Great Wave

by Fischer, David Hackett;

  The day of reckoning came on October 19, 1987. The New York stock market suddenly crashed. The same processes of programmed trading that had brought the market to dizzy heights, now sent it tumbling down again in its worst collapse since 1929. Panic-stricken investors rushed to sell large quantities of stock, often at a heavy loss. The Dow Jones industrial average plunged 500 points, and billions of dollars vanished in an afternoon.

  On the morning after, some experts explained that the collapse was merely a massive correction of grossly inflated stock-prices. They did not ask how the inflation had happened in the first place. Others believed that the crash was caused by programmed trading in stock futures on commodity exchanges where margin requirements were low or nonexistent. Many small investors concluded that financial markets had become corrupt casinos, in which the games were rigged by insiders.

  After the crash, the confidence of investors collapsed, and the stock market was unable to serve its primary economic function of mobilizing capital for investment. In 1988, more than 100 major American corporations found themselves unable to issue new stock offerings for their capital needs. Neither the securities industry nor the Reagan administration were able to agree on regulatory reforms. In the two years that followed the Crash of 1987, Congress and the federal government failed to enact a single substantive reform for securities markets.

  The Cost of Anti-Inflation:

  Price Fears and Policy Recessions, 1980–95

  In the 1980s, the battered world economy slipped into another recession. This one was deep—the deepest since the 1930s. It was marked by excess capacity and plummeting commodity prices. Producer prices of food and raw materials fell steeply from 1981 to 1986, reaching their lowest levels since the Great Depression. Oil declined from $40 a barrel to $8 in 1986. Tin dropped from $8 a pound to $2.50; copper slipped from $1 to 45 cents; silver plummeted from $54 to less than $5 an ounce. But even in the very depth of this recession, consumer prices continued their inexorable advance. Inflation slowed, but did not cease.17

  When the major industrial economies began to revive, prices of raw materials started to climb again. In 1987, the price of oil doubled. Cotton and lead trebled. Strong upward trends appeared in the price of copper, nickel, aluminum, wool, hides and rubber. Overall, commodity prices rose by nearly one-third in a single year, and further increases followed in 1988.18

  A large part of this increase was due to hoarding, in fear of higher prices ahead. Economic forecasters predicted further price increases, and an inflationary psychology rapidly strengthened throughout the world. Fear of inflation began to be more disruptive than inflation itself. The expectation of rising prices caused prices to rise higher.19

  By 1989, as producer prices were rising sharply, world leaders openly discussed the need for driving the economies of the industrial world into a yet another “policy recession.” They did so at a time when markets and economies were deeply unstable. Governments worked to “cool” their economies by raising interest rates. In the United States, the Federal Funds Rate was driven up from 6.7 percent in 1987 to 9.2 percent in 1990. Consumer interest rates climbed much higher. Other fiscal and monetary measures were also adopted, but now that price controls were discredited, the remedy for double-digit inflation was double-digit interest.

  This policy of using high interest rates to control high inflation had many economic and social effects. It increased inequality, discouraged investment, diminished productivity, reduced demand, and drove up unemployment. Ironically, in some ways it also promoted inflation. The cost of housing, for example, rose sharply in part because home construction was inflated by builders’ capital costs, which increased with the rate of interest. Interest-rate manipulation was a very powerful instrument of economic policy. Its impact was much broader than it was meant to be.

  The result was yet another recession in 1990–91. In that year, the United States had negative rates of economic growth, falling per capita income, and growing unemployment. The rate of inflation slowed from 5.4 percent in 1990 to 3 percent in 1992. Economists and politicians declared that inflation was “under control.” It wasn’t. Even in the midst of the recession, consumer prices continued to climb. The rate of gain even in this recession remained higher than the average inflation in any previous price-revolution in world history.

