader who fervently believed in free markets and smaller government, and had no patience whatever for gussied-up academic theories that justified federal meddling, spending, and borrowing. Thus, when asked at a congressional hearing whether he intended to use the full-employment budget as a fiscal guide, Simon bluntly replied, “No, sir.”

Accordingly, Simon wasted no time in summarily discarding the budget for fiscal year 1975 which the Nixon White House had submitted earlier in the year. Shultz had claimed it embodied an $8 billion full-employment “surplus,” but it actually amounted to an actual $10 billion deficit.

So from the “day Simon took over the Treasury in May,” noted historian Allen Matusow, “his goal was to get rid of this deficit by slashing $10 billion from expenditures.”

Peering through Keynesian glasses, Matusow judged Simon's efforts to be “folly,” but from the perspective of today's smoldering budgetary ruins, his crusade to cut federal spending looks more like a last, fleeting moment of fiscal sanity. The temporary drop in real GDP during the winter of 1974–1975 was not a valid excuse for higher spending and bigger deficits. It represented the final liquidation of the inflation-swollen inventories that had been accumulated in American factories and warehouse, not the mysterious disappearance of an economic ether called “aggregate demand.”

Simon was also criticized for holding the antediluvian view that budget deficits were inflationary. Yet during that era, before mercantilist foreign central banks were heavily in the business of pegging their currencies against the dollar, fiscal deficits did encourage the Fed to accommodate the Treasury's borrowing requirements via rapid expansion of its balance sheet. This injection of reserves into the banking system stimulated lending until a renewed bout of inflation finally forced the Fed to reactively throttle back on runaway credit growth.

In fact, Simon well understood that the pro-business variant of Keynesian macro-management which had become institutionalized in the Nixon White House was a dangerous perpetual motion machine of financial instability. When the Fed fuels inflationary booms, it results in excessive inventory accumulations that will inevitably be liquidated once rapid credit expansion stops.

The so-called “cost” of recession is thus not really an avoidable cost; it is actually only a “giveback” of phony “growth” recorded in the GDP accounts from inventory building a few quarters earlier. The kind of stop-go monetary policy and the resultant business cycle instability unleashed after August 1971 thus generated no lasting expansion, but only what amounted to hopscotch GDP.

Moreover, as shown in
chapter 11
, the Eisenhower administration had already proven that the essential premise of Keynesian countercyclical stimulus was flawed. By generally refusing to employ discretionary fiscal stimulus during the two 1950s recessions, it had demonstrated that inventory liquidations burn themselves out on their own.

Bill Simon was thus ahead of his time, even if he was dismissed by the enlightened conservative economists of the day as a hidebound Hooverite. He recognized that fiscal stimulus in the face of an inventory liquidation cycle is actually a destructive catalyst for a renewed cycle of boom and bust. In the absence of Volcker-like resolve at the Fed, it initially fosters a recurrence of inflationary monetary expansion, and then a run-up of prices and excess inventory that necessitates a recessionary correction all over again.

HOW THE BUDGET BECAME A JOBS MACHINE

Simon's fiscal fundamentalism embodied another, even more crucial truth. Once the old-time balanced budget rule was discarded and the federal budget was turned into a tool of economic stabilization, the fundamental process of fiscal governance was thrown out of kilter. Every spending program and every feature of the revenue code became a “jobs” program and a tool of countercyclical macro-management.

The current-year budget was thus taken hostage by the alleged performance shortfalls of the national economy. Painful deficit reductions were continuously postponed until the US economy achieved full recovery. Alas, that condition never arrived, but the endless delay of the fiscal reckoning did soon cause a mutation of the budget-making process itself.

The old balanced budget rule provided a policy framework that was focused on the budget's internal details and priorities. Special interest groups
had to compete for scarce budget resources and politicians became schooled in the art of making choices and trade-offs.

By contrast, the Keynesian framework transformed the budget into a type of macroeconomic plumbing system under which spending programs and tax expenditures became mere conduits through which to pump dollars into the economy. Such flows would compensate for the alleged shortfall of “aggregate demand,” according to the classic Keynesians, or spur underinvested and incentive-deprived sectors of the economy, according to the “business lite” Keynesians.

In either case, politicians became immersed in logrolling among claimants for tax relief or spending increases to spur output and jobs. Meanwhile, their comprehension of the dollars and cents of budgeting was overwhelmed by a cavalcade of spurious economic justifications.

In a process that was subtle, cumulative, and inexorable, the federal budget was thereby captured by the forces of special interest lobbies and crony capitalism. Once the latter occupied the moral high ground and could argue that in raiding the treasury they were actually serving the public good of more jobs and more growth, the frail fiscal defenses of popular democracy were easily demolished.

Bill Simon's militant crusade within the Ford administration for the old-time fiscal religion and unfettered free markets was consequently short-lived. To be sure, his advocacy was not the run-of-the-mill Republican bombast about private enterprise. In speeches and congressional testimony, Simon offered consistent, forceful, and intelligent opposition to all forms of federal market intervention designed to stimulate the general economy or boost particular sectors like housing, agriculture, and energy.

Simon was especially ferocious in his opposition to the bailout of failing industries and enterprises. Indeed, he made no bones about the fact that crony capitalism was as blameworthy as liberalism for the rise of Big Government.

He thus noted later that “the attachment of businessmen to free enterprise has weakened dramatically as they discovered they could demand—and receive—short run advantages from the state … I watched with incredulity as businessmen ran to the government in every crisis, whining for handouts or protection.”

In famously telling New York City to “drop dead” in its request for federal money, Gerald Ford betrayed a fundamental sympathy with his treasury secretary's approach to fiscal rectitude. Yet the economic wreckage left behind by the Nixon abominations soon overwhelmed Ford's best intentions.

HOW GERRY FORD LOST THE BUDGET BATTLE AND OPENED THE ERA OF BIG DEFICITS

As the US economy weakened in the winter of 1974–1975, the Ford administration reversed direction at the urging of businessmen like OMB director Roy Ash and big business lobbies like the Committee for Economic Development. In the place of October's tax surcharge to close the budget gap, Ford proposed in his January 1975 budget message that Congress enact a $16 billion tax cut, including a $12 billion rebate to households designed to encourage them to spend.