BOOK REVIEW

The Great Inflation and its Aftermath
by
Robert J. Samuelson

FUTURECASTS online magazine
www.futurecasts.com
Vol. 11, No. 8, 8/1/09

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Chronic inflation:

 

 

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  It took inflation two decades from 1960 to rise from 1.4% to 13.3%, and about two more decades to decline to 1.6%. There were profound impacts both on the way up and the way down, not just on the U.S. economy, but also on its politics, society and international affairs. Few people today appreciate these impacts, and most people don't even think about it any more.
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The business cycle turned vicious with interest rates, price inflation and unemployment all rising to double digit peaks before it was over.

 

As price inflation declined in the 1980s and 1990s, interest rates declined, unemployment rates declined, the business cycle was greatly moderated and stock prices pushed persistently higher. The nation enjoyed two decades of increasing prosperity and international influence highlighted by victory in the Cold War. 

  In "The Great Inflation and its Aftermath: The Past and Future of American Affluence," Robert J. Samuelson explains the political and societal forces that generated the government policies that caused the Great Inflation and discusses the continuing economic impacts of such forces today.

  "It's impossible to decipher our era, or to think sensibly about the future, without understanding the Great Inflation and its aftermath."

  The Great Inflation was profoundly destabilizing, Samuelson emphasizes. The business cycle turned vicious with interest rates, price inflation and unemployment all rising to double digit peaks before it was over. Public confidence in its leaders and government collapsed. It made Ronald Reagan's election possible.
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  By successfully reining in inflation - by "disinflation" - all of these miseries were reversed. As price inflation declined in the 1980s and 1990s, interest rates declined, unemployment rates declined, the business cycle was greatly moderated and stock prices pushed persistently higher. The nation enjoyed two decades of increasing prosperity and international influence highlighted by victory in the Cold War.  Under U.S. leadership, globalization spread prosperity broadly around the world to all nations participating in globalization, NATO spread security in Central Europe, EU expansion promoted democracy and capitalism among European spin-offs from the Soviet bloc, and troubles in the Balkans, the Middle East and elsewhere were contained.

  "Paradoxically, this prolonged prosperity also helped spawn complacency and carelessness, which ultimately climaxed in a different sort of economic instability and the financial turmoil that assaulted the economy in 2007 and 2008."

  There are disturbing similarities between current conditions and those of the early 1970s. Samuelson questions whether the nation has the self-discipline to avoid another Great Inflation. He reminds us of how the inflationary conditions of the 1970s were generated.

  "Our acceptance of present pain was so slight that it led not to future gain but to ever-greater doses of future pain. Inflation rose; recessions got worse. In their early phases, the social and economic costs of inflation are not immediately apparent. Indeed, the first effects are often pleasurable. People and firms believe their incomes are higher. They suffer 'money illusion' -- the mirage that higher wages, salaries and profits signify real gains in purchasing power, when in fact they reflect only the deceptive side effects of inflation. By the time people awaken to reality, inflation has secured a strong beachhead in wage and price behavior that can be reversed only with difficulty. Inflationary psychology and an upward wage-price spiral have taken hold."

  FUTURECASTS has been explaining these aspects of inflation and the Great Inflation period of the 1970s for more than a decade already.

Only government can expand the money supply sufficiently to generate chronic price inflation.

 

Before the triumph of Keynesian concepts, the Korean War was fought without substantial chronic inflation.

 

"This inflation was a self-inflicted wound."

  Inflation is always caused by government. Only government can expand the money supply sufficiently to generate chronic price inflation. The Great Inflation was caused by the greatest domestic policy blunders since WW-II, and the federal government is now at risk of repeating them.
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  Samuelson acknowledges that the Vietnam War played some role in generating the Great Inflation, but he minimizes the economic impacts of the war and the related budget deficits. After all, before the triumph of Keynesian concepts, the Korean War was fought without substantial chronic inflation.
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  Samuelson correctly discounts the "oil shocks" as primary causes of the Great Inflation. He correctly identifies the primary culprit. "The main villains were our own poor economic policies."

  "America's most protracted peacetime inflation was the unintended side effect of economic policies designed to reduce unemployment and eliminate the business cycle. This inflation was a self-inflicted wound that resulted from collective hopefulness and intellectual overconfidence."

  In fact, the oil shocks could not have occurred in the absence of the previous decade of monetary inflation that was undermining the purchasing power of the dollar. With monetary inflation being determinedly employed to keep real interest rates near or below zero, oil in the ground was worth more than oil produced.

The Keynesians blamed the electorate - the people. The U.S. was 'ungovernable," they lamented.

  Some of the economic and social impacts of rapid inflation are summarized by Samuelson.

  "[Inflation] destroys both the economy and public trust. Private virtues -- hard work, saving, planning ahead -- are neutralized, because savings can be rendered worthless and hard work becomes pointless when pay depreciates so rapidly in value. People devote more time to spending their earnings quickly -- as opposed to working and producing -- before the paper money becomes entirely useless."

  Keynesian economists denigrated inflation worries, asserting that inflation could always be readily controlled. They didn't want fear of inflation to obstruct the aggressive use of budget deficits and monetary inflation to stimulate the economy.
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  By the end of the 1970s, however, the Keynesians were forced to admit that inflation could only be controlled by policies of austerity severe enough to cause a severe recession. So severe was this prospect that they despaired of getting the public to accept the economic pain involved. The Keynesians despaired of finding politicians willing to spend the political capital to support austerity. They thus implied that government and its Keynesian economic policies were not to blame. The expectations of continued increases in economic prosperity were to blame. They blamed the electorate - the people. The U.S. was 'ungovernable," they lamented.

  "But in the end, these theories were not so much explanations of the country's mood as excuses not to do anything about inflation, and the point at which they became less believable was the 1980 election."

High inflation meant high unemployment and low productivity growth. Most important, interest rates rose and fell with inflation rates, albeit with a time lag.

