The economic program of the Reagan administration, like that of the Thatcher government in Britain, manifests a conservative counterrevolution in the theory, ideology, and practice of economic policy. The aim of the counter-revolution is to shrink the economic influence of government, especially central government, relative to that of private enterprise and free markets. Three kinds of policies are at stake, concerning respectively (1) macroeconomic stabilization—the use of fiscal, monetary, and other policies affecting national production, employment, prices, and other variables of economy-wide significance; (2) economic inequality—the use of the public fisc to redistribute income and wealth; (3) resource allocation—national priorities among various public and private goods; (4) regulation of economic activities and markets. I shall speak principally about the first two categories.

I have referred to a counterrevolution, so I should remind you of the revolution to which it is the counter. That took place some thirty-five to forty-five years ago, just before and after the Second World War, in this country and in other Western capitalist democracies. Radical changes occurred in the practice of economic policy and in the theory of political economy. Live memory of the Great Depression created a broad consensus that the state must assume responsibility for maintaining prosperity, as well as for protecting individual citizens against the inevitable insecurities of life in a market economy. The New Deal in the United States and social democratic movements in Europe were the agencies of these changes. They also expanded government investment in schools, housing, transportation, and other public goods, and augmented the market power of workers, trade unions, and farmers vis-à-vis business. Over three postwar decades these changes were largely accepted by all mainstream political parties and extended by governments of various political colors. Though rumblings of discontent have been heard in increasing volume over the past fifteen years, only recently have the counterrevolutionaries gained political power.

I shall confine myself mainly to the United States and the first two issues on the agenda of the revolution and counterrevolution—macroeconomic stabilization, and redistribution of income and wealth. Two acts of Congress symbolize the revolution. The Employment Act of 1946 dedicated federal power to the achievement of “maximum employment, production, and purchasing power.” Ten years earlier, under the Social Security Act, the federal government recognized an obligation to protect individual citizens from personal economic misfortunes—workers without jobs, aged without funds, children without fathers. The New Deal had already put the federal government in the business of welfare and work relief, insurance of bank deposits and mortgages, and other “safety nets.” By 1947, then, the federal government had assumed responsibilities both to maintain general prosperity and to insure and indemnify the worst individual casualties of depression and economic change.

These really were new responsibilities. Fiscal and monetary policies were not significantly dedicated to macroeconomic stabilization before the late 1930s. In 1929-1934 both Hoover and Roosevelt raised taxes and sought vainly to balance the federal budget; they were worried about the Depression’s effect on the budget, not the budget’s impact on the economy. Throughout the precipitous decline of 1929-1932 monetary policy gave second priority to the American economy, and primary emphasis to defending US gold reserves and the gold value of the dollar—until the disasters of the winter of 1932-1933 forced Roosevelt to suspend gold convertibility and devalue the dollar. As for relief of the victims of the Depression, Hoover—a Quaker who had earned worldwide fame as a humanitarian in directing relief efforts in devastated parts of Europe after the First World War—regarded it in principle as the responsibility of private charity and local government, not the federal treasury. Roosevelt, fortunately, was a pragmatist.

Similar redefinitions of the economic responsibilities of central government occurred in other advanced democracies in the 1930s and 1940s. In Britain two wartime reports by Lord Beveridge, one on social insurance and one on full employment, set the stage for postwar macroeconomic strategy and “welfare state” legislation.

To these political developments there were important intellectual counterparts and foundations. A revolution in macroeconomics and in the theory of monetary and fiscal policy began with J.M. Keynes’s General Theory of Employment, Interest, and Money in 1936 and spread through the English-speaking world and after the war to continental Europe and Japan. This provided the rationale for the full-employment commitments of the several countries, along with guidance on how to implement them. The business cycle was no longer to be seen, as both orthodox and Marxist economists saw it, as an inevitable and functional characteristic of capitalism. According to Keynesian theory, economy-wide fluctuations in economic activity are wasteful; they can be avoided by active fiscal and monetary intervention, socalled stabilization policies.

