From Smith to Keynes: A History of Economic Policy
The economic history of the past hundred years can be divided into three periods, each guided by one of two different economic theories: classical and Keynesian economics.
At the turn of the 20th century, classical economic theory was dominant. There was fairly universal consensus that when it came to markets, the government had no place. This of course doesn’t mean that the economy at the time was in a constant boom; on the contrary, it repeatedly fluctuated between panics and periods of growth. Economists and politicians accepted this pattern, known as the business cycle, and were perfectly content to wait out the bad times with the knowledge that good times were just around the corner. Nevertheless, in response to a particularly nasty recession, the Federal Reserve Act was passed in 1913*, creating a lender of last resort for banks in the hopes that it would prevent, or at least mitigate, future panics.
Of course, October 24, 1929* changed things a bit. As bank after bank closed and the unemployment rate steadily rose, it became clear that this economic panic would be bigger and more devastating than any before. In response, FDR, Congress, and the FED began experimenting with new means of stimulating the economy. The FED used its newly-established power of monetary policy and unfortunately, made some misguided decisions. In an effort to curb inflation and discourage banks from making poor investments, the FED raised the interest rate, decreasing the money supply. However, this action not only discouraged general investment (which decreased total output and further increased the unemployment rate), but also prevented banks from borrowing money to stay in business and caused more of them to fail. Congress, on the other hand, made things slightly better. FDR’s famed alphabet soup programs increased government spending, creating jobs for many unemployed workers, and benefits for ordinary citizens. And with these programs, fiscal policy was born.
We don’t know just how successful FDR’s fiscal policy was because World War II came after only 9 years of a plateauing depression and created a sudden demand for jobs, businesses, and investment. There is little doubt among economists that the war which claimed so many lives was also largely responsible for restarting the economy. But the lesson of the depression had been learned, and from 1946*, the government turned to the ideas of a British economist named John Maynard Keynes.
*Source: US Economic Timeline
Keynesian economics is fairly straightforward: it claims that the government is responsible for controlling the economy, creating jobs for the unemployed, and countering the effects of the business cycle. In times of economic expansion, the government should keep the economy from growing too fast by raising taxes and cutting government spending. In times of economic recession, the government should stimulate the economy by cutting taxes and raising government spending. Monetary policy works similarly, with high interest rates in times of expansion (to discourage investment) and low interest rates in times of recession (to encourage investment). (Here’s a useful link that helps explain fiscal and monetary policy.)
The Great Depression had taught politicians that the economy cannot go entirely unregulated; however, a new debate had sprung up over how much regulation was needed. In the 1990’s in particular, many so-called “classicalist” economists insisted that there was too much regulation, and successfully pushed for less. Furthermore,while contractionary fiscal policy may be good for the economy, it does not sit well with the public or politicians. (Because how many people can get elected campaigning for more taxes and less government spending?)
Another issue with Keynesian economics is that it focuses largely on the demand side of the economy. Until the mid-1970’s, economists looked largely at output (fiscal) and the demand for money (monetary), but when the oil shocks of 1973 and 1979 came, this was no longer the case. The attempt to keep oil prices low further decreased supply and caused greater shortages.
In case you haven’t picked up on it, most economic models were developed as a result of major crises. With each panic, recession, or depression, fiscal and monetary experiments allowed economists and politicians alike to learn how to stroke the economy’s fur in the right direction.