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The Visible Hand

December 1, 1993 Topic: Economics Regions: Americas Tags: Baltic SeaEconomic Liberalism

The Visible Hand

Mini Teaser: Today, as in the past, no statesman can afford to wait for the "invisible hand" of the free market to do his job for him.

by Author(s): William Hawkins

A hundred years ago, Great Britain, then the world's premier power, went into a long-term decline. Annual economic growth 1871-1913 averaged only 1.6 percent and historians have labeled this era "the Great Depression." During this period, the U.S. and Germany both passed England as an industrial power. After the adoption of free trade in the 1840s, a quarter century of economic dominance continued, but by 1873 observers such as Lord Penzance were warning: "The advance of other nations into those regions of manufacture in which we used to stand either alone or supreme, should make us alive to the possible future. Where we used to find customers, we now find rivals....Prudence is not alarm, and prudence demands a dispassionate inquiry into the course we are pursuing, in place of a blind adhesion to a discredited theory."

Still, nothing was done. The landslide victory of the Liberal Party in 1906 won the debate for laissez-faire and free trade. It was not until the 1920s, after the shock of World War I, that the British government under a revived Conservative Party began to directly manage trade and promote industrial policies to foster growth. By then, however, it was too late. England had already lost too much ground. Soon it found great power status too heavy a "burden" to bear and began its long retreat.

A century after Britain's decline began, in the 1970s, the U.S. went into what some have termed a "Silent Depression." From a technical standpoint, depression is too strong a term as the economy has continued to grow, though at a diminishing rate. From 1950 to 1973, the real rate of American economic growth averaged 3.6 percent. But from 1973 to 1991 this fell to only 2.0 percent. Even the best period since 1973, President Ronald Reagan's second term, did not match the 1950-1973 average. The dramatic slowing of the growth rate has not only heightened social problems at home, but has degraded the nation's ability to sustain its preeminent position in world affairs despite its victory in the Cold War.

England after 1846 and the U.S. after 1945 embraced the free-trade philosophy at times when their economic leadership was unchallenged. The mercantilist principles on which that leadership, in each case, had been built were abandoned. It took a generation for major economic rivals to materialize; when they did, laissez-faire provided no defense against their assault. The British and U.S. experiences are uncanny in their parallel development separated as they are by almost exactly 100 years. Now, despite being the only superpower, U.S. budgets have been drawn up in recent years on the assumption (apparently shared by leaders in both parties) that the United States can no longer afford the military establishment, overseas presence, and foreign aid programs that were created and carried forward with relative ease in past decades. Will American geopolitical decline, following American economic decay, make the parallel with British decline exact?

For decades, Washington has been dominated by politicians and analysts on both the left and the right who reject the idea that the nation-state has legitimate economic interests of its own, apart from the short-term interests of consumers in general or the influential interest groups favored by one party or the other. The nation, in this view, is less than the sum of its parts. It is this neglect of national interest in economic policymaking that is the greatest threat to the long-term security and prosperity of the United States--as it was the source of the failure of the recent experiment in laissez-faire.

The Invisible Hand

The supply-side theorists and free traders who dominated the Reagan and Bush Administrations were fully committed to the same laissez-faire notions that paralyzed England during its decline. Among these are the belief that the government should not bias decisions by individuals between savings and consumption or between domestic and foreign purchases, and the conviction that economic activity is in some autonomous sector detached from other national concerns.
In fiscal policy supply-side theory led to a misguided focus on the household rather than on the production (business) side of the economy. Tax rates were reduced, but a host of deductions, credits, and exemptions were also removed. What others saw as incentives, the reformers regarded as distortions. The expectation was that lower taxes would increase capital formation (savings) as the after-tax return increased, thus promoting growth and higher productivity. This is a basic Keynesian concept. But while Keynes applied it to business only, the supply-siders as "individualists" tried in vain to apply it to households trusting in "the market" to do the rest. Their mistake was soon evident: the savings rate fell in the 1980s from just over 8 percent at the start of the decade to about 5 percent at the end despite the curbing of inflation. The tax cuts went to support consumer demand, not savings. Much of this demand was satisfied by imports since domestic producers did not have the capital needed to rapidly expand to meet the demand.

