Bretton Woods, Nixon Shock, OPEC, Yom Kippur War, Oil Embargo, Stagflation, Paul Volcker, Ronald Reagan and Morning in America

Posted by PITHOCRATES - October 1st, 2013

History 101

(Originally published September 18th, 2012)

Under the Bretton Woods System the Americans promised to Exchange their Gold for Dollars at $35 per Ounce

Wars are expensive.  All kinds.  The military kind.  As well as the social kind.  And the Sixties gave us a couple of doozies.  The Vietnam War.  And the War on Poverty.  Spending in Vietnam started in the Fifties.  But spending, as well as troop deployment, surged in the Sixties.  First under JFK.  Then under LBJ.  They added this military spending onto the Cold War spending.  Then LBJ declared a war on poverty.  And all of this spending was on top of NASA trying to put a man on the moon.  Which was yet another part of the Cold War.  To beat the Soviets to the moon after they beat us in orbit.

This was a lot of spending.  And it carried over into the Seventies.  Giving President Nixon a big problem.  As he also had a balance of payments deficit.  And a trade deficit.  Long story short Nixon was running out of money.  So they started printing it.  Which caused another problem as the US was still part of the Bretton Woods system.  A quasi gold standard.  Where the US pegged the dollar to gold at $35 per ounce.  Which meant when they started printing dollars the money supply grew greater than their gold supply.  And depreciated the dollar.  Which was a problem because under Bretton Woods the Americans promised to exchange their gold for dollars at $35 per ounce.

When other nations saw the dollar depreciate so that it would take more and more of them to buy an ounce of gold they simply preferred having the gold instead.  Something the Americans couldn’t depreciate.  Nations exchanged their dollars for gold.  And began to leave the Bretton Woods system.    Nixon had a choice to stop this gold outflow.  He could strengthen the dollar by reducing the money supply (i.e., stop printing dollars) and cut spending.  Or he could ‘close the gold window’ and decouple the dollar from gold.  Which is what he did on August 15, 1971.  And shocked the international financial markets.  Hence the name the Nixon Shock.

When the US supported Israel in the Yom Kippur War the Arab Oil Producers responded with an Oil Embargo

Without the restraint of gold preventing the printing of money the Keynesians were in hog heaven.  As they hated the gold standard.  The suspension of the convertibility of gold ushered in the heyday of Keynesian economics.  Even Nixon said, “I am now a Keynesian in economics.”  The US had crossed the Rubicon.  Inflationary Keynesian policies were now in charge of the economy.  And they expanded the money supply.  Without restraint.  For there was nothing to fear.  No consequences.  Just robust economic activity.  Of course OPEC didn’t see it that way.

Part of the Bretton Woods system was that other nations used the dollar as a reserve currency.  Because it was as good as gold.  As our trading partners could exchange $35 for an ounce of gold.  Which is why we priced international assets in dollars.  Like oil.  Which is why OPEC had a problem with the Nixon Shock.  The dollars they got for their oil were rapidly becoming worth less than they once were.  Which greatly reduced what they could buy with those dollars.  The oil exporters were losing money with the American devaluation of the dollar.  So they raised the price of oil.  A lot.  Basically pricing it at the current value of gold in US dollars.  Meaning the more they depreciated the dollar the higher the price of oil went.  As well as gas prices.

With the initial expansion of the money supply there was short-term economic gain.  The boom.  But shortly behind this inflationary gain came higher prices.  And a collapse in economic activity.  The bust.  This was the dark side of Keynesian economics.  Higher prices that pushed economies into recessions.  And to make matters worse Americans were putting more of their depreciated dollars into the gas tank.  And the Keynesians said, “No problem.  We can fix this with some inflation.”  Which they tried to by expanding the money supply further.  Meanwhile, Egypt and Syria attacked Israel on October 6, 1973, kicking off the Yom Kippur War.  And when the US supported their ally Israel the Arab oil producers responded with an oil embargo.  Reducing the amount of oil entering America, further raising prices.  And causing gas lines as gas stations ran out of gas.  (In part due to Nixon’s price controls that did not reset demand via higher prices to the reduced supply.  And a ceiling on domestic oil prices discouraged any domestic production.)  The Yom Kippur War ended about 20 days later.  Without a major change in borders.  With an Israeli agreement to pull their forces back to the east side of the Suez Canal the Arab oil producers (all but Libya) ended their oil embargo in March of 1974.