  So steep was the recession in 1990–91 that the managers of the American economy, in fear of a full-blown depression, shifted suddenly from the brake to the accelerator. Interest rates were driven down to historic lows. The Federal Funds Rate dropped from 9.2 percent in 1989 to 3.5 percent in 1992.

  Industrial economies began to revive, first in America (1992), then in Europe (1993); but this was the halfway prosperity that had happened in the late stages of every price-revolution. Many workers remained jobless. In May 1994, rates of unemployment were above 6 percent in the United States, 8 percent in Germany, 9 percent in Great Britain, II percent in Italy, 12 percent in France, 13 percent in Belgium, 24 percent in Spain, and 50 percent in South Africa. These were the official rates. The true numbers were higher, and even they did not begin to measure the social costs. For every worker without a job there were others who had been unemployed in the recent past, and many more who feared that they might be jobless in the immediate future.

  The social cost of anti-inflationary policies had become more destructive than inflation itself. Opportunities diminished. Inequalities increased. The principal victims were not a class but a generation—young people who had no hope for the future and no memory of better times in the past. The result was a rapid growth of alienation, anomie, confusion, and despair.

  Through it all, consumer prices kept on climbing. Economic managers nervously shifted their weight from accelerators to brakes, then back to accelerators and once more to brakes. Inflation diminished but did not disappear. In early 1995, prices rose at annual rates of 4 percent in Germany, 6 percent in Britain and Switzerland, 8 percent in Italy and Spain. Lower rates prevailed in Japan and the United States, where some observers argued that inflation had been conquered. It was not so. Prices continued to outpace wages. Real income fell, and families were desperately hard pressed. Institutions of many kinds operated under heavy fiscal strain, and struggled to balance their budgets at heavy social cost.

  Growing Imbalances

  These stresses rose directly from the structure of the price-revolution itself. Every great wave had been much the same that way. In the late stages of these long movements, severe strains began to develop within social systems. The damage was done not by price-inflation itself, but by disparities in its operation.

  Some prices inflated more rapidly than others. Price-relatives were much the same as in every long wave since the middle ages. Once again, as thrice before, soaring prices of food and energy and raw materials had led the inflationary advance. Prices of manufactured products such as cars, textiles, appliances, toys, leisure goods, and furniture all lagged behind. The cause was the same as in every other price-revolution. The consequences fell most cruelly upon the poor, who paid a large proportion of their income for food, fuel and shelter.20

  Suffering was compounded by wage-movements after 1975. During the early and middle decades of the twentieth century, workers had done better than in previous price-revolutions. In the United States real wages kept rising through most of the period from 1896 to 1975.21 The cause was to be found in a combination of union activity, minimum wage laws, productivity gains, and social welfare legislation.22 During the early 1970s, that trend reversed. Real wages fell sharply after 1973, dropped again from 1978 to 1982, and declined once more from 1984 to 1996. Broadly similar trends were evident in both white collar and blue collar jobs.23

  Figure 4.18 shows a pattern of price relatives in the 20th century that was broadly similar to earlier price revolutions, but different in important details. Once again the cost of energy, raw materials and farm products led the advance. Once more, wages and manufactures lagged behind. Two differences separate
d the 20th century price revolution from its predecessors. The cost of food increased less rapidly, re, relative to other raw materials; and wages rose a little more rapidly in relative terms, though still falling behind the cost of living. The source is Statistical Abstract of the United States (1978) 765.

  While real wages fell, returns to capital rose more rapidly than the general price level. This was most dramatically so for landed capital. The cost of rent and real estate in the United States multiplied sixfold from 1960 to 1992, while the consumer price index increased threefold. Prime real estate went up tenfold or more. On Manhattan’s Upper East Side, a cooperative apartment that had gone for $60,000 in 1968 rose as high as $600,000 twenty years later. In Boston suburbs with good schools, modest homes that sold for $20,000 in 1965 brought $400,000 in 1986. Similar trends occurred in western Europe and east Asia. In Tokyo, prime commercial real estate rose so high that it was sold by the square meter, at prices between $200,000 and $300,000 for an area 40 inches on a side.24

  Interest rates also increased more rapidly than prices. During the early years of the twentieth century, interest had fluctuated more or less in proportion to the cost of living. In the 1960s, a different pattern appeared. Rates of interest on home mortgages trebled in fifteen years. In New England, mortgage rates rose from 5 per cent in 1965 to 16 per cent by 1979, a rate of increase half again higher than consumer prices in the same period. Consumer loans and credit-card interest went above 20 per cent.