 

We are today repeating many of the mistakes of the 1960s and 1970s.

  Ronald Reagan had the courage to spend political capital. Federal Reserve chairman Paul Volcker was able to restrict money growth and put the nation through the 1980-1982 depression because Reagan provided the essential political support. By 1984, Reagan was easily reelected on a wave of returning public optimism.
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  The correlation between unemployment, productivity and inflation rates during the four decades from 1950 is emphasized by Samuelson. Low inflation meant low unemployment rates and high productivity growth. High inflation meant high unemployment and low productivity growth. Most important, interest rates rose and fell with inflation rates, albeit with a time lag.
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  The many pervasive, noxious economic impacts of inflation are summarized by Samuelson. There were frequent and increasingly vicious and lengthy economic recessions, there was the collapse of the savings and loan banks, boom and bust on the farms, the third world debt crisis (presided over by Robert McNamara as president of the World Bank in his usual cock-sure but totally inept manner), and a 16 year period from 1966 of range-bound stock prices that were actually falling rapidly behind the pace of inflation.
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  As inflation declined after 1980, on the other hand, there were many pervasive virtuous economic impacts. Interest rates declined, unemployment declined, the business cycle was greatly moderated, the stock market doubled and doubled and doubled again in "real" inflation adjusted terms. Ultimately, however, confidence became overconfidence and economic expansion became economic and financial bubbles. There were, of course, a multitude of factors involved in these events, but the rise and fall of price inflation rates were by any measure among the most significant.
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  Yet most economic and political history today tends to minimize the role of inflation during the post WW-II period. This absent-mindedness is dangerous, Samuelson points out. We are today repeating many of the mistakes of the 1960s and 1970s.
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Economists are loath to remind the public of the immense damage that they caused.

 

Economists have generally declined to write for the public about the economic history of the Great Inflation and their role in it.

 

Whether your policies caused the Great Inflation or combated it by causing the 1980-1982 depression, there is no incentive to dwell on it.

  It was the containment of inflation, not the marginal increases and decreases in taxes, government spending and deficits, that was primarily responsible for the increasingly prosperous two decades of the Great Moderation after 1982. Lower tax rates and declining deficits helped, but were not decisive. The containment of inflation was the "major economic event of this period." And this change was world wide.
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  One reason for this determined memory lapse is professional embarrassment. Economists are loath to remind the public of the immense damage that they caused. Historians write mainly political, social and military  history. They highlight Vietnam and oil embargoes, tax policy and budget policy. Economics baffles them so they generally just note major economic events without explanation or economic context. Economists have generally declined to write for the public about the economic history of the Great Inflation and their role in it.

  "At its base, double-digit inflation was their doing. It resulted from bad ideas that -- promoted by many leading economists and converted into government policies -- produced bad results. There is now a widespread recognition of this, and although there are many technical studies of inflation and of the period of high inflation, there has not been much in the way of public apologies -- from those who were complicit in the error -- or reprimands -- from those who were not, because they either dissented or were too young --. There seems to be an unspoken pact of self-restraint to let bygones be bygones, perhaps out of collective embarrassment or a recognition that dwelling excessively on past failures might compromise economists' prospects as government advisers and high-level appointees."

  Moreover, we are still too close to these events. Political and ideological biases color current history. Political memoirs give the Great Inflation short shrift. Whether your policies caused the Great Inflation or combated it by causing the 1980-1982 depression, there is no incentive to dwell on it. "History skimps on economics, and economics skimps on history."
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Keynesians:

 

 

 

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  The triumph of Keynesian economics during the Kennedy and Johnson administrations started the ball rolling downhill. Kennedy brought Keynesian economists into his administration, and they entertained no doubts about the effectiveness of Keynesian policies.

  Samuelson explains the intellectual background of the Keynesian ideological triumph. His explanation contains a few dubious assertions, but is adequate for the purposes of this book.

The Keynesians assured everyone that government could "obsolete" the business cycle. Periods of high unemployment would not be tolerated. With the advent of the Nixon administration, Republican and well as Democratic politicians recognized high employment levels as more important than price stability.

  At first, everything went according to plan.  A big tax cut boosted economic growth and reduced unemployment to 4% in 1965. Moreover, there was no increase in price inflation.

  The dollar was still pegged to gold during the 1960s. The inflationary pressures could thus be fended off by sales from the nation's large but rapidly declining gold reserves. These substantial benefits of the gold standard were widely ignored and even disparaged. Samuelson, too, ignores them.

  The widespread acceptance of Keynesian concepts meant that politicians would henceforth have intellectual support for taking credit for prosperity, but would not be able to avoid blame for economic contractions. After all, the Keynesians assured everyone that government could "obsolete" the business cycle. Periods of high unemployment would not be tolerated. With the advent of the Nixon administration, Republican and well as Democratic politicians recognized high employment levels as more important than price stability.

  "The result of this mind-set was that the same mistakes were repeated for fifteen years. Inflation was underestimated; policies to 'stimulate' the economy -- tax cuts, budget deficits, easy money -- were overused; and wage-price controls, either 'voluntary' or mandatory, were seen--despite constant failure--as a reasonable way to reconcile 'full employment' with low inflation. Wishful thinking triumphed. People believed what they wanted to believe."

  By 1966, inflation at 3.5% was being determinedly ignored by the Johnson administration. A tradition of underestimating future inflation levels began and continued throughout the 1970s. Economic policy failures were determinedly ignored. When price inflation reached crisis levels and could no longer be ignored, it became a matter of crisis management.

  "Most presidents' first impulse was to prevent inflation from frustrating other goals -- including 'full employment' --, not to sacrifice other goals to suppress inflation. The result was that these presidents did not devote to inflation the time or rigor required to develop an independent judgment as to what could or should be done. Instead, they went along with what seemed most convenient."

