This Cambridge series, Political Economy of Institutions and Decisions, is built around attempts to answer two central questions: How do institutions evolve in response to individual incentives, strategies, and choices; and how do institutions affect the performance of political and economic systems? The scope of the series is comparative and historical rather than international or specifically American, and the focus is positive rather than normative.

Charles Stewart's work has two important features. One is his use of rational models of congressional changes in budget procedures between the Civil War and the end of World War I. Linking congressmen's career objectives to their local constituencies, he applies the modern Congress model in which a decentralized electoral process leads congressmen to prefer particularistic, localistic policy production over national-interest legislation. He shows that this demand for localistic policy leads to institutional or structural fragmentation, and conflicts with existing leadership and committee structures as well as with the centralizing demands of war and other crises. The political economy of this conflict, which produces opportunities for countervailing reforms, explains the evolution of budget procedure in the long run.

The other prominent feature of the book is Stewart's careful quantitative modeling of budget and spending decisions and outcomes with explicit reference to the impact of institutional constraints. Analyzing the devolution of budget powers of 1885 and its attendant surges in spending, he argues that rather than devolution of power causing spending, both follow from broader social and economic changes that increased demand for spending.

Political justification and metaethics

How does one go about justifying a form of political ideals and a form of government? Moral philosophers are broadly in agreement. Those who support anarchism are exceedingly scarce. Some form of democracy enjoys a wide degree of support, as does the ban on slavery. So also does the requirement that people who drive automobiles observe rules calculated to facilitate the movement of traffic and to protect the safety of those using the highways. Yet if one ventures into the field of metaethics, it soon becomes apparent that agreement on principles of political ethics by no means implies agreement on the method of arriving at, and substantiating, those principles. On that point the doctors are in sharp disagreement, and James Fishkin, for example, finds this discord disturbing. The first step for one who would justify a form of government, he believes, is to select the proper “moral decision procedure.” Yet this is the very matter on which disagreement is rife. It is not just as a philosopher that this lack of agreement concerns him; he fears the practical consequences. From his own empirical studies he has concluded that the person in the street believes in moral absolutes.

For those overwhelmed with the dimensions of the federal budget in the 1980s, budgeting in the sixty years after the Civil War must seem idyllic. In these present days of deficits denominated in the hundreds of billions of dollars; myriad committees with various powers over budget authority, outlays, and entitlement authorization; and great debates over the mix of fiscal policy instruments, the nineteenth century seems like placid waters. In the late-nineteenth and early-twentieth centuries deficits were denominated in the hundreds of thousands of dollars, with $100 million surpluses common. Before the Civil War, jurisdiction over both spending and taxing was consolidated in only one committee in each chamber. Even when appropriations jurisdictions were parceled out among seven House committees after 1885, the numerous centers of budgetary power were at least well-identified and were controllable by party leaders. And in a pre-Keynesian world, government just did not worry about fiscal policy, only about budget policy (Kimmel 1959).

Yet to paint a picture of utter serenity would be grossly misleading. By today's standards budgeting between 1865 and 1921 was simple and manageable, but seen at its own scale, and examined at a closer level, budgeting was quite contentious. For, no less than today, the federal budget stood as the best symbol delineating who were the government's winners and losers. By modern comparison the size of federal spending was small; but what little there was, was fought over fiercely.

The simplified contours of legislative life that I outlined in Chapter 1 are not alien to anyone knowledgeable about the modern Congress. The major actors and constraints that were discussed – constituents, rank-and-file legislators, committees, party leaders, the president, reelection, checks and balances, the state of the economy, and the budgetary problem – have all been staples of modern congressional scholarship. The theoretical tack I have taken in this study – that of constrained goal pursuit by rational politicians – is more controversial, even if it is becoming a very popular direction to take.

What is open to dispute, more than the theoretical use of rational choice, is whether the legislative world I abstracted in Chapter 1 is plausibly relevant to the legislative world of the nineteenth century. After all, a century ago legislators eschewed reelection as a rule, political parties were dominant, autocratic Speakers ruled the House floor, national issues infused local congressional elections, and there was little of the structural complexity and differentiation that currently describe the modern Congress. What could be more different from the House of the 1970s and 1980s? Nevertheless, it is a premise of this study that these descriptive differences between eras are essentially epiphenomenal. It is important to pay careful attention to the changes in career opportunity structures, legislative institutionalization, and party power that have altered the description of the constraints that individual MCs have faced over the century.