It was Morning in America thanks to the Abandonment of Keynesian Inflationary Policies

So oil flowed into the US again.  But the economy was still suffering from high unemployment.  Which the Keynesians fixed with some more inflation.  With another burst of monetary expansion starting around 1975.  To their surprise, though, unemployment did not fall.  It just raised prices.  Including oil prices.  Which increased gas prices.  The US was suffering from high unemployment and high inflation.  Which wasn’t supposed to happen in Keynesian economics.  Even their Phillips Curve had no place on its graph for this phenomenon.  The Keynesians were dumfounded.  And the American people suffered through the malaise of stagflation.  And if things weren’t bad enough the Iranians revolted and the Shah of Iran (and US ally) stepped down and left the country.  Disrupting their oil industry.  And then President Carter put a halt to Iranian oil imports.  Bringing on the 1979 oil crisis.

This crisis was similar to the previous one.  But not quite as bad.  As it was only Iranian oil being boycotted.  But there was some panic buying.  And some gas lines again.  But Carter did something else.  He began to deregulate oil prices over a period of time.  It wouldn’t help matters in 1979 but it did allow the price of crude oil to rise in the US.  Drawing the oil rigs back to the US.  Especially in Alaska.  Also, the Big Three began to make smaller, more fuel efficient cars.  These two events would combine with another event to bring down the price of oil.  And the gasoline we made from that oil.

Actually, there was something else President Carter did that would also affect the price of oil.  He appointed Paul Volcker Chairman of the Federal Reserve in August of 1979.  He was the anti-Keynesian.  He raised interest rates to contract the money supply and threw the country into a steep recession.  Which brought prices down.  Wringing out the damage of a decade’s worth of inflation.  When Ronald Reagan won the 1980 presidency he kept Volcker as Chairman.  And suffered through a horrible 2-year recession.  But when they emerged it was Morning in America.  They had brought inflation under control.  Unemployment fell.  The economy rebounded thanks to Reagan’s tax cuts.  And the price of oil plummeted.  Thanks to the abandonment of Keynesian inflationary policies.  And the abandonment of oil regulation.  As well as the reduction in demand (due to those smaller and more fuel efficient cars).  Which created a surge in oil exploration and production that resulted in an oil glut in the Eighties.  Bringing the price oil down to almost what it was before the two oil shocks.

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Bretton Woods, Nixon Shock, OPEC, Yom Kippur War, Oil Embargo, Stagflation, Paul Volcker, Ronald Reagan and Morning in America

Posted by PITHOCRATES - September 18th, 2012

History 101

Under the Bretton Woods System the Americans promised to Exchange their Gold for Dollars at $35 per Ounce

Wars are expensive.  All kinds.  The military kind.  As well as the social kind.  And the Sixties gave us a couple of doozies.  The Vietnam War.  And the War on Poverty.  Spending in Vietnam started in the Fifties.  But spending, as well as troop deployment, surged in the Sixties.  First under JFK.  Then under LBJ.  They added this military spending onto the Cold War spending.  Then LBJ declared a war on poverty.  And all of this spending was on top of NASA trying to put a man on the moon.  Which was yet another part of the Cold War.  To beat the Soviets to the moon after they beat us in orbit.

This was a lot of spending.  And it carried over into the Seventies.  Giving President Nixon a big problem.  As he also had a balance of payments deficit.  And a trade deficit.  Long story short Nixon was running out of money.  So they started printing it.  Which caused another problem as the US was still part of the Bretton Woods system.  A quasi gold standard.  Where the US pegged the dollar to gold at $35 per ounce.  Which meant when they started printing dollars the money supply grew greater than their gold supply.  And depreciated the dollar.  Which was a problem because under Bretton Woods the Americans promised to exchange their gold for dollars at $35 per ounce.