Nixon responded with wage and price controls and the abandonment of the dollar peg to gold. This freed the Federal Reserve to attack unemployment with aggressive monetary expansion in preparation for the 1972 election.

  Johnson didn't intend to let inflation - or Vietnam - get in the way of his Great Society ambitions, so he kept trying to push them both onto the back burner. Unfortunately, they wouldn't stay there. For Nixon  and Carter, inflation was just "an annoying distraction" that kept getting in the way of their domestic and foreign affairs agendas.
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  Inflation hit 6.2% in 1969. It only dropped to 5.6% during the mild 1970 recession even though unemployment surged to 6%.  The high unemployment exposed Nixon to political attack by the Democrats, so Nixon responded with wage and price controls and the abandonment of the dollar peg to gold. This freed the Federal Reserve to attack unemployment with aggressive monetary expansion in preparation for the 1972 election.
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  Economists, Democrats and many Republicans, the business community, and the public as well, applauded. Nixon won a landslide victory in 1972. Keynesianism was triumphant throughout the nation.
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Keynesian stimulation as always stimulated nothing but higher inflation, higher interest rates, higher unemployment, and greater economic instability.

  However, controls as always quickly became unmanageable and had to be removed. With the lid off, price inflation surged to double digit levels. Carter learned nothing from this episode and determinedly refused to confront his inflation problems until they approached 15%. Unemployment was still stubbornly high at 5.4% when he took office. Government economists assured him that a Keynesian stimulus program of accelerated monetary expansion and deficit spending would push inflation no higher that 5.8%. Keynesian economists from both political parties and the business community supported this view. However, 1978 saw 9% inflation - and 6% unemployment. Keynesian stimulation as always stimulated nothing but higher inflation, higher interest rates, higher unemployment, and greater economic instability.
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  Only Gerald Ford determinedly grappled with inflation during this period - at the cost of the severe 1974 recession and 9% unemployment. He brought inflation down from 12.3% to under 5%, and the economy was beginning to recover by 1976, but politically it was too late. He was rewarded by the public with electoral defeat in 1976.

  "But it is misleading to blame individuals, when the real source of error lay in prevailing doctrines. It was the power of ideas that ordained failure, not the shortcomings of individuals. All these presidents and their advisers embraced the same basic concepts that, despite modest differences and disagreements, inevitably led them to make bad decisions in the name of a good cause. Different people adopting the same ideas would have ended up in virtually the same place. For the political logic of the 'new economics' virtually guaranteed inflation that would, almost automatically, become too great to be halted painlessly."

  It was reducing unemployment that was the political imperative.

  "The fact that unemployment tended to decline before inflation rose -- reflecting a 'lag' between tight labor markets and higher wages -- only made the policy more hazardous. The obsession with lowering unemployment meant that, even if there had been no Vietnam War or oil price explosion, there would have been high inflation. The outcome was built into the system."

  However, the politicians were in fact primarily to blame. The reason why Keynesian concepts triumphed was because the politicians loved being told they could deficit spend and employ monetary inflation, so they hired Keynesian economists despite the patent ridiculousness of Keynesian theory. See, Keynes, "The General Theory, "Part I, "Elements of the General Theory," and Part II, "Interest Rates, Aggregate Demand & the Business Cycle." Ultimately, this supported Keynesian domination of the academic field as well. Politics and the lure of political appointments corrupted the entire academic field.

  Economists kept hunting for the point along the "Phillips Curve" for the optimum tradeoff between inflation and unemployment. However, the Phillips Curve was just another Keynesian illusion. Rising rates of inflation, after an enticing lag, always cause higher unemployment. Samuelson provides an explanation by Milton Friedman for how inflation causes higher unemployment (but this explanation just scratches the surface of all the noxious economic impacts of inflation).
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  By the end of the 1970s, inflation was at double digit levels even though unemployment was rising. Misguided by an intellectual community in thrall to ridiculous Keynesian concepts, there was widespread public and political despair that inflation could ever be controlled.

  "Government wouldn't suppress it, because doing so would involve large, politically unacceptable social costs--higher unemployment, lower incomes and profits. As long as people believed this, meaning as long as they harbored high inflationary expectations, they would act in ways that made an acceleration of inflation self-fulfilling. Workers would seek wage increases compensating for past inflation, plus a little more, and companies would meet these expectation, because they believed they could pass the higher labor costs along in higher prices. Inflation would feed on itself, and if government permitted it by creating ever-larger amounts of money, it would be unstoppable."

  There is no such thing as "cost-push" inflation. Even "demand-pull" inflation is a misleading half-truth since in omits the monetary expansion that causes the increase in demand. There is no such thing as "wage-push" inflation.
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  These concepts are just some more Keynesian myth adopted to deflect blame away from Keynesian policies of budget deficits accommodated by monetary expansion. Chronic inflation is ALWAYS a monetary phenomenon. It begins - albeit with a misleading time lag - with monetary inflation and can continue only so long as the deflationary impacts of price increases are offset - "accommodated" is the misleading term used by economists - by monetary inflation. It is the Keynesian policy of monetary inflation - not the wage demands of labor or rising costs of production or rising demand from consumers - that causes chronic inflation. See, "Understanding Inflation."

  As Samuelson accurately points out, it is a "truism that all major inflations involve 'too much money chasing too few goods.' America's worst peacetime inflation occurred because the government, through the Fed, created too much money."
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  However, this is actually only part of the story. Fed Chairman Arthur Burns and most of the Fed had become enthusiastic Keynesians. They were willing participants in the grand experiment of using monetary expansion to manage the economy and reach higher employment levels.
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  Samuelson explains Fed "monetary policy. (See, "Friedman & Schwartz, "Monetary History of U.S." Part III, "The Age of Chronic Inflation (1933-1960)."  and Meltzer, "History of Federal Reserve, Part III," The Engine of Inflation (1933-1951).") The Keynesian belief was that as long as the economy had "ample slack -- meaning unemployed workers and spare industrial capacity," it could not generate price inflation. (We hear this same song again today.) Supply would be able to expand to meet extra demand created by monetary expansion. Neither "wage push" nor "demand pull" inflation would occur.
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  Samuelson blames two errors for the failure of this policy. He asserts that the "full employment" rate was thought to be between 4% and 4.5% when it was really about 6%, and that productivity growth was thought to be 2.5% to 3% when it was only about 1%.

