The "neither a state nor a bank ever has had unrestricted power of issuing paper money, without abusing that power." David Ricardo

The Setting for the Monetarist Experiments

The 1960s will be remembered for "sex, drugs, rock-n-roll, and fiscal policy." It was a decade viewed by many as the Golden Age of Capitalism, but by the decade's end there were signs all was not well and the mood was beginning to change. Americans began to realize many of the promises of the 1960s could not be easily delivered, but nothing could have prepared the nation for the 1970s.

In Vietnam, the war expanded beyond anyone's expectations in the 1960s with 500,000+ American troops being deployed by the end of the decade. At home the war triggered widespread campus antiwar protests including one at Kent State where national guardsmen killed four students in May of 1970. The truth was, the war was winding down as Nixon and Kissinger looked desperately for an exit strategy that would allow the US to "save face." By 1973, in a sure sign of the war’s winding down, the military draft ended, and two years later it was "official" when the North Vietnamese entered Saigon and US helicopters evacuated the US embassy.

With the end of the Vietnam conflict, the Cold War seemed to thaw a bit with President Nixon visiting both Russia and and by the end of the decade lengthy negotiations with the produced the Strategic Arms Limitations Talks (SALT II) in 1979 to limit offensive nuclear weapons. There was also change in China with Mao’s death in 1976 and the eventual emergence in 1979 of Deng Xiaoping who would transform China into the world economic power that it was by the beginning of the 21st century. Also occurring in Asia in the decade was a conflict between Pakistan and that produced a new country in 1971 – Bangladesh – and the rise of the who took control of after the collapse of Vietnam and launched a cleansing campaign that may have reduced the country’s population by ¼ by the decade’s end.

The end of the Vietnam War did not, however, bring peace to the US or the world. The 1970s was a decade where terrorism replaced traditional war as the primary concern of Americans and the news was dominated by stories of international terrorist groups. With the arrival of larger jets like the Boeing 747 introduced in 1969, international travel was growing rapidly and this provided a very visible target for terrorists. The result was a rash of plane hijackings.i In one day in September of 1970 there were five hijackings of planes headed to by members of the Popular Front for the Liberation of Palestine. Two years later, the Palestine Liberation Organization (PLO) group "" entered the Olympic athletes' compound in Munich and people around the world watched a standoff that resulted in the killing of the hostages in a gun battle at the airport that I’ll never forget – those images on TV of the attackers in ski masks on the porch of the dorm. A year later, in1973 there was the assassination of the U.S. Ambassador to Sudan by the same group, and the bombing at LAX.

Closer to home, the Cold War did not show signs of thawing. The decade opened with winning the presidential election in Chile, and after surviving some US led efforts to kidnap him, he set out to implement his socialist agenda that included nationalization of key industries, land redistribution, and default on international debts. What followed was a period of hyperinflation, rising unemployment, and political unrest that set the stage for a coup in 1973. The decade closed with President Anastasio Somoza being overthrown in by leftists.

The 1970s was also a decade in which the Middle East got the attention of Americans. In 1972 Iraq and the Soviet Union signed a 15-year Treaty of Friendship and Cooperation and within months Iraq became the first Arab nation to nationalize its oil industry. With Soviet technical help, it cranked up its oil output and become the region's second largest oil producer by 1979 - the year the anti-communist Saddam Hussein assumed power. There was also another Arab-Israeli conflict - this one the Yom Kippur War in 1973.What was clear in this war

1 was the military superiority of had disappeared and the balance of power in the region had shifted. This helped bring and Israel to the bargaining table and in 1979 Egypt and Israel signed a peace treaty known as the Camp David Accord. Israel kept the land it had gained in the earlier war - the Gaza Strip and Golan Heights - areas that to this day remain a major problem in the region.ii

It was the OPEC embargo of 1973, however, that had the biggest impact on the lives of all Americans. The Arab countries that dominated the OPEC cartel retaliated against the US for its support of Israel in the 1973 war by cutting off oil supplies.iii There was simply not enough oil at the existing price, which had been set earlier by price controls, so an alternative scheme for the rationing of oil appeared. It was looooong lines, and I can assure you this was not pretty. There was lots of time spent in long lines, more than a few fights as tempers flared, and weekend trips cancelled because gas stations were closed.

