The visible hand.

• Author: Hawkins, William R.
• Position: Laissez-faire

A HUNDRED YEARS ago, Great Britain, then the world's premier power, went into a long-term decline. Annual economic growth 1871-1913 averaged only 1.6 percent and historians have labeled this era "the Great Depression." During this period, the U.S. and Germany both passed England as an industrial power. After the adoption of free trade in the 1840s, a quarter century of economic dominance continued, but by 1873 observers such as Lord Penzance were warning:

The advance of other nations into those regions of manufacture in which we used to stand either alone or supreme, should make us alive to the possible future. Where we used to find customers, we now find rivals....Prudence is not alarm, and prudence demands a dispassionate inquiry into the course we are pursuing, in place of a blind adhesion to a discredited theory.

Still, nothing was done. The landslide victory of the Liberal Party in 1906 won the debate for laissez-faire and free trade. It was not until the 1920s, after the shock of World War I, that the British government under a revived Conservative Party began to directly manage trade and promote industrial policies to foster growth. By then, however, it was too late. England had already lost too much ground. Soon it found great power status too heavy a "burden" to bear and began its long retreat.

A century after Britain's decline began, in the 1970s, the U.S. went into what some have termed a "Silent Depression." From a technical standpoint, depression is too strong a term as the economy has continued to grow, though at a diminishing rate. From 1950 to 1973, the real rate of American economic growth averaged 3.6 percent. But from 1973 to 1991 this fell to only 2.0 percent. Even the best period since 1973, President Ronald Reagan's second term, did not match the 1950-1973 average. The dramatic slowing of the growth rate has not only heightened social problems at home, but has degraded the nation's ability to sustain its preeminent position in world affairs despite its victory in the Cold War.

England after 1846 and the U.S. after 1945 embraced the free-trade philosophy at times when their economic leadership was unchallenged. The mercantilist principles on which that leadership, in each case, had been built were abandoned. It took a generation for major economic rivals to materialize; when they did, laissez-faire provided no defense against their assault. The British and U.S. experiences are uncanny in their parallel development separated as they are by almost exactly 100 years. Now, despite being the only superpower, U.S. budgets have been drawn up in recent years on the assumption (apparently shared by leaders in both parties) that the United States can no longer afford the military establishment, overseas presence, and foreign aid programs that were created and carried forward with relative ease in past decades. Will American geopolitical decline, following American economic decay, make the parallel with British decline exact?

For decades, Washington has been dominated by politicians and analysts on both the left and the right who reject the idea that the nation-state has legitimate economic interests of its own, apart from the short-term interests of consumers in general or the influential interest groups favored by one party or the other. The nation, in this view, is less than the sum of its parts. It is this neglect of national interest in economic policymaking that is the greatest threat to the long-term security and prosperity of the United States--as it was the source of the failure of the recent experiment in laissez-faire.

The Invisible Hand

THE SUPPLY-SIDE theorists and free traders who dominated the Reagan and Bush Administrations were fully committed to the same laissez-faire notions that paralyzed England during its decline. Among these are the belief that the government should not bias decisions by individuals between savings and consumption or between domestic and foreign purchases, and the conviction that economic activity is in some autonomous sector detached from other national concerns.

In fiscal policy supply-side theory led to a misguided focus on the household rather than on the production (business) side of the economy. Tax rates were reduced, but a host of deductions, credits, and exemptions were also removed. What others saw as incentives, the reformers regarded as distortions. The expectation was that lower taxes would increase capital formation (savings) as the after-tax return increased, thus promoting growth and higher productivity. This is a basic Keynesian concept. But while Keynes applied it to business only, the supply-siders as "individualists" tried in vain to apply it to households trusting in "the market" to do the rest. Their mistake was soon evident: the savings rate fell in the 1980s from just over 8 percent at the start of the decade to about 5 percent at the end despite the curbing of inflation. The tax cuts went to support consumer demand, not savings. Much of this demand was satisfied by imports since domestic producers did not have the capital needed to rapidly expand to meet the demand.

It didn't start out this way. The 1981 Economic Recovery Tax Act (ERTA) contained many useful provisions aimed at the capital formation and production side. The investment tax credit was extended and depreciation liberalized. Eligibility for Individual Retirement Accounts (IRAs) were extended to all working households. The top rate for capital gains was reduced to 20 percent. Unfortunately, movement started away from such provisions immediately. The 1982 Tax Equity and Fiscal Responsibility Act (TEFRA) scaled back the investment tax credit and canceled planned accelerations in the depreciation schedule. The Alternative Minimum Tax (AMT), which limits the value of incentives by disallowing their full use, was strengthened. The Deficit Reduction Act of 1984 again made depreciation schedules less favorable.

The 1986 Tax Reform Act (TRA) eliminated the investment tax credit...