Capitalism-and-Its-Critics-A-History-From-the

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A number of factors created the conditions for this metamorphosis. The most important was a steady rise in inflation that undermined the political foundations and intellectual hegemony of Keynesianism. In 1965 the US inflation rate was 1.6 percent; by 1970 it had reached 5.8 percent.5 One driver of this rise was a surge in government spending. Lyndon Johnson’s administration fought an expensive war in Vietnam and simultaneously enacted costly domestic programs. Federal outlays as a percentage of GDP rose from 15.9 percent in 1965 to 18.2 percent in 1970.6 Strong aggregate demand drove the unemployment rate down to 3.5 percent in 1969.7 As wage bills and input prices increased, businesses passed along their rising costs in higher prices for the goods and services they produced.

From late 1967 onward, the Federal Reserve raised interest rates to slow the economy and bring down inflation. The rising cost of borrowing eventually brought on a recession. In early 1971 Richard Nixon, the Republican president who had succeeded Johnson, proposed an expansionary budget to get the economy going again, telling some television journalists in an off-camera comment that he was “now a Keynesian in economics.”8 Months later Nixon introduced emergency controls on wages and prices to tackle the stubbornly high inflation rate, which, among other things, was putting more pressure on the dollar in foreign exchange markets. Officials at the Treasury Department and the White House believed a currency devaluation was necessary to relieve the pressure on the dollar and boost the competitiveness of US exports—a weaker dollar makes American goods cheaper overseas—but that would involve breaking the long-standing gold parity. On Sunday, August 15, after spending a couple of days with his economic advisers at Camp David, Nixon announced that his administration was closing the gold window, which meant international investors could no longer swap their dollars for gold. The postwar era of fixed exchange rates was at an end. A few days later, at the headquarters of the IMF, someone circulated a note that said: “R.I.P. We regretfully announce the not unexpected passing away after a long illness of Bretton Woods at 9 P.M. last Sunday. Bretton was born in New Hampshire in 1944 and died a few days after his 27th birthday.”9

For a time, Nixon’s expansionary policies seemed to work. In the presidential election of 1972, he trounced Senator George McGovern, his Democratic opponent. By January 1973, when Nixon reentered the White House, the economy was growing again, and the jobless rate was back below 5 percent. The inflation rate was only 3.6 percent. But then came the Yom Kippur War of October 1973, which prompted Arab oil producers to introduce an embargo of Western nations that supported Israel. In a matter of months, the price of crude oil more than tripled, plunging the gasguzzling American economy into the deepest recession since the 1930s. Unlike in previous slumps, inflation and unemployment spiked simultaneously. By the start of 1975, the inflation rate was around 12 percent and the unemployment rate stood at 8.1 percent. Speaking to the British House of Commons a decade earlier, the Conservative politician Iain Macleod had referred to a combination of high inflation and stagnant economic growth as “stagflation.” The oil price shock created an acute version of stagflation and presented a major challenge to Keynesian doctrines.

According to the Phillips Curve, a version of which Bill Phillips, of the London School of Economics, had formulated in the late 1950s, unemployment and inflation were supposed to be inversely related: if the jobless rate went down, the rate of inflation would go up, and vice versa. This trade-off seemed to offer policymakers the option of choosing a low jobless rate at the cost of somewhat higher inflation. But now the two variables were going up together. How could this be explained? The answer wasn’t immediately obvious, but one person who had an explanation was Friedman. In a December 1967 presidential address to the American Economic Association, he had argued that there was a “natural rate of unemployment,” and that if policymakers tried to keep the jobless rate below this figure inflation would accelerate.10 Another way of expressing Friedman’s argument was to say that the long-run Phillips Curve was vertical, so policymakers couldn’t maintain low unemployment by accepting higher inflation. “There is always a temporary trade-off between inflation and unemployment,” Friedman said. “There is no permanent tradeoff.”11 Given this reality, Friedman argued, Keynesian efforts to keep unemployment low by using fiscal and monetary policy to manipulate aggregate demand were doomed to failure. The best thing policymakers could do was ensure slow but steady growth in the money supply, which would keep inflation anchored. This was the policy doctrine that became known as “monetarism.”

