The 1980s "Reaganism was the rejection of traditional Republican policies of ‘austerity’ - sometimes called castor-oil economics or deep-root-canal economics. But it was more than that. It was an assertion these policies could be rejected without also rejecting many conservative objectives or totems."

The Setting for a Shift to the Right

The 1970s will be remembered as a troubled decade, one that opened with TV images of terrorists in Munich's Olympic Village and ended with images of Soviet tanks rushing into Afghanistan, Iranians storming the US embassy in Tehran, and a botched military attempt at freeing the hostages. In between was a decade in which American companies seemed overmatched by European and Japanese competitors who were the primary beneficiaries of globalization's return. It was also a good decade for OPEC that successfully orchestrated two huge oil price shocks in the decade that raised substantially the price of oil. The wages of American workers, were hammered by job loss and those rising energy prices, began to fall by mid decade as the industrial heartland of the country became the Rust Belt, littered with empty factories and abandoned cities as the deindustrialization and suburbanization of the US economy gained momentum.i

It was no surprise the American people punished the incumbents and voted for change in 1980. In a landslide, Ronald Reagan beat President Jimmy Carter and promised to reestablish the military and economic superiority of the country. Reagan opened his presidency with the evil empire speech in which he promised to launch "a crusade for freedom" built on a revitalization of the defense industry that had been in decline since the Vietnam War.ii The country was desperate for some successes, and it got one when US troops invaded the small Caribbean island of Grenada in 1982 and quickly declared victory. It got another at the end of the decade when marines led an invasion of Panama to rid it of Manuel Noriega. In between the Reagan administration helped fund the overthrow of the leftist Sandinistas who had taken control of Nicaragua in 1979 with "profits" from arms sales to Iran - a scandal known as the Iran-Contra Affair.iii

The 1980s "get tough" policies of Ronald Reagan appeared to pay dividends. In Poland, an electrician at the Gdansk shipyards named Lech Walesa led a 1980 strike opening the way to the formation of a free trade union - Solidarity. It did not seem like much at the time, but it was the beginning of a process that would ultimately bring to an end the Cold War, which is why TIME magazine recognized Walesa as one of the world's 100 most important leaders & revolutionaries of the 20th century. By the mid 1980s the Soviet Union was faltering and Mikhail Gorbachev, who assumed power in 1984, was proposing a two-pronged solution - perestroika, a program of economic and political reform designed to institute market type reforms, and glasnost, a policy of openness.

What Gorbachev unleashed was a series of reforms leading to the formation of a new Soviet parliament in the spring of 1989, the same year the communist government of East Germany collapsed and the Berlin Wall – the most well known symbol of the Cold War - was dismantled. A wall that had been constructed to keep East Germans from fleeing to the West in 1961 was now being torn down to keep people in the East from moving westward. In Romania, Ceausescu was overthrown in a single week in mid December of 1989 and executed on December 25th of that year.

A decade that opened with the US locked in a deadly battle with the "Evil Empire" ended with the Empire imploding. In 1990 the Russian Republic's declared its sovereignty under the leadership of Boris Yeltsin, and by 1992 the Soviet Union no longer existed. Russia and ten other republics formed the Commonwealth of Independent States with Russia taking over the powers once wielded by the Soviet Union. In addition to these political moves, Gorbachev reigned in the Soviet Union's military sector and worked with the US to back away from the Cold War.iv The US could begin to think about investing the much-anticipated "Peace Dividend."

1 In the other communist giant there were also dramatic changes taking place. In 1979 China's new leader, Diang Xiaoping, took China in a new direction. While maintaining the absolute political power of the Communist Party, he introduced market reforms in the country and chose to follow the East Asian model of export-led growth. China opened its borders to the inflow of foreign capital and European, Japanese, and American companies were more than happy to establish production facilities to take advantage of China's low wages. By the end of the decade, however, there were real concerns about China’s future after the government’s suppression of the Tiananmen Square protest – the one with the picture of the solitary Chinese citizen in a standoff with military tanks.

