A more equal capitalism: preserving the free-market consensus.

FEARS of a recession have suddenly made economic policy a hot topic among the chattering classes. It is a fashionable belief among elites that the Reagan economic policy of lower taxes and freer markets has run out of gas, that the problems of high taxes and overregulation are mostly solved, and that we need to move on to address the new and different economic problems that we now face. I believe that this analysis misreads both the Reagan

Revolution and our current economic situation. Post-war U.S. economic policy was made by a generation of statesmen who dealt themselves a great hand of cards, and then played it brilliantly. It is hard to exaggerate the strength of the U.S. competitive position in the world economy in June 1945: America accounted for an absolute majority of all global manufacturing output, had the most technologically advanced economy in the world with ample supplies of natural resources, and could protect this state of affairs with an invincible military that possessed a nuclear monopoly. Most of the rest of the world was either in ruins, pre-industrial, or under the control of Communist regimes that smothered economic energies.

The reaction of most great powers in this situation would have been to declare direct, long-term control over as much of the globe as possible. Instead, the U.S. established itself as the primus inter pares of a loose coalition of nations that became known as the Free World, and established a set of politico-economic institutions and programs--NATO, the Marshall Plan, the Bretton Woods system, the IMF, the World Bank, and so forth--that encouraged rapid economic development within this coalition. Combined with the containment approach vis-a-vis the Soviet Union, this worked out very well for us.

One of the problems with this strategy, of course, was that it did work. While America got much richer, those nations in the coalition that had previously had advanced economies, predominantly Western Europe and Japan, really did develop to the point that by the 1970s they started to become economic competitors to the U.S.

The global circumstances that allowed the United States to have it all--high rates of economic and wage growth along with a high degree of economic equality--changed for the worse in the 1970s as other countries started to compete more effectively and the oil shocks battered the economy. Repeated attempts to apply Keynesian band-aids failed to get the economy to perform as it had in prior decades. The feeling of crisis at that time was not illusory.

Reagan's solution proceeded from two diagnoses: that macroeconomic pump-priming was merely creating inflation, not growth, and that the U.S. economy had large untapped growth potential that was thwarted by many of the restrictions on markets that were part of the then-current economic consensus, including everything from price controls to government support for private-sector unionization to zealous antitrust enforcement. The Reagan economic strategy was therefore sound money plus deregulation, broadly defined.

It succeeded. Conventional wisdom in 1980 was that the U.S. would not be able to compete with Europe and Japan without becoming more statist, but over the past 25 years the U.S. has reemerged as the acknowledged global economic leader. Economic output per person is 20 to 25 percent higher in the U.S. than in Japan and the major European economies, and the U.S. economy dominates in size and prestige.

Ironically, with our victory in the Cold War, international economic competition has only become more severe. The primary geostrategic fact in the current world is the economic rise of the Asian heartland. While precise long-run predictions are usually a fool's errand, it's a pretty safe assumption that economic and strategic competition is likely to increase yet further over the next several decades. The economic world of 1955 is gone. Even if we wanted it back, short of emerging from another global war unscathed while the rest of the world is smoking rubble, we could not have it. The alternative strategy of simply opting out of international economic competition in order to focus on quality of life is not feasible without some kind of external military protection. Sooner or later, those who oppose our values would become strong enough to take away our wealth and freedom. And to remain strong enough to protect ourselves, we must have the economic performance created by freer markets.

PROSPEROUS BUT UNEQUAL

It is true, however, that as America has continued to become much richer over the past several decades, it has also become more unequal. The share of income received by households in the top fifth of the income distribution, after taxes have been paid and government transfers have been received, rose from 42 percent in 1979 to 50 percent in 2004, while the share of income received by those in the bottom fifth of the distribution declined from 7 percent to 5 percent. The share of after-tax income garnered by the households in the top 1 percent of the income distribution increased from 8 percent in 1979 to 14 percent in 2004. A workaday senior partner in an investment-banking, corporate-law, or management-consulting firm can now expect to make $1 million per year. In the stratosphere of the economy, the increases in wealth have been mind-boggling. According to Forbes, the 400th wealthiest person in America in 1982 had $91 million (in 1982 dollars); today the 400th wealthiest American is a billionaire.

This inequality is partially driven by several major transitions that began to occur in the economy and society in the 1970s. First, U.S. domestic production of oil peaked in 1971, oil imports doubled between 1970 and 1975, and OPEC was able simultaneously to drive large price increases. This oil shock was directly regressive, but also tended disproportionately to hammer those industries that were the source of high-wage union jobs. Second, in 1970 "non-distributive services" (i.e., finance, professional services, health care, and so on) became for the first time a larger part of the private economy than goods-producing industries. The shift to services, especially as leveraged by the increasing technology dependence of the economy, tended to enhance the prospects of the cognitive elite at the expense of traditional industrial workers. Third, the combination of changes in cultural mores and social programs began to disassemble the traditional family. The social capital transmitted by intact families became a more and more relevant source of competitive advantage to those individuals raised in functioning homes as this family structure became less universal. Fourth, the foreign-born percentage of the U.S. population, which had reached its historical minimum in 1970, began to rise rapidly as massive immigration resumed after a multi-decade hiatus. This increased inequality by introducing a large low-income group to the population, and also by intensifying wage competition at the lower-skill end of the income scale.