It didn't start out this way. The 1981 Economic Recovery Tax Act (ERTA) contained many useful provisions aimed at the capital formation and production side. The investment tax credit was extended and depreciation liberalized. Eligibility for Individual Retirement Accounts (IRAs) were extended to all working households. The top rate for capital gains was reduced to 20 percent. Unfortunately, movement started away from such provisions immediately. The 1982 Tax Equity and Fiscal Responsibility Act (TEFRA) scaled back the investment tax credit and canceled planned accelerations in the depreciation schedule. The Alternative Minimum Tax (AMT), which limits the value of incentives by disallowing their full use, was strengthened. The Deficit Reduction Act of 1984 again made depreciation schedules less favorable.

The 1986 Tax Reform Act (TRA) eliminated the investment tax credit entirely. Also eliminated were IRAs for people with employee-provided plans. Depreciation rules were made still less favorable and the AMT was increased. The capital gains tax rate was upped to 28 percent. William A. Niskanen, a member of Reagan's Council of Economic Advisors and now president of the libertarian Cato Institute wrote in his book Reaganomics (1988) that even though "Total investments by Americans is likely to decline about 3 percent...and domestic investment by corporations may decline as much as 8 percent" due to the "increase in the effective marginal tax rate on new investment in the corporate sector from 37.2 percent to 42.1 percent" the TRA will still have a "small positive effect" because "the reduction in the variance in effective marginal tax rates on corporate investments will improve the allocation of economic activity." In other words, for ideological reasons, it was better to have investment fall than to have the government distort markets by stimulating it. This was Supply-side/laissez-faire fiscal policy taken to a reductio ad absurdum.

Unfortunately the "free market" did not satisfy the requirements for domestic economic growth. Between 1986 and 1991, business sector output per hour, a key measure of productivity growth, rose at only a 0.1 percent annual rate. Productivity growth, the main cause of higher living standards, was lower after 1986 than during the 1973-81 period despite the oil shocks and inflation of the Ford and Carter Administrations and much worse than during the 1982-85 period when annual productivity gains made it up to 1.7 percent.

In addition to serving as a poor guide for domestic policy, the free-market model proved to be disastrous in trade policy. The Reagan and Bush administrations moved toward freer trade and away from industrial policy just as commercial rivals in both Asia and Europe made their push. The U.S. merchandise trade balance had gone into deficit in the 1970s (after a century of surpluses) due to the rise in oil imports. In 1983 the trade balance in manufactured goods turned negative and stayed there, resulting in a transfer of wealth overseas approaching $1 trillion by 1993.

A lengthy 1991 study by the Congressional Office of Technology Assessment (OTA) entitled Competing Economies: America, Europe and the Pacific Rim noted that "most advanced countries do lend policy support to certain industries, and the criteria for selection are generally the same; they favor industries that are knowledge intensive....that have good prospects for growing markets, and that are built on versatile core technologies with spillovers to other industries."
The OTA concluded that "the United States will lag behind its major competitors, especially Japan, if current trends continue." Though this study had been commissioned by the late Republican Senator John Heinz, the Bush Administration would have none of it. Michael Boskin, Chairman of the Council of Economic Advisors, repeatedly rejected measures to advance American high-tech industries as "silly attempts at industrial policy." Boskin is also known for his much quoted opinion that from an economic policy perspective there is no difference between "potato chips and computer chips."

Equally dogmatic was the attitude taken by Treasury Secretary James Baker who under Reagan opted for dollar devaluation as a free-market solution to the problem of America's burgeoning manufacturing trade deficit with Japan. That policy failed to reduce the trade deficit, as Japanese firms responded by altering their prices for the American market. However, a weaker dollar dramatically (and unintentionally) increased the cost of projecting American power overseas. A proper policy would have sought to eliminate the trade deficit while maintaining the strength of the dollar as a strategic asset.