To explain and evaluate the macroeconomic policy of the Reagan administration, one needs to review the economic situation as it existed in the United States in 1980. The Reagan policy started as a response to what were, or were perceived to be, the problems in the years leading up to the 1980 election. The extent to which those problems were solved is the natural standard for measuring the achievements of Reagan economics; and the extent to which they were not solved, or their “solutions” caused other problems, creates the agenda for economic policy in the years ahead.

Problems seen in 1980

When candidate Reagan asked his famous question in 1980, “Are you better off than you were four years ago?” the statistics gave at best an ambiguous answer. One could certainly have argued that we were better off. Between 1976 and 1980 real output had increased by 3.1 percent per annum, almost exactly the average of the 25 years before 1976. In those four years real per capita disposable income had increased at an average annual rate of 1.5 percent, only a little less than the rate of the preceding 25 years. Total employment had increased greatly – 10 million, or more than 10 percent, in four years. The unemployment rate in 1980 was 7.0 percent, down from 7.6 percent in 1976.

Yet Mr. Reagan could ask that question in 1980 with confidence that most Americans would respond that they were worse off.

A Japanese renaissance

One of mankind's oldest myths, long antedating Tchaikovsky's ballet or Grimm's fairy tales, is the legend of the sleeping beauty who is awakened back to life by the kiss of a prince charming. What we are not told is whether, after the princess is brought back to life, the couple really did live happily ever afterward.

Were there no quarrels? Did the wife come to outstrip the husband in earning power? What kept their balance of payments in equilibrium? The tale ends just when the real-world problems begin.

If it is not too fanciful, think of 1945 Japan as the helpless and sleeping beauty. Cast the MacArthur occupation authority in the role of the prince charming. In doing so, no prejudgment is being made about how the credit should be divided for bringing about the postwar Japanese miracle. After all, even in the folk story, it is possible that the princess was already awakening of her own accord and that the prince was merely a lucky passerby who happened to appear on the scene at the critical moment.

The takeoff of the Japanese economy after 1945 might even be considered a second rerun of the sleeping beauty legend. The first would have to be the case of Commodore Perry's opening up of Japan just prior to the Meiji Restoration. Admittedly, the 1950–75 takeoff of Japan does have to be regarded as something of a miracle.

The issue of trade imbalances can be viewed from a number of perspectives, but each of these perspectives reaches a similar conclusion. The changes that would have to be made to solve the imbalances are not marginal changes but major microeconomic structural changes. They are in fact so major that one can reasonably argue that what is required is economically or politically impossible. Yet they have to be made. They either will be made as a matter of public policy or they will be forced by the market. However, if forced by the market, the changes will have to be made in the midst of an economic crisis, the only unknown of which is its timing.

This unfortunate conclusion flows from the fact that the imbalances in today's trading systems are not minor but major. More important, these imbalances are such that they become larger and harder to correct the longer they are allowed to exist. In this case, to postpone the problem is to have a much larger problem.

Current trading problems are also not going to be solved with macroeconomic tinkering. Changes in macroeconomic policies are necessary, but more fundamental microeconomic structural changes will be necessary to put the world's trading system back on an equilibrium path.

A black hole

The American trade deficit is rapidly becoming the economic equivalent of the astronomer's black hole. Everyone's economy is adjusting to it and the larger it becomes and the longer it lasts, the harder it is going to be for anyone to escape from it.

Introduction

Japan's success in coping with two rounds of skyrocketing oil prices in the 1970s has dramatically changed both its economic structure and competitiveness in the world market. The oil shocks of the 1970s were regarded in Japan as a national emergency to a country poor in raw materials and arable land. As a result, the government and the business community worked rigorously to maintain the competitiveness of Japanese industry through research and development to reduce energy costs and industrial restructuring efforts.

