On February 8, the chairman of the Federal Reserve Board, Paul Volcker, testifying to the House Budget Committee, said that we were “playing Russian roulette” with our economy. The stock market, which had been in an increasingly nervous state for the previous several weeks, quickly went into a steep decline, prompting Mr. Volcker, the next day, to calm things down by saying that the market had “overreacted.” The chairman was right the first time, however, and so was the stock market; we are indeed playing Russian roulette with the economy. We are doing so by allowing our budget to go out of control, by allowing the international monetary system to go out of control, and by allowing the rapid industrial adjustment that is occurring now to take place without the slightest attempt to guide its direction or to dampen its shocks.
The economy’s strong rebound from the 1981-1982 recession has provided us with an opportunity to take actions that could put the economy on a sounder basis for a long time to come. These actions would require statesmanship and courageous political leadership from the executive and the legislative branches of the government, from both Republicans and Democrats. They would require a change from the economic and social Darwinism that is the current philosophical position on the appropriate role of government in our society. Since none of these actions seems likely to be taken in the near future, the opportunity will probably vanish. When you play Russian roulette, sooner or later there will be a live round in the chamber.
Let us first look at our financial management. Our national debt currently stands at about $1.4 trillion; it was about $500 billion in 1975 and $280 billion in 1960. It will be about $2 trillion by 1986 and will continue to grow. Practically any forecast of deficits based on the budget submitted by the administration shows that additional borrowing of between $750 billion and $1 trillion will be required over the next five years. We have been able to borrow the huge amounts required by our budgetary deficits by attracting foreign capital with our high interest rates. We have become the largest borrower on the international markets. The result is an overvalued dollar which is destroying our export industries as well as those of our domestic industries (automotive, steel, etc.) that must compete with imported products. Borrowing on such a scale makes us vulnerable to the suppliers of foreign capital just as we have been vulnerable to the suppliers of foreign oil.
Why is this so dangerous and why is time so short? The economy is currently still growing vigorously in a recovery from the 1981-1982 recession. Inflation is down, unemployment is down, and the economy could easily absorb a major program to reduce deficits without endangering the recovery. On the contrary, a package of cuts in defense and entitlements, along with the imposition of new taxes (such as energy or gasoline taxes, minimum corporate income taxes, and simplified personal income taxes), could be designed to reduce the deficit by $50 billion initially (as Paul Volcker suggested) and by more later. An attempt should now be made to schedule deficit reductions of $200 billion over the next three years. The result would be significantly lower interest rates, a big psychological boost, and a cheaper dollar. It is likely that we would be on the road to continued growth with low inflation for some time to come. With a lower dollar and lower interest rates the international financial climate would improve growth in the OECD countries and would ease the third world debt problem. These would seem to be powerful incentives for action now. An even greater incentive is an evaluation of the risk involved if we do nothing or very little.
When the Federal Reserve reversed its tight monetary policy in the summer of 1982 and Congress passed a $100 billion tax package, the stock market began a steep climb. Markets today are huge beyond anything in our previous experience. The increase in stock market values, which added up, at one point, to $600 billion, certainly had a lot to do with the recovery that started three or four months later. What goes up, however, can come down. The markets were fueled by lower interest rates and funds flowing out of money market accounts, by foreign funds looking for political safety, and by expectations of recovery. But as it has become clear that we are not willing to put our financial house in order, the markets have become weaker. Capital that flowed in could begin to flow out; funds looking for capital appreciation could look for safety.
A weak stock market could trigger an outflow of foreign capital. While a gradual decline of the dollar is highly desirable, an abrupt dollar crisis could be very destabilizing. Interest rates would have to go up to induce foreign funds to continue to finance our federal deficits. The combination of a weak stock market and higher interest rates would create an environment likely to bring about a new recession. And a recession in such an environment could create a national financial situation of dangerously high risk.