And things looked even worse as the decade closed. In 1979 the Shah of , an ally of the US, was overthrown by Ayatollah Khomeini and Americans faced a second round of OPEC price increases that threatened those muscle cars that dominated this country in the 1960s and watched on TV as US hostages were taken by protestors in Tehran. And if that was not bad enough, the Soviet Union invaded , a decision that would ultimately bring a decade-long military conflict that would hasten the collapse of the Soviet Union - but at the time it was viewed as a loss in the Cold War.

The dramatic oil price increases were only one of the shocks to the US economy during the decade. This was also a decade when globalization returned to the US. The international flow of goods and people that had been severely reduced during the Great Depression and WWII, returned in the 1950s and 1960s and then accelerated in the 1970s. In the decade the ratio of imports to GDP more than doubled - from under 4% to over 8% and the US began running trade deficits as Americans began to buy imported cars, VCRs, and Sony Walkman's in substantial numbers. The expanded trade also showed up in the manufacturing sector where employment growth slowed from 15% in the 1950s and 1960s to 4% in the 1970s, and we began to see on Time magazine’s covers stories about rising competition from and Japan. The deindustrialization of the US economy was underway and by the end of the decade anxiety about the conditions of American workers rose among workers and policy makers.

The rising inflow of goods in the 1970s was accompanied by a rising inflow of people. Between 1950 and 1970, the percentage of the nation that was foreign-born actually dropped slightly, but this was reversed in the 1970s. Immigration was overshadowed, though, by the three dominant demographic phenomena of the 1970s. The first was acceleration of the movement out of the North and East as people moved out of the older, energy-dependent, manufacturing regions in the north and east (New (NE), Middle Atlantic (MA), East North Central (ENC)). This region experienced slower than average growth, as people moved toward the energy-rich West South Central (WSC) and Mountain (MT) regions that were experiencing rapid growth. This was the era where TV aired the show Dallas captured the excesses of a region experiencing new-found wealth and where news programs ran stories of people packing all of their belongings into their cars and heading west looking for jobs.

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The second demographic phenomenon was acceleration in the suburbanization of the population. In the nation's twenty largest metropolitan areas, a net gain of less than 100,000 in the central cities in the 1960s turned into an exodus in the 1970s. During the decade population declined in fifteen of these cities for a total loss of about 3 million. In some metropolitan areas, such as St. Louis, , and , the central cities lost 20+ percent of their 1970 population during the decade, and by mid decade stories of New York City’s potential bankruptcy were in the news.iv The nation’s major cities were also hurt by rising crime rates that had Time magazine running lead stories such as “The cities lock up: Fear of crime creates a life-style behind bars,” “Cops v. crime: Ready for a hot summer,” “The urban guerillas” and “Crime: Why and what to do.” The third demographic shock was the movement of the leading edge of the baby boomers into the labor market that helped push the labor force growth rate to its highest level since WWII.

The combined impact of the oil price shocks, coupled with the baby boomer's flooding of the labor market and the return of globalization that flooded the US with foreign imports and immigrants, helped push real wages lower - erasing nearly all of the increases of the 1960s. These were unsettling times in the country, and if you wanted an indicator of the level of anxiety - you need to look no further than the price of gold. Investors tend to flock to gold in uncertain times, and at the end of the decade the price of gold increased from $35 to almost $1,000 an ounce. This is the picture of fear.