The Reagan economic revolution achieved success by forcing an extremely painful restructuring on industry after industry. One critical consequence of this restructuring was a new compensation paradigm--one that relies on markets rather than corporate diktats, regulation, or historical norms to set pay; accepts a much higher degree of income disparity based on market-denominated performance; and expects that most people will exploit the resulting market for talent by moving from company to company many times during a career. These factors interacted with and exacerbated trends toward inequality in the U.S. Growing inequality was a price we paid for the economic growth that we needed.

Absolute income equality, a.k.a. communism, is a poor goal, but if inequality becomes sufficiently extreme it undermines the social support required for a democratic and capitalist society to flourish. To take only the most obvious example, how much do you think high-income Americans would make in the absence of our armed forces? All of the material delights that we enjoy ultimately require men to stand watch all night looking through Starlight scopes mounted on assault rifles, and die if necessary, to protect the commercial, law-bound society that provides those delights. Would you do that for a millionaire hedge-fund manager who happens to live within a country that he considers some lines on a map, and who considers you a sucker for doing it? The United States is nowhere near such a dystopia, but it's generally not a good idea to keep pulling bolts from an airplane in mid-flight just because it hasn't crashed yet.

So here we have our current economic situation: We are rich and economically successful, but increasingly unequal. If we give up the market-based reforms that allow us to prosper, we will lose by eventually allowing international competitors to defeat us; but if we let inequality grow unchecked, we will lose by eventually hollowing out the middle class and threatening social cohesion. This, not some happy-talk about the end of history, is what "globalization" means for the U.S.

OLD SCHOOL

Liberals are reaping great political gains by talking about these problems, even though their proposed solutions remain antediluvian: Solve the problem of inequality by raising taxes on the "rich"; reregulate the economy to protect the "weak"; and deploy Mondale-style industrial policy by other names to deal with the challenges of globalization. Senator Barack Obama has proposed a combination of a higher income tax and elimination of the income cap on Social Security contributions that would, when all added up, push the effective maximum marginal tax rate to about 55 percent. Hillary Clinton has seriously called for a 90-day foreclosure moratorium and a five-year freeze in rates on subprime mortgages. The Democratic party has never assimilated the need for an increasingly market-based economy, so their "solutions" are a recipe for decline. But you can't beat a horse with no horse, and conservatives need to propose policies that address the real problem of growing inequality and consequent feelings of economic insecurity.

Seen in this light, the challenge in front of us is clear: How do we continue to increase the market orientation of the American economy, while helping more Americans to participate in it more equally?

Many longstanding conservative policies, like reducing the capital-gains tax rate, serve the goal of increasing performance, but at the expense of increasing inequality. Many recent reform policies, like expanding the child tax credit and applying it against the payroll tax, serve the goal of increasing equality, but don't contribute (at least directly) to greater performance. Both are excellent ideas, and should be championed, but we also need to search for policies that can serve both goals simultaneously.

Consider the problem of education. U.S. public schools are in desperate need of improvement, and have been for decades. We do not prepare the average child in the U.S. to succeed against international competition. Schools can do only so much to fix this--in a nation where 37 percent of births are out of wedlock, many children will be left behind--but it would be a great start if so many schools didn't go out of their way to make kids lazy and stupid.

No amount of money or number of programs will create anything more than marginal improvements, because public schools are organized to serve teachers and administrators rather than students and families. We need competition for students among public schools in which funding moves with students, and in which schools are far freer to change how they operate. As we have seen in the private economy, only markets will force the unpleasant restructuring necessary to unleash potential. Conservatives have long had this goal, but are unprepared to win the fight. Achieving it would be at least a decade-long project.

We should start at the state and local level by scaling up the numerous existing demonstration projects to district, city, and state levels. This can be used to build sufficient pressure to force national action, using the federal education budget as a lever. The model to follow is the successful campaign to reform welfare. The biggest difference in this case is the presence of the extremely powerful teachers unions. Ultimately, political leaders will have to break them as decisively as Thatcher broke the coal-miners union in Britain.

The role of the federal government could be limited, but crucial. Suppose it established a comprehensive national exam by grade level to be administered by all schools and universities that receive any federal money, and required each school to publish all results, along with other detailed data about school budgets, performance, and so forth, each year. Secondary, profit-driven information providers, analogous to credit-ratings agencies and equity analysts, would arise to inform decision-making. The federal role would be very much like that of the SEC for equity markets: to ensure that each school published accurate, timely, and detailed data.

Once success is obvious, this can act as a platform for further change. This approach will build a constituency with an entrenched interest as powerful as the one that protects Social Security, and eliminate a major prop of the statist coalition. Inevitably, parents will demand and win the right to apply these vouchers to private schools. This would also become a model for other reforms--of entitlement programs from retirement accounts to medical care.

Or consider immigration. What if, once we had control of our southern border, we came to view the goal of immigration policy as recruiting instead of law enforcement? Once we established a target number of immigrants per year, we could set up recruiting offices looking for the best possible talent everywhere from Beijing to Helsinki. It would be great for America as a whole to have, say, 500,000 very smart, motivated people move here each year with the intention of becoming citizens. It would also do wonders for equality if they were not almost all desperately poor, unskilled, and competing with already-low-wage workers.

Other examples of policies that can raise competitiveness and reduce inequality--ranging from reduced small-business regulation to allowing individuals tax deductibility for private healthcare purchases to automatic (with an opt-out) enrollment for 401(k) plans--become obvious once you start to look for them. What they tend to have in common is a focus on building human capital and effective market institutions.

That is: They build the key resources of the new economy.

Mr. Manzi is the CEO of an applied-artificial-intelligence software company.