If we run $200 billion deficits in a relatively robust recovery, what would be the deficit created by a recession? $250 billion? $300 billion? By next year, the national debt will be at a level of between $1.5 and $1.6 trillion, and policy makers could be faced with the following choices: 1) Greater tax increases and deeper cuts in military and social spending to close the budget gap. Clearly, these are not the kinds of actions to stimulate the economy out of a recession; or 2) Borrowing $250 to $300 billion, at high interest rates in extremely difficult credit markets. This would saddle the budget permanently with at least another $25 to $30 billion of added annual interest costs and would probably soak up between two-thirds and three-quarters of all capital raised. The result could be a crisis for the dollar in the foreign exchange markets.
Interest costs on the national debt have grown from $9.2 billion in 1960 to an estimated $165 billion in 1985, or more than 4 percent of the GNP.1 Indeed, the increase in interest costs since 1980 has more than offset all domestic spending cuts made since then. Heavy and growing additional borrowing would be dangerous but, in a recession, dramatic budget cutbacks and tax increases could be just as damaging. While it is by no means certain that we will have to face these choices, the level of risk is clearly increasing; we are no longer dealing with just a little dark cloud on the horizon.
These policy choices, or some combination of them, would have to be made against a background of highly volatile markets for securities and for foreign exchange. Furthermore, a recession in the US, especially one accompanied by continued high interest rates, could create insurmountable problems to certain of the third world borrowers, many of which are still in a very fragile condition. In the face of possible defaults by third world countries, US policy makers would have to shore up the banking system to maintain liquidity as well as confidence—an additional economic challenge at a time of extreme tension. The political pressures to reinflate the economy at a rapid rate by printing more money would be enormous, but the resulting inflation could itself get out of control.
It is well to remember that the current administration, while attempting to create a “supply-side” recovery spurred by investment and savings, achieved just the opposite. It created, more or less fortuitously, a classical Keynesian recovery, driven by high consumption, high deficits, and the lowest level of savings in decades. It is also well to remember that, while Keynes favored deficits in recessions, he was equally firm in recommending budget surpluses, in periods of recovery, to avoid inflation. The current level of deficits, in a period of strong recovery, would have been appalling to John Maynard Keynes.
The conventional wisdom states that a program to reduce the budget—through a $100 billion three-year “down payment” on the deficit, for example—cannot be enacted during the election year, but that budget action in 1985 is all but assured. The financial markets, however, may not wait until 1985, by which time the economy may be weakening. And while this is happening at the federal level, major changes are taking place within our economy.
The recent recession, while exceedingly costly and harsh in its consequences for many people, nonetheless gave many American businesses the opportunity to vastly improve their efficiency. Some took advantage of the opportunity and their costs were lowered dramatically. Many of our industries are now significantly more competitive than before, and results would be even better if it were not for grossly misaligned foreign exchange rates. Nonetheless, this has happened in a climate of abrupt deregulation of industry and changing interpretations of the antitrust laws. The precise consequences of both are unpredictable, but some of the dangers and opportunities they present have already become clear.
We are in the throes of rapid changes in many of our economic structures. These changes are driven by different forces, and they affect practically every sector of our society. Technology is possibly the most important of such forces. In the manufacturing as well as in the service industries, machines can often do what people used to do, and do it better and more efficiently. This not only requires major adjustments in our domestic work force, but also makes it possible for foreign firms to take over activities that hitherto were protected from competition. The ability to store and transmit large amounts of data instantaneously enables financial institutions to process their paper work wherever it is cheapest, whether in the US or abroad. Computer-assisted design and manufacturing make it possible for less-developed countries with less skilled labor to manufacture sophisticated products at a fraction of our cost.
Deregulation in industries such as airlines and financial services are creating major and rapid changes in their methods of doing business. Changes in technology as well as changes in the regulatory climate are moving too swiftly for our legal system. The best example is the current inconsistency in antitrust interpretations.