All the news was not good, however. Things did not go so well in the Middle East. The 1980s opened with Iraq invading Iran, the opening of a decade-long war in which millions would perish as the combatants used human waves (Iran) and chemical weapons (Iraq).v In this war the US supported, and supplied, the Iraqis under the leadership of Saddam Hussein, in their battle against America’s new enemy. Also in the Middle East Israel invaded Lebanon in 1982 in an attempt to halt terrorist attacks, and within months the US, under the auspices of the UN, sent troops into Beirut to allow an Israeli withdrawal. Things went badly, though, with 63 people killed in a bombing of the US embassy in Beirut and 241 members of the US peacekeeping force killed by a car bomb at the marine barracks in Beirut. By early the following year the troops had left the country, but the Middle East remained dangerous.vi In the decade the US also bombed Libya for its support of terrorist activity, which was a front-page story in the decade. Egypt’s Anwar Sadat and India’s Indira Gandhi were assassinated, and the Pope barely escaped the same fate.

This was also a very bad decade for Latin America. In the 1970s the region had been the recipient of enormous sums of money, loans from those who had benefitted from the steep run-up in the price of oil. The governments of South America – think Brazil, Mexico, and Argentina - looked like great bets since they could always raise taxes or print money to pay the debts – or at least that was what they thought. But, in a preview of what we would see in the Great Recession of 2008, the debt became unmanageable in the severe recession of the early 1980s, and as a result there were defaults and a decade of economic stagnation.

It was also a decade marked by numerous natural and man-made disasters. Earthquakes in San Francisco and Mexico City and a famine in Ethiopia that gave rise to the Live Aid concert followed the massive eruption of Mount Saint Helena that opened the decade. It was also the decade in which we became aware of the Aids epidemic. As for man-made disasters, there was the poison gas leak at the union Carbide plant in Bhopal, India that is estimated to have injured more than 500,000 people, and the meltdown at the Chernobyl nuclear power plant in the Ukraine.

On the domestic front, Ronald Reagan followed the lead of Kennedy and moved the economy to center stage in his presidential campaign when he told the American people, "We are in the worst economic mess since the Great Depression." The stock market, one barometer of confidence in the American economy, continued to fall throughout the 1970s and by 1980 it was down nearly 50 percent from its peak in the mid 1960s. By the end of the 1970s the dollar, another barometer of confidence, was also down - nearly 20 percent from its peak. Inflation, after rising "gently" through the 1960s, twice reached double-digit rates in the 1970s and by the early 1980s interest rates on short-term borrowing were well into double digits and mortgages were on their way to nearly twenty percent. You did read that right - I paid 18% on a mortgage at that time. In March of 1980s Time magazine was describing the economy as "scary" as it reported president (Carter) declaring, "We have reached a crisis stage" and well-respected investor Felix Rohatyn warning "We are headed for a national bankruptcy."

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Americans had also witnessed a substantial increase in the size of the federal government and the federal tax burden was increasingly falling on individuals who were ready for a tax revolt, which they got in CA in 1978 when the voters passed Proposition 13 that lowered property taxes 53%. At the federal level there was little room for a tax cut given the existing finances. On the outlay side of the ledger there were some substantial changes taking place in the 70s, most notably the rise of uncontrollable entitlements such as Medicare and Social Security. In the decade discretionary spending fell from about 70% to 50% of total federal outlays, while defense spending, the largest component of discretionary spending, fell from 50% of outlays to 22%. Over the decade taxes failed to keep pace with outlays and the budget deficit grew to nearly 3 percent of GDP by the decade’s end.

As evidence of the sorry state of the economy, Reagan emphasized the Misery Index, which is defined as the sum of inflation and unemployment rates. By 1980 the misery index stood at approximately 20 percent, twice the level of a decade earlier and its highest level since the Depression.

There is one graph, however, that best captures the anxiety of the American people and their disillusionment with the economy in the late 1970s. For the Great Depression of the 1930s it was the

3 unemployment rate graph, while for the 1970s it was the graph of real wages. After a virtually uninterrupted climb beginning after World War II, real (inflation-adjusted) wages for American workers stopped rising in the recession of 1973-75, and continued to fall for the remainder of the decade. By 1980 nearly one-third of all the gains in earnings made since 1948 had disappeared and real wages stood at the same level they had been in 1962.

As real wages fell, so too did confidence in the prevailing theories / policies to turn things around. The situation was beginning to resemble the early 1930s - an economic problem too large to ignore, yet beyond the abilities of the prevailing theories to explain. Liberal Keynesian economists were unable to produce a set of policies to cure the simultaneous rise of unemployment and inflation. This is certainly not what the Phillips Curve promised policy makers. This was new, so it was given a name - stagflation - the combination of higher inflation and higher unemployment.