It wasn’t immediately clear to some people at the time, but Friedman was resurrecting two highly problematic pre-Keynesian economic theories. One of them was the claim that the economy automatically gravitates to a position of balance: in his model, this resting spot was at the natural rate of unemployment. Friedman didn’t really explain what determined this rate. He merely said it was the result of “the Walrasian system of generalequilibrium relations,” which was a jargon-ridden way of saying it depended on many other things in the economy. Friedman also revived the ancient quantity theory of money, which, in its simplest form, says that the price level is proportional to the money supply. One appeal of this theory is that it suggests that policymakers can control inflation simply by restricting the money supply, but in reality things aren’t so straightforward. In modern economies, the size of the money supply is largely determined by the banking system rather than by policymakers. Bank deposits make up the biggest component of the supply, and the relationship between the overall quantity of money and inflation is tenuous, at best. But despite its theoretical and empirical shortcomings, Friedman’s revival of pre-Keynesian economics had one great strength: it seemed to fit the moment.

During the late 1960s and early ’70s, US policymakers had tried to keep the jobless rate at a low level, and price rises had accelerated, just as Friedman’s “natural rate” model predicted. Then unemployment and inflation had risen simultaneously, which further discredited the downwardsloping Phillips Curve and the simplistic forms of Keynesianism that relied on it. In view of this record, many economists and policymakers were willing to gloss over the details of Friedman’s theoretical framework. In the United States, the natural rate of unemployment and the vertical long-run Phillips Curve quickly became fixtures of mainstream economics textbooks. Elsewhere, textbook writers didn’t take long to adopt the same theory.

At the policy level, the onset of stagflation seemed to have left the Keynesians stymied, and by the mid-1970s, even some center-left policymakers had lost faith in their prescriptions. In 1976 James Callaghan, the new prime minister of Britain, said at the annual conference of his ruling Labour Party: “We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists and that insofar as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step.”12 If the 1962 Economic Report of the President represented the high point of postwar Keynesianism, Callaghan’s speech marked its existential crisis. A day after he delivered it, his government took the humiliating step of asking the IMF for an emergency loan, which the British Treasury deemed necessary because of a large budget deficit and downward pressure on the pound sterling. Looking on from Cambridge, Joan Robinson lamented these developments. “The hopes which accompanied the Keynesian revolution, of reforming capitalism so as to ensure continuous prosperity with full employment, are now all but extinguished,” she commented in a 1977 article that she cowrote with a colleague. “The slide into crisis in the capitalist world has re-established the pre-Keynesian orthodoxy as the conventional wisdom in economic policymaking at both the national and international levels. The inevitable consequence of this is a much higher general level of unemployment and recurrent crises, involving a massive waste of resources and considerable human misery.”13

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Rising inflation was the cudgel that conservative economists and politicians wielded to bash Keynesianism, but it can’t fully explain the demise of the postwar policy consensus. Ultimately, sustained inflation is the product of a distributional struggle over who gets what in the economy. As costs rise, workers try to protect their living standards by demanding higher wages, and companies try to protect their profit margins by raising prices. Friedman’s solution to this dilemma was to raise the unemployment rate to a level at which labor unions and workers didn’t have sufficient bargaining power to push through higher wage demands. He called this level of joblessness the “natural rate,” but there was nothing natural about it. He was essentially calling on policymakers to restore Marx’s “reserve army” of the unemployed to a level at which it could exercise its traditional role of disciplining labor and ensuring that businesses could maintain control of the workplace.