  Figure 4.19 shows the long fall in real wages that began circa 1970, and continued with brief reversals to 1996. The price revolution of the twentieth century had differed from its predecessors in the rise of real wages before 1970. Thereafter, it conformed to the common pattern. Returns to labor fell for American workers, both blue collar and white collar, while returns to capital increased. The result was a growth of inequality that appears in figure 4.22 below. The source is the U.S. Bureau of Labor Statistics, Employment and Earnings (1992); Statistical Abstract of the United States, (1976), table 590); (1981), table 676; (1993), table 667.

  Figure 4.20 shows that real estate values in the United States kept pace with rising prices to 1985, then rose more rapidly. It compares the median sale price of new privately owned one-family houses in the United States, 1970-92, with consumer prices, indexed to 1982-84=100. The sources are Statistical Abstract of the United States (1993), tables 756, 1225; U. S. Dept. of Housing and Urban Development, New One-Family Houses Sold (1994).

  In other price-revolutions, rates of interest had risen more rapidly than prices, but this time another factor was also at work. During the late twentieth century, interest rates were deliberately driven up as a way of managing the economy and controlling inflation. When prices accelerated, the central banks raised interest rates to depress demand. In periods of recession, interest rates were driven down to stimulate economic growth.

  That, at least, was the idea. In practice the policy was distorted by a classic example of a “ratchet-effect,” which allowed rates to move more freely up than down. When the Federal Reserve Board raised interest rates in the United States, retail bankers instantly passed on the increase to their borrowers. When the Fed lowered interest, the banks were slower to follow suit. From 1970 to 1981, for example, the Federal Funds Rate rose from 7.2 to 16.4 percent, and the cost of a conventional fixed-rate, long-term mortgage went from 8.6 to 16.6 percent. But when the Federal Reserve reduced its discount rates from 9.2 to 3.5 percent (1989–92), the cost of fifteen-year fixed mortgages fell very little, from 9.7 to 7.8 percent. This ratcheting of rates reinforced the upward secular trend.

  Figure 4.21 follows the rise of interest rates, which exceeded the pace of price inflation during the twentieth century. The sources are Homer, History of Interest Rates, 343-63, 416-17, 434-35, 448-49; Statistical Abstract of the United States, (1981-93); Annuaire Statistique de la France (1984-93); Great Britain, Annual Abstract of Statistics (1984-93).

  When real wages fell and real returns to capital increased, the social consequences were inexorable. Inequality increased. In the United States this trend began circa 1968.25 Great fortunes grew steadily greater, and the upper middle class also flourished, while poverty and homelessness increased. The upper third of the nation gained ground; the lower two thirds fell behind. The work force was increasingly polarized into two labor markets. The upper market offered high pay, fringe benefits, and long tenure; the lower market was for jobs with low pay, no fringes, and frequent layoffs.26

  Figure 4.22 shows the growth of equality before 1968, and growing inequality thereafter. The graph includes annual Gini ratios for the distribution of income. The Gini ratio is a measure of concentration in which .00 represents perfect equality and .99 is perfect inequality (the upper percentile owns everything). The table to the right lists income shares for six specific years.

  Data are from surveys by the Census Bureau, the oldest and best annual series on income distribution in the United States. They are useful as trend-indicators, but understate levels of inequality by omitting unrelated individuals (whose income is less equally distributed), and by excluding capital gains (which in 1992 raised the top quintile’s share from 44.6 to 50 percent).