The problem, in retrospect, is that stagflation could not be treated with traditional AD oriented monetary and fiscal policies. Keynesian fine-tuning policies that seemed to work so marvelously in the 1960s, failed to work in the 1970s. The timing was perfect for a candidate with a simple cure for the Carter malaise. That candidate was Ronald Reagan who sold the American people the idea that it was time to return to the policies that had made this country great, it was time for a shift to shift back to the ideological right and revive the supply-side policies of the 1920s that favored business over labor.

In business the decade opened with Ted Turner launching the cable news network CNN, which carried stories on the first woman to be nominated to the US Supreme Court (Sandra Day O'Conner) and the first space shuttle to be launched into space, on the antitrust breakup of AT&T’s monopoly in the phone business in 1984 and the Supreme Court’s OK to home video taping of TV shows. For the Coca Cola Company it was not a good time as it quickly took New Coke off the market. It was also not a good decade for Savings and Loans.

This was also a decade in which we began to confront the deterioration of the environment. The decade opened with a Time magazine cover story on “The Cooling of America,” but by the decade’s end Time’s lead stories had changed to “The Heat is On: How the Earth’s Climate is Changing.” In fact, in 1989 Time replaced its Man of the Year with Planet of the Year and named endangered Earth as the recipient of the award. This was also when we discovered a hole in the ozone, the driving force behind passage of the Montreal Protocol in 1989.

In area of technology, we were beginning to see glimpses of the future where technology plays a much bigger role in the lives of Americans. Things began to get smaller and more mobile. The Sony Walkman was a big hit early in the decade as people began to take their music with them, and by mid decade cell phones had arrived, although they looked more like home phones than today’s sleek items. And now movie taking went mobile with the camcorder, and we could save those movies as well as movies with VCRs once the courts OK’d it.

4 Computer games had arrived, and everyone was “crazy” about Pac-Man. In fact Pac Man was named Time magazines' "man of the year." IBM launched its PC and by the decade’s end we had our first Dell computer and Microsoft’s killer app – Excel. Apple launched the Macintosh computer with its mouse and graphical interface, but the Mac’s future was sealed when Windows appeared in 1985 because now there was a competitor to Apple's user-friendly machines.

The Internet did not yet exist, but the groundwork was being laid. The TCP/IP protocol was accepted - a BIG first step towards the modern Internet, and the Domain Name System (DNS) was introduced and by the end of the decade Time was running a over story “Computer viruses.”

In entertainment and arts, Star Wars: Episode V - The Empire Strikes Back and Airplane! (1980), Raiders of the Lost Ark (1981), and Ferris Bueller's Day Off (1986), Indiana Jones and the Last Crusade (1989) and the Vietnam war movies The Killing Fields (1984), Platoon (1986) and Full Metal Jacket (1987), opened in the nation’s theaters. In literature Stephen W. Hawking's A Brief History of Time and Salman Rushdie's The Satanic Verses were published, while in music Michael Jackson's album Thriller was released (1982).

The Shift to the Right: Supply-side Economics

The 1980s election victory for Ronald Reagan ushered in a notable shift toward the conservative right in US politics and economic policy. It reflected a lack of confidence in government's ability to manage the economy that was described in a 1985 article in the New York Times.

The Reagan administration believes, contrary to the activist Keynesian view that emerged in the 60's, that economies cannot be managed by the use of tax and budget policy. They reject any notion of 'fine-tuning' policy to try to eliminate the ups and downs of the business cycle. ...The reality is that microeconomics ...has come to the fore in the Reagan years...But macroeconomics...is on the skids.

The “bible” for those trying to move the economy to the right was Milton Friedman’s classic, Free to Choose. Friedman, who had won the Nobel prize in Economics in 1976, maintained that markets were better than government at allocating resources, and in 1980 he put those ideas into a popular, readable book with a simple message: “The combination of economic and political freedom produced a golden age in Great Britain and the United States. … and the secret was a limited role for government.

