GFC 2007: Twentieth Century Economics (Part 1 of 3)

Valencia and Laeven document approximately 150 monetary crises over the period 1970-2011. The biggest of these was undoubtedly the Global Financial Crisis of 2007. The response to this crisis, in terms of major re-thinking of foundations of economic theory, has been surprisingly mild. This is because the roots of the crisis go very deep, and have not been properly understood. This is the first of a three part series designed to explore and expose these roots, as a first step towards the radical re-thinking required to re-create economic theories and institutions which would not be subject to these periodic crises which cause deep distress to millions.  The full three-part article, and links to newspaper published versions, can be accessed here: The Current Crisis in Economics.

20th Century Economics: Rise & Fall of Keynes

The human tragedy of the Great Depression has been graphically depicted by John Steinbeck in his moving novel, The Grapes of Wrath. The crisis it created for economic theory is not so well known. Leading economists kept forecasting prosperity and quick recovery, creating embarrassment for the profession as a whole. In 1927, Keynes had flatly stated that “there will be no more crashes in our time.” The shock of the Great Depression led him to create an entirely new economics. The Keynesian revolution created the field of Macroeconomics which gave a vital role to the government in removing unemployment.

At the dawn of the twentieth century, Laissez-Faire economics was the dominant school of thought. Laissez-Faire economics says that free markets without government intervention automatically lead to the best possible economic outcomes. The folly of this position was made obvious to all by the Great Depression. Paul Samuelson and other disciples of Keynes were the only economists with quantitative and, apparently, rigorous answers to questions about the Great Depression. They enjoyed a monopoly on the field of Macroeconomics until the 1970’s. Then things changed.

The OPEC countries imposed an oil embargo to retaliate for USA support of Israel in the Yom Kippur War in 1973. The sudden rise in energy prices led to “stagflation” – unemployment and recession occurring simultaneously with inflation – in the US economy. This was contrary to the central tenets of Keynesian economics which held that only one or the other (unemployment or inflation) was possible. The damaged prestige of Keynesian economics allowed a counter-revolution to be launched. Surprisingly, most of these new macroeconomic theories went back to the laissez faire ideas of pre-Keynesian economics.

Milton Friedman and his followers, labeled Monetarists, lost no time in re-interpreting the Great Depression along lines which would suit laissez-faire theories. On this re-interpretation, the Great Depression was actually caused by inept government policies related to the money supply. Many economists have remarked that theories so violently in conflict with facts became acceptable in the late 70’s only because the generation which had experienced the Great Depression had passed away.  Regardless, the old wine of laissez-faire was presented in new bottles, and rose to prominence once again. Reagan in USA and Thatcher in UK implemented these bold ‘new ideas’ by tax cuts and reduced spending to minimize the role of the government. The failure of Thatcher’s economic policies eventually led to her forced resignation.  It is a puzzle that the same policies were apparently quite successful at reducing unemployment and creating growth in the USA under Reagan.

A deeper look into the difference between what Reagan said and did can resolve this puzzle. Tax cuts for the rich were balanced by increased taxes on the poor.  Large reductions in government expenditure on social security and welfare were more than made up for by massive increases in defense expenditures. What was advertised as a reduction in the role of the government led to a quadrupling of the government budget deficit. Reagan restored the tarnished reputation of Laissez Faire economics by using traditional Keynesian methods of expansionary fiscal and monetary policy, labeled as free market economics.

The collapse of communism further enhanced the prestige of the Laissez Faire economists. The IMF and World Bank enforced the Washington Consensus all over the globe. The poor results of these free market policies disappointed even Williamson, the economist who invented the term. However, instead of rethinking the underlying paradigm, failures were attributed to the wrong sequencing of the economic reforms, and the lack of institutional structures necessary to support the free market. Thus Laissez Faire economics was again the dominant paradigm at the dawn of the 21st century. Economists were just as unprepared for their encounter with reality in the form of the Global Financial Crisis of 2008 as their predecessors had been for the Great Depression. The mistaken overconfidence of Keynes prior to the Great Depression was replicated by Robert Lucas, in his 2003 presidential address to the American Economic Association. Lucas declared that the “central problem of depression-prevention [has] been solved, for all practical purposes” just a few years prior to the Global Financial Crisis of 2008, which provided an empirical refutation of his Nobel Prize winning theories on rational expectations

Next Post: GFC 2007 Historical Roots .

Short Posts on Diverse Topics: My author page on LinkedIn. Other works: Index . Related: The Keynesian Revolution and the Monetarist Counter-Revolution and Why Did No One See It Coming


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