Historians/History

Review of Thomas E. Hall's The Rotten Fruits of Economic Controls and the Rise from the Ashes, 1965-1989 (University Press of America, 2003)

by J. Pete Ferderer

Mr. Ferderer is Associate Professor of Economics at Macalester College. His current research focuses on early twentieth century financial markets and herding among macroeconomic forecasters. Recent publications include: "Institutional Innovation and the Creation of Liquid Financial Markets: The Case of Bankers' Acceptances, 1914-1934," Journal of Economic History 63(3) September 2003). 666-94.

What caused the United States economy to be so unstable between 1965 and 1982 and why did it stabilize after 1982? For Thomas E. Hall, Professor of Economics at Miami University, the answer is clear: "an unprecedented number of policy errors" (p. 1) caused the pre-1983 instability. Once policy became more enlightened -- i.e., relied more on market forces and embraced monetarist principles -- inflation was wrung out of the system, the economy stabilized and the stage was set for the "greatest supply-side economic expansion since the 1920s" (p. 237).

At its core, The Rotten Fruits is about "the evolution of macroeconomic thinking, and how people learn (albeit slowly) from past mistakes" (p. 16). This is an important story and Hall does an excellent job telling it.

At the macro level, the biggest mistake was the belief -- promulgated by Robert Solow, Paul Samuelson and others -- that the Phillips curve represented a stable and exploitable trade-off between unemployment and inflation. Armed with Gordon's (2000) potential GDP series (and 20-20 hindsight), Hall shows that the Fed's attempts to exploit the Phillips curve were often mistimed and created a wage-price spiral that proved costly (i.e., the deep 1982-83 recession) to tame.

According to Hall, other macro mistakes were committed. The Bretton Woods system of fixed exchange rates led to balance of payments crises because it did not embrace "the reality of the marketplace" and "was ultimately a costly experiment whose burial created the opportunity for a new era of free trade and growth" (p. 56). Moreover, the "credit view mind-set" (p. 62) embraced by Arthur Burns and William Miller (Fed Chairmen from 1971 to 1979) caused them to overlook that: a) inflation was largely a monetary phenomenon, b) lower interest rates in the short run can lead to higher rates in the long run as expected inflation rises, and c) interest rate targeting makes monetary policy procyclical. As a result, the low interest rate policy begun under Burns blew up in Miller's face in the late 1970s.

However, macro mistakes alone cannot explain the instability of the 1970s and one of the true achievements of The Rotten Fruits is to show how the interaction between these macro errors and an array of regulatory mistakes is an essential part of the story.

The Glass-Steagall Act of 1933 is a case in point. It was motivated by the belief -- now widely discredited -- that competition between banks for deposits caused the banking crises of 1930-33. As a consequence, Regulation Q established maximum interest rates banks could pay on deposits. This did not create a problem as long as market rates remained low. However, when failed attempts to exploit the Phillips curve caused inflation to ratchet up beginning in the mid-1960s market rates rose above the Q ceilings, causing widespread disintermediation out of banks and thrifts. Consequently, home building collapsed and the business cycle became more volatile.

An area where the interaction between macro and micro mistakes proved particularly combustible was the energy market. Quotas on imported oil in the 1950s and 1960s made the U.S. dependent on foreign producers (the "drain America first" policy, p. 120) and caused exporters (i.e., Venezuela) to retaliate by forming OPEC. In turn, OPEC's ability to form a cartel was strengthened between 1970 and 1973 as: (a) price controls encouraged (discouraged) domestic consumption (production), (b) a monetary-driven boom caused excess capacity in oil production to dry up, and (c) dollar depreciation lowered the real value of OPEC's oil revenues. Thus the energy crises of the 1970s "largely resulted from misguided policies carried out in the United States" (p. 128).

This is an important claim because it challenges conventional wisdom that the oil shocks were driven by exogenous political events in the Middle East. Hall's use of the historical record to make the case is persuasive and macroeconomists are starting to listen (see Barsky and Kilian [2004]). Clearly, this is an issue that cannot be settled with calibration exercises or VARs.

Although free market economists had been opposing these policies for years, it took the 1970s morass to trigger a "genuine intellectual revolution" (p. 235). A true testament to the power of ideas is that the deregulation movement it spawned was a bipartisan effort that began under President Ford and picked up steam during the Carter Administration.

One important outcome of this revolution was the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980. By eliminating Regulation Q and allowing thrifts to diversify, Hall argues that the Act stabilized the financial system and "dampened the homebuilding cycle" (p. 177). However, providing a pretty balanced assessment, he does acknowledge DIDMCA's role in the savings and loan crisis of the 1980s, referring to it as "one of the genuine disasters of the 1970s and 1980s deregulation movement" (p. 178).

There are several heroes in Hall's account. Milton Friedman and Edmund Phelps "revolutionized the way economists think about economic policy" (p. 29) by pointing out that the Phillips curve was unstable and developing the natural rate hypothesis. Paul Volcker is also exalted for being "the principal architect of monetary policies that broke the trend of rising inflation" and having the "strength of character" to stick with tight monetary policy when the going got tough (p. 166). Ronald Reagan, like Volcker, recognized that inflation was a monetary phenomenon and admonished Americans to "stay the course" (p. 229). According to Hall, the post-1982 expansion would not have been possible without first breaking the back of inflation and eliminating its growth-reducing distortions (e.g., portfolio shifts toward gold and real estate and away from stocks and bonds; reduced R&D spending due to high discount rates). Reaganomics mattered, but primarily through demand channels (government and investment spending).

The Rotten Fruits has its flaws. It could have presented a more nuanced discussion of the financial market regulation that emerged from the 1930s (e.g., the problem of asymmetric information and the role of the Securities and Exchange Commission). Hall's criticism of Bretton Woods largely ignores the historical circumstances which made this institution necessary and his discussion of macro stabilization policy masks the true complexity of this endeavor. Finally, the book runs out of steam toward the end when Hall attempts to make the case that the technology boom of the 1990s was a legacy of Reaganomics.

These criticisms are not meant to diminish the overall value of The Rotten Fruits. Hall does an excellent job of telling an important and controversial story and I am excited to share it with my students next fall.

References:

Barsky, Robert B. and Lutz Kilian. "Oil and the Macroeconomy since the 1970s," forthcoming in the Journal of Economic Perspectives, 2004.

Gordon, Robert J.Macroeconomics, 8th edition (New York: Harper-Collins, 2000).
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This article first appeared on H-Net.