JP Morgan - A Fiftieth Meeting Celebration - 2000

Three Decades of Economic Change
By Martin Feldstein

The third of a century since the founding of the J.P. Morgan International Council has been a time of profound change in economic policies and in the thinking of the economists and government officials who shape those policies. The change has been most dramatic in the former Soviet Union and in China, where central planning and communist ideology have given way to market economies and to a belief in capitalism. Similar hut less extreme changes are occurring among many other emerging market economies. In the United States and Britain, and perhaps to a lesser extent in Western Europe, there has been a more subtle but no less fundamental shift away from the Keynesian policies of the previous 30 years and to policies that rely less on government intervention and more on individual incentives. This shift has been the result of economic experience. Economists changed their views and countries changed their policies when experience showed that the previous world view was wrong and that the previous policies were failing. There is of course a strong reluctance to change both ideas and practices. Failures can temporarily be attributed to specific external events and data can be misinterpreted in the light of old theories. But eventually the weight of experience and evidence prevailed. The political process and the intellectual climate changed.

These economic changes can be seen as a return to the basic ideas that Adam Smith developed 200 years earlier in The Wealth of Nations. The primary lesson that Smith taught is the importance of incentives and of competitive markets. The key to national prosperity is the individual pursuit of self-interest, controlled by competition, and exercised within a framework of laws that protect property rights and the enforcement of contracts. That simple formula is as true today as it was when Smith argued for it in the 18th century.

From Communism to Capitalism

In a successful market economy, each firm must be free to decide what to produce, how to produce it, and how much to charge for its products. Managers must have the incentives that come with the private ownership of firms, even if that ownership is diffused by widespread share-holding and indirect corporate governance. Individuals must also be free to compete with existing firms and to sell their services on the national market. Governments must promote financial institutions and securities markets that protect the suppliers of equity and debt capital and, more generally, must provide a legal system that protects all forms of economic activity.

These simple principles are the antithesis of the Marxist philosophy and practice that dominated more than half of the worlds population just 30 years ago. In Russia and China, and to a lesser extent in India, the goal was to replace self-interest with the interest of the state, of the collective. Instead of competition, there was centralized government planning. Property rights were severely limited and the legal structure was a way of enforcing government edicts. Banks were channels of government planning and budgeting.

The system worked temporarily by forcing high rates of saving and channeling those savings into heavy industry. But the system failed as the economies became more complex. Growth depends on productivity improvement and not just on the accumulation of resources. And those productivity improvements in a complex economy depend on the incentives that were destroyed by the system of central planning and government ownership. The standard of living in China and India fell sharply relative to the rapidly rising levels in the countries of southeast Asia that relied on much more market-oriented systems. And Russia saw its standard of living falling further behind that of Western Europe and its ability to compete militarily with the United States and NATO being undermined by its relative economic weakness.

China began its transition from Marxism to a market economy in the early 1980s by giving rural families the de facto ownership of their previously collectivized farms. Gradually over time, the government also allowed small-scale individual enterprises and larger collectively owned township and village enterprises. Central planning became weaker and the managers in large state enterprises were given the ability to decide what to produce, how to produce it, and how much to charge for their products. But the needed incentives were missing until more ownership was allowed, with large-scale private firms and the full privatization of most of the township and village enterprises. China is still struggling to improve these policies, to strengthen its legal system, to reform its financial institutions, and to create useful securities markets. There is no opposition to this shift to capitalist ideas among Chinas top political leaders or among the intellectual leaders in universities and think tanks. The reward has been two decades of rapid growth and a transformation of the standard of living of Chinas urban population.

In Russia the change came later but much more rapidly. After a brief period with a very limited scope for private retail markets in food and restaurant services, the entire economic planning system was abandoned in the name of economic "restructuring". Central control of quantities and prices ended. Private ownership became the norm. Russia still lacks the legal structure needed for a successful market economy, the protection of property rights, and an operational financial market that can channel capital efficiently. The government is still unable to enforce those economic laws that do exist and cannot yet carry out such basic government activities as collecting taxes. But there is no doubt that the intellectual revolution to capitalism has occurred and that Russia will rebuild its weak economy on the basis of a system of private ownership and individual incentives.