In terms of public policies, the decade opened with an ambitious legislative agenda. The National Highway Traffic Safety Commission (NHTSA) was established to regulate auto safety (1970), the Occupational Safety and Health Administration (OSHA) was established to monitor business safety and health (1971), the Environmental Protection Agency (EPA) was charged with the control of pollution (1972) and by mid decade it was dealing with the Love canal disaster, the Consumer Product Safety Commission began regulating the safety of products (1972), and the Departments of Energy (1977) and Education (1979) came into existence. The existence of these regulatory agencies was not, however, enough to avoid The New York City Blackout (1977) or the Meltdown at Three-Mile Island (1979) where the US barely averted nuclear disaster.

The decade was also one where significant advances were made by women - the right to an abortion (Roe v Wade, 1973), equal protection clause of Constitution extended to women (Reed v Reed, 1971), and guaranteed equal opportunity for all workers Equal Employment Opportunity Act of 1972, although the Equal Rights

3 Amendment that passed Congress in 1972 failed to be ratified by the states. In higher education, in 1978 the Supreme Court ruled in the Bakke case against the use of racial quotas (Regents of the University of California v. Bakke) in admissions policies and a new competitor to traditional higher education institutions such as URI appeared on the scene when the University of Phoenix (1978), the nation's largest for profit university, gained accreditation. It was also a time where all Americans were given access to government information (Freedom of Information Act, 1974).

The BIG domestic issue of the decade, however, was Watergate - a story of crime in the highest offices that gripped the nation and ended with impeachment hearings and the eventual resignation of president Nixon in August of 1974.v

As for technology, the 1970s was a decade of significant advances that formed the base for what we know today as the Internet. In 1970 the first commercial fiber optic cable was introduced by Corning, and the following year Intel introduced the 1st microprocessor - the brains of computers. The following year a Cambridge, MA computer scientist, Ray Tomlinson, introduced email and used the @ to separate the user and the network, and by the middle of the decade microcomputers were appearing. The first BIG move was the appearance of an ad in an electronics magazine for a kit for an Altair 8800 microcomputer for less than $400. This caught the attention of Paul Allen and Bill Gates who moved to Albuquerque where the Altair computers were being manufactured and eventually started a new company Micro Soft that developed the Basic computer software to control the machine. In 1977 Apple, Radio Shack, and Commodore sold the 1st fully assembled personal computers, and in 1979 the first spreadsheet - VisiCalc was sold.

As for the "business" news, the US began running trade deficits in this decade as Americans began buying foreign goods including Sony's new VCR and Walkman and one of the nation's most respected companies - the Penn Central Railroad - collapsed in (1970). Volkswagen opened a production plant in Pennsylvania, Miller introduced Lite beer, Southwest Airlines begins flying (1971), Federal Express began shipping overnight (1973), and Wall Street's fixed commissions came to an end and discount stock brokers appeared (1975). In the entertainment and arts area, this was the decade of the movies MASH (1970), A Clockwork Orange (1971), The Godfather (1972), Deliverance (1972), American Graffiti (1973), The Exorcist (1973), Godfather: Part II, (1974), Jaws (1975), One Flew Over the Cuckoo's Nest (1975), Monty Python and the Holy Grail (1975), Rocky (1976), Annie Hall and Star Wars (1977), and Close Encounters of the Third Kind (1977). And American table tennis players played in China (1971) signaling improved China-US relations.

On the macro front, it turned out to be a very bad decade in which the nation was plagued by strikes and Keynesians were not able to deliver on their promise to 'fine-tune' the economy. During the 1970s the economy suffered through two painful recessions, unemployment was noticeably trending upward, the inflation rate by the decade's end approached 14 percent, and the nation was facing persistent budget and trade deficits.

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The difficulties encountered in 1970s seemed to take the nation and its policy makers by surprise, just as we saw in the 1930s in the Great Depression, but maybe we should not have been so surprised. The 1970s began with , a conservative Republican in the White House, delivering a speech on , 1971 in which he announced his New Economic Policy that was designed to simultaneously cure two big problems - the loss of gold due to a trade deficit and a slowdown in the economy. The Nixon "solution," summarized in the New York Times headline, "NIXON ORDERS 90-DAY WAGE-PRICE FREEZE, ASKS TAX CUTS, NEW JOBS IN BROAD PLAN: SEVERS LINK BETWEEN DOLLAR AND GOLD" was a desperate move.