The government insisted on breaking up the most successful and efficient regulated utility in the world, AT&T. The result will probably be higher costs and poorer service for the customer. At the same time we permit greater concentration than ever before in the oil industry, yet forbid steel mergers aimed at greater productivity. We have pushed our automotive industry to invest tens of billions of dollars to manufacture small, fuel-efficient cars as a result of the oil shocks of the 1970s; but, with the decline in gas prices, large cars are back in fashion, and small-car production may be driven out of the US by arrangements such as the GM-Toyota joint venture. Partly finished or abandoned nuclear power plants are scattered from Long Island to the Pacific Northwest, at huge expense to rate payers, taxpayers, and stockholders, while in France and Japan nuclear power is both safe and economical.
In all of these cases, the government has covertly been applying what could be called an “industrial policy”—but one that is confused, contradictory, and damaging to the national economy. Such recent developments point up the need for a more coherent approach. Indeed, if we examine them closely, we can see why many of the current objections to coordinated national industrial policies are based on myths—the myth of “national planning,” the myth of “propping up losers,” the myth of “inefficient capital allocation.”
Let us first look at the current state of antitrust policy. The antitrust regulations embody a fundamental industrial policy whose aim is to maintain competition. Two recent decisions of the Justice Department and the Federal Trade Commission are particularly worth scrutinizing for their effects on the economy: the decision to allow Texaco, Inc., to acquire the Getty Oil Company for $10 billion, and the decision to prohibit LTV and its subsidiary Jones & Laughlin Steel Company from merging with Republic Steel.
Texaco was permitted to acquire Getty because, by the measure of the world markets for oil and natural gas, both companies had proportionately small market shares. The implications for US energy and industrial policy are, however, quite different. It is likely that the Texaco-Getty transaction, which would not have been legally proposed five years ago, will result in a major concentration in the domestic oil industry. Already Royal Dutch Petroleum has proposed to acquire for $5 billion the 30 percent interest in Shell Oil it does not currently own as a first step to further acquisitions. It is not far-fetched to assume that between $50 and $100 billion will be spent by the major oil companies to acquire independent US producers in the next year or two. This means that the acquiring companies will be buying oil reserves at $4 to $5 per barrel because of under-valued stock prices, as opposed to spending perhaps $10 per barrel or more to find new oil. Such purchases clearly make sense for the acquiring company. They also make sense for the stockholders of the acquired company: Getty Oil stock was traded at between $60 and $80 per share before it was acquired by Texaco for $128 per share, almost double its previous market price. But do such mergers make sense from the point of view of national needs for energy and for industrial growth?
If we take Texaco’s acquisition of Getty Oil to be the beginning of a trend, a trend that I believe is now inevitable, we can expect several important consequences to follow. First, the major oil companies will be borrowing from $50 to $100 billion in order to acquire smaller independent companies. This will have some upward impact on interest rates, although part of the capital will be recycled by the shareholders of the acquired companies. Second, the capitalization of the oil industry will be much more heavily burdened with debt since practically all of the acquisitions will substitute debt for equity. The result will be less capital for new exploration, upward pressure on oil prices, and greater vulnerability to the next OPEC oil shock.
Even though the antitrust decision may be legally impeccable, its consequences for national energy and industrial policy could be damaging. At a time of high interest rates and constraints on capital, the huge amounts of money being borrowed will not have the effect of adding to the nation’s energy reserves or improving its competitive position in the world. This is not a sound policy.
Simultaneously with the Texaco-Getty transaction, LTV, Inc., a holding company having as one of its subsidiaries the J & L Steel Company, proposed to merge with Republic Steel. The merger was prohibited on the grounds of the significant shares of the domestic market held by both companies. As with the Texaco-Getty merger, the decision may very well be defensible on legal grounds. But it, too, looks quite different when considered from a national industrial point of view.
