Part I: Twentieth Century Economics
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 interventions automatically lead to the best possible economic outcomes. The folly of this position was made obvious to all by the Great Depression. 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.
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” in the US economy — unemployment and recession occurred simultaneously with inflation. 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 followers, labeled Monetarists, lost no time in re-interpreting the Great Depression along lines which would suit the 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 on 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 Twenty First 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.