  Samuelson here mistakes cause and effect - a common failing in economic analysis given the endless chains of cause and effect. The 6% "full employment" rate and 1% productivity growth rate were not natural limits that caused inflation. It was inflation that reduced productivity growth to 1% and rendered unsustainable unemployment rates below 6%. Indeed, even 6% unemployment and 1% productivity growth became unsustainable because of inflation.

  Thus, Samuelson becomes an apologist for Keynesian policy failures. The policies weren't wrong, they were just applied too aggressively as the Fed tried to fulfill popular wishes and political agendas.
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Monetary history:

 

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  A brief history of U.S. monetary history is provided by Samuelson. (See, the three articles beginning with Friedman & Schwartz, "Monetary History of U.S." Part I, "Greenbacks and Gold," and the three articles beginning with Meltzer, "History of Federal Reserve," vol. 1, Part I, "The Search for Monetary Stability (1913-1923).")

  Samuelson believes the monetarist myth that a lack of aggressive Fed monetary expansion "permitted" the Great Depression. It is true that the Fed played a significant role in that vast tragedy, but those errors were only part of the story - and at no point were even the most significant part. The Fed could definitely have mitigated some of the impacts of the Great Depression in several ways, but could never alone have prevented it or even materially shortened it.
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  The limits of aggressive monetary policy can be seen again during the Credit Crunch. Aggressive monetary policy - indeed more than a doubling of the basic money supply along with two trillion dollars in budget deficits - failed to avoid the Credit Crunch economic contraction and is failing to materially shorten it. It will continue until the fundamental cause - the housing inventory bubble - is sufficiently  liquidated by market forces. Throwing vast sums of money at the problem does no more than mitigate some of its impacts and must leave a residue of problems that will constrain the recovery. See, Great Depression: "Summaries of Controversies and Facts: The Great Deception."

  The abandonment of the gold standard set the stage for the Great Inflation.

  "The gold standard was hardly ideal. Had it remained, the U.S. economy and those of other countries would probably have fared worse after World War II than they did. Growing economies need more money and credit. The gold standard limited money and credit, reflecting the metal's rigid and unpredictable supply. But this vice was also, to some extent, a virtue. It imposed limits on money and credit creation that prevented runaway inflation. The removal of these limits created an entirely new situation, requiring new understandings and obligations. Inflation would no longer control itself. It had to be controlled--and so the ideas, beliefs, motives and behavior of people charged with controlling it mattered. They had to understand why preventing it was important and that it was their job to do so. These responsibilities got lost."

  Determined ignorance of economic realities led to repeated efforts to control price inflation by means of price and wage controls. The myth that controls worked during WW-II was widely believed (and is still believed by some even today). Price and wage controls - administered alternatives to market prices - are actually impossible. 

  This is something the Securities and Exchange Commission proved back in the 1960s, but which is generally determinedly ignored by the rest of the government. See, Administered Prices & Health Care." at segment on "The SEC studies."

  Like the mad scientists in Gulliver's Travels, political leaders and their Keynesian economists followed failure after failure with one repetitive attempt after another. Samuelson's account of the varying rationalizations used to support these doomed efforts is both comic and a sad reflection on the economic ignorance of the nation's leaders and of the electorate that accepts their excuses. These efforts did give the appearance that government was doing something about price inflation, and so were repeated to sooth public ire during election years.

  "Indeed, all the programs of wage and price restraints actually made matters worse by obscuring the essential nature of inflation. The deplored behavior of wage and price increases of firms, unions and workers were not themselves the cause of inflation. They were not spontaneous and independent events--as they were often portrayed--reflecting economic power, selfishness or self-interest. They were, rather, the consequences of lax money and credit policies, centered at the Federal Reserve. Companies and workers were merely defending themselves against and, in some cases, exploiting an inflation that was not of their own making."

  Wage and price controls designed to restrain price increases are inherently inflationary. They do nothing to restrain demand and do nothing to encourage production.

Austerity - with restraints on both spending and monetary growth - and the severe economic contraction that austerity brings - has always been and remains the only remedy for established price inflation.

  Everyone was looking for an easy escape from inflation. (Unfortunately, none has ever been found in the 2,500 years of monetary history.) Austerity - with restraints on both spending and monetary growth - and the severe economic contraction that austerity brings - has always been and remains the only remedy for established price inflation.

  "By the late 1970s, the Fed had maneuvered itself into a political and intellectual cul-de-sac. The advent of fiat currency had transformed its chief responsibility into guarding the stability of the nation's currency. Yet both the public at large and the nation's political leaders saw the Fed as an essential instrument in achieving rapid economic growth and maintaining 'full employment.' The Fed had adhered to economic doctrines that promised to accomplish both these goals, but in practice, it was achieving neither. There seemed to be no way out, and there wouldn't be until both economic ideas and political objectives changed."

Volcker and Reagan:

  Paul Volcker and Ronald Reagan provided the necessary leadership. They grabbed hold of the nation's economic history and changed its course. Their alliance was implicit rather than explicit, but it held fast.
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  Volcker bludgeoned the economy with monetary austerity, and Reagan expended the political capital needed to give him political cover. Samuelson provides many of the specifics.
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  Prime interest rates soared to 21.5%. Industrial production plunged 12% in little more than a year from the middle of 1981. Unemployment hit 10.8% by late 1982. It was the worst economic contraction since the Great Depression. It was truly a small "d" depression. Along with extensive deregulation, the 1980-1982 depression knocked the stuffing out of inflation. Price inflation declined from 11.8% to 3.7%. In 1983, it declined to 0.6%.
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  Samuelson asserts convincingly that no other potential president, Democratic or Republican, would have stood the political heat. Reagan was truly the man for the moment. Politicians from both parties, along with the liberal press and a wide variety of interest groups howled in pain and called for Volcker's head, but Reagan's support for Volcker remained unflinching. Even as unemployment surged into double digits, inflation remained his "number one enemy," and he continued to express confidence in Volcker.