Virtually everyone who has carefully analyzed the US steel industry agrees that it needs to reorganize itself, to close inefficient facilities and invest in modern ones, to eliminate wasteful work practices and inefficient management, to become smaller and leaner. Government policy under recent administrations has been to provide the industry with tariffs and other forms of protection. The government has also given the steel companies both tax benefits and relief from regulation in the hope that the industry (both labor and management) would improve its performance. This is an explicit industrial policy; the only trouble is that it has not worked. US Steel’s most recent major investment has not been in improving its productive plant but in acquiring Marathon Oil, a large petroleum company, for $6 billion. In the steel mills themselves, management and labor have failed to arrive at agreements. Investment has lagged, and the demands by the industry for protectionism have become more insistent.
It is true, as the American steel companies claim, that foreign steel production is often heavily subsidized. The response of a national industrial policy to such foreign advantages should be clear and simple. It should be to encourage mergers in the steel industry in order to make it more competitive, to limit the level and duration of trade protection, and to make government assistance conditional on a more competitive structure within the industry itself. Mergers such as the one between J & L and Republic Steel, or the one now proposed between US Steel and National Steel, could meet these goals if the following elements were included in the merger plans:
1) The trade protection requested by the industry should be limited to a sharply defined transition period.
2) Explicit commitments should be made by both management and labor to curtail the use of inefficient facilities and to make new investments in technologically advanced processes.
3) Labor should make commitments to wage restraint and improvements in productivity in exchange for profit-sharing and/or stock ownership; management should commit itself to exercise restraint in price increases.
4) Management should also make commitments to provide both retraining and funds for relocation to displaced workers—the financing for both to be drawn from a portion of the savings from increased productivity.
5) Government should make available loans or guarantees for part of the capital required, if such financing is needed to carry out such a plan.
Applying such a policy to the steel industry would make sense. It would, I should add, bring into play the principles recently recommended by the study group on national industrial policy headed by Irving Shapiro, Lane Kirkland, and myself. We advocated: 1) that cooperation among business, labor, and government should be the basis for any national industrial policy; 2) that strict conditions should be placed on any aid from government; 3) that the plans themselves should be proposed by industry, with limited assistance from the government; 4) that no general government plan should be imposed or coercion take place; 5) that no government assistance should be provided without contributions by both management and labor.
The changes in institutional relationships required for such an approach were also considered by our group. It proposed a tripartite board of representatives from business, labor, and government, with the power to recommend plans to the president and Congress. It also proposed an industrial financing agency, under the authority of the board, which could finance some of the projects once they were approved.2 The overall objectives are to create more competitive enterprises and to recognize and cushion the social shocks inevitably created by the process of adjusting to changing technological and international conditions.
Changes are currently taking place in the attitudes of business and labor toward each other. We can see that the principles I have cited have already been reflected in recent industrial developments, for example in the rescue of the Chrysler corporation from impending bankruptcy. In this case, labor contributed to saving the company by accepting lower benefits and improvements in productivity. The banks converted loans to equity. The government gave limited financing assistance. Douglas Fraser, the president of the UAW, was elected to the Chrysler board.
More recently, Weirton Steel was acquired by its employees through an employee stock ownership plan (ESOP). The employees essentially exchanged reductions of 23 percent in wages and benefits for the ownership of the company. The participants in ESOP elected a board of directors which then hired professional management. Financing was arranged from private institutions as part of a package including a six-year labor contract with a no-strike provision and no cost-of-living allowances but with provisions for profit sharing.
Paul Volcker recently recommended to business leaders that they control inflationary pressures through more cooperative relations with labor, including labor representation on boards of directors. That proposal certainly would not have been made a few years ago. Senator John Heinz recently introduced a bill requiring that trade protection through tariffs or quotas be conditional on contributions by both management and labor, and that a tripartite board consisting of representatives from business, labor, and government be set up for this purpose.
These are all examples of how an “industrial policy” could work. The rhetoric surrounding such a policy is still heavily affected by ideology and politics, conservative versus liberal, Democrat versus Republican. But in the actual industrial world, cooperative ventures have begun to take place—not, however, enough of them.
