How did Democrats lose the white working class?

This post proposes that the New Deal feature that won Democrats lasting political influence was the widely-shared prosperity of the postwar economy. During the postwar heyday of Democratic economics (1948-73), real per capita GDP (GDPpc) rose at a 2.5% annual rate. This is a good result but not that different from the 2.4% rate achieved during the 1920-29 heyday of Republican economics or the 2.2% achieved during the 1981-2001 era of Reaganomics. Real unskilled wages tell a different story. They rose at a 2.5% rate over 1948-1973, compared to 0.8% over 1920-1929 and only 0.14% over 1981-2001.

Republicans argue the unusually high wage gains in the postwar era reflected the fact that the US had escaped the devastation of WW II and faced reduced foreign competition from the shattered economies of the rest of the developed world. This explanation is not very convincing because trade did not account for a large portion of the US economy even in the period before the war. This was likely the result of protective tariffs that the US had maintained for more than a century before the war. It has only been over the last several decades that trade has grown to a point where foreign competition could play a significant role in lack of wage growth.

Another possible explanation is the natural growth rate of the economy and the economy’s ability to generate wage growth has diminished with time. I note that the 1948-73 period of high wage growth occurred after the 1920-29 period lower wage growth, arguing against this idea. It is possible that this observation reflects my cherry-picking of the periods for comparison. If we compare the 1929 to 1981 period of Democratic ascendancy to the previous 1880-1929 Republican era, we see GDPpc growth of 2.0% and 1.5%, respectively. For wages, growth was 2.2% and 1.6%, respectively.

The two periods are each about fifty years long and contain a major great power war plus a couple of lesser ones and so should be comparable. Thus, the pattern of superior Democratic results relative to an earlier Republican era is still present when looking at the complete periods. Note that I included the entire Great Depression and the 1970’s slump into the Democratic period, while the Republican period is the very “golden era” of laissez-faire capitalism that Republicans see as their ideal. Even with this very favorable to Republicans choice of periods, the Democratic era comes out better. The story for the post-1981 era of Reagonomics is also instructive. Growth in GDP per capita through 2016 has been 1.7%, actually better than the earlier Republican era, but unskilled wage growth has been 0%.

Figure 1. Inequality over 1880-present

See reference 1 for details on inequality calculations.

So what is going on? Figure 1 shows that from 1880 to 1929 economic inequality rose, while from 1929 to the later 1970’s it fell, and since then it has been rising. The reason why wage growth was so good during the period of Democratic economic management was because the New Dealers enacted policy specifically intended to reduce economic inequality in order to build credibility with working class voters, who responded by becoming loyal Democratic voters.

How the New Dealers created postwar prosperity and won working class support for decades

The problem faced by the New Dealers was a depressed economy. The solution they crafted was centered on massive economic stimulus coming from government expenditures. In 1938 government expenditures were 7.8% of GDP compared to revenues of 7.7%. Unemployment was 19%. Through programs like Lend Lease, spending increased nearly 40% over the next two years. Over this time unemployment fell to 14%. War broke out in 1941, and spending soared to over 40% of GDP by 1944, by which time unemployment had fallen to 1.2%.

New Deal economic policy was not just stimulus. WW I had also brought stimulus, which generated gains to working people: note the steep decline in inequality as a result of that war in Figure 1. But the gains were temporary. The war stimulus was accompanied by massive inflation, the control of which resulted in the undoing of much of the benefit from the war. To prevent this from happening again the New Dealers enacted wage and price controls for the duration of the war. Furthermore, they structured these controls in such a way as to deliberately reduce economic inequality (see reference 1 for details).

Most importantly, they raised taxes to very high levels and kept them high afterward in order to effect a rapid transition from deficit-fueled stimulus to a budgetary surplus which acted as a brake on inflation (this is known as austerity). Taxes were raised during the war so that revenues rose from 6.4% to 19.8% in 1945. Spending was much higher so the deficit rose from around 3% of GDP in 1940 to 21% in 1945, creating pent up inflationary forces, which would be released when controls were removed at the end of the war. After the war, spending fell dramatically as the country demobilized so by 1948 spending had fallen to just 11% of GDP--only 18% higher than the spending in 1940. Taxes stayed high, however. Revenues in that year were 15% of GDP, more than twice the 1940 level. Inflation did break out after the war, but it was moderated by the large budgetary surpluses collected over that time.