  "Both men believed, mostly as a matter of faith, that high inflation was shredding the fabric of the economy and of American society. The country could not thrive if it persisted. Buttressed by these beliefs, they broke with the past. Each had a role to play, and each played it somewhat independently of the other."

  This belief was more than just a "matter of faith." It was knowledge based on 2,500 years of monetary and economic history.
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  Rather than being unstoppable, history demonstrates that inflation is always ultimately stopped. The obvious reason is that, despite the very real pain of austerity, the pain of inflation becomes worse - indeed, unbearable. Moreover, austerity at least promises better days ahead, while inflation is unending and persistently worse over time until austerity is finally accepted. It is another economic myth that society can "live with inflation." If inflation continues unchecked, it destroys nations and societies.

  "Reagan counted, because the Fed needed political protection. One threat to Volcker's policies was congressional action forcing the Fed to relent. Like any bureaucracy, the Fed tries to placate its adversaries, sometimes by giving ground to them. The paradox: To safeguard its independence, the Fed may sacrifice its independence."

Reagan understood that inflation had to be contained at any cost, that it was a monetary phenomenon, that regulatory control was impossible, and that Volcker was competently doing what had to be done.

  The political backlash became vicious. All manner of ham handed bills were introduced in Congress to impose explicit political controls on the Fed and dictate monetary inflation. Reagan stood fast, even as his popularity polls declined to 35%. He matched Volcker's monetary actions with tax cuts and substantial cuts in discretionary spending. He understood that inflation had to be contained at any cost, that it was a monetary phenomenon, that regulatory control was impossible, and that Volcker was competently doing what had to be done.
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  Volcker had been chosen as Fed chairman in 1979 because Pres. Carter couldn't get any of the other qualified alternatives to preside over his inflationary mess. Volcker quickly decided to decelerate the growth of the money supply. The low - and  frequently negative - "real" inflation adjusted interest rates of the 1970s would no longer be tolerated. Interest rates immediately surged higher into double digit levels.
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  Samuelson relates the technical complications and uncertainties that bedeviled this effort. The modern definition of "money," after all, is not that definitive. The politics of the 1980 election year intruded. The credit controls that Carter initiated were a disaster. Controls and other administered alternatives to market mechanisms always seem so easy in contemplation, and always fall apart under an avalanche of unintended consequences. Congress, with its usual brilliance, attempted to block the incoming tide. It issued warnings that the effort to curb inflation must not cause recession. By the second quarter of 1980, the economy was in a depression. "To succeed against entrenched inflation, policies had to be harsh."
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The resulting economic contraction was the worst since the Great Depression.

  Even Volcker had to bend to political realities - especially during an election year. He responded to the economic contraction of the second quarter with a rapid spurt in the money supply. The economy rebounded through the election period - and so did inflation. This economic rebound was completely artificial and unsustainable. (Many economists stupidly consider these two quarters as a period of real economic revival, and it is so presented by the Business Cycle Dating Committee of the National Bureau of Economic Research. ) In November, 1980, having lost a year in the effort, Volcker again tightened the monetary screws. The resulting economic contraction was the worst since the Great Depression.
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  Public and political pressures against Volcker and the Fed were fierce. Samuelson describes the economic pain, ruined plans and lives. (He does not do nearly so good a job in describing the economic disruptions and pain of double digit inflation.) The economic contraction was considerably deeper and longer than expected.
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  By mid 1982, there was fear of a full fledged financial collapse. There were increasing doubts at the Fed. However, monetary progress became apparent in July, and the Fed took the opportunity to ease somewhat. Discount rate cuts came in steady succession, inflation was down to 3.8% by the end of 1982, and economic growth began in early 1983. The stock market responded vigorously, beginning an historic 18 year bull market run.
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How can the political system "take actions though immediately painful and unpopular, seem essential to the society's long term well-being."

  This was just in time in several ways. 1984 was a presidential election year, and the Fed had to have progress to show for the pain of its austerity program. The Democrats were strengthened by the 1982 congressional elections, and a liberal Democratic Congress could turn ugly.

  "[The] taming of inflation reinvigorated the economy as nothing else; the expansion lasted from early 1983 until the late summer of 1990. At the time, it was the second longest peacetime expansion in U.S. history. The Volcker-Reagan campaign discredited many of the ideas that had misgoverned national economic policy for nearly two decades. The notion  that the Federal Reserve couldn't control inflation was discredited. The notion that a little less unemployment could be exchanged for a little more inflation was discredited. In their place, a consensus slowly developed that 'price stability'--a vague term that both Volcker and his successor, Alan Greenspan, defined as inflation so low that it barely affected people's decisions--was desirable and would promote a more stable and productive economy."

  Reagan and Volcker launched a frontal attack on a predominant problem of democratic governance. How can the political system "take actions that, though immediately painful and unpopular, seem essential to the society's long term well-being."
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  It takes real leadership. For two decades, no other administration and Fed leadership had been able to square this circle. By their courage and determination, they permitted the economy to stabilize and resume sustainable growth, and restored American confidence in its leaders and government.
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Capitalist markets brought a flood of opportunities and material benefits, but also imposed the risks of the market. Competition imposed its discipline and direction on an unruly economic world. It was hardly perfect, but it was always far more effective than any administered alternative.