With the encouragement of Fed Chairman Burns, Nixon proposed an incomes policy to reduce inflation without causing increases in unemployment.vi Although Burns was a conservative who had been a critic of the Kennedy- Johnson guidepost policy, by the early 1970s he was proposing establishment of a wage-price review board. The theory was simple; wage and price controls could break the back of inflation, which would quickly translate into lower inflationary expectations. This was the story line, but the evidence seems to suggest the controls did little to slow the inflation that returned as soon as the controls were lifted. Here we had a conservative Republican pushing for more government control of prices and the end of gold as a backing for the US $ that had been a key part of the conservative system.

And things got worse when, in one of the worst policy moves, president Ford appealed to the American people to wear "Whip Inflation Now" (WIN) buttons as part of his solution to lower inflation. Needless to say, the program was a nonstarter, and after Ford faced stiff competition in the presidential primary from Ronald Reagan, a former actor and governor of California, he went on to lose the election to a relatively obscure Georgian named . Like Kennedy before him, Carter successfully exploited the weaknesses of the economy under a Republican president, as you can see in his Labor Day speech in 1976.

This year, as in 1932, our country is divided, our people are out of work, and our national leaders do not lead. Roosevelt's opponent in that year was also an incumbent president, a decent and well-intentioned man who sincerely believed our government could and should not with bold action try to correct the economic ills of our nation.

Once in office, Carter set about the task of dealing with the 7+% unemployment rate. He had "promised" full employment in the election, and beginning in 1977 he promoted an expansionary policy including a temporary tax cut, although the tax cut was never enacted. In an effort to keep monetary and fiscal policy on the same expansionary page, president Carter replaced Arthur Burns with G. William Miller as Chair of the Federal Reserve in January of 1978. Miller was a team player and monetary policy would do its share of shouldering the burden of reaching full employment.

But, soon he was changing direction. In October of 1978 Carter announced an anti-inflation policy including fiscal restraint, wage and price guidelines, and an immediate hiring freeze for the federal government and employment reductions in 1979. Things did not improve and in August 1979 President Carter, after a retreat at Camp David at which over 100 leaders were consulted, delivered his "malaise speech" in August of 1979.

5 All of the legislation in the world can't fix what's wrong with America. It is a crisis in confidence. It is a crisis that strikes at the very heart, soul, and spirit of a national will ... and it is threatening to destroy the social and political fabric of America.

To restore confidence Carter announced a purge of nearly half the Cabinet plus the Chair of the Fed, but by November Congress had gutted Carter’s guidelines and the dollar was in a free-fall. And to make matters worse, the Iranian revolution had pushed oil prices up sharply in the first seven months of 1979. Quite simply the macro economy was in shambles and Americans had lost faith in their government's ability to solve some of its most pressing problems.

The time was right for another BIG ideological shift in economic theory and economic policy. Just as the Great Depression had revealed the inability of the Classical economists to 'solve" the problems of the 1930s and opened the door to the Keynesians who offered a way out of the mess, the 1970s revealed the inability of Keynesians to solve the problems of the Great Stagflation and opened the door for an ideological shift towards a "new-and-improved" version of conservative economic theory and policy in the 1980s. First, however, we will look more closely at the 1970s since the Keynesians still had one card to play in their game of fine-tuning the economy. Thanks to Nixon's severing of the link between the dollar and gold, this was the decade to play the monetary policy card, which is why in the 1970s unit we will focus on money and monetary systems. In fact there are two units, the first will focus on the international monetary system and the second will be on the domestic monetary system with a focus on the role of the Federal Reserve, a very important institution we have talked very little about so far.