With the Korean war taxes were increased to match expenditures. As a result, whereas WW II had an accumulated deficit of 85% of GDP, the Korean war had only 1.7%. The war generated no inflationary forces, yet it was stimulatory, unemployment fell from 5.2% to 2.9%. After that war taxes were not reduced. Revenues averaged 16.5% over the next decade while spending averaged 17%. This near-balanced budget meant the national debt rose more slowly than GDP. Although the debt was not being paid off in nominal dollars (the nation was not running regular surpluses) it was being paid off in real dollars.

In the pre-Depression world, when inflation was automatically controlled using a gold standard, the government tended to run surpluses during peacetime in order to pay off debt incurred during wars. The result was steady deflation during peacetime. Such an economy is prone to frequent financial crises and depressions. These grew in severity with time until they got so bad the gold standard was ended in 1933. In the post-Depression world (also known as the Bretton Woods era), inflation was controlled using a fiscal standard. This worked as follows: the government levied high taxes to pay for most spending and should it come to pass that they did incur deficits during a depression or war, they were to follow them with surpluses to quell inflationary forces produced by those deficits. In actual practice they ran near-balanced budgets for more than twenty years after the war. The natural result of this policy would be price stability (0 inflation). However Democratic economic management was intrinsically pro-wage growth (recall that the New Dealers had engineered wage and price controls to benefit workers). They decided a little inflation was not a bad thing and so they had the Fed run a low interest policy that boosted economic growth (and inflationary forces).

So, the postwar economy was a fine-tuned for strong employment and wage growth, but was inherently prone to inflation. The only thing that held inflation to a tolerable level was high taxes and spending discipline to generate balanced budgets. In other words, in the post war economy (as under the gold standard) deficits mattered. Most wealth is in terms of financial assets whose values are adversely impacted by inflation, because they are priced in dollars, the real value of which fell during inflation. Labor is less impacted because like other commodities, its dollar price rises with inflation. Thus, under a gold standard, or the postwar Bretton Woods system, Republicans were afraid of deficits and were willing to raise taxes and keep them high if this would prevent deficits. That is, Republicans were fiscal conservatives. Thus, when spending increased for programs Republicans saw as politically necessary (such as national security) or which they believed were politically untouchable (see Eisenhower’s letter to his brother in reference 2) they were willing to support high taxes if that would ultimately prevent inflation, which they feared and hated even more than taxes.

As long as the government could manage a balanced budget, policymakers should see low inflation with low interest rates. This should then give strong wage growth. But there is another problem. Low interest rates and low inflation are perfect conditions for asset price inflation (i.e. rising prices in investments like stocks, real estate or collectables, which eventually results in a financial bubble, which when it deflates, gives financial crisis and serious recession which hurts wage-earners (recall the post-WW I experience). To prevent financial bubbles from wrecking the economy it is necessary to drain the financial sector of excess cash through very high taxation. Thus, to create the excellent economic performance of the postwar Bretton Woods era, three things were necessary: balanced budgets, low interest rates and very high taxation on wealth holders. Disrupt any of these and one could kill the goose that laid the golden eggs.

How the Democrats killed the goose

During the 1948-73 heyday of Democratic-style economic management inflation averaged only 2.5%, despite the strong growth. It was only in the final years of the Democratic era that inflation got out of control, leading President Carter to implement a new policy of controlling inflation with interest rates by appointing Paul Volcker as Fed Chairman (see Appendix A). As Figure 1 shows, the shift from falling inequality to rising inequality occurred around the same time as the Carter presidency.

Carter had no real choice but to enact the new policy, inflation was out of control. Democratic economic management had failed and a new policy had to be enacted, which meant there no longer would be significant wage gains for unskilled workers. In this way Democrats failed their wage-earner base. Democrats replaced labor-friendly politics with what is now known as identity politics. In just one year their ability to implement any sort of pro-worker policy would be lost by the 1980 Reagan victory, a situation that would persist to this very day.