Another side effect of the devaluation strategy, combined with a laissez-faire attitude toward international economic activity, was that American productive assets were suddenly available at bargain prices. In testimony before the House Armed Services Sub-Committee on Investigations in August 1992, Linda M. Spencer of the Economic Strategy Institute presented a list of over 700 proposed foreign acquisitions of American high-tech companies between October 1988 and April 1992. Spencer's list included 608 consummated deals involving aerospace, advanced materials, chemicals, computers, electronics, semiconductors, biotechnology, and telecommunications. Most had Pentagon or other U.S. government contracts. In two out of three cases, the foreign party became the majority owner. Of the 608 cases, Japanese interests accounted for 399 acquisitions. Japan's six largest keiretsu industrial combines (Fuyo, Sumitomo, Mitsui, Mitsubishi, DKB, and Sanwa) alone grabbed up 244 American high-tech companies. Hard-pressed American firms strapped for capital make easy prey for the Japanese who have earned hundreds of billions from their trade surplus with the U.S. The Bush administration's interagency Committee on Foreign Investment in the U.S. investigated only fourteen of these proposed deals and recommended against approval only once (in a case involving China after Tiananmen Square).

All of these deals have been in fields identified as "strategic" by the Office of Technology Assessment. They are at the center of the world-wide struggle to dominate the twenty-first century economy. Buying entire organizations is more than just eliminating a rival. Many of today's technological advances are incremental, based on learning curves and proprietary knowledge. The organization is part of the technology. The future flow of ideas can be redirected overseas to aid commercial rivals, which may be military rivals tomorrow. Japan's industrial priority list, for example, includes steel, shipbuilding, machinery, electronics, nuclear power, automobiles, computers and aerospace--an industrial core that can be readily converted to military production.

The unwillingness of America's economic rivals to behave as laissez-faire theory claims they should has also plagued the U.S. in the Uruguay Round of the GATT. American efforts to strengthen rules against predatory trade practices such as dumping have been rejected by the Europeans and the Japanese who routinely use these tactics to displace American firms. This tactic is supported by foreign governments who subsidize their export industries. In regard to both dumping and subsidies, GATT wants to move dispute settlement procedures to a supranational body which could require the U.S. to rewrite its trade laws to conform to the wishes of its rivals. Policies to expand the U.S. economy could be declared illegal by a foreign tribunal without appeal. Unlike the United Nations where the U.S. is a permanent member of the Security Council, at GATT the U.S. does not have a veto. Once it signs a gatt accord, it will only have one vote among those of over a hundred other countries on how the new rules will be implemented.

The Uruguay Round has been in session since 1986. Not even such trusting free traders as Reagan and Bush could accept the terms that have been proposed. Perhaps it is time to question the dogma that multilateral liberalization should be a goal in itself. For twenty years the open U.S. market has been the "engine of growth" for the rest of the world. During this same period, America's own growth rate has slowed significantly. In light of this historical experience, it is increasingly difficult to take seriously the arguments by free-trade ideologues that an economic golden age can result from further liberalization under the auspices of GATT. While GATT reduced tariffs, the most visible policy tool, non-tariff measures appeared in their place which were not so transparent. Not only are these measures harder to identify and negotiate over, but they allow governments plausible deniability to the extent that they seek to manage trade in the interests of their national industrial policies. The manipulation of exchange rates, agreements to control exports, and the creation of trade blocs add further proof to the argument that genuinely free trade is impossible because it poses an unacceptable threat to national economic objectives.

All too often the importance of free trade for domestic economic growth is grossly exaggerated. Astute national leaders know that while there are gains to be made from trade, they are small compared to the gains that can be realized by advances in domestic productivity. It remains a fundamental fact that no people can, in the long run, live beyond their own ability to produce and generate wealth. Trade can impact this process, but not always or automatically in a positive fashion. Proponents of laissez-faire underestimate how difficult it is to progress, whether as a single company or as a major nation. The notion that one only has to "get out of the way" as progress storms ahead is terribly romantic and terribly misleading. If progress were that easy, the world would be a far better place than it is. Instead, progress is the result of hard work, sustained effort, and a little luck. Every effort must be mustered to support it, including effort by government which is the largest single actor in the economy.

The strategic reasons for government intervention in the economy are even more compelling than the domestic reasons. A government's concern for the industrial composition of its national economy must go beyond the problem of stagnation in output or income. The basic insecurity of a nation-state in an unstable global system compels an alert government to foster and maintain strategic heavy and high-tech industries. The major source of international trade rivalry, since the dawn of the industrial revolution, has been the military power base provided by modern industry and technology. More than factories and inventions is involved. National security depends on raw materials and energy supplies; on links of military industries with other industries and associated services; on improved transportation and communications; and on the organized support of education and basic research. The advantage in world politics goes to those states that can effectively unify all key sectors under one national or imperial authority.