  Sources are Current Population Reports, series P-60; Historical Statistics of the United States (1976), series G85-90; Statistical Abstract of the United States (various issues); and Lynn A. Karoly, “The Trend in Inequality among Families, Individuals, and Workers in the United States: Twenty-Five Year Perspective,” in Sheldon Danziger and Peter Gottschalk, eds., Uneven Tides: Rising Inequality in America (New York, 1993), 27.

  America in the late twentieth century was becoming two nations. In New York City, the contrast between wealth and poverty had always been great. Now it became increasingly visible, and more extreme than ever before. Studies by the author and his students found that after 1975, Gini ratios of wealth inequality reached their highest levels in four centuries of American history. Inequality of income also climbed steeply from 1968 to 1996.

  On a bitter cold Saturday evening in the winter of 1986, the author remembers seeing crowds of opulent shoppers strolling on Madison Avenue, while homeless men and women in filthy rags lay silently on steam grates, next to battered shopping carts that held all their worldly goods. In 1989, Manhattan boutiques sold mink coats for four-year-old children (“a steal at $1,200”), while homeless children slept in the streets and subways. Similar sights were to be seen in other cities.27

  Growing imbalances of another kind weakened the powers of governments and private institutions, when they were needed most. Fiscal and monetary disparities developed in public and private institutions. In the United States, President Ronald Reagan repeatedly overruled his advisors and refused to raise taxes, while he increased spending. As a consequence, the revenue of the federal government lagged far behind its expenditures, and the national debt increased at an unprecedented rate. In eight years, the Reagan administration increased the national debt more than all previous presidencies combined.28

  The American national debt, large as it may have been, was only a small part of total indebtedness in the United States. While federal indebtedness soared above $1 trillion, private individual debt rose beyond $2 trillion, and debts owed by business corporations—the most profligate borrowers of all—exceeded $3 trillion. By 1987, the United States had become the world’s leading debtor nation. This mountain of debt created dangerous imbalances in the American financial system. In Illinois, Texas, California and New York, some of the nation’s biggest banks failed during the 1980s. Government intervention succeeded in preventing a general collapse, but by 1989 the American banking system had become the hostage of economic fortune. Any sort of setback—an international crisis, an economic recession, a rogue trader, or a run of bad weather—threatened major disaster.

  Even more unstable than the banks were savings and loan associations. After deregulation, these institutions were so badly managed that by 1988 more than 500 were near bankruptcy, and
the price of solvency was a huge taxpayer “bailout” which deepened Federal deficits. Investigators calculated that half of the losses were caused in part by fraud.

  Instabilities also developed in international trade. The economic policies of the leading western nations differed profoundly in the 1980s. In the United States, the Reagan administration adopted “supply-side” policies which sought to stimulate the economy by deregulation, tax cuts and other incentives. Other nations such as Japan and Germany on the other hand, pursued a policy of slow growth, balanced budgets, strict regulation, and conservative management. These policies made a difference in rates of economic growth, which in turn distorted international trade. The American economy imported vast quantities of foreign goods, but found comparatively static or even shrinking markets abroad. As a consequence, imbalances increased in American foreign trade.

  These trade imbalances contributed to monetary disorders. The Nixon administration had deregulated the international monetary system, destroying the Bretton Woods agreement in 1971–73, and allowing exchange rates to float. After it did so the international monetary system became increasingly unstable. The Reagan administration drove down the dollar relative to other currencies, in hopes of making American products more competitive. The dollar lost more than half of its value against several major currencies. Exports from the United States sluggishly revived, but Americans continued to import foreign products in large quantity, and their cost in devalued dollars was greater than before. The result in 1988 was the growth of imported inflation—a price surge led by rises in the cost of clothing (much of it made abroad) and other imported goods. American trade policy thus contributed directly to inflation and instability.