Although India never experienced a full conversion to Marxism, the policies of the successive Indian governments after independence were based on a kind of English Fabian socialism that emphasized state ownership, Five-Year Plans, and excessive regulation of every aspect of economic life. The result was an extremely low rate of economic growth and an essentially stagnant standard of living. A few leading economists in the Indian government service saw the need for change and seized the opportunity provided by the balance of payments crisis in the early 1990s to begin the process of market-oriented economic reform. Although the process of change has been very slow, the rise in Indias rate of economic growth to more than 6 percent a year for the 1990s has reinforced the nations willingness to make changes in trade policy, domestic regulation, and state ownership. A new generation of economic advisers in key government positions has brought a different world view to Indian policy, and the key political leaders and senior bureaucrats are now clearly engaged in transforming the Indian economy.

Closer to the United States, many of the governments in Latin America have been making similar shifts from relatively closed and statist economies to nations that rely on increased exports, that welcome foreign investment, that have eliminated many of the previous excesses of regulation, and that have privatized much of the industry that was previously in government hands. It is not a coincidence that the key economic advisers in these countries and, in many cases, the most senior government officials, were trained in economics in the United States.

The Retreat from Keynesian Economics

The changes in economic thinking and policy in the United States were much less dramatic than the events that I have just been describing, but here too they represented an important change in the world view of economists and policy officials. Although significant changes in economic

ideas and policies also occurred in Great Britain and in Western Europe, I will pass over that experience to focus on the country that I know best.

Much of the change in the United States can be summarized by saying that the past three decades have seen a shift from a mind-set that had been generated by the depression of the 1930s and that resulted in the ascendancy of Keynesian economics. During the quarter century after World War II, economic thinking focused on avoiding a return to the very painful Depression of the prewar decade. Budget deficits were seen as necessary for maintaining full employment. Inflation was not regarded as a problem. Easy monetary policies were prescribed as a way to increase business investment. Fixed exchange rates were praised as necessary for international trade. High marginal tax rates and generous transfer payments were seen as desirable ways to redistribute income without any worry about the effects on incentives. These views translated into practices that led to rising inflation and greater unemployment, an escalating national debt, an exchange-rate mechanism that collapsed in the 1970s, and a burdensome system of taxes and transfers.

These specific policy prescriptions reflected a view that the economy was fundamentally unstable and therefore subject to repeated downturns that could only be avoided or mitigated by active fiscal policies that involved manipulating taxes and spending to manage aggregate demand. The experience of the 1930s also appeared to persuade economists and policy officials that individuals were not very responsive to tax and transfer policies that altered incentives.

In contrast, todays leading economists have views that are virtually the opposite of those of their intellectual predecessors. The national economy appears to be relatively stable. Activist fiscal policies are not necessary and are likely to destabilize the private sector. Individuals are much more sensitive to incentives than previously believed. These new views have led to a reversal of the previous policy prescriptions. Budget deficits and inflation are now seen as bad. Easy monetary policy is counterproductive. Exchange rates should float. And taxes and transfers should be designed with a view to incentive effects. These new views are mirrored in current economic policies.

This change in economic thinking and practice can be regarded as a retreat from the Keynesian economics that had previously dominated both academic thinking and "common sense" economic policies. John Maynard Keynes was undoubtedly the most influential thinker of the postwar decades. His views, formed in Britain during the Depression, were elaborated and formalized into a theoretical structure by his American followers. Theoretical constructs can have a powerful effect on the way we view the world even as changing conditions make the theory less relevant. Academic economists, policy officials, congressional staffers, journalists, and others continued to see the world through a Keynesian perspective long after the economic conditions had changed in ways that made it an inappropriate basis for policy.

Although economists focused on the technical aspects of Keynesian theory and embodied these ideas in increasingly elaborate statistical models, it was the broader aspects of the Keynesian world view that shaped policy and that characterize the fundamental changes that have occurred in the past 30 years.

The central idea of Keynesian economics was the notion that national income depends on the level of aggregate demand. According to this view, when consumers and businesses and governments want to spend more, national income and employment increase. When they want to spend less, national income and employment decline. This emphasis on demand is the opposite of the view held by economists ever since Adam Smith that national income is determined by the available supply of capital and labor and by productivity.

There is of course some truth to both the Keynesian demand-side story and the Smithian supply-side story. Keynes can be right in the short run, particularly when the level of demand is less than the economy is capable of supplying on the basis of the available capital and labor. But Keynesians essentially ignored the supply side and focused on trying to raise output and employment by government outlays, by tax cuts to stimulate private spending, and by low interest rates to stimulate business investment and housing construction.