  The economy was not just freed from inflation. Deregulation - begun towards the end of the Carter administration - introduced competition into major industries such as the railroads, trucking, phone and airlines with rapid improvements in productivity and massive benefits for consumers. Globalization broadened both competition and opportunities, undermining pricing power and rent seeking by large corporations and their unions in such industries as steel, automobiles, machine tools, televisions, clothing, with additional major improvements in productivity and benefits for consumers.
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  The capitalist economic system was rejuvenated. The dollar strengthened, the United States regained world leadership, and Evil Empire and socialist autocracies collapsed throughout the second and third worlds. Samuelson explains how a strong U.S. economy with a strong dollar facilitated globalization and widespread prosperity.
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  With the collapse of utopian illusions ranging from socialism to a benevolent "mixed economy" and the entitlement welfare state, capitalist markets brought a flood of opportunities and material benefits, but also imposed the risks of the market. Competition imposed its discipline and direction on an unruly economic world. It was hardly perfect, but it was always far more effective than any administered alternative.

  "Contrary to much commentary, government's size did not shrink in the new economic order. Government regulation remains pervasive. But there was a shift in its role and in perceptions and emphasis. Government became less ambitious, because people lost faith that new programs could solve all social and economic problems. That was a major political legacy of inflation and the failure to end the business cycle. Ideas changed. This was particularly true of economic policy. At the Fed, Friedman's view that money creation is at the core of inflation became conventional wisdom."

  Price stability - control of price inflation - was recognized as a necessary part of any economic policy.
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The Great Moderation:

  The characteristics of the "Great Moderation," which extended over two decades from the end of 1982, are discussed by Samuelson.
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The old order was based on utopian illusions that were disastrous in execution. The current economic system was not a conscious choice of conservative ideologues and profiteering businessmen. It was a series of essential reactions "to the crippling shortcomings of the old order."

  Competition ruled this world, introducing numerous economic threats and offering glittering opportunities.

  "[The new economic order] has delivered a perplexing prosperity with manifest imperfections. Jobs are more plentiful--but less secure. Living standards are higher-- but incomes are more unequal and less predictable. Business cycles are milder--but financial markets seem more erratic and unstable. Competition has inspired new technologies and products--but has also threatened companies and industries wedded to old technologies and products. The economic adaptability that we admire--the ability to make the most of change--seems to inflict the very insecurity that we deplore. 'Hardly any company is too successful nowadays to consider a large-scale cutback in jobs,' social critic James Lardner has written."

   Critics assert that the previous economy was more humane, morally superior and more concerned with "fairness." However, their views of both the previous economy and the current economy are just caricatures of reality. The old order was based on utopian illusions that were disastrous in execution. The current economic system was not a conscious choice of conservative ideologues and profiteering businessmen. It was a series of essential reactions "to the crippling shortcomings of the old order."

  "The central contradiction was that an economic system premised on change could simultaneously banish change. We would enjoy the gains and avoid the pain. The fact that the ideal seemed to have been realized briefly in the late 1960s, when American companies dominated the world and the U.S. economy was in the midst of a fabulous boom, created the myth--still cherished by some--that the old order was a practical possibility. In fact, this temporary triumph was mostly the result of the first intoxicating phase of inflationary economic policies -- which created the initial boom -- and the lingering aftereffects of World War II -- which eliminated most international competition --. In the 1970s, both props collapsed." (Not just coincidentally, the gold peg prop under the value of the dollar also gave out at this time.)

  No matter how good the current reality, it can never match the "imagined and romanticized version of the old order," much less the impossible utopian alternatives. The two decades of the Great Moderation constituted an extraordinary rebirth of economic prosperity and power for the U.S. Competition made companies and workers far less secure, but the business cycle had never been so mild for so long. Job changes - forced and voluntary - were twice as frequent, but the instabilities of runaway inflation were gone and unemployment levels were several percentage points below previous levels.
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  Economic inequality increased dramatically, but the assertion that "typical living standards have stagnated" is preposterous. 

 "Since 1980, most households have experienced substantial income gains. Vast numbers of Americans enjoy gadgets and conveniences that didn't exist then or barely existed -- computers, cell phones, flat-screen TVs --. Homes got larger. Poverty rates fell. In the 1970s and 1980s, a third or more of blacks routinely had incomes beneath the government's official poverty line. By 2001, that had dropped to 22.7 percent." (It has since risen somewhat, but the poverty line itself has risen considerably.)

  The availability of credit became widespread, but the abuse of credit bred instability among individuals, businesses, nations, and throughout the global economy. Credit fueled the tech boom and supported a wide variety of new businesses, but abuses brought the 1987 stock market crash, the 1997-1998 Asian Contagion crisis, the 2000 tech bust and the 2007-2008 mortgage-backed-securities bubble Credit Crunch.
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  In fact, the uncertainties of flexible labor markets and competitive globalized markets are responsible for rapid productivity growth and the more competitive economy that sustains both prosperity and overall stability. That this vast and complex economy still harbors many weaknesses and abuses is nevertheless inevitable. There are always some in management who abuse credit in constructing houses of cards or are involved in abuse of their position and even outright fraud. Samuelson mentions the spectacular increase in CEO pay, but this is just the tip of the iceberg. (See, Tavakoli, "Dear Mr. Buffett.")

  • Corporate allegiance "no longer counts for so much," but as of 2006, more than a quarter of workers 55 to 64 had put in 20 years or more with their current employer and almost 70% had put in 5 years or more. Workers still value the benefits of an existing job and corporations still value worker experience and capabilities as they reach their most productive period. However, corporations have been driven by competition to adjust to changing conditions often at the expense of some of their workers, and workers feel more free to seek better opportunities elsewhere. About 30% of job changes are voluntary.
  • Corporations no longer shield workers from risks. "The web of formal and informal guarantees that protected many workers from joblessness, steep health care costs and poverty in old age has shredded." However, such protections have never been even remotely universal, and substantial protections still in fact exist for many. Corporations still contribute towards health insurance and pensions. Fear of loss of productive employees provides strong incentives to improve wages, benefits and working conditions. (So do unions or the fear of unionization.)