The shift to the ideological right did not, however, originate in the US.7 The Republican's victory in the US had been preceded by the decisive Conservative Party victory in the United Kingdom's 1979 election that brought Margaret Thatcher to Downing Street and "Thatcherism" to the country. As Ms. Thatcher described things in Bolton on May 1, 1979:

[u]nless we change our ways and our direction, our greatness as a nation will soon be a footnote in the history books, a distant memory of an offshore island lost in the mists of time - like Camelot remembered for its noble past.8

In the US, the conservative message delivered by Reagan was a simple one, and one modeled closely on Roosevelt's message in 1932. Reagan challenged the American people in 1980 to reflect on the past four years and ask the question:

Can you look at the record of this administration and say, 'Well done'? Can anyone compare the state of the economy when the Carter administration took office with where you are today and say, 'Keep up the good work'? Can you look at our reduced standing in the world and say, 'Let's have four more years of this'?

Reagan knew that for too many people the answer in 1980 was NO - and he believed he had the policies that would turn things around.

5 On the macro side, there were three key elements of the Reagan agenda: reduce inflation, balance the budget, and reduce the size of the government. The American workers had seen inflation erode their buying power as the progressive tax system drove them into higher tax brackets that financed an expansion in the size and scope of government. There was a tax revolt underway in CA and a candidate would be well served by a platform including a tax cut. In fact this is the beginning of the Republican emphasis on tax cuts that continued through to the Bush tax cuts.

But there was a problem with each piece of the agenda. First, significant reductions in inflation would require substantial increases in unemployment - the old Phillips Curve tradeoff. Second, balancing the budget would mean tax cuts, long a favorite Republican proposal, would be impossible to achieve. Third, the budget situation could not be improved with substantial cuts in government spending without a loss in benefits received from the government. When Margaret Thatcher approached a similar situation in England, her solution was based explicitly on the premise that the economic ills could only be cured after a painful period of transition. Ronald Reagan, on the other hand, offered the American people an alternative to the Carter's drift and Thatcher's austerity - what George Bush, Reagan's opponent in the Republican primary, called "voodoo economics" and Herbert Stein called "the economics of joy." Ronald Reagan had lost the Republican candidacy on an austerity campaign in 1976 and he would not make that mistake again. The most striking feature of Reaganomics was it offered a painless solution to stagflation.

Reaganism was the rejection of traditional Republican policies of "austerity" - sometimes called castor-oil economics or deep-root-canal economics. But it was more than that. It was an assertion these policies could be rejected without also rejecting many conservative objectives or totems.vii

One thing was certain - the move would need to be dramatic and quick as Reagan and his supporters felt it was essential to change expectations. As Reagan's supporters and policy advisors saw it:

Thatcherism' can only be avoided if the initial economic policy package simultaneously spurs the output side of the economy and elicits a swift downward revision of inflationary expectations in the financial markets...President Reagan should declare a national economic emergency soon after inauguration. He should tell the Congress and the nation that the economic, financial, budget, energy, and regulatory conditions he inherited are far worse than anyone imagined. He should request that Congress organize quickly and clear the decks for exclusive action during the next 100 days on an Emergency Economic Stabilization and Recovery Program he would soon announce. If Reagan were to deliver on his promises, then the assumptions upon which his program was based would need to be accurate since it was a finely balanced plan. For that reason, in the first section of this unit the theories and assumptions upon which supply-side economics was based will be described. The revival of interest in the supply side of the economy also triggered a revival of interest in the long-run growth of the economy, and thus economic growth will be the topic in the unit's second section. We will focus our attention on the importance of growth differentials and explanations of the pattern of world economic growth that tend to center on the concepts of productivity growth and technological change. The section will close with a discussion of the problem known as the cost disease of the service sector.