Such policies had adverse effects on inflation, unemployment, capital accumulation, and entrepreneurial incentives. Attempts to reduce unemployment by demand policies alone led to rising inflation. Inadequate attention to the incentive effects of unemployment insurance caused the level of unemployment to rise, inducing yet more expansionary demand policies and thus more inflation. The notion that national output is determined by demand caused a neglect of the sources of a nations capacity to produce, particularly the role of entrepreneurial incentives and capital accumulation.

The Keynesian emphasis on demand implied a fear of saving. Keynes argued that the Depression was caused by too much saving and too little consumer spending. The remedy was therefore both government dissaving (i.e., budget deficits) and policies to discourage private saving. This fear of saving led to policies that caused a low saving rate in the United States: tax policies that reduced the net return on saving, Social Security benefits that made retirement saving unnecessary for a large fraction of the population, budget deficits that absorbed private saving, and financial regulations that kept interest rates low for both savers and borrowers.

Although there had always been some economists who did not share this view of the economy and of the appropriate policies, they were in a minority during the quarter century after World War II. But by the 1970s, an increasing number of economists began to recognize that the old Keynesian view of the economy was inappropriate and that the policies that it had spawned needed to be changed. The economy was experiencing slow growth and rising inflation, implying that the problem was not a lack of demand.

The policy changes of the past 30 years reflect this rejection of the Keynesian emphasis on demand and of the Keynesian fear of saving. Marginal tax rates are down substantially. Explicit saving incentives (IRAs and 401(k) saving plans) mitigate the adverse effects of the remaining high tax rates for many savers. Budget deficits have given way to surpluses. Unemployment insurance and welfare have been changed to reduce the adverse incentive effects. Interest rates are no longer regulated. Although the strength of the stock market and the general optimism about the future have caused personal saving rates to decline sharply in the 1990s, the combination of large budget surpluses and strong corporate retained earnings mean that the U.S. national saving rate is now higher than it had been in the past.

The evolution of policy toward inflation deserves special attention. In the 1960s, the nature and consequences of inflation were not well understood. Economists underestimated the adverse effects of inflation and the political process continued to fear the return of high unemployment more than the acceleration of inflation. Many economists argued that inflation was the result of the struggle between labor unions and companies and analyzed inflation in terms of a "cost-push" theory that virtually ignored demand. Others emphasized the idea of a permanent trade-off between inflation and unemployment, implying that a low rate of inflation would entail a permanently higher rate of unemployment. In practice, the Federal Reserve reacted timidly to increases in inflation, raising interest rates by less than the increase in inflation so that real interest rates actually declined as inflation rose, exacerbating the initial increase in inflation.

As a result of all this, inflation rose from less than 2 percent in the early 1960s to more than 10 percent by the end of the 1970s. By that point the public was concerned that inflation might spiral out of control. The 1980s finally saw a determined and successful attempt to bring down inflation. The experience since then has convinced virtually all economists as well as policy officials that inflation reflects demand in general and monetary policy in particular and that low inflation does not raise unemployment. The Federal Reserve has reacted aggressively to observed increases in inflation by raising the real rate of interest. And economists are beginning to recognize that even moderate inflation is harmful to economic activity and that low inflation may increase economic growth and the efficiency of economic markets. Although the United States does not have the formal inflation targets that have been adopted in some other countries, it appears clear that for now there is an implicit inflation goal of 2 percent or less.

Perhaps the most general change in American economic policy in the past 30 years has been a declining role for the federal government. As a share of GDP, nondefense discretionary spending by the federal government fell by one third between 1980 and 1999. And despite the aging of the population and the general rise in health-care costs, federal government spending on entitlements including Social Security and Medicare was no higher as a share of GDP in 1999 than it had been in 1980. This experience stands in sharp contrast to the prior two decades when nondefense discretionary spending doubled as a share of GDP and entitlements rose from 6 percent of GDP to 11 percent. No doubt some new programs that might previously have been done by direct government spending are now achieved indirectly through refundable tax credits. But the fundamental change in the path of government spending in the economy is undeniable.

I have purposely ignored the differences between Republicans and Democrats in my description of the changes in economic policy and economic philosophy. Those differences remain and they are important. But the overall shift of both parties during the past two decades is probably more significant than the important differences that remain.

In describing the changes over the past 30 years I have implicitly indicated that I think that the new policies are better than the old and that they will lead to better economic performance in the decades ahead. This optimism may of course reflect the very good economic performance of the past 10 years. It should serve as a warning that economists 30 years ago had also just witnessed a decade of remarkably strong growth with relatively low inflation and were also convinced that they understood the economy and had the right policies for the future.