  Most of the insecurity arises from health care cost inflation, not some reduction in corporate contributions. Nevertheless, an increase in insecurity and the risks of some substantial financial setback are undeniable for both corporations and their workers. Competitive markets are stern taskmasters.

  • There has been a widening of income differences since 1980. However, the figures generally cited are pretax and omit fringe benefits such as health insurance and government non-cash benefits such as food stamps. They are also generally based on "household" income and ignore the substantial changes in the characteristics of "households."

  By 2006, almost 20% of U.S. households had reached the previously exclusive level of $100,000 or more in pretax income. Moreover, there are now far more elderly, divorced individuals, single parents and singles capable of affording their own homes or apartments and thus constituting a "household." Between 50% and 75% of the increase in the household inequality figure has been attributed to such broad social changes.

  "When households are examined by size--that is, by the way people actually live--income gains are larger. From 1990 to 2005, the median household income rose 6.8 percent. But median income rose 10.6 percent for households with three people, 15.8 percent for those with four people and 16.9 percent for those with five people."

  Indeed, less than half the heads of households in the lowest 20% were married. A third were not even meaningfully participating in the economy, so they really shouldn't be counted at all. A large proportion of this lowest 20% is made up of unskilled immigrants. Since 1980, the Hispanic share of all households has increased from 4.7% to 11.2% in 2006. One reason why worker compensation growth looks meager is that 35% of it has been eaten up by the increased costs of health benefits.
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  Measured in terms of access to ordinary material goods and services, all those who engage meaningfully in economic activity have enjoyed substantial gains since 1980. It is envy, not poverty, that modern inequality creates.
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  Of course, this book ends amidst the Credit Crunch in October 2008. Samuelson provides a casual explanation of the Credit Crunch that depends on theory and lacks examination of particulars, and is thus of dubious value. However, he does correctly note that the decline of U.S. economic and financial dominance - manifested in a weakening dollar - can leave the world without a financial leader capable and willing to act in emergencies. The last time this happened was after WW-I when Great Britain was in decline and the U.S. was determinedly unwilling to engage. That period climaxed in the Great Depression and then WW-II.
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Acceptance of creative destruction: 

 Entitlement psychology is a primary danger in this economic world.
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Entitlement psychology arose from the post-WW-II prosperity when all the other major economic powers were in disarray. It arose from the absurd notion of Keynesian economists that the business cycle can be controlled. Creative destruction, and the declining industries, bankrupt companies and lost jobs involved in business cycle contractions, are essential. 

  The business cycle is not just an inevitable part of a prosperous capitalist market economy, it is an absolutely essential factor in that prosperity. But only government policy mismanagement and constraint of essential market mechanisms can change it from a series of modest infrequent contractions of less than three years duration to decade long periods of depression or inflation.

  Economic contractions shift this process into overdrive and sweep the system clean of the houses of cards and fraudulent activities that can otherwise grow to such enormous size and absorb immense resources.

  "Some of our economic desires are at cross purposes, at least partially. We want higher incomes and the 'new and improved' -- the faster computer, the cheaper airfare, the breakthrough medical device. But the very process of 'creative destruction' that brings forth these gains may undermine or demolish the stability and security that we also crave."

The populist threat:

  We enjoy an excellent economic system. It offers an abundance of opportunities and a fair - but not assured - degree of security. Political efforts to improve on this constitutes the greatest threat to its continuation. Samuelson calls this "the curse of good intentions."
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Despite elaborate computer models, economists have a poor record in predicting recessions, interest rates, inflation and productivity trends. If economists can't forecast them, it's doubtful they can accurately foretell the full effects of many proposed changes in government policies.

  Political programs based on good intentions and determined ignorance of economic realities bring the law of unintended consequences into play. The Great Inflation (like the Great Depression) was one result. It can happen again, Samuelson warns.

  "With hindsight, we know that the idea that the economy's adequate, if imperfect, performance could be substantially improved was a pipe dream. The resulting policies not only didn't do what they promised, they actually did the opposite -- led to more, not fewer, recessions; to higher, not lower, unemployment; to slower, not faster economic growth; to more, not less. economic anxiety. What is relevant for our era is that these policies were not undertaken on ignorant whim. Rather, they embodied the thinking of most of the nation's top economists, reflecting a broad consensus among their peers."

  The Keynesian concepts involved were certainly no mere "whim," but they were certainly "ignorant" of economic reality.

  Today, after a quarter century of prosperity, there are still complaints that it is not good enough. Government must protect the middle class, provide universal health care, exorcise corporate greed, control globalization, and even curb global warming. However, government capabilities are more than just a little suspect.

  "Americans' reformist enthusiasms face practical obstacles. When thinking about the economy's future, we ought to acknowledge how little--not how much--we know. Despite elaborate computer models, economists have a poor record in predicting recessions, interest rates, inflation and productivity trends. If economists can't forecast them, it's doubtful they can accurately foretell the full effects of many proposed changes in government policies. Economic models that purport to predict the future often offer no more than the pretense of knowledge."

  In fact, they don't even offer the pretense of knowledge. They just provide illusionary "projections" to impress the press and other credulous sectors of society. These "projections" never survive the next substantial turn in the business cycle.

Academic pedigree alone is not a guarantor of useful knowledge and wisdom. Skepticism ought to qualify and restrain our reformist impulses."

  Today, an accumulation of new taxes, programs and regulations - each of which on its own may be justified and harmless - accumulate to burdensome levels. Like in the 1960s and 1970s, intellectuals of impeccable credentials guide economic policy and reform.

  "They were credentialed by some of the nation's outstanding universities: Yale, MIT, Harvard, Princeton. But their high intellectual standing did not make their ideas any less impractical or destructive. Scholars can have tunnel vision, constricted by their own political or personal agendas. Like politicians, they can also yearn for the power and celebrity of the public arena. Even if their intentions are pure, their ideas may be mistaken. Academic pedigree alone is not a guarantor of useful knowledge and wisdom. Skepticism ought to qualify and restrain our reformist impulses."