When other nations saw the dollar depreciate so that it would take more and more of them to buy an ounce of gold they simply preferred having the gold instead.  Something the Americans couldn’t depreciate.  Nations exchanged their dollars for gold.  And began to leave the Bretton Woods system.    Nixon had a choice to stop this gold outflow.  He could strengthen the dollar by reducing the money supply (i.e., stop printing dollars) and cut spending.  Or he could ‘close the gold window’ and decouple the dollar from gold.  Which is what he did on August 15, 1971.  And shocked the international financial markets.  Hence the name the Nixon Shock.

When the US supported Israel in the Yom Kippur War the Arab Oil Producers responded with an Oil Embargo

Without the restraint of gold preventing the printing of money the Keynesians were in hog heaven.  As they hated the gold standard.  The suspension of the convertibility of gold ushered in the heyday of Keynesian economics.  Even Nixon said, “I am now a Keynesian in economics.”  The US had crossed the Rubicon.  Inflationary Keynesian policies were now in charge of the economy.  And they expanded the money supply.  Without restraint.  For there was nothing to fear.  No consequences.  Just robust economic activity.  Of course OPEC didn’t see it that way.

Part of the Bretton Woods system was that other nations used the dollar as a reserve currency.  Because it was as good as gold.  As our trading partners could exchange $35 for an ounce of gold.  Which is why we priced international assets in dollars.  Like oil.  Which is why OPEC had a problem with the Nixon Shock.  The dollars they got for their oil were rapidly becoming worth less than they once were.  Which greatly reduced what they could buy with those dollars.  The oil exporters were losing money with the American devaluation of the dollar.  So they raised the price of oil.  A lot.  Basically pricing it at the current value of gold in US dollars.  Meaning the more they depreciated the dollar the higher the price of oil went.  As well as gas prices.

With the initial expansion of the money supply there was short-term economic gain.  The boom.  But shortly behind this inflationary gain came higher prices.  And a collapse in economic activity.  The bust.  This was the dark side of Keynesian economics.  Higher prices that pushed economies into recessions.  And to make matters worse Americans were putting more of their depreciated dollars into the gas tank.  And the Keynesians said, “No problem.  We can fix this with some inflation.”  Which they tried to by expanding the money supply further.  Meanwhile, Egypt and Syria attacked Israel on October 6, 1973, kicking off the Yom Kippur War.  And when the US supported their ally Israel the Arab oil producers responded with an oil embargo.  Reducing the amount of oil entering America, further raising prices.  And causing gas lines as gas stations ran out of gas.  (In part due to Nixon’s price controls that did not reset demand via higher prices to the reduced supply.  And a ceiling on domestic oil prices discouraged any domestic production.)  The Yom Kippur War ended about 20 days later.  Without a major change in borders.  With an Israeli agreement to pull their forces back to the east side of the Suez Canal the Arab oil producers (all but Libya) ended their oil embargo in March of 1974.

It was Morning in America thanks to the Abandonment of Keynesian Inflationary Policies

So oil flowed into the US again.  But the economy was still suffering from high unemployment.  Which the Keynesians fixed with some more inflation.  With another burst of monetary expansion starting around 1975.  To their surprise, though, unemployment did not fall.  It just raised prices.  Including oil prices.  Which increased gas prices.  The US was suffering from high unemployment and high inflation.  Which wasn’t supposed to happen in Keynesian economics.  Even their Phillips Curve had no place on its graph for this phenomenon.  The Keynesians were dumfounded.  And the American people suffered through the malaise of stagflation.  And if things weren’t bad enough the Iranians revolted and the Shah of Iran (and US ally) stepped down and left the country.  Disrupting their oil industry.  And then President Carter put a halt to Iranian oil imports.  Bringing on the 1979 oil crisis.