Eastern Air Lines was recently on the verge of bankruptcy before it negotiated an agreement whereby its employees gave up $290 million in wages and benefits in exchange for 25-percent ownership in the company and representation on its board of directors. At the same time, however, Continental Air Lines filed for bankruptcy under Chapter XI. TWA is locked in a bitter dispute with its unions. Non-union airlines, created as a result of deregulation, made such traumatic changes inevitable. The Eastern agreement represents a kind of industrial policy, one that is hastily improvised. An institution such as the tripartite board I have mentioned could have started the dialogue between the industry and the unions much earlier, creating a basis for adjustment long before all the parties faced ruin. Clearly, a national transportation policy should be an essential part of an industrial policy. Questions of safety, availability of service, financial capacity, all require thoughtful review and provisions for adjustment when a shock such as rapid deregulation is imposed.
An equally vital, and equally neglected, issue of industrial policy is energy, and specifically nuclear power. In the 1970s, while resolutely avoiding the taxation of energy the government encouraged conservation and the development of different sources of energy. The automobile industry invested tens of billions of dollars to build fuel-efficient cars in order to meet market demands and stringent fuel-consumption standards that were determined by the government. Nuclear power was encouraged. The government-sponsored Synthetic Fuels Corporation (SFC) was created to work with private enterprise to develop shale oil and other synthetic fuels. A national energy policy was cobbled together, although it was incomplete and came late in the day.
Today, that policy no longer exists. As gasoline prices went down as a result of recession and conservation, both the government and private industry seem to have concluded that the energy crisis of the 1970s was over—a conclusion as remarkable for its amnesia about the recent past as for its blindness to the daily headlines about the Middle East. Nevertheless, bigger cars are back in style and it is only marginally profitable to manufacture small cars in the US. In fact, General Motors will soon cease to produce small cars here and will assemble what are essentially Japanese-made units in the jointly owned GM-Toyota plant in California. I doubt that it is in our national interest to drive small-car manufacturing and its related technology out of the US. As for alternative sources of energy, synthetic fuels are no longer much discussed and the SFC sits idle with about $18 billion of capital.
Finally, the problems of the nuclear power industry require national attention. From Shoreham, Long Island, to the Pacific Northwest’s Washington Public Power company, nuclear power plants costing tens of billions of dollars remain unfinished. Both the government and the utility industry joined in a headlong rush to nuclear power during the 1960s, and they were further encouraged by the first oil shock in 1972. The disasters that over-took the industry had many causes. Dramatic cost overruns were caused by regulatory and judicial delays. Equipment manufacturers and contractors failed to build safely and efficiently; the utility companies were often shortsighted and incompetent. Government oversight was confused and uncertain. Both energy requirements and the prices of fossil fuels were lower than expected. The result, the abandonment of facilities in which vast investments have been made, is an appalling waste. The losses, in the tens of billions, will be absorbed partly by the rate payers and the stockholders; but in the last analysis, one way or the other, taxpayers will foot the bill without having one megawatt of additional power to show for it. An industrial policy dealing with nuclear energy could have avoided much of this and might still bring something out of the current chaos.
The experience of France, Germany, and Japan shows that nuclear power plants can be built and operated both economically and safely. Neither country has had crises of the kind that arose at Three Mile Island. In both countries strong government supervision of, and cooperation with, the operating companies is taken to be essential. France, unlike the US, has arrived at a standard reactor design. The highly experienced managers of the French nuclear industry can have a working reactor constructed in six to seven years, as against fourteen years in the US. Safety standards are tougher there than here, and the operating costs are lower than those for generating electricity with oil or coal. Could a comparable record of safety and efficiency be achieved in the US? Our alternatives for producing electricity are coal and oil. Oil is scarce, and subject to the vagaries of foreign pricing and production. The environmental damage caused by burning coal—acid rain and sulfur oxides, among other forms of pollution—and the operating costs of extracting and using it do not make coal a very attractive source of fuel.