6 1980s Setting i For those interested in images of this era, you should check out the movie Miracle about the US Olympic hockey team that beat the Russians in the 1980 games. It opens with a montage of images from the 1970s that captures the mood of the country. ii In 1983 protestors filled the streets of Europe protesting the deployment of Pershing missiles aimed at the Soviet Union, while at home many questioned the viability of the Space Defense Initiative (SDI) - the shield to protect the country from missile attacks iii The Executive Summary of the Report of the Independent Counsel for Iran/contra matters contained the following description. In October and November 1986, two secret U.S. Government operations were publicly exposed, potentially implicating Reagan Administration officials in illegal activities. These operations were the provision of assistance to the military activities of the Nicaraguan contra rebels during an October 1984 to October 1986 prohibition on such aid, and the sale of U.S. arms to Iran in contravention of stated U.S. policy and in possible violation of arms-export controls. In late November 1986, Reagan Administration officials announced that some of the proceeds from the sale of U.S. arms to Iran had been diverted to the contras. iv For some background on the collapse of the Soviet Union you can check out Time's 10-year anniversary article including pictures that include the one shown here. v The Federation of American Scientists describes the situation leading up to the war as follows: Many observers, however, believe that Saddam Hussein's decision to invade Iran was a personal miscalculation based on ambition and a sense of vulnerability. Saddam Hussein, despite having made significant strides in forging an Iraqi nation-state, feared that Iran's new revolutionary leadership would threaten Iraq's delicate Sunni Shia balance and would exploit Iraq's geostrategic vulnerabilities--Iraq's minimal access to the Persian Gulf, for example. In this respect, Saddam Hussein's decision to invade Iran has historical precedent; the ancient rulers of Mesopotamia, fearing internal strife and foreign conquest, also engaged in frequent battles with the peoples of the highlands. vi In the same year Terry Anderson was kidnapped and held hostage, one of many hostages taken in Lebanon in this period. The decade of terrorism closed out with the bombing of Pan Am flight 103 over Lockerbie Scotland. The Italian cruise ship Achille Lauro was high jacked off the coast of Egypt in 1985 and the highjackers killed a wheel chair bound American and then threw him off the boat. Shortly after the highjacking of the cruise ship, TWA flight 847, with over 150 passengers flying from Athens to Rome, was high jacked by members of the Islamic Jihad. This was a made for TV high jacking with hour after hour of prime-time TV coverage of the thousands of miles flown between Beirut and Algiers, before the plane was eventually blown up. Terrorist attacks were not constrained to the Middle East in the 1980s. In Asia, the Tamil Tigers's quest for independence from Sri Lanka was deadly, and in India the conflict between the Indian army and the Sikhs was responsible for over 300 deaths in 1984 and 750 people in 1988. vii Ms. Thatcher assumed the job at a time where prices and wages were rising at rates exceeding 15 percent, spurred on by money supply (M1) growth that peaked at 22 percent in 1978. The unemployment rate was in the mid 5 percent range, up from the mid 2 percent range before the 1975 recession, economic growth put it at the bottom of the OECD countries, and productivity growth was limited. The result was unit labor costs rising at double-digit rates and import competitiveness falling sharply. The exchange rate continued to fall throughout the decade, falling a full 20 percent between 1975 and 1978, while the balance of trade deficit continued to rise. In fact in December 1976 the IMF needed to 'rescue" the pound. As economists Richard Caves and Lawrence Krause saw things, "Britain's economic malaise stems largely from its productivity problem whose origins lie deep in the social system."2 The people of the United Kingdom and the United States were ready to listen to, and elect, people who offered them a way forward, and that was Margaret Thatcher in the UK and Ronald Reagan in the US. The "malaise' in the two countries was quite different because of different institutions and policies. One of the BIG differences was the fact that in the UK most of the major industries were nationalized. On the policy side, the UK experimented extensively with incomes policies during the decade as a means of dealing with inflation, something the US did not experiment with extensively. The result was little good news on the inflation front and plenty of bad news on the strike front - the low points being a miners' strike in the winter of 1974-75 that forced the country onto a three- day work week and a series of disruptive strikes in the winter of 1978-79. For Margaret Thatcher, a "disciple" of Milton Friedman and Freidrich von Hayek, the "solution" to the economic malaise had three major components. First, strict monetarism was the answer to inflation. Second, government interferences with the economy needed to be reduced - in large part to be accomplished by "rolling back" the reach of the public sector. She also set about to reduce government spending, but she was less successful at achieving the second of these goals. Third, productivity growth needed to be increased, an outcome that relied on increases in incentives. The Conservative manifesto states the case as follows: "To become more prosperous, Britain must become more productive and the British people must be given more incentive." Part of the incentives came in the form of tax changes. People should be rewarded, not penalized for working, and thus in the first Conservative budget income taxes

7 were cut, especially at the high end, and consumption taxes (Value added tax (VAT)) were raised. The result was a deep and troubling recession in 1980-1981 - prompting comparisons between the early 1980s and the 1930s. Rising interest rates drove up exchange rates that made it hard for manufacturing firms to compete, and between 1979 and 1981 manufacturing employment fell by 16 percent. In addition to the economic slide, there was also a notable increase in inequality, with the manufacturing centers in the North and West experiencing double-digit unemployment rates. One success, however, was a sharp reduction in inflation, which was down to 4.5 percent in 1983. Another was the victory in the very brief conflict with Argentina over the Falklands Islands in 1982.

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