  The same kind of intellectuals - the "best and the brightest" - led the nation into the Vietnam war during that period and the Iraq war in the current period. See, Posner,  "Public intellectuals," and Kuklick, "Blind Oracles."

As the dollar weakens, there is increasingly a vacuum of financial power.

 

The optimistic projections concerning green jobs come from computer-driven econometric models, but searching econometric models for projections is the modern day equivalent of searching for omens in the entrails of a pig. Corn ethanol is just one example of the disasters that can be expected.

  Current threats to the economy include the welfare state - especially the entitlements that are now out of control; disruptions in the financial or physical flows of globalization; and the massive accumulation of household debt - which has risen from 23% of household income in 1946 to 134% in 2006. (This is a very misleading use of statistics. 1946 is a very unrepresentative point for comparison, coming as it did at the end of WW-II.)
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  Samuelson provides a catalogue of the various threats that a still dangerous world poses to the global economic system. As long as global flows are uninterrupted, globalization is a great engine of prosperity for all participating nations. However, trade and payments imbalances pose immediate financial threats. Short term foreign capital flows provide a risky basis for long term investments and loans. Military threats at present are actually minor, but both China and Russia are rapidly building formidable regional military strength with uncertain intentions.
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  Meanwhile, as its dollar weakens, the ability of the U.S. to fulfill a stabilizing role diminishes. Other nations just pursue their own narrow interests. As the dollar weakens, there is increasingly a vacuum of financial power.

  • Controlling inflation is the absolute prerequisite for prosperity. This need constrains the degree to which the Fed can use monetary inflation to mitigate the business cycle. During the 1930s, it erred on the sided of too little monetary expansion, in the 1970s it erred on the side of too much. Politicians and some economists don't like to admit it, but the public will have to understand that to some significant extent, the business cycle must be tolerated and permitted to perform its essential functions.

  It is encouraging that, even as the Fed more than doubles the money supply, Fed chairman Bernanke and cognizant officials in the Obama administration are warning that the recovery and progress in reducing unemployment will have to be slow. High levels of price inflation will surely accompany any effort to accelerate the recovery. The Credit Crunch has reduced the purchasing power of credit in the financial system by many trillions of dollars, something only the most rabid Keynesians suggest the Fed should attempt to fully offset.
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  Nevertheless, it will take extraordinary leadership from Bernanke - if he is reappointed Fed Chairman - and the Obama administration to support the tough monetary measures that will be needed to avoid a major surge in price inflation. Bernanke's prior record does not provide reason for confidence. Bernanke has expressly warned that he intends to keep interest rates low for an extended period of time. He has always exhibited a cavalier attitude towards his primary responsibility - preserving the purchasing power of the dollar. After all, The Treasury will be busy financing huge budget deficits at the same time and will not be happy having to pay high real interest rates.

  • Government industrial policies that pick the winners and losers and constrain domestic and foreign competition always increase costs and make it harder to control inflation.
  • The entitlement welfare state must be limited to what the nation can afford. Samuelson reviews the bleak alternatives available. However, the most daunting problem is the refusal of government to even confront the entitlement problems it has created.
  • Globalization must no longer be used as a scapegoat for the economic and financial problems we create for ourselves. It is domestic productivity that has reduced manufacturing jobs, and this is a good thing. Manufacturing in the U.S. has doubled in the last quarter century even as manufacturing employment has declined. The increase in inequality has been far more due to the growth of domestic services, especially financial services, than globalization.
  • The limited capacity to deal with global warming with present day technology must be faced. Any diminution of greenhouse gases in advanced nations will be swamped by population and economic growth in developing nations. Proponents are delusional in their expectations concerning the ease of shifting to renewable energy sources and the ability of "green" jobs to make up for job losses elsewhere as green policies raise costs. The optimistic projections come from computer-driven econometric models, but searching econometric models for projections is the modern day equivalent of searching for omens in the entrails of a pig. Corn ethanol is just one example of the disasters that can be expected.

Reagan and Volcker austerity "constituted the single most beneficial act of economic policy in the past half century."

  Intentional denial of reality characterizes global warming policy as well as entitlement policy and much more of our political approach to economic policy.

  "Our politics seem predisposed toward denial. We won't admit the inconsistence, conflicts and simplicities of many appealing goals. We strive for the impossible and ignore the obvious."

  There is an eternal political conflict between long run economic benefits and short term economic pain that all to often is resolved in favor of avoiding the short term pain. There is an eternal political conflict between short term benefits that produce long term pain that again is often resolved in favor of grabbing the short term benefits.

  "Here, we encounter a powerful parallel with double-digit inflation. It took hold because the policies that produced it were initially so appealing--the first effect was a boom--and the policies to reverse it were unappealing. What was remarkable about the Volcker-Reagan policies is that they defied the standard political logic. All the adverse consequences -- high unemployment, lost profits -- were up front. All the benefits were indeterminate and lay in the hazy future. Their actions constituted the single most beneficial act of economic policy in the past half century. But at the time, what they were doing was highly unpopular, even if most Americans deplored inflation and wanted government to get rid of it." (Will Obama and Bernanke or his successor be able to perform as well?)

The business cycle is both inevitable and essential to the nation's market economic system and continuing prosperity.

  An evaluation of future economic prospects is provided by the author at the end of this book. He dutifully provides both a pessimistic and an optimistic scenario. In other words, he doesn't have a clue.
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  However, one thing he sees clearly and gets clearly right. Perfect stability is unattainable, and policies designed to achieve it will increase instability by interfering noxiously with market functions. The business cycle is both inevitable and essential to the nation's market economic system and continuing prosperity.

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Copyright 2009 Dan Blatt