This crisis was similar to the previous one.  But not quite as bad.  As it was only Iranian oil being boycotted.  But there was some panic buying.  And some gas lines again.  But Carter did something else.  He began to deregulate oil prices over a period of time.  It wouldn’t help matters in 1979 but it did allow the price of crude oil to rise in the US.  Drawing the oil rigs back to the US.  Especially in Alaska.  Also, the Big Three began to make smaller, more fuel efficient cars.  These two events would combine with another event to bring down the price of oil.  And the gasoline we made from that oil.

Actually, there was something else President Carter did that would also affect the price of oil.  He appointed Paul Volcker Chairman of the Federal Reserve in August of 1979.  He was the anti-Keynesian.  He raised interest rates to contract the money supply and threw the country into a steep recession.  Which brought prices down.  Wringing out the damage of a decade’s worth of inflation.  When Ronald Reagan won the 1980 presidency he kept Volcker as Chairman.  And suffered through a horrible 2-year recession.  But when they emerged it was Morning in America.  They had brought inflation under control.  Unemployment fell.  The economy rebounded thanks to Reagan’s tax cuts.  And the price of oil plummeted.  Thanks to the abandonment of Keynesian inflationary policies.  And the abandonment of oil regulation.  As well as the reduction in demand (due to those smaller and more fuel efficient cars).  Which created a surge in oil exploration and production that resulted in an oil glut in the Eighties.  Bringing the price oil down to almost what it was before the two oil shocks.

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LESSONS LEARNED #75: “Lower income tax rates generate more tax revenue by making more rich people who pay more income taxes.” -Old Pithy

Posted by PITHOCRATES - July 21st, 2011

Inflation is a Bitch

The top marginal tax rate during the Eisenhower administration peaked at 92%.  When it wasn’t at 92% it was at 91%.  This was post-war America.  A happy time.  They even named a TV series after this time.  Happy Days.  Life was good.  There were jobs aplenty.  And lots of baby making.  Everyone lived happily ever after.  Until the war-devastated economies rebuilt themselves and didn’t need American manufacturing anymore.

Things started to change in the Sixties.  Sure, a top marginal tax rate of 92% was high.  But few paid it.  Creative accounting and useful tax shelters avoided that punishing rate.  But government was still fat and happy with the money it was collecting.  Until the Vietnam War came along.  Johnson‘s Great Society.  And let’s not forget the Apollo moon program.  With renewed competition for American manufacturing, trouble in the oil-rich Middle East and rising inflation, the Seventies weren’t going to be happy.

And they weren’t.  Oil shockNixon shockStagflationMiseryKeynesian economics says to tax and spend to tweak the economy back to health.  When you can’t tax enough, you borrow.  When you can’t borrow, you print.  Nothing is more important than creating demand where no demand exists.  Give consumers more money to spend and ignore the debt, deficit and inflation.  The problem is, inflation is a bitch.

Reaganomics increased GDP 82.9%

Ronald Reagan routed Jimmy Carter in the 1980 presidential election.  Carter’s economic numbers were some of the worst in history.  Double digit interest rates, unemployment and inflation.  All being flamed by an expansionary Keynesian monetary policy.  Until Paul Volcker took over the Fed during Carter’s last year or so in office.  And there really is only one way to cure a bad inflation.  With a bad recession.  And the Reagan recession of the early 1980s was one of the more severe ones.

Reagan was from the Austrian school of economics.  Supply-side.  His Reaganomics embraced the following tenets: cut spending, cut taxes, cut regulation and cut inflation.  In 1980 the top marginal tax rate was 70%.  When he left office it was 28%.  During his 8 years in office he took GDP from $2,788.1 billion to $5,100.4 billion (an increase of 82.9%).

The Reagan critics will note this explosive economic growth and say, “Yeah, but at what cost?  Record deficits.”  True, Reagan had some of the highest deficits up to his time.  But those deficits had nothing to do with his tax cuts.  For Reagan increased tax revenue from $798.7 billion to $1,502.4 billion (an increase of 88.1%).  Those deficits weren’t from a lack of revenue.  They were from an excess of spending.  And, therefore, not the fault of the Reagan tax cuts.