A rational industrial policy would explore the ways by which nuclear power could safely contribute to the country’s energy needs. More active federal participation in the nuclear power industry, in partnership with the states and the utility companies, should clearly have been provided for from the beginning. The federal government should have been in a position to insist on standardized design, on tougher oversight of contractors and utility management in both construction and operations. It should not have been necessary for legal proceedings to drag on, and there should have been a more consistent regulatory climate. Regional nuclear facilities operated by technically qualified companies (whether industrial or utility) should have been selling their output to smaller utility companies. The federal government should have provided limited financial assistance for such regional nuclear development, but only after assuring itself that costs were being controlled and safety protected
It is not too late to salvage something from the appalling waste existing today by applying these principles to some of the unfinished nuclear projects that are now being abandoned. Few things are certain at this point, but another “energy crisis” and then another crash program for “energy independence” are both likely in the years to come. A rational approach would be to treat nuclear power as a national problem requiring a national industrial policy to deal with it.
Business and government must also collaborate, in my view, on the urgent problem of third world debt. Since 1982, intense efforts by Paul Volcker and the Federal Reserve, the IMF, and the commercial banking system avoided the bankruptcy of Mexico and Brazil, Argentina, and a number of other third world debtor nations. The international credit system has been kept going without a major default by the process of “rolling over” short-term debt when it matures and, in effect, lending the borrowers the money to pay their interest charges. Mexico appears to have made the most successful adjustment to its debt problems, but Brazil and Argentina are struggling to do so at a time of considerable social and political tension. There is not only a financial but a geopolitical need to relieve the pressure of debt on some of these countries. If their economies crumble, they risk becoming socially and politically radicalized, easier prey for communist influence. A militantly radical Mexico, with a population reaching 100 million by the year 2000, could make our current problems with Cuba and Central America seem paltry. Some combination of government guarantees in exchange for significant stretch-outs of maturities and sharp reductions in interest rates will be needed to protect US banks as well as to assist countries like Brazil and Argentina to grow to regain their place as large customers of the West, and to strengthen their rather fragile democratic institutions.
The Kissinger commission has recommended military and economic assistance for Central America amounting to more than $8 billion. But the future of the southern half of the continent largely depends on how successfully Mexico, Venezuela, Brazil, and Argentina will deal with their external debt and their internal social institutions. Those are the countries we ought to concentrate on; once again, doing so will require an active government determined to work out cooperative arrangements with the private sector.
In listing some of the principal needs of the economy, I have no illusion they will soon be met. I have listed them because dealing with them sooner or later will require a philosophy of government that will be the alternative to Reaganism. Our runaway budget, our runaway national debt, the lack of any sense of direction with respect to the future of our key industries, the lack of involvement with respect to the international financial system—all of these call for change. It is far from certain that this change will occur in 1984. On the contrary, a strong recovery fueled by budget deficits, by consumer spending and by foreign borrowing—the classic Latin American-style boom frowned upon by the IMF—may very well last into 1985.
The combination of our apparent economic well-being and the lack of an articulated alternative policy, one combining financial moderation with active cooperation among government, business, and labor, is likely to keep us on our present course for another four years. It is also likely that, between now and 1988, the realities we have ignored will take their revenge: we may have to face financial and economic difficulties of a type and a dimension that no one has had to deal with before. As a result, in 1988 we may be looking for a modern Franklin Roosevelt to pull the country together in a time of great economic and social stress.
The sequence of events that could bring us to that point is not inevitable but remains a serious possibility: a US recession in 1985-1986; an increase in our federal deficits to $250-$300 billion or more; higher interest rates as a result of dollar outflows; sharp downward movements in the securities and foreign exchange markets; and defaults of certain third world borrowers. If this were to happen no one can predict what it would lead to. One thing is certain, however: a policy intended to reduce to a minimum the level of government involvement in the economy would have created a situation in which such government involvement would have to return to its highest level since 1932. At this moment, the greatest thing we have to fear is not fear, but overconfidence and complacency. In the most pro-business administration in decades, we are violating the most basic rule of business: we are betting the company.
March 29, 1984