By the end of the 1970s, these objectives had been largely achieved. Japan had invested almost twice as much as the United States in research and development to reduce energy costs and to create newer and younger vintages of capital stock in Japan. Overall investment in Japan has grown much faster than overall investment in other advanced countries. For instance, capital perunit of employment between 1973 and 1979 increased at an average annual rate of 6.1 percent in Japan, whereas in the United States it grew at an average annual rate of only 0.9 percent. Japanese imports and exports roughly balanced at the rate of 16 percent of GNP in 1981 and the excess of savings over domestic investment exactly matched the government's budget deficit, leaving domestic effective demand and supply in equilibrium.

In the early 1980s there was a growing concern among government officials and business groups, notably the Keidanren (the most powerful federation of business organizations in Japan), that the large government deficit would eventually cripple the economy and that the size of the government was becoming too large.

Japan–U.S. trade relations are strained at present. They are apt to get worse. The specter of U.S. protectionism is lurking just beneath the surface, and apparently Japan and the United States are putting insufficient effort into preventing its eventual rise.

What has caused this problem? How significant is it, in fact, and what are its possible implications? Is it primarily a U.S. problem, a Japanese problem, something in between, or something else entirely? These are the questions that must be carefully addressed if the bilateral trade imbalance and the resulting trade friction are to be understood and if meaningful solutions are to be found. Insights gleaned from considering these questions should also be useful for improving future bilateral trade relations between Japan and the United States.

In this volume, a distinguished group of economists do battle with these issues. As the problems addressed are often complex and multidimensional, opinions are divided and predictions differ. Of necessity, then, this volume attempts to persuade the reader rather than provide definitive proof on one side or the other of a specific issue. To some extent, this implies that the reader must draw his or her own conclusions from the opinions and available evidence presented here. But such is the task of most public policy decision making. In our view, the information presented in this volume can serve as an important input into the decision-making process.

Introduction

The past decade has seen major changes in U.S. macroeconomic and micro-economic policies. The large magnitude of these changes reflects fundamental changes in philosophy rather than countercyclical adjustments of policy. Such grand-scale experimentation with the economy has produced gross imbalances, which became indisputable in 1984 and 1985: (1) a federal deficit so large that it could not be cured by growth alone; (2) a dollar exchange rate so strong and a domestic market so open to international trade that most U.S. manufacturing sectors experienced recession-like conditions, even as national spending continued to rise strongly; and (3) monetary policies so narrowly focused on reducing inflation that surprisingly sharp and negative growth and trade consequences occurred.

At the same time, the trading partners of the United States pursued independent courses that proved to be very much at odds with U.S. policy. The government deficit reduction that was sought in Europe and Japan posed substantial problems for U.S. exporters and hence for national income and employment. The dollar rose sharply to reduce the market share of American goods, while fiscal restraint simultaneously reduced the growth of the total market. Finally, the consequent weakness in overseas labor markets prevented dismantling of protectionist barriers to U.S. exports of agriculture, technical products, or basic manufactured goods.

Now, in late 1985 and early 1986, policies are about to change course radically once more. The Federal Reserve explicitly broadened its objectives to include management of the exchange rate and support of real growth as at least equal priorities with inflation control.

Developments in the U.S. economy in the first half of the 1980s were dominated by a dramatic shift in the mix of fiscal and monetary policy. A restrictive monetary policy aimed at controlling inflation was combined with a highly stimulative fiscal policy that propped up domestic demand. The major benefit of the policy mix has been a large decline in inflation at less cost in terms of domestic unemployment than would otherwise be the case. The combination of fiscal expansion and monetary restraint also led to an appreciation of the dollar exchange rate, thereby reducing import prices and inflation while sustaining domestic output. The exchange rate revaluation shifted much of the burden of reducing inflation to other countries, as the price of internationally traded goods fell in dollars and rose in other currencies.

The cost has been the decline in the national saving rate and large current account deficits. Thus, the policies placed a burden on future generations, who will inherit less wealth; and the loss of international competitiveness has had a severe impact on U.S. export- and import-competing industries. The federal budget deficit now absorbs nearly two-thirds of net private saving and the United States must borrow 3 percent of its income annually overseas. Between 1980 and 1985 the rise in the exchange rate drove up the cost of producing goods and services in the United States by more than 40 percent in comparison with the cost to its major competitors.