The Experiments With Money

Money is the oil in the economic machine, and without money it would be hard to envision the world as we know it, which is why money is one of the more important innovations of all time - right up there with fire and the wheel. Each country / society invented its own currency to facilitate trade and exchange, just as each society developed its own language to facilitate communications. As long as communication took place between two people speaking the same language, or the transactions took place between people using the same money, there was no need for a translator. But if Americans are buying electronics from Korea and selling machine tools to Mexico, then there is a need for an international monetary system linking the currencies and a translator linking the two languages. To facilitate international trade there needs to be an international monetary system and in the first unit of the 1970's we examine the evolution of the international monetary system through its three stages - the gold standard, the Bretton Woods system, and flexible exchange rates that emerged after Nixon closed the gold window in 1971.vii

When severing the link between gold and dollars, Nixon also freed monetary authorities to use monetary policy to fine-tune the economy, and they did jus that. Monetary authorities around the world seized upon the opportunity and began running their printing presses, which David Ricardo warned about back in the 19th

6 century when he wrote "neither a state nor a bank ever has had unrestricted power of issuing paper money, without abusing that power." In the second section of this unit we will begin by filling in some of the details on money. We start with a brief history of the evolution of money - from salt tablets - to animal skins - to gold - and then to dollars. The price of money is the interest rate and this unit contains a section on the market for money that provides the framework to understand interest rates. This is followed by a detailed treatment of the money supply process including a discussion of the banks and the Fed that together "create' money as well as the tools the Fed has to change the supply of money. The unit closes with a detailed treatment of the Keynesian and monetarist views of the relationship between monetary policy and the performance of the economy, the basis for monetary policy.

7 1970s Setting i . The situation at the outset of the 1970s is described in Britannica as follows A more dangerous and destructive spate of hijackings occurred in Europe and the Middle East from 1968 onward. Between 1968 and 1970 alone there were nearly 200 hijackings. The participants often were politically motivated Palestinians or other Arabs who commandeered airplanes while in flight and threatened harm to the passengers and crew unless certain of their comrades were released from jail in Israel or some other location. Some of these hijackers also held the passengers and crew captive and demanded large ransom payments from the hostages' governments. The climax of this new form of terrorism occurred in September 1970, when an 11-day sequence of hijackings resulted in 300 passengers being held hostage for a week and the destruction of four jet aircraft (on the ground) worth a total of $50 million. Middle Eastern and leftist hijackers abducted, confined, and even occasionally murdered individuals traveling on airplanes that were diverted from scheduled routes. One response was the FAA's authorization of searches at airports in 1973, but it did not stop members of the Baader-Meinhof Group and the Popular Front for the Liberation of Palestine (PFLP) who, in 1976, hijacked an Air France plane with 258 passengers flying from Israel to Paris. The world watched as the plane flew to Libya and then on to Entebbe, Uganda where it sat on the runway for days as negotiations took place. While the pace of plane highjacking slowed appreciably after an Air France High jacking in 1976, there were two more notable terrorist events. The first occurred in 1978 when former Italian Prime Minister Aldo Moro was seized by the Red Brigade and eventually killed. The second was the 1979 takeover of the US embassy in Iran by 3,000 militants that took 54 hostages and held them for 444 days. The stage had been set for the hostage crisis in early 1979 when the Shah of Iran, who had been a strong US ally, left a country embroiled in civil unrest. Into the power void stepped the Ayatollah Khomeini who was returning from his exile in Turkey to assume power. For those interested in an insider's story, you should check out Robert C. Ode's Excerpts from an Iran Hostage's Diary. ii There had been increasing animosity between Arabs and Israelis since the last war and on the eve of Yom Kippur, a Jewish holiday, Egypt launched an attack east from the while opened up a second front and entered from the North. The invasions were initially successful because they caught Israel with "its defenses down," but eventually Israel "forced" Egypt into a cease-fire in less than a month. The war with Syria continued on into the next year until a cease-fire could be negotiated by the US. iii This is described in an Energy Administration PowerPoint. iv Population of Nation's Largest Cities in 1960

