As usual each winter, journalists have focused myopically on the current debate about whether to push the budget a few inches to the left or right. To gain a fresh perspective and think in feet, not inches, let us rewind history to Jan. 20, 1981, and pretend that economic progress had never been sidetracked by Reaganomics. Our story takes the form of a set of policies instituted by an imaginary, newly elected party called "The Center."
As 1981 began, all Center Party officials agreed that the nation's two basic economic problems were excessive inflation and the disappearance of productivity growth. Also high on the agenda were the perennial problems of poverty and economic inequality. Two key decisions formed the heart of the new administration's program. First, the conquest of inflation had to take a back seat to raising productivity. Second, progress on productivity required abandonment of decades of liberal and conservative dogma; human capabilities and skills had to be developed without any further increase of the share of government spending in national income.
Ending inflation appeared to require either wage and price controls, or the traditional "brute force" method of tight money, layoffs and bankruptcies. But either of these solutions would have run into the same institutional roadblock: the unique American system of three-year union wage contracts having staggered expiration dates. If the United States had shared the Japanese system of one-year contracts expiring simultaneously each spring, then the new Center administration could have slowed the growth of wages, prices and the money supply simultaneously in the spring of 1981 when those contracts expired.
Because of the U.S. contract system, however, wage controls would be unfair and unworkable, while tight money would not instantly end inflation. Instead, each union would try to emulate the wage increases negotiated it still-effective 1979-80 contracts that they knew would continue to push up the cost of living it 1981-82. Thus, tight money would duplicate the Thatcher scenario in the United Kingdom -- falling production and rising unemployment with slower inflation coming slowly and pain fully.
The Center administration rejected the high-unemployment solution to inflation. A tactic better suited to cavemen, it would have amounted to little more than the Federal Reserve's hitting the labor unions over the head with a club. The resulting blood bath would have been no ordinary recession, but a half-decade-long slump costing $1,000 billion, or $10,000 per family, in lost income and production. Even worse, the high-employment tight-money tactic would have derailed the more pressing task of resuscitating productivity growth. Faster growth required each worker to be provided with more modern equipment, and it was no less important to make workers better able to read, to program computers and otherwise qualify for skilled job slots. The caveman approach would erode the incentive to invest by cutting factory utilization and raising real interest rates, while making business firms unwilling and unable to provide manpower training.
The revival of productivity growth required a higher share of gross national product going to investment in plants, machines and people, and a smaller share going to consumption. To encourage saving, the Center administration introduced a five-year tax reform package that ended the taxation of saving by steadily lifting the legal limits on Keough and IRA deductions, thus in effect shifting to a progressive consumption tax. At the same time, tax rules were rewritten to allow borrowers to deduct only "real" inflation-adjusted interest payments.
Administration officials were disturbed that the Japanese, with half our population, were training 50 percent more electrical engineers, that U.S. schools were starved for teachers of computer science, and that SAT scores had been falling for almost two decades. To foster human investment without raising the share of government spending in GNP, the federal budget was redirected away from enforcing environmental regulations that hindered productivity and from multi-billion dollar synthetic fuel projects that had little social payoff. To expand engineering and computer science training, bonuses were provided for teachers in these shortage areas. To stimulate vocational training, student loan programs were liberalized, but extra budgetary cost was avoided by charging market interest rates and requiring borrowers to repay loans through IRS-enforced payroll deductions from future earnings. Reading skills in elementary and secondary schools were fostered by providing bribes for states to reorient curricula toward the "3 Rs." Ghetto youths were encouraged to stay in school by generous federal allotments of personal computers for inner-city classrooms. Ghetto jobs were encouraged by avoiding recessions, by elimination of the minimum wage and by a national identity card system to control competition for jobs by illegal aliens.
Also disturbing was growing evidence that a Japanese management takeover seemed to be the best way to boost an American factory's productivity, making officials doubt the superiority of U.S. business executives and graduate business education. As officials developed new corporate tax rules, they designed special breaks for firms that introduced profit-sharing bonus payments, greater in-plant worker-manager equality, and other hallmarks of Japanese industrial relations.
The administration saw through the media hysteria about inflation, the public was less bothered by inflation itself than by 1) the squeeze on real earnings imposed by the 1974 and 1979 oil price hikes, and by 2) the costs that inflation needlessly imposed through tax rules that soaked savers and rewarded borrowers. To cope with 1), a heavy tax was levied on oil imports to raise U.S. gasoline prices toward European levels, thus reducing oil demand and putting downward pressure on the OPEC oil price. The proceeds of the oil import tax were used to bribe the states to reduce their retail sales tax rates, thus minimizing its inflationary impact. To cope with 2), the tax reforms designed to encourage saving, including the shift to a progressive consumption tax, and the reform of interest deductions, had the side benefit of reducing the costs of inflation.
The tax reform and training subsidies were accomplished without a budget deficit, an apparent miracle that was achieved not just by avoiding a tight-money recession, but also through reform of Social Security financing that gradually increased the eligibility age from 65 to 68. Cost-of-living adjustments in Social Security benefits were omitted for one year to offset the mismeasurement of inflation by the consumer price index between 1977 and 1981. Defense preparedness was improved without a massive spending increase by the new administration's refusal to fund the B1 bomber, MX missile and other strategic programs of dubious value, and by a vigorous campaign against damn-the-cost weapons procurement.
Overall, the share of government spending in GNP was held constant, while tax rates were set to yield a surplus at a 6 percent unemployment rate. The Federal Reserve was instructed to keep the unemployment rate from rising above 7 percent, but to prevent it from falling into the "danger zone" below 6 percent, to avoid the acceleration of inflation that had occurred in 1964-69, 1972-73 and 1978-79. An unemployment rate below 6 percent could not be achieved by monetary expansion, but had to wait for the long-run payoff of training and education programs aimed at reducing the perennial mismatch between job requirements and the capabilities of unemployed individuals.
Compared with the Center Party's program, Reaganomics seems stunningly misdirected in almost every aspect, from its caveman monetary policy, to its gold-plated defense budget, to its disregard for the long-run payoffs of training and education. We still await the new broom of a politician who will sweep away the liberal and conservative dogmas of the past, as well as the damage inflicted in 1981-82.