Keynesian macroeconomics does not logically lead to any position for or against welfare-state measures. But, again in contrast to both right and left, it certainly does not say that redistribution of income and wealth by taxation and transfer is fatal to capitalism, or even damaging. In Keynes’s personal view, “The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.” He was confident that both flaws could be corrected without sacrificing the efficiency and progressiveness of market capitalism, for which he had the same respect as his classical forebears and colleagues. Twenty years later Paul Samuelson, the principal architect of the synthesis of Keynesian and neoclassical theories that became the orthodox main current of American economics, expressed this optimistic view very clearly:


A community can have full employment, can at the same time have the rate of capital formation it wants, and can accomplish all this compatibly with the degree of income-redistributing taxation it ethically desires.

Keynes and Samuelson are saying, in other words, that an amalgam of capitalism and social democracy is both workable and robust. In contrast, both extreme right and extreme left argue that capitalism cannot afford or survive egalitarian policies.

The postwar era, especially its first twenty-five years, appeared to justify the optimism of Keynes and Samuelson. In no other period of similar length have productivity per worker and living standards grown so fast, or aggregate production and employment advanced so steadily, or world trade expanded so greatly. The last ten years have been disappointing compared to the 1950s and 1960s. But we should not lose perspective.

The main source of disappointment and disillusionment with the revolution was the stagflation of the 1970s—the combination of high inflation and high unemployment. Even during the era of their apparent success, Keynesian policies for full employment and countercyclical stabilization aroused chronic anxieties about inflation. Indeed the principal advocates themselves, beginning in the 1940s, warned that full employment, removing the wage discipline exerted by unemployment and the threat of layoffs, might not be compatible with price stability. Some of them foresaw the need for direct restraints on wages and prices to reconcile the two goals. The economy would have a “secular” or long-term bias toward inflation, they observed, if wages and prices rose freely in expanding industries, and during economy-wide booms, but fell slowly if at all in declining sectors and during short recessions.

Moreover, inflationary bias was exacerbated by social welfare legislation, extended and expanded as it was by postwar administrations and Congresses of both parties, most dramatically beginning with the Great Society programs of the late 1960s. Social insurance dulls to some degree the incentive to seek and accept employment, especially the less remunerative or attractive jobs.

Probably more important were developments that fall under the fourth of my initial classifications. The Rooseveltian political coalition opened old-fashioned interest-group politics to large groups that previously had been excluded. Like all governments, our federal government has always catered ad hoc to private business interests with political clout, as our history of tariffs, “internal improvements,” land grants, bank charters, and subsidies amply ilustrates. Beginning in the 1930s trade unions gained federal protection for organizing and bargaining. Wages, hours, and conditions of work became subject to federal standards. Farmers were not only subsidized but organized into federally administered cartels. The promotion of monopolistic powers for unions of workers and farmers was justified by J. K. Galbraith and others as “countervailing” the monopolistic powers of big business, to the benefit of the society as a whole.

This dubious proposition was never congenial to liberal Keynesians devoted principally to full employment and diminished inequality. In any event, these countervailing powers increased inflationary bias. Workers, unionized or not, had more power to gain wage increases in booms but resist cuts in downturns. Agricultural price supports diminished the downward trends and cyclical declines of food and materials prices that contributed so much to price stability in the 1920s and earlier.

Nevertheless, the inflation record of the United States was very good until the late 1960s. That deficit financing of the Vietnam War then overheated an economy already operating at capacity was no surprise to any economist, Keynesian, monetarist, or classical. That inflation accelerated during the 1970s, in spite of monetary policies that triggered three recessions, in spite of unemployment higher than in the two previous decades, is the great disappointment to theory and policy that set the stage for the counterrevolution. Many observers would explain the stagflation by the series of external shocks, unprecedented in their severity, that hammered the world economy during the 1970s: the depreciation of the dollar after Nixon proclaimed it inconvertible into gold in 1971, the worldwide commodity shortages and speculative booms in 1973, the two big OPEC shocks, 1973-1974 and 1979. Others blame over-stimulative monetary and fiscal policies in 1972-1973 and 1977-78. The controversy is far from being resolved, but the Reagan administration is sure of its diagnosis: the disappointments of the 1970s were the inevitable outcome of mistaken policies followed throughout the postwar decades.