It is a mistake to believe that "the military-industrial complex" can be neatly separated from a larger economy in which global market forces, not national strategic decisions, are of ultimate importance. Military demands long ago outgrew the capacities of state-owned arsenals and shipyards, while private enterprise demonstrated its superior ability to organize and innovate. Dual-use technology, applicable to either the commercial or military sectors, has been important throughout the industrial era, from the Bessemer process for steel-making (used in the manufacture of heavy artillery) to the dsp computer chip, which is reviving the U.S. electronics industry (and is a critical component of guidance systems). The close connection between civilian and military industry means that the government must cultivate peacetime markets to keep private industry healthy, operating, and ready to mobilize.

The claim that government cannot or should not pick winners and losers is a phony issue. Not only is government influence on economic decisions unavoidable in the case of a government with a $1.5 trillion budget, but it is an essential responsibility of government to formulate policies to advance the nation's comparative economic standing. The success of Cold War programs in military-industrial sectors in which the U.S. leads the world attests to the ability of government and business to work closely together. It is no accident that America's top export industry is the area of greatest government investment--aerospace.

These considerations suggest that the original ideal of GATT, the creation of a world of harmonious free trade, was never tenable. Economic independence, the ability of a country to shape its own destiny and be free to choose when and where to act, is a central concern of nation-states in an anarchic world. Samuel P. Huntington notes that "economic activity is a source of power as well as well-being. It is, indeed, probably the most important source of power...increasingly important in determining the primacy or subordination of states."

Clintonomics

Three of the four presidents who have served since the break in American economic growth in 1973 have been denied re-election to a second term. That a lagging economy means political doom should have been impressed on Clinton's mind given the tone of the campaign which elected him. The 1992 election indicates that the American people will not accept a passive economic policy. They want faster economic growth with more and better paying jobs. This was the meaning of the flight of formerly Republican voters from George Bush to Ross Perot (and to a lesser extent, Bill Clinton). The American people expect the government to act.

What is needed are policies that will not only restore a bias toward savings and investment, but promote the development of high-tech industries and the winning back of overseas and domestic markets. Not only a return to incentives for the private sector, but increased direct government action to upgrade education, rebuild the nation's infrastructure, manage trade to the advantage of American firms and workers, and support research and development programs to advance living standards.

President Clinton's naming of Laura D'Andrea Tyson to chair the Council of Economic Advisors could not mark a greater change from the Boskin era. At the time of her appointment Tyson directed the Berkeley Roundtable on the International Economy, a group that has been in the forefront of work on a new trade and industrial paradigm. In Politics and Productivity (1989) Tyson stated that "the world is at the beginning of something akin to a third industrial revolution...and that Japan is at the forefront." Tyson believes that Japan owes its position to government strategies that "guided Japan's industrial structure" and that U.S. policy must break with the outmoded idea that America can maintain its position without a determined effort. A more activist partnership between government and business is needed, or the U.S. risks becoming one of the "weaker" economies subject to greater instability, a falling dollar, and a decline in relative living standards.

Others in the Clinton administration subscribe to this view. Treasury Secretary Lloyd Bentsen has long favored targeted tax incentives for business rather than across-the-board rate reductions for individuals. In the 1980s, Bentsen also became a "trade hawk" calling for tougher negotiations with Japan and others. Bentsen represents the view that the volume and composition of trade in key industries will have to be managed in some cases rather than left to the market.
Unfortunately, Clinton's plan so far is more talk than action. His vaunted investment tax credit is paltry and permanent only for very small firms ($5 million or less in annual revenues). The same charge of parsimony applies to his R&D credit and his cut in capital gains taxes for new, small ventures. These measures will not be of much help to those medium and large American firms that are locked in mortal combat with foreign combines for control of strategic and high-tech industries. Firms do not have to be gargantuan to be leaders in industrial expansion, but they do have to be substantial.