So how did they get into this situation? In the early 1960’s President Kennedy proposed a 20-percentage point tax cut in top rates (with additional cuts at lower income levels). This tax cut was implemented by his successor Lyndon Johnson, whose main policy goal was his Great Society Programs. Thus, like a certain Republican forty years later, Kennedy-Johnson thought it a good idea to pass a big new welfare benefit, start a war of choice, and top it all off with a tax cut for the rich. They began two programs, one of which (the war) would bring no tangible benefits to their working class-base, that together would result in a 93% increase in outlays in 1968. But with their tax cut, revenues rose only 65%.

It worked, the stimulus of additional federal spending gave rise to the longest economic expansion up to that time during which unemployment fell to 3.5%, the lowest level in 15 years. What the 1960’s Democrats did was potentially no different than what was done in WW II. Unlike after WW II, this stimulus was not countered by a period of austerity afterward. Democrats did pass a small tax increase so that the 2.7% deficit in 1968 was followed by a 0.3% surplus in 1969, but this was a one-year event, and was followed by more deficits. What they should have done was what had been done for the Korean war, keep the taxes high and pursue only those projects that could be paid for, e.g. keep the Great Society (which Johnson really wanted to do) and ditch the war of choice. Deficits would not have emerged, and the inflationary forces would have been kept at bay.

Instead, the Democratic war of choice led to their defeat in 1968, just as George W Bush’s war did 40 years later. The new Republican president faced a quandary. As a conservative Nixon believed that if one enacted major new welfare benefits, began a war and then cut taxes the results should be economic disaster. Yet the Democrats seemed to have gotten away with it; he had inherited a strong economy and a balanced budget. Proclaiming that he was now a Keynesian in economics, Nixon decided to run deficits like a Democrat. He and his successor eliminated the 1968 increase and oversaw spending increases that turned a 0.3% surplus into a 3.9% deficit. That is, he followed the 1960’s stimulus with yet more stimulus.

When the Carter administration began in January 1977, inflation was running at 5.2%, compared to 3.3% at a similar point in the previous business cycle and 1.3% in the one before that. This trend was ominous. What was needed was austerity: higher taxes, spending constraint, or both. Carter was a fiscal conservative, elected by worried Democratic base who had made the right choice. But Congressional Democrats were in no mood for spending restraint after winning control of the government again after eight divisive years under a Republican administration. So deficits continued, 2.6%, 2.5%, 1.5% and 2.6% in each year of the Carter administration, while inflation steadily marched upward: 6.8%, 7.7%, 11.3%, 13.1%.

In the 1980 election, candidate Reagan touted the Kennedy tax cuts as the solution to the country’s economic woes. Although Kennedy had sold his tax cuts as “Keynesian stimulus” (which they were) Reagan justified them to a still fiscally-conservative Republican party with the new notion of “supply side economics” a brand of economic silliness his running mate had correctly identified as “voodoo economics”. His campaign came up with a clever metric, the “misery index” which was the sum of inflation and unemployment. At 20.7%, the misery index in 1980 was at the highest level it had been since the first years of the Roosevelt administration.

Reagan won, and by 1984, thanks to the Volcker Fed’s new policy of inflation control by interest rates, the misery index had been cut in half, to 11.8%. Reagan won in a landslide. His voodoo economics came to be called “Reaganomics” and became the Republican economic policy consensus. Meanwhile, the deficit, about which Carter had fretted, had risen from the 2.6% in 1980 to 5.7% in 1983, before falling to 4.6% in 1984. For the rest of his term, the deficit would remain higher than its 1980 level, yet inflation remained low, reaching 1.9% in 1986, with an average level of 4.7% during Reagan’s time in office, thanks to the Fed policy of controlling inflation with interest rates rather than spending. With interest rate policy it doesn’t matter how high you run deficits, you can always keep inflation by squeezing workers harder. As Dick Cheney would later remark, “Reagan proved deficits don’t matter”.[3] Republicans ceased being concerned about deficits and inflation (except when Democrats were in the White House) and now opposed all tax increases on wealth reflexively.