To the revolution that took place some thirty-five to forty-five years ago, Reaganomics is, like Thatcherism in the UK, the political and ideological counterrevolution. Just as Keynesian theory inspired the revolution, so a wave of professional reaction to the synthesis of Keynesian and neoclassical doctrines that became orthodoxy in the 1960s sustains the counterrevolution. In both instances, of course, there are many divergences among economic theory, popular ideology, and actual policy. Nonetheless, in both cases, a common tide of opinion floods academic journals, popular media, political rhetoric, Congress or Parliament, and the guiding philosophies of president or prime minister. Rightly or wrongly, the revolution is blamed for the “stagflationary” disappointments of the 1970s, the high rates of unemployment, inflation, and interest, the depressed stock market, the slowdowns of productivity growth and capital formation. The old doctrines and policies, new forty years ago, are discredited, replaced by new doctrines and policies, old forty years ago.

Respecting stabilization, the new doctrine is that active fiscal and monetary intervention—characterized or caricatured as “fine-tuning”—is the problem, not the solution. The government should forswear countercyclical policies and let the market economy stabilize itself, as it will, given confidence that government policies will be stable. Thus the central bank should tie itself, or be tied to, a fixed-rate rule of monetary growth, independent of the state of the economy. Likewise federal tax and expenditure legislation should not be responsive to business conditions. Various proposals to make macroeconomic policies blind to cyclical fluctuations, including constitutional amendments to require annual budget balancing and to restrict government expenditure and monetary growth, are currently before the country and the Congress and are viewed benignly by the Reagan administration.

One of the arguments against the countercyclical policies of the past is that they fostered inflation by removing from business firms and workers the incentive to lower prices and wages during recessions in order to protect sales and jobs—why not just wait until the government pumps up demand again? In Britain Margaret Thatcher has put her countrymen and -women on notice that the only way they can restore the jobs and prosperity lost in the current slump is to disinflate. Her Majesty’s government will do nothing about it.

The same warning has been repeatedly issued in America by Chairman Paul Volcker of the Federal Reserve, who, unfortunately for the effectiveness of the warnings, does not quite command the same audience as a head of government. President Reagan has not made Volcker’s threat credible to those who determine wages and prices; instead he has undermined it by promising disinflation without tears, an instant spurt of rapid growth, falling unemployment, and declining inflation. Recently, it is true, his Treasury secretary has lapsed into old Keynesian “error,” urging the Fed to loosen up a bit to forestall incipient recession. On the other hand, the administration is not fine-tuning fiscal policy in an anti-recessionary direction. Instead, its current fine-turning is aimed in the other direction—it is trying like Hoover and Roosevelt in the early 1930s to offset the effects of the recession on the budget deficit by cutting the budget further. (However, recent statements by OMB director Stockman show awareness of the futility of aiming at specific budget deficits in a weakening economy.)

The renunciation of stabilization policy implies, if actually carried through, that the government no longer has meaningful goals for real economic variables—e.g., for employment and unemployment, national production and its growth. Of course, any political administration will publish its projections, scenarios, and hopes. But these will mean nothing if the government eschews measures to make them come true. The Thatcher and Reagan governments both say that they are providing a stable monetary and fiscal framework within which private enterprise and free markets will restore prosperity and non-inflationary growth. Another way to put it is that whatever economic outcomes private agents generate within the framework are by definition optimal. This is how the current chairman of the Council of Economic Advisers, Murray Weidenbaum, puts the case, even if his client doesn’t yet quite understand it that way.

Clearly this is a 180-degree reversal of the commitment of the Employment. Act of 1946, not to mention the Full Employment and Balanced Growth Act of 1978 (the “Humphrey-Hawkins Bill”). To be sure, employment goals have been slipping for a long time. The unemployment rate was 3 percent at the end of the Korean War, 4 percent at the peak of the boom in the mid-1950s when the Fed applied the brakes by raising interest rates, and 5 percent at the next cyclical peak in 1960. The Kennedy-Johnson administration officially adopted a full-employment goal of 4 percent unemployment, achieved it in 1965, and overachieved it during the Vietnam War. During the 1970s operational unemployment targets were not made explicit, but policy moves revealed implicit targets of 5 percent, then 6 percent, now probably 7 percent or more.

