annenberg media ♪ annenberg media ♪ in 1981, the federal reserve set out to permanently quell inflation. a year later, 12 million workers were unemployed. why was it hard to stop inflation? in 1985, industrial world leaders gathered in bonn to ask, "why was a growing international trade making it harder to solve domestic economic problems?" by 1985, the economy appeared to be slowing down, and economists were still asking what to do about the next recession.

activist theories of fiscal and monetary policy have dominated economics since the depression. by the mid-1980s, we were doubting our ability to manage the economy. stabilization policy-- are we still in control? we'll investigate that with economic analyst richard gill's help on this edition of economics usa. i'm david schoumacher.

for many years after the great depression, national economic policy's basic goal was minimizing unemployment. but the winter of 1982 saw 12 million unemployed. many complained they were victims of a needlessly cruel government policy. public enemy number one was inflation, and jobless workers were the war casualties. the battle cast new doubt on the government's ability to manage the economy or the wisdom of even trying. why was stopping inflation so hard? the time has come for decisive action to break the vicious circle of spiraling prices and costs. inflation is domestic enemy number one. present high inflation threatens the economic security of our nation.

from richard nixon through jimmy carter, president after president set out to fight inflation. when that threatened to increase unemployment, president after president reversed course, opting for stimulative policies to keep the economy growing and unemployment low. we must shift our emphasis from inflation to recession. the economy grew little, prices a lot. america ended 1979 with significantly higher inflation than we had in 1970. by the decade's end, most americans expected inflation to be with them forever and conducted themselves accordingly. fred schultz was federal reserve board vice-chairman in 1979. when you have inflation, money becomes worth less and financial assets of bonds and stocks don't respond as well.

you need to go out and buy things. you need to buy art, stamps, gold, land, and houses. people got in the habit of going out and borrowing all they could borrow and spending all they could spend. it takes a long time to change the way people carry out their activities. in the 1970s, people were convinced we would get inflation under control, and only in the latter part of the 1970s, '78 and '79, did they become convinced that we wouldn't. that's when inflation really began to heat up very rapidly. in 1979's closing months, federal reserve chairman paul volcker announced a new tight money policy to counter inflation. he was forced to abandon this in 1980's recession.

1981 brought a new president and renewed determination to clamp down on inflation. but the reagan administration wanted it all, both lower inflation and higher growth. the fed sent out warning signals. we kept saying, all through the earlpart of 1981, that if there's too big a tax cut or if it is not matched by expenditure cuts, that's going to make the monetary policy more difficult. if you're putting fiscal thrust into the economic system and are trying to restrain it with monetary policy, interest rates will be higher than they would have been. we made speech after speech, had meeting after meeting, in which we said, "if this tax cut's too big "or expenditure cuts are too small, interest rates will go very high." they did.

when the federal reserve began tightening the money supply, workers and businessmen refused to believe the government was serious about ending inflation. wages and prices continued upwards, growing faster than the money supply. the economy was out of balance. it was bound to topple, and it did. in 1981, the economy headed into a recession. millions headed for the unemployment line. even as the unemployment line grew, workers continued asking for increases to pay for the inflation. the fed stuck to its guns. by spring of 1982, things were bad throughout america. by summer, they were worse. fred schultz had to explain why the fed was causing so much pain. but i'll never forget that, um... the worst thing that happened

while i was on the fed board was trying to explain. i spoke to a group of automobile dealers. one of them said, "i understand what you're doing, "but i've tried over 30 years "to build a successful dealership. next week, i'm closing my doors." that kind of thing stays with you. it was very hard on us, trying to be in a position where you know you're causing individual pain. it's not just theoretical. you know you're hurting people out there. it is tough when you're doing it, but i think the results have shown it was successful. the country is on a much sounder path. as the summer wore on and unemployment passed 10%, the inflation rate began to drop. in august, volcker announced an easing of monetary policy.

wall street was first to respond. bitter memories of the recession lingered on, and faith in countercyclical policy was a casualty. many people blamed the misery on the failures of 1970s stabilization policies. others, like congressman reuss, blamed the unnecessarily harsh policies of the 1980s. in my view, curing inflation could have been done without stepping on the brake so hard the economy was thrown through the windshield. by christmas, the economy was growing again. workers began returning to their jobs, and inflation held at 4% throughout 1983. by 1985, after two years of recovery, inflation remained at 4%, but the economy still bore the recession's scars. millions of manufacturing jobs were gone.

unemployment remained stuck at 7%. 15 years of entrenched inflationary expectations had been sharply reduced, but only after the government proved willing to pay the price to wring inflation out of the economic system. we asked richard gill why tight monetary policy caused such hardship. taking a benign view, one could argue the difficult times of the early 1980s reflected the success of our past policies. keynesian economics was directed at stabilizing the growth of real national income. comparing recent decades with decades before world war ii, the american economy did pretty well. here's the way the growth of our gnp fluctuated before world war ii. here's what happened from the 1950s to 1980. in real terms, the economy was more stable

in the recent period. the suess of these policies undoubtedly contributed to recent inflationary tendencies and, perhaps more significantly, to the expectation of future inflation. by 1980, they'd created a general sense that the government would back down when it began to create recession and unemployment. people began betting on continued inflation. this made the government's task more difficult. the government had to act to break the back of these well-entrenched inflationary expectations. it had to fight inflation and a belief it wouldn't fight inflation that hard. expectations are important in economics. they made the task of monetary policy harder in the early 1980s. some economists have concluded that they make stabilization policy virtually useless.

