Political Economist

The cost and benefit analysis

The Fed imposed the most severe discipline on the US economy ever attempted in the history of the American central bank for thirty-three months. The Fed’s monetary policy had forced interest rates up to the highest levels over 20 percent. In effect, credit was rationed for two and a half years, and the scarce supply of credit was allocated by price. The high price of money effectively eliminated borrowers who were too small or underfinanced to afford the loans.

Despite various problems, however, this policy worked. “The GNP contracted in real terms by more than $82 billion from its peak, and since 1979 the country had accumulated as much as $600 billion in lost economic output. The excess supply of goods, the declining incomes, and the surplus labor had worked to force down their wages and commodity prices. Overall price inflation fell dramatically from above 13 percent to less than 4 percent by 1983.”(507)

Even though the Fed succeeded in its anti-inflation campaign, the cost was tremendously high. We can analyze this cost in its effects on the transformation of the US economy, the changes of consumption patterns, the regressive changes of income distribution.

First, the Fed’s tight money policy affect unevenly on various industrial sectors. As we already mentioned, those who borrowed huge amount of money to expand their lands and production facilities had to face dire circumstances in which their debt burdens increased substantially in a short notice. Those who borrowed money to buy house and car had to suffer from both their reduced incomes and increased interest payment at the same time. Some of farmers and small scale manufacturers went bankrupt losing everything. Some households had to lose their real estates, and suffer from credit (mortgage and loans interest) payment for a long time.

However, there was another manufacturing industry which gained the monopolist profit. Apart from financial investors, the military industry was a major winner under the Reagan-Volcker’s strategy. The production of armaments was an important special case among manufacturing sectors. “The defense companies and their allied support industries enjoyed two special advantages under Reagan administration. Firstly, the massive budget increases for defense sector expanded their market enormously. Secondly, arms manufacturers benefited from cheaper labor, as wages for skilled industrial workers were depressed generally by the slack employment.” (600-601)

Second, the Fed’s stabilization of money was also an underlying cause driving the frenzy of corporate take-over battles in the 1980s. “The Fed deplored the practice and even introduced regulations to curb the use of the junk bond used to finance many of the corporate buy outs. Nonetheless so long as monetary policy maintained such high real returns for financial investments and simultaneously depressed the return from real assets, smart investors would naturally seek ways to get their capital out of one and into the other.” (661)

Third, there is another issue related with household’s consumption patterns. In the age of inflation, it was wise decision for ordinary consumers to buy houses and cars with mortgage or credit whatever the interest rate might be. If the inflation continues, buying something today is a good deal because the credit interest rate will be undermined by high inflationary pressures. From this era on, the ordinary Americans’ consumption pattern would be a good source for boastful strong consumer power.

However, this pattern did not change even after their real incomes were reduced substantially because even under these circumstances people had to buy something to live. But the behind logic became different. While American consumers tried to buy today during the inflationary era because it was a good deal, this time they do the same thing because they could not accept the new reality of their reduced status. “By going deeper into debt, they kept spending and hoped that their prospects improved. Millions of families borrowed money to spend during and since Reagan administration. Personal debt accumulated rapidly.”(656)

From now on, previously praised strong American consumer powers now started to turn out to be a castle in the air. The US’s total outstanding debt – government and private – was $7.1 trillion at the end of 1984, nearly doubled since 1977. The alarming point was that domestic debt had increased by more than 25 percent in 1983 and 1984 alone. The outstanding debt had become more than 60 percent larger than GNP.

The Reagan and Volcker’s economic policies also revealed the changing pattern of the US consumer market structure and aggravating standards of living. First of all, since 1980s “the mass market became shrank and split apart. The auto industry, including the rising sales volume captured by foreign imports, never recovered the same market that it had enjoyed in the 1970s.”

Secondly, the retreat from home buying was more fundamental to the American standard of living. During the 1980s, a lot of young couples were priced out of the housing market by high mortgage interest rates or by reduced personal incomes that were too depressed to support a mortgage. For the first time in forty years, the percentage of American families that owned their own house actually decreased during the Reagan Presidency. “The rate of homeownership among Americans had increased steadily from 44 percent in 1940 to 66 percent by 1980. Starting in 1981, homeownership began to decline for the first time since World War II. By 1984, it was down to 64.5 percent. By 1986, it fell to 63.9 percent.” (654)

Finally, the Reaganomics had detrimental effects on income distributions. The 1981 tax legislation proved to be regressive in a more fundamental way. It became the pretext for a vast redistribution of incomes, flowing upward on the income ladder, through another powerful channel – interest rates. The largest benefits in reduced tax burden went to the wealthiest taxpayers, and the tax relief became proportionately smaller and smaller for families that were less well off.

According to the US Census, “only families on the top 20 percent of the economic ladder enjoyed real increases in their after-tax household incomes from 1980 to 1983. The others, the bottom 80 percent actually lost. The highest fifth, families earning $38,000 or more, gained an average of $1,480 per household in real income, and the top 5 percent, earning more than $60,000, gained an average of $3,320. Families in the middle lost about $560 and the working poor lost about $250.”(401)

Apart from these analyses, the author argues that the Fed strategy may have left larger consequences for the US economy as a whole. Once the boom was broken, “the economy never regained a normal vigor. After the second quarter of 1984, the path of expansion remained below the historic trend line for economic growth, even below the growth rate during the decade of the 1970s, which was universally considered disappointing. The economy did not go into recession. But it sputtered and started and disappointed normal expectation.” (647) From then on, the US economy has showed staggering economic growth patterns and has entered the new era which Paul Krugman once called “the age of diminished expectation.”