Even before inflation emerged as a serious problem, there were other indications that the long period of low unemployment had shifted the industrial power balance toward workers, including a reduction in corporate profit margins. Among the first observers to highlight this issue were two English economists of a left-wing bent, Andrew Glyn and Bob Sutcliffe. “As foreign trade gathered pace and labour markets grew tighter in the late fifties and early sixties, the tendency for the profit share to be squeezed between the pressure of wages and international competition emerged as a clearly observable trend in more and more countries,” Glyn and Sutcliffe wrote in a 1972 book, Capitalism in Crisis.14 The extent of the profit squeeze varied across countries, they noted. It was most notable in Great Britain, but especially from the second half of the 1960s it was also visible elsewhere. Britain, as the oldest capitalist economy, was providing “an example of the path which other capitalist economies might quite rapidly follow,” the two economists suggested. They included a chart showing that between 1950 and 1970, the share of wages and salaries in total income— the obverse of the profit share—had risen in the United States, Germany, France, Italy, the Netherlands, and Japan as well as Britain.15 During the earlier part of this period, the two economists noted, rapid productivity growth had alleviated the pressures on profitability and allowed businesses to maintain high levels of capital investment, which in turn sustained high rates of growth in output-per-worker and GDP. But now a decline in productivity growth and profitability was making it difficult to maintain a high level of capital accumulation, and “the foundations of the long postwar expansion have been undermined.”16

Leftist economists weren’t the only ones raising concerns about a profits squeeze. In 1970 Arthur Okun, a Yale economist who had just completed a two-year stint as chairman of the White House Council of Economic Advisers in the Nixon administration, coauthored an article that highlighted how the US profit share had fallen from 11 percent of gross national product in 1966 to 8 percent four years later. Okun and George L. Perry, of the Brookings Institution, attributed this development to a decline in productivity growth, which meant that wages were rising faster than output and crimping their profit margins. The two economists expressed the hope that these trends were “attributable to transitory factors,” particularly a slowdown in GDP growth.17 When growth picked up, productivity growth and profits should rebound sharply, they said. But this prognosis turned out to be overly optimistic. After reviving in 1971–73, the share of corporate profits in US GDP turned down again in 1974.

Undoubtedly, some special factors made the 1970s especially challenging for Western capitalism, including the OPEC oil price shock. But the decline in profit rates went further back, and Glyn and Sutcliffe were surely right to argue that it reflected some deep underlying trends. Back in the late 1930s and early ’40s, at the start of the Keynesian era, Sweezy and Kalecki had warned that a long period of low unemployment could turn business interests and their political representatives against the Keynesian policy regime. Robinson had raised the specter of rising inflation. Experience confirmed the prescience of these warnings.

In theory, there was a cooperative way to relieve distributional conflicts and prevent a wage-price spiral. If workers agreed to moderate their wage demands, if firms agreed to keep price rises modest, and if the government kept up the level of overall demand, inflation could be brought down without a recession. But how could workers be persuaded to hold back without the threat of higher unemployment? At the end of 1970, the Organisation for Economic Co-operation and Development (OECD), an intergovernmental research organization based in Paris, issued a report on inflation that addressed this issue. “Circumstances vary considerably from country to country, but the fundamental problem is how to get people to exercise the moderation that they would do if they believed that a major recession was possible, without actually having to administer the lesson,” the report said.18

One possible solution was an economy-wide “incomes policy,” in which the government, after consulting with representatives of labor and capital, would suggest (or dictate) an annual level of wage and price increases that was consistent with productivity growth. From a societal perspective, the logic of tying increases in wages to productivity growth was clear. But for an individual union or the employees at a given plant, obtaining a bigger wage increase is always a plus, so they are unlikely to exercise restraint. The same goes for price-setting by individual businesses. In terms of game theory, the players face a Prisoner’s Dilemma, and the dominant strategy is to defect from the cooperative solution. Or, as the OECD report put it: “It is thus all too easy for leaders on both sides to be persuaded into accepting over-ambitious commitments on behalf of their members.”19 Income policies would be hard to sustain.