according to this new school-- the so-called "rational expectationists"-- only unexpected government policies are likely to affect the economy, and their effect is likely to be harmful. so far have we come from the keynesian revolution! in 1983, america came bouncing out of the recession, but a funny thing happened on the way to prosperity. out of billions of dollars of consumer spending, too much was pouring overseas. foreigners held a high percentage of our national debt. by 1985, economists here and abroad were asking, "is our domestic economy the hostage of international forces?" those international forces had been building throughout the 1970s. the percentage of our economy devoted to foreign trade doubled, passing 10% by 1981. what problems would this create

for conduct of economic policy? we asked economist robert gordon. the problems that creates would be no problem if it weren't for the flexible, variable exchange rate of the dollar, which means conducting policy in washington now has side effects that didn't exist before, namely, if we decide to fight inflation with tight money and loose fiscal policy, the policies of the 1980s, then we'll find that part of our economy is harmed while another part benefits. we're taking from peter to pay paul. in 1983, economic recovery surged ahead. it soon became obvious many americans were being left behind. while millions of jobs were being created in the service industries, millions more in manufacturing appeared gone for good,

lost to overseas competition. there's no question about it. we're in deep trouble here in tarrytown, where about 2,000 people will be laid off. i don't know anybody who will hire 2,000 people. in the sixties and seventies, expansive economic policies created jobs for american workers. now these same policies were creating jobs overseas while americans remain unemployed. the situation was causing severe problems for american policymakers, as federal reserve governor henry wallich explains. you may want to expand the economy, let us say, by budget deficit or easier money. some of this demand goes abroad. you get expansion in japan but not in detroit. we've got a 200-odd billion dollar budget deficit, but half of the money is going abroad,

so we're getting stimulation only from half. fiscal policy is losing much of its power. no one in reagan's administration had foreseen this effect when it first embarked on its expansive course. but as our trade deficit shot past $100 billion, economists and politicians alike began to search for a solution. most economists agreed the trade deficit was caused by the overly strong american dollar caused by the budget deficit. many politicians began to argue for trade barriers to keep out the flood of imports. the reagan administration resisted this approach. all economists-- i'd say 99.9% of economists-- believe we all gain from free trade. this administration believes we gain from free trade. therefore we are not going to lead the world

down a protectionist road which will reduce our standard of living and reduce standards of living abroad. in may 1985, heads of state of the free world's industrial nations met in a summit in bonn, west germany, trying to resolve differences in economic policy. europeans and the japanese urged the u.s. to control its budget deficit. we urged them to expand their economies to create markets for american goods. no firm decisions were made, but international cooperation remains a promising economic approach. beryl sprinkel speaks for the reagan administration. when governments recognize a particular set of policies are in their interest, they're very likely to move in that direction. the difficulty is getting them to do something which is against their interest. they won't do it.

we won't do it. but working together, you can make some progress, and i think we have done so over the past five years. five months after the bonn summit, the u.s., japan, france, britain, and germany announced a coordinated effort to reduce the u.s. dollar's value. the move was a promising effort to ease the u.s. international trade dilemma and possibly create more american jobs. but major problems remained. by 1985, the united states was running $200-billion budget deficits. but half the economic stimulus, the u.s.trade deficit, was going overseas, and any effort to contain this deficit or promote continued growth would have major world impact. we asked economist richard gill why the international aspect was important. the international aspect is so important

because the numbers are so big. we had our first postwar merchandise deficit in 1971, a little over $2 billion. by 1984, our merchandise deficit was over $105 billion. these numbers mean we can't separate our domestic stabilization policies from our international trade policies. for example, it has been argued that our trade deficit in 1984 was mainly due to an overvalued dollar. this made exports too expensive and imports too cheap. the dollar's value is determined by supply and demand. the dollar's high value must have been due to a great demand for dollars in relation to supply. simple solution-- increase the supply of dollars. have the fed start printing money and buying back u.s. treasury securities held by foreigners. but hadn't we just undergone

a painful period of monetary restraint to break the back of inflation? if the fed printed money, what would happen to those dread "inflationary expectations" we had been trying to destroy? the fact is that, in an interdependent world economy, we have more variables to consider, and this creates still another difficulty for our already rather shaky efforts at economic stabilization. the employment act of 1946 created a council of economic advisors to give the president the best professional economic thinking. for almost 40 years, this advice was to manipulate the economy to prevent inflation and promote growth. it was called countercyclical policy. by 1985, the man in this office was urging a receptive president to keep his hands off. whatever became of our ability to fine-tune the economy?

