Three centuries of economics
Updated: Nov 14, 2020
How to fight economic recessions? The answer of economists throughout centuries.
The first economists
There are no proper economists per se before the 18th century. This is what we may call the stone age of economics. Governments use naive economic ideas like: “We have to prevent the population from buying goods that are not from our country. By doing so, the gold will stay inside our borders and make us richer!”
But economists are going to change everything. The first well-known economist, Adam Smith, studied the economy of his time carefully. He noticed that many things worked quite well without any government intervention, and sometimes even better, simply by letting people freely interact and exchange goods and services.
Many economists are going to follow his ideas and give similar recommendations. For instance, fixing minimum or maximum prices is a bad idea, because it prevents the law of supply and demand from properly working. In order to improve the living standards of the population, one needs to let economic actors interact freely. Today, we call these ideas classical liberalism, but they were revolutionary at the time. At these times, politicians were convinced they were making smart decisions while trying to control the economy.
This shift to a more free economy was a success. A long era of growth followed, which tremendously improved living conditions for the entire population.
This free economy is globally fine, but there are temporary setbacks. From time to time, a recession occurs: growth stops and unemployment suddenly increases. But it doesn’t last long and the economy is quickly back on track. New growth compensates for the losses of the recession, and employment goes back to pre-recession levels. The reaction of economists is to say that we need to accept these harder times and wait for the return of growth. Some economists even think that recessions are actually useful to get rid of inefficient companies. Those conclusions seemed globally satisfying at this time.
The Great Depression
But everything is going to change. In 1929, a violent recession starts. Unemployment in industrialized countries reaches levels ranging from 20% to 30%. As we know from later on, this economic context will fuel the ascent of Hitler.
This is when the economist John Maynard Keynes enters the scene. At that point, the crisis is so serious that many intellectuals have come to think that we should abandon capitalism and instead adopt socialism like the USSR, which at that time appealed to many intellectuals. But for Keynes, the capitalist economy is like a car where all the parts are perfectly fine except the starter which is broken. We don’t need to scrap the car but only to fix the broken component.
Keynes theory is that the issue is insufficient aggregate demand. To be clear: people and companies do not buy enough goods and services compared to what the economy is capable of producing. According to classical economists, the law of supply and demand will solve the issue automatically: wages and prices are going to fall, and the economy is going to reach a new equilibrium with full employment.
But this phenomenon is slow because of wage stickiness. Bosses cannot just one day say: “Let’s reduce the wages by 30%!”. Contracts with employees need to be honored and the agreed on wage cannot be changed. On the other hand, it is possible to fire people, which is what happens. Of course, in the long run, wages will fall anyway because employees who fear being fired will accept cuts to their pay, and newly hired employees will accept lower wages. According to classical economists, these mechanisms will get rid of the recession in the long run. But for Keynes, “In the long run we are all dead”, which is a way to say that we cannot afford to wait for things to improve. We need to act now to get out of this crisis.
Act now? But what should we do? Keynes proposes to use two tools:
Monetary policy: The central bank could lower its interest rate to give an incentive to entrepreneurs to borrow more money. They would then use it to build new factories. Building those will require more workforce, which will employ new workers.
Fiscal policy: The government can temporarily increase its spending to compensate for the “missing” aggregate demand, by launching infrastructure works (roads, bridges, tunnels…). Building those will also increase employment.
In Keynes times, interest rates were already very low, so Keynes thought that using fiscal policy would be more efficient. What matters is to trigger a virtuous circle: if people get back to work, they will have a new salary to spend, and will spend it in shops which can then hire new workers, and so on.
You might be tempted to say: “I know what happened: governments listened to Keynes, this was a huge success and that’s what made him famous.” Actually it’s not what happened. Governments did not really listen to Keynes.
Time goes by and the recession continues. In the following years, Hitler comes to power in Germany and then World War II begins. But then the US goes to war too, and this requires massive public spending. From an economic point of view, this plays the role of a fiscal stimulus in this US. And it works! Economy is back on track, with sustained growth even after the end of the war. Keynes supporters, who we now call Keynesian economists, see this as evidence for their theory.
Inflation of the 70s
In the following years, the Keynesian methods are going to be used and abused to fight recessions. And in the 70s things start going wrong…
For politicians, Keynesian economics feels like magic: it allows to reduce unemployment just by lowering interest rates. So let’s go all the way to full employment! But strangely, unemployment seems to be unable to go below some kind of incomprehensible threshold (around 4% in the US).
There is also a new issue: a very high inflation, around 10% in industrialized countries. Inflation is a measure of how much prices rise in an economy, based on an average set of frequently bought goods. An inflation of 10% means that money you put on a bank account will basically lose 10% of its purchasing power after one year. In just 8 years, it will lose half its value.
Some economists, including the now famous Milton Friedman, accuse the low interest rate of the central bank. Their work leads to discover an amazing fact: if we lower the interest rate too much, the positive effect on employment stops, and instead inflation starts to rise.