The other potential solution to the inflation problem was the confrontational one that Friedman and other conservative economists recommended: dismantle the power of organized labor by raising the level of unemployment, weakening labor laws, and removing other restrictions on businesses. As efforts to introduce price controls and income policies foundered, this was the option that a number of Western countries would gravitate toward. By the mid-1970s, one high-inflation nation outside of the Western core had already adopted such a strategy, with Friedman’s explicit approval: General Pinochet’s Chile.

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After deposing Salvador Allende, the country’s first socialist president, in September 1973, the Pinochet regime rounded up many of Allende’s supporters and killed a large number of them. It banned the leftist political parties that had made up his coalition and suppressed labor unions. The new economics minister was a general, Rodolfo González, but the key development was the appointment, as a senior adviser to González, of Sergio de Castro, a free market economist. De Castro was one of “the Chicago Boys,” a group of young Chileans who had studied economics at the University of Chicago under an arrangement with the Catholic University of Chile. (De Castro had obtained a doctorate.) Pinochet and other members of the new junta in Santiago didn’t know much about economic theory, but with the unemployment rate in the double digits and inflation running at about 700 percent, they were keen to get the Chilean economy going again. De Castro and some of his fellow Chicago Boys had developed a lengthy economic plan, which became known as El Ladrillo (in English, The Brick).

In his 2023 history, The Chile Project: The Story of the Chicago Boys and the Downfall of Neoliberalism, Sebastian Edwards, a Chilean-born economist at the University of California, Los Angeles, recounted how The Brick was commissioned before the coup by a former naval commander and active admiral who were considering toppling Allende.20 Edwards said it’s still not clear how many of the eleven economists who wrote the report— nine of whom had attended the University of Chicago—knew about its origins in military plotting. In any case, the report was completed before Allende was overthrown. By today’s standards, Edwards writes, its policy recommendations “look mild and quite run-of-the-mill.”21 But that wasn’t how they appeared to the report’s authors, or to some of Pinochet’s generals, who were suspicious of the free market economists.

The Brick called for rolling back some of Allende’s income-support measures and focusing anti-poverty programs on the extremely poor. More broadly, it demanded a historic break with the import-substitution and stateled economic development policies that Chilean governments had followed during the postwar decades. Rather than relying on state planning, the country should allow market forces to allocate resources. It should eliminate government controls, privatize state-owned businesses, replace the state pension scheme with a system of individual savings accounts, free up the financial sector, and, except in the case of monopolies, eliminate price controls, which were practically universal. To promote competition and trade, the blanket quotas that restricted imports and protected Chilean producers should be replaced with a uniform tariff of 30 percent.

The generals weren’t the only influential Chileans who were initially lukewarm about the Chicago Boys’ proposals. Many business leaders, who were used to operating in protected markets under government direction, were initially resistant to making a radical shift, and it wasn’t clear if Pinochet and his colleagues would go down that route. In March 1975, Milton Friedman visited Santiago for six days with one of his colleagues from the University of Chicago economics department, Arnold “Al” Harberger, who spoke Spanish, was married to a Chilean woman, and had written a journal article on inflation in Chile. The inflation rate was still running at nearly 350 percent, and unemployment had risen sharply since the coup.22 Friedman and Harberger met for about three-quarters of an hour with Pinochet, and Friedman advised the Chilean leader to introduce a program of “shock treatment,” consisting of deep spending cuts and measures designed to liberalize the economy. Pinochet “was sympathetically attracted to the idea of a shock treatment but was clearly distressed at the possible temporary unemployment that might be caused,” Friedman later recalled in a memoir.23

After Friedman returned home, he wrote the Chilean leader a lengthy letter that began “Dear Mr. President” and advised him to adopt an eightpoint program that could “end inflation in months, and would set the state for the solution of your second major problem—promoting an effective social market economy.”24 Friedman’s proposals included cutting government spending across the board by 25 percent within six months, pledging to stop printing money to finance government spending, and removing “as many obstacles as possible that now hinder the private market.” He also advised the dictator to continue with efforts to liberalize trade and assured him, “If Chile now takes the right track, I believe it can achieve another economic miracle.”