in the 1960s, we were convinced that we had unlocked the mysteries of economics and learned to control the ravages of the business cycle. walter heller served two presidents as chairman of the economic council. we asked him, "was the 1964 tax cut a success?" it came from and went back into textbooks as the greatest success in modern fiscal policy. it came into an economy without inflation. the federal reserve was able to cooperate and accommodate this stimulus to purchasing power, and it worked like a charm. walter heller left the council in 1964. by 1985, the man in this office rejected the idea that the government could fine-tune the economy. we cannot do it now, and we couldn't do it then. some of my predecessors believed they could.

so far as the reagan administration is concerned, we recognize that. we try not to fine-tune because it would be a road toward disaster. what happened between the sixties and the eighties? the seventies happened, bad years for theory and practice of macro-economics. monthly fine-tuning of monetary policy created havoc in the economy, as martin feldstein explains. i think the 1970s, in particular, was a decade in which monetary policy pursued the wrong goals, was based on the wrong premises, and got us into terrible trouble. it was money's excessive growth, more than anything else, that brought us to the double-digit inflation rates. in the seventies, fiscal policy was not much better.

by the time congress got around to changing fiscal policy, a tax cut or an increase in spending, it was too late. instead of dampening the business cycle, they were increasing the fluctuations in unemployment and inflation. by the decade's end, fine-tuning the economy was a thoroughly discredited idea. when paul volcker initiated policy designed to permanently quell inflation, he made much of the fact that the policy was for the duration. when ronald reagan embarked on the most expansive fiscal policy in history, he locked it in place three years in advance. 1983 and 1984 were years of growth in the american economy, but, as the economy grew, the budget deficit grew even faster. by 1985, many economists felt that fiscal policy was dead,

a casualty of the towering deficit. we're almost forestalled from using positive fiscal policy when we're running deficits of $200 billion. can you imagine the president and congress saying, "well, we're running $200-billion deficits, "but they really ought to be $300 billion because we need to rev up the economy"? we may be denying ourselves an important antirecession tool because of these deficits. the only effective option is monetary. that doesn't mean it's a desirable option. conservative economist milton friedman. because the tendency has always been to respond too late and too much and to create a subsequent period of bumps. in my opinion, the right way to respond-- the most desirable way to respond to recession-- is to have a policy of steady monetary growth.

as a result, recessions will be mild and will correct themselves as the effects of various forces unleashed by the recession work out. you won't have a perfectly steady economy, but a much stabler economy. i don't believe that. with all the information we have about the economy, there should be feedback. you should feed back into the policy process what you can learn from the economy and then adjust policy, not every day, but over a cycle or in light of various crises that hit the economy. you should adjust it in light of the information. i would say you can't iron out the little wiggles in the business cycle, that countercyclical policy may be useful if the economy gets very much off track.

we have monetary and fiscal tools for dealing with that situation. we won't see the kind of experience we had in the 1930s. the policies that were pursued in the sixties and seventies-- trying to prevent 1 or 2% increases in unemployment that come about because of changes in consumer preferences or changes in investment behavior-- that's a futile activity, and it almost inevitably leads to worse problems than the problems it's trying to cure. in 1985, sour notes in our economic performance warned that inflation and unemployment were still with us. the economic community thought the most effective response was a policy of coarse-tuning rather than more active management. as paul volcker continued to point out, hard choices remained and could not be put off forever.

richard gill comments on future trends. in the 1950s and 1960s, the keynesian view was dominant. with slight turns in monetary and especially fiscal policy, one could, most economists felt, steer the economic ship past dangers of inflation and unemployment. today, even neo-keynesians concede that economic navigation may be less of an exact science than was imagined. the shift of emphasis from fine-tuning to coarse-tuning has been a shift from the short to the longer run. active intervention in the short run may only intensify our longer-run problems. there is no real agreement what the important long-run factors are. the monetarists, under professor friedman,

stress steady, long-run growth of the money supply. the supply siders, who came to prominence after the oil shocks of the 1970s, emphasize cutting taxes and stimulating long-run growth of investment, technology, and labor supply. and finally, there are the rational expectationists, who argue that in the long run, business, labor, and consumers will figure out what the government is doing and ll respond in ways that defeat the government's intentions. the future of countercyclical policy? it is likely to be less interventionist, more long-run oriented, and more careful about international consequences than in the early postwar period. we shouldn't overlook achievements in that period. equally, we cannot overlook the different problems that lie ahead. can we control the econo?

we were convinced that we could. economists are no longer so hopeful. the problems of entrenched inflation, the effect of expectations on people's behavior, and increasing interdependence of the world's economies have forced policymakers to face difficult and complex decisions. but the american economy continues to be a powerful force throughout the world. prudence demands that it be kept under some control. how, and how much control, continues to be the topic of lively debate. for economics usa, this is david schoumacher. captioning is made possible by the annenberg/cpb project captioning performed by the national captioning institute, inc. captions copyright 1986 educational film center

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