A Downward Trend in Prices is like an Upward Trend in Wages

And the Reagan critic will counter this with, “Sure, the economy grew.  But the rich got richer and the poor got poorer.”  Yes, his income and capital gains tax cuts made a lot of rich people.  But they also transferred the tax burden from the poor to the rich.  In 1980, the top 1% of earners paid 19.1% of all federal income taxes.  By the time he left office that number grew to 27.6% (an increase of 44.8%).  Meanwhile the bottom 50% of earners paid less.  Their share fell from 7.1% to 5.7% (a decrease of 18.9%).

Of course, the Reagan critic will then note that Reagan slashed domestic spending to pay for his military spending.  Well, yes, Reagan did spend a lot.  He increased spending from $846.5 billion to $1,623.6 billion (or an increase of 91.8%).  But he made a tax deal with Congress.  For every new $1 in taxes Congress would cut $3 in spending.  Those spending cuts never came.  Hence Reagan’s monstrous $200 billion deficits.  That’s a lot of money for both guns and butter.

But the greatest thing he did for low-income people was curbing inflation.  High inflation makes everything cost more, leaving low-income people with less to live on.  In 1980, inflation was at 13.5%.  When Reagan left office he had lowered it to 4.1% (a decrease of 69.6%).  No one benefited more from this reduction in inflation than low-income people.  A downward trend in prices is like an upward trend in wages.

The Reagan Economy was Better than the Clinton Economy

The Reagan critic likes to point to the Clinton years as a better economic period with better economic (and fairer) policies.  The Nineties were a period of economic growth.  But even with the dot-com bubble near the end of that period the Clinton GDP growth of 56.9% was less than Reagan’s 82.9%.   

Whereas Reagan achieved spectacular GDP growth while fighting inflation, the Clinton growth did not have to slay the inflation beast.  In fact, inflation rose from 3.0% to 3.4% during his two terms, indicting the GDP growth was not as real as Reagan’s.  Reagan’s was measured with a strengthening dollar.  Clinton’s was measured with a weakening dollar.  Also, real prices fell under Reagan.  While they rose under Clinton.  Making life more expensive for low-income people under Clinton than under Reagan.

Thanks to the dot-com boom, though, Clinton continued to transfer the tax burden to the rich.  He experienced a wind-fall of capital gains tax revenue when all those rich dot-com people cashed in their stock options.  In 1992, the top 1% of earners paid 27.4% of all federal income taxes.  By the time he left office that number grew to 37.4%.  This was an increase of 35.9% (compared to Reagan’s 44.8%).  Meanwhile the bottom 50% of earners paid less, too.  Their share fell from 5.1% to 3.9%.  This was a decrease of 22.7% (compared to Reagan’s 18.9%). 

Over all, though, Clinton’s policies increased tax revenue 69.8% compared to Reagan’s 88.1%.  And this was with the dot-com boom thrown in.  Had there been no dot-com bubble (that burst after he left office) no doubt his GDP and tax revenue would have been less.  Some of this economic dampening perhaps being caused by his increase of the top marginal tax rate from 31% to 39.6%. 

Both Reagan and Clinton made more Rich People

Reagan’s tax cuts led to an economic boom.  He cut inflation making life more affordable for lower-income people.  And he transferred the tax burden to the rich.

Clinton increased taxes.  His economic boom was good but not great.  A big part of his GDP growth and tax revenue was due more to irrational exuberance than real economic growth. 

But both Reagan and Clinton made more rich people.  And these rich people paid more taxes.  And because they did low-income people paid less.  Which would seem to prove that the best way to increase tax revenue (and make the tax system more progressive) would be to create more rich people.  And yet the very people who want to do this advance policies that work against these objectives.  Why?

Politics.  Sure, the Austrian school of economics has a proven track record over the Keynesian school.  But Austrian school economics has a terrible side affect.  It doesn’t grow government.  And all the economic growth and tax revenue doesn’t mean a thing if you lose your comfy federal job.  At least to a Big Government politician.

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