One hopes that the Clinton administration will free itself from the conservative obsession with small enterprises. Only larger firms can afford the pay and benefits Americans have come to identify with middle class life. Small business did provide the bulk of the new jobs of the 1980s, but that was part of the problem. It marked a tendency of American entrepreneurs to seek niches away from foreign competition. Often these new businesses were dedicated to selling or servicing products manufactured overseas. There was a mood of resignation and defeatism at the center of government, only lamely covered by brave talk about the "spirit of enterprise." In the 1980s it became popular to denounce American corporations being pushed back by overseas rivals as "dinosaurs" properly headed for extinction even though their advancing rivals were also behemoths. This was part of the "sour grapes" mentality adopted by officials who were constantly looking for excuses not to act. The country would take what its rivals left it and learn to like it.

America's industrial decline is not inevitable. Firms across the spectrum are "reinventing" themselves; changing their organization, adopting innovative technology, and boosting productivity. Increased productivity, however, results in job losses as it takes fewer people to produce a given amount of goods. To generate net new jobs at the high end of the wage scale, increases in productivity must be coupled with expansion of the market. This is why trade strategy that aims to secure through political action large markets (both at home and within carefully defined trade blocs) will take on an ever more important role in the nation's overall economic policy. American firms, with the active support of the U.S. government, must take back markets lost in the 1980s as well as carve out new ones.

The United States, as the most affluent continental nation-state, has the advantage in this struggle for markets. This advantage could have been expanded if the North American Free Trade Agreement (NAFTA) had been managed so as to create a true trade bloc that can be dominated by American firms while the opportunities for the firms of rival overseas industrial states are curtailed. However, since the Bush administration explicitly rejected this approach while negotiating NAFTA, and because none of Clinton's side agreements address it, the national strategic economic case for NAFTA is unconvincing. Indeed, it may even be harmful, if U.S. firms relocate to Mexico, using it, along with other low-wage Third World nations, as an export platform to manufacture goods for the American market. Free traders who cite lower prices as gains to consumers from this strategy forget that people must first work and earn income before becoming consumers, something that becomes more difficult as jobs are exported and real wages driven down in the U.S. in the name of "competitiveness."/

The Lessons of History

Historian Robert L. Reynolds, writing of the era when Europe was starting the expansion that would bring the entire world under its influence, argued that "it was a great asset to the Europeans in commerce that European governments put their whole strength behind mercantile enterprise, and considered the devising of ways and means for making their merchants richer and strong a valid activity....Those governments had a theory that if their merchants were strong and rich, the governments themselves would carry greater weight in war and diplomacy."

Today, as in the past, the classical liberal view of harmonious trade holds only where trade is trivial in value or impact. Where trade really matters, it becomes inseparable from the general struggle for wealth, power, and security. When a zero-sum trade war is being fought to control key economic sectors, surrendering strategic industries in accordance with the classical theory of specialization and division of labor is unacceptable. It becomes the responsibility of governments to manage trade in the national interest as it manages other aspects of international relations.

The post-World War II liberal internationalist era, like the mid-19th century, was an atypical period resulting from special circumstances that could not last. Princeton political economist Robert Gilpin describes the instability of an open trading system that depended so heavily on the willingness of a single "hegemon" to bear a disproportionate share of the costs in The Political Economy of International Relations (1987): "The hegemon grows weary and frustrated with the free riders and the fact that its economic partners are gaining more from liberalized trade than it is....In time, the hegemon becomes less willing and able to manage and stabilize the economic system."

After World War II, the United States played the role of benevolent hegemon, accepting the costs of maintaining an open world trading system. Since American productivity growth began its long decline in the 1970s, the U.S. has tried to shift the burden from itself to multilateral coordination through the G-7, but the clash of national and regional interests has prevented any consensus forming other than a desire by the other six members to keep the U.S. passive in the face of the predatory policies of its trading "partners."

Free traders have greeted Clinton's appointments and talk of a tough new trade policy with fear that the liberal world order they have embraced with ideological fervor is coming to an end. If true, this would not be an unexpected or unusual event. The modern world trading system has been in existence for some five centuries. For most of this time, it has not been conducted under cover of a self-sacrificing, liberal hegemon. World trade will simply revert to its more traditional pattern: what the seventeenth century French mercantilist statesman Jean-Baptist Colbert called "a perpetual and peaceable war of wit and energy among the nations." This has been the norm all along. Today, as in the past, no statesman can afford to wait for the "invisible hand" of the free market to do his job for him. The invisible hand does not hold aloft any particular national flag; the hands of a statesman must.

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