1960 1970 1980 60-70 70-80 New York City NY 7,781,984 7,894,862 7,071,639 112,878 -823,223 IL 3,550,404 3,366,957 3,005,072 -183,447 -361,885 CA 2,479,015 2,816,061 2,966,850 337,046 150,789 Philadelphia PA 2,002,512 1,948,609 1,688,210 -53,903 -260,399 Detroit MI 1,670,144 1,511,482 1,203,339 -158,662 -308,143 Baltimore MD 939,024 905,759 786,775 -33,265 -118,984 TX 938,219 1,232,802 1,595,138 294,583 362,336 Cleveland OH 876,050 750,903 573,822 -125,147 -177,081 Washington DC 763,956 756,510 638,333 -7,446 -118,177 St. Louis MO 750,026 622,236 453,085 -127,790 -169,151 WI 741,324 717,099 636,212 -24,225 -80,887 San Francisco CA 740,316 715,674 678,974 -24,642 -36,700 MA 697,197 641,071 562,994 -56,126 -78,077 Dallas TX 679,684 844,401 904,078 164,717 59,677 627,525 593,471 557,515 -34,054 -35,956 Pittsburgh PA 604,332 520,117 423,938 -84,215 -96,179 San Antonio TX 587,718 654,153 785,880 66,435 131,727 San Diego CA 573,224 696,769 875,538 123,545 178,769 Seattle WA 557,087 530,831 493,846 -26,256 -36,985 Buffalo NY 532,759 462,768 357,870 -69,991 -104,898

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v We pick up the story of Watergate with the New York Times' publication of The Pentagon Papers on June 13, 1971 that gave a history of US involvement in Southeast Asia since WWII. For those who want a more personal view of the release of the papers, you should check out the following sites. • Richard Nixon, The Memoirs of Richard Nixon (New York: Grosset & Dunlap, 1978), pp. 508-515. • , Years of Upheaval (Boston: Little, Brown and Company, 1982), pp. 115-118. • H.R. Haldeman, The Haldeman Diaries (New York: Berkeley Books, 1995), pp. 363-371, 378. And while you’re at it, you should check out the audiotapes to hear Nixon's phone messages. A particularly good one is Nixon phone call with Alexander Haig, 13 , 12:18 p.m when he is informed of the New York Times' publication of the papers. The person responsible for release of the Pentagon Papers was Daniel Ellsberg, and according to the Washington Post, on September 3, 1971 "the White House "plumbers" unit - named for their orders to plug leaks in the administration - burglarized a psychiatrist's office to find files on Daniel Ellsberg, the former defense analyst who leaked the Pentagon Papers." In the following year, on June 17, 1972 "five men, one of whom says he used to work for the CIA, are arrested at 2:30 a.m. trying to bug the offices of the Democratic National Committee at the Watergate hotel and office complex." Post Story. For a detailed timeline of the events following the break-in you should visit the Washington Post's site that clearly shows the mounting evidence of corruption, which was not enough to keep the American people from reelecting Nixon in 1972 in a landslide. You will also see how soon after the election and the resignations and firings of his top advisors (Haldeman, Ehrlichman, and Dean Nixon announces, "I'm not a crook." vi An incomes policy is a strategy to lower inflation by some form of restriction on rising wages and prices. It actually should not have been such a surprise since Dr. Burns had expressed his doubts about the ability of the economy to produce low inflation and unemployment simultaneously in his presidential speech to the American Economics Association in 1959. At that time Dr. Burns noted that: during the postwar recessions the average level of prices in wholesale and consumer markets has declined little or not at all. The advances in prices that customarily occur during periods of business expansion have therefore been cumulative. All these appear to be symptoms of a continuation of inflationary expectations or pressures. vii In Japan, the shocks from the end of Bretton Woods system and the OPEC oil-price hikes pushed the Japanese toward financial liberalization.

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