The slippage of course reflects the primacy given to the frustrating battle against inflation. But if and when the battle is won, I doubt that the Federal Reserve and the administration would risk reigniting inflation by relaxing the monetary screws enough to permit much reduction of unemployment from the 7 to 8 percent range. More likely they would settle for a resumption of normal sustainable real growth at prevailing rates of capital utilization, and would not provide financing for temporarily higher growth to absorb the slack created during the anti-inflationary fight. This scenario is, by the way, explicit in the projections of the UK Treasury.

In the US today macroeconomic policy and prospect are dominated by Federal Reserve monetary policy. The Reagan administration assigned disinflation to the Fed, chided the governors for past mistakes, and urged them to be tough. The Fed is being tough, and as Chairman Volcker has repeatedly made clear, proposes to be gradually but resolutely tougher every year until inflation rates are insignificantly different from zero. As Volcker and his colleagues appreciate much better than President Reagan and his associates, Federal Reserve money-supply policies will not allow room for real economic growth unless wage and price inflation melts by a point or two a year. Given the stubbornness of built-in wage and cost inflation, there is likely to be considerable economic pain and damage during a transition of several years.

The administration rejects on principle any direct wage and price policies, formal or informal, even diffuse persuasive appeals by the president. In their absence, the only mechanism by which monetary deceleration produces disinflation is by creating sufficient economic distress that workers and employees, desperate to protect jobs and solvency, settle for lower wage and price increases than those currently prevailing. We can see this process at work across the Atlantic, where midway in Mrs. Thatcher’s five-year term the record unemployment rates are in double digits while inflation rates are still in double digits but slowly declining.

A Thatcher scenario was not quite what the Reagan administration had in mind. The “supply-side” tax cuts were intended to unleash a surge of investment, enterprise, and productive effort. Supply-siders were impatient with traditional conservative orthodoxies that tax stimuli must wait for budget balance and disinflation. Exploiting the eager competition of both parties in Congress, they succeeded in promoting tax cuts that outdistanced the budget cuts of the redoubtable Mr. Stockman. But the tax bill only solidified the firm resolve of Mr. Volcker, and he is bound to win a fiscal–monetary tug-of-war. As the securities markets perceived, the situation is a Catch-22. Interest rates cannot be low enough to sustain expansion unless the economy is in recession.

I turn now to a second dimension of the counterrevolution, the distribution of income and wealth as affected by federal taxes and transfers.

Equality of opportunity has been an American ideal and an American excuse. The ideal of capitalism in a democracy is a fair race from an even start. Big prizes go to the swift, but all participants are rewarded—the more rewarded the faster everybody runs. True, economic and social outcomes are highly unequal. The excuses are that the racers all have the same opportunities and that differential prices generate even larger rewards for all participants.

Opportunities are actually far from equal. We Americans escaped the feudal castes of the Old World, but erected our own racial, religious, and ethnic barriers. Even as these are overcome, the hard fact remains that the children of parents of high economic and social status gain a head start—better education at home and school, better nutrition and medical care, as well as more gifts and bequests of worldly goods. To give children these advantages has indeed been traditionally a strong motivation for work, saving, and enterprise.

Wealth breeds wealth and poverty breeds poverty. Despite legendary examples of spectacular social mobility, the unequal outcomes of one generation are generally the unequal opportunities of the next. Here as in other democracies, governments have sought to arrest the momentum of inequality by free public education, social insurance, “war on poverty” measures, and progressive taxation.

The US budget and tax legislation of 1981 is a historic reversal of direction and purpose. Existing institutions, commitments, and “safety nets” can’t be rapidly dismantled, but the message is clear enough; inequality of opportunity is no longer a concern of the federal government.

The government has virtually abandoned all pretense of taxing transfers of wealth between generations. Capital gains on assets so transferred are excused from income tax, and now most of them will be free of estate and gift taxes as well. In the hasty competition of both parties for the favor of wealthy constituents, Congress casually liberalized these taxes without concern for unchecked dynastic wealth and inequality of opportunity.