So began the modern economic era. By the time Democrats came back to power in 1992, top tax rates had been slashed to 31% and Democrats had moved to the right on trade, passing NAFTA and towards fiscal conservativism, raising taxes to a top rate of 39.6% resulting in a fiscal shift from a 4.4% deficit to a 2.3% surplus during Clinton’s time in office, the largest dose of austerity since the period after WWII. Inflation, which stood at 3.0% when Clinton took office was down to 1.6% in 1998 before rebounding to 3.4% at the end of Clinton’s term. Clinton achieved a reduction of unemployment from 7.5% to 4.0% without resorting to stimulus, something not even attempted since the Eisenhower administration.

Clinton and the Democrats tried (and failed) to pass a national health insurance plan in 1993. In the following year, they saw Republicans win control of both houses of Congress for the first time in 40 years. With a Republican Congress, Clinton signed into law more Reaganomics: a capital gains tax cut in 1997 and repeal of Glass-Steagall in 1999. Democratic economic policy consistent with Republican economics of the old school (balanced budgets) and the new school (deregulation/market-orientated policies) is called neoliberalism and it has become the default economic stance for mainstream Democrats. The next Obama administration more or less stayed with the Clinton neoliberal consensus, which brings us to the present day.

References

1. Alexander, Michael A. 2017. Involvement of a Capitalist Crisis in the 1900-30 Inequality Trend Reversal. Cliodynamics 8: 18-47. http://escholarship.org/uc/item/42p5m46m

2. Eisenhower letter to Edgar Newton Eisenhower, November 8, 1954. http://web.archive.org/web/20051124190902/http://www.eisenhowermemorial.org/presidential-papers/first-term/documents/1147.cfm

3. John Nichols, “Gotta Sequester? Or Was Cheney Right That ‘Deficits Don’t Matter’?”, The Nation, March 1, 2013. https://www.thenation.com/article/gotta-sequester-or-was-cheney-right-deficits-dont-matter/

Appendix: Why economic management is really inflation management

Recently the Federal Reserve has been increasing interest rates to ward off incipient inflation. A key sign of incipient inflation is strong employment, which can lead to wage increases which provide consumers the funds needed to bid up prices of goods and services, which is, of course inflation. This line of thinking can lead to the idea of NAIRU, the level of unemployment below which inflation starts rises. NAIRU-thinking suggests that conditions conducive to wage growth are also conducive to inflation, and so to suppress the latter you must suppress the former. Vox’s Matthew Yglesias observes that the Fed seems concerned about job growth:

After years of holding short-term interest rates at essentially zero, the Fed raised rates in December 2015 and then again in December 2016. And since the economy keeps growing, the Fed keeps raising rates — doing so twice so far this year and clearly signaling a desire to keep hiking as long as the economy keeps adding jobs.

Presumably the Fed has a NAIRU-like concept in mind. Yglesias’ observation and the NAIRU concept shows that the Fed is using interest rates as a way to oppose the tendency to economies with low unemployment (i.e. those most likely to spur wage growth). This strategy reflects the adoption, after October 1979 of a new strategy of economic management:

on October 6, 1979, the Federal Reserve adopted new policy procedures that led to skyrocketing interest rates and two back-to-back recessions but that also broke the back of inflation and ushered in the environment of low inflation and general economic stability the United States has enjoyed for nearly two decades. The dramatic policy actions by the Federal Reserve in 1979 represented an important break with the past, both in the way monetary policy was conducted and in the importance placed on controlling inflation.

The policy was adopted because in 1979 inflation was rising to ominous levels, and would go still higher in the next couple of years, until it was brought under control by extremely high interest rates. This strategy of using interest rates to control inflation is largely what is being used today. As a result, over the 1981-2001 Republican era of moderate growth, inflation has been held to 3.4%, less than the 4.1% seen over 1948-1981. To accomplish this lower inflation, corporate interest rates averaged 9.3% for an average real interest rate of 5.9%. In contrast, during the 1948-81 post-war Democratic era, interest rates averaged only 5.6% compared to for an average real interest rate of 1.4%. Simply put, on average, real interest rates were much lower during the Democratic era, leading to much stronger wage growth, but more inflation.