Friedman subsequently claimed that, even before he arrived in Santiago, the Chicago Boys had decided on a program of shock treatment, and the role that he and Harberger played was merely to give this program a “stamp of approval, and help to sell it to the public and the military junta.”25 The sales effort seems to have worked. The month after Friedman left, Pinochet’s regime adopted a Plan for Economic Recovery and appointed Sergio de Castro as minister of economics.26 The new plan, which Pinochet enacted by presidential fiat, included a pledge to slash government spending by 15 percent—not quite the 25 percent that Friedman had recommended, but still a huge cut. It also called for the elimination of price and import controls, the privatization of publicly owned firms and the public pension system, and deregulation of the financial sector. Shock treatment it was.

From some perspectives, the combination of deep austerity and radical liberalization worked as planned. In the late 1970s, Chile’s inflation rate fell sharply: by 1981, it was under 10 percent.27 Business investment revived, exports rose, and in the four years from 1977 to 1980, inflation-adjusted GDP grew at an annual rate of 8.5 percent.28 However, the shock treatment also exacted heavy social and economic costs. Among Chile’s poor, the cuts to government programs caused a great deal of hardship. By 1978, inflation-adjusted wages had fallen by nearly a quarter, and close to 20 percent of the workforce was unemployed or on emergency government programs that paid minimal wages.29

Moreover, the strong GDP growth didn’t last. In late 1981 Chile experienced a foreign debt crisis. During the years of growth, it had built up big external debts. But now its currency fell sharply, and the government was forced to take over a number of large banks, which were teetering on the edge of collapse, prompting some wags to point to “the Chicago road to socialism.”30 The economy entered a deep recession, in which the jobless rate rose to more than 25 percent and inflation started rising again.31

Defenders of the Chicago Boys and Friedman point out that between 1973 and 1990, when Chile returned to democracy, its GDP per capita rose by about a third, which was a strong performance compared to the country’s history.32 The supporters of the shock therapy don’t tend to dwell on the fact that it had been made possible only by the elimination of Pinochet’s political critics, the suppression of the labor movement, and the brutal exercise of absolute power. (During the seventeen years of military dictatorship, according to a subsequent report by the Chilean National Commission on Truth and Reconciliation, 2,279 people were killed for political reasons. Tens of thousands more were tortured.)33 One of Pinochet’s former ministers did subsequently acknowledge the political reality that underpinned the free market shock treatment, noting that the Chilean experiment “could be so revolutionary because we had a very authoritarian regime.”34

None of this would have come as a surprise to Karl Polanyi, of course. In The Great Transformation, he had emphasized that, historically, it had taken strong states to create the conditions in which free market capitalism could consolidate itself and thrive: a Smithian economy didn’t emerge naturally.

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In the big Western democracies, the shift to the right in economic policymaking was more gradual but increasingly visible. During the 1976 US presidential campaign, Jimmy Carter, running as a moderate Democratic outsider, criticized President Gerald Ford, Nixon’s Republican successor, for running big budget deficits and allowing inflation to rise. After Carter won the election and entered the White House, he focused on restraining spending and bringing down the deficit: during his four-year term, the deficit as a share of GDP declined from 4 percent to 2.6 percent.35 Carter’s embrace of fiscal rectitude didn’t buy him lasting relief from price pressures, though. During his first two years in office, the inflation rate averaged about 7 percent, and the unemployment rate barely dropped below 6 percent. And in 1979, after the Iranian Revolution sent the price of crude oil and gasoline soaring again, the inflation rate rose to double digits.36 On July 15, 1979, with the public mood souring, Carter delivered a prime-time address in which he said, “The erosion of our confidence in the future is threatening to destroy the social and the political fabric of America.”37 Carter also vowed to make the United States energy independent, but that wasn’t what the address was remembered for. Although he didn’t use the term malaise, it subsequently became known as the “malaise speech.”