Capital income, in contrast to wage income, is increasingly free of federal tax. Even before the 1981 tax law, the Treasury calculated that only one-third of capital income showed up as taxable personal income.* Taxable capital gains are seldom realized; when they are the top tax rate will now be only 20 percent. Deferment of tax on income saved for retirement, easily accessible via employer or do-it-yourself plans, effectively frees the returns of such saving from tax and generally moves the principal into a lower bracket. The new tax-exempt All Savers’ certificates carry no risk and beat the current inflation rate by several points.

The monetary–fiscal policies of the administration are, in fact, a recipe for high interest rates; the tax bill eases the pain for upper-bracket taxpayers, who can escape tax on interest receipts while claiming deductions for interest paid on mortgages, consumer debt, and other loans. The sophisticated rich know how, or know lawyers who know how, to combine depreciation and interest deductions with preferential capital gains rates to shelter salaries and self-employment incomes from taxation. Though many tears were shed in the successful effort to reduce those high-bracket taxes alleged to deter saving and investment, especially the 70 percent rate now abruptly lowered to 50 percent, few inhabitants of those brackets paid such taxes or will pay them now.

The government is a partner in business enterprise, and recent legislation impairs its equity—almost to the point where the Treasury’s share in investment costs and risks exceeds its share in prospective earnings. This is the result of combining greatly accelerated depreciation, “15-10-5-3,” with the investment tax credit—its value multiplied by leaseback arrangements—and interest deductions.

At the low end of the economic spectrum, federal efforts to bolster incomes and opportunities are being abandoned. As federal funds for welfare, food stamps, Medicaid, jobs and training, aid to education, and other residues of the war on poverty are reduced and combined into block grants, the beneficiaries will be at the mercy of local legislators and taxpayers. This process is just beginning. About $150 billion in 1984 tax revenues have been given away, and thanks to bracket indexing none will be recouped by inflation thereafter. The president has now donned his budget-balancing hat and presses Congress to redeem his promises by making budget cuts even greater than those enacted earlier this year. They won’t be found in defense, public-debt interest, or even in social security. There will be further cuts in social programs, more doses of the “new federalism” that devolves these responsibilities and their funding on to states and localities.

The Reagan economic program is advertised to cure inflation and unemployment, to revive productivity, investment, hard work, and thrift. It probably cannot achieve those wonderful results. What it is sure to do is to redistribute wealth, power, and opportunity to the wealthy and powerful and their heirs. If that is its principal outcome, the public will become considerably disenchanted.

Despite its free-market ideology, the administration has done little to dismantle regulations and subsidies that are costly, inefficient, and inflationary. Agricultural programs still not only subsidize producers but do so in ways that raise prices to consumers. Taxpayers, consumers, and shippers pay for our high-cost, noncompetitive merchant marine. The Carter administration deregulated airlines, but analogous measures for surface transport are stalled. The current administration is ready enough to liberalize or discontinue regulations of business when the opposing values are consumer protection or environmental conservation. It is by no means so devoted to market freedom, competition, and consumer interest as to challenge important business, labor, and farm constituencies. These politically sacred cows have been around a long time, and no other administrations have mustered the will or the power to kill them either. But an administration that claims a popular mandate for counter-revolution should not leave unscathed the most objectionable features of the old order.

The outlook for the American economy in the 1980s contains some bright spots and some dark prospects. On the bright side, it seems unlikely that the US and the world will be hit by external shocks of the magnitude of those of the 1970s. Though the present oil glut may not continue, Americans are now much better adapted to high oil prices and much better prepared to cope with future increases. To the extent that productivity and capital formation were held back in the 1970s by energy shocks and uncertainty about how to adapt to them, they should rebound in the 1980s.

On the dark side, the purely monetary cure for inflation can hold down the economy for half the decade, with capital formation discouraged either by high real interest rates, or by gloomy profit expectations, or both. The “new federalism,” as is only beginning to be realized, will have devastating effects on the finances of many state and local governments and on the services they render, especially to the poor. Meanwhile the tax cuts will be widening the gulf between the living standards of the rich and those of the poor, without the promised compensation in the conquest of stagflation. In the end, I think, a democratic polity will not tolerate in its government and central bank an economic strategy of indifference to the real state of the economy.

This Issue

December 3, 1981