Why? We can intuitively explain it. In a perfect labor market where everyone can find a job easily, there remains some minimal level of unemployment, as some people may between two jobs for instance. If we try to reduce unemployment even more, we actually create a shortage of workers, which give them a strong position to negotiate higher wages. To pay for these higher wages, most companies raise their prices: this is inflation.
To make things worse, once inflation is around 10%, it tends to stay there. Companies come to expect an inflation of 10% in their spendings, so they raise their own prices in anticipation. Workers do the same and demand annual raises indexed on inflation. Companies therefore see an increase in costs both in wages and providers and so increase their own prices, and the circle goes on.
For economists, the only way out of this is to artificially trigger a recession by massively increasing interest rates. Unemployment will then rise and workers will eventually have to give up the systematic 10% raise and indexation clauses in their contracts. Companies will get used to low inflation and stop increasing their prices every now and then.
Triggering a recession may sound an insane thing to do, but it actually worked and inflation went back to a normal level which is below 5%.
The consensus of economists
What economists remember of this misadventure is that an expansionary (low interest rate) monetary policy is good to fight recessions, but can be dangerous if abused. Also, we need to keep an eye on inflation. This new mission is given to central banks:
If inflation is too high, they raise the interest rate.
If a recession occurs, unemployment will rise and inflation will fall, possibly going negative (this is called deflation). To fix that, the central bank lowers the interest rate, which stimulates the economy, decreases unemployment and increases inflation back to a normal value.
The commonly accepted goal is to have an inflation around 2%. Why not target a perfect price stability at 0%? One of the reasons is that a low inflation is useful to companies because it allows them to progressively adjust wages downwards if necessary. An absence of raise during a year with 2% inflation is actually a 2% reduction in “real” salary since this salary purchasing power is 2% lower.
In the following years, the fight against recessions and inflation becomes the exclusive responsibility of central banks, which implies that only monetary policy (playing with interest rates) is used and fiscal policy (temporarily increasing government spending) is left unused.
Why not use fiscal policy? An issue is that it requires to decide what to fund, which is a very political matter. This can lead to long debates and conflicts of interest. It also takes time to launch projects, which delays the effect on the economy.
This is why economists and governments focus on monetary policy and entrust this task to central banks, which are given independence from political power. This is to prevent politicians from being tempted to give temporary “boosts” to the economy for political opportunism, for example just before elections.
The Great Recession of 2008
This new economic management strategy will work well until the 2000s, but a new difficulty will present itself. In 2007–2008, the subprime mortgage crisis in the United States triggers a very serious recession called the “Great Recession”.
Faced with this situation, central banks know what to do and lower their interest rate. But this time the recession is so bad that they need to lower it all the way down to 0%. And that’s still not enough! Unemployment continues to rise, up to 10% in the United States and Europe.
So what can we do? Keynesian economists answer: “It’s like in Keynes’ time! Fiscal policy should be used!” According to them, the government must spend more to fill the gap in private spending. (I recommend this nice video Fight of the Century: Keynes vs. Hayek which presents in a rap battle the opposing arguments of the two sides)
Faced with this crisis, the United States follows a Keynesian policy, with the American Recovery and Reinvestment Act of 2009 launched by Obama, which uses fiscal policy to stimulate the economy.
In addition to that, they try a new tool called Quantitative easing. The idea is to buy stocks or bonds with money created ex nihilo by the central bank. This new money ends up in the pockets of the former shareholders and creditors. They can then use this money to fund new things, which will require hiring people, therefore reducing unemployment. However, the effectiveness of quantitative easing is still debated among economists.
Complications in Europe
What is particularly interesting is that the political reaction to this recession is very different in the European Union and in the United States. While the US adopts an unambiguous Keynesian policy at the federal level, in Europe it’s more complicated.
The difference is that in Europe, the central bank is at the EU level, while the governments that can use credit to stimulate the economy are the individual countries of the European Union. The federal budget of the European Union is very low and the EU is not allowed to have a deficit anyway. It is actually the exact opposite of the USA, where individual states are not allowed to have a deficit while stimulus policies can be deployed at the federal level.
In addition to this, European countries face trust issues on their debt: creditors are afraid that governments might not pay back, so they increase the interest rate they demand. Why is this suddenly an issue? Because debt “automatically” increased during the recession, as social spending increased (because of unemployment) while revenues decreased (less things bought = less taxes collected by governments).
This leads European governments to implement austerity policies, which are the exact opposite of Keynesian fiscal stimuli. In practice, this means that they increase taxes and reduce public spending. The extreme example is Greece, which faced with a debt crisis, ends up implementing a policy of radical austerity.
The result is a relapse into recession for countries that have applied austerity, while countries that have applied Keynesian stimuli have returned to normal growth. Keynesian economists see these events as evidence for their ideas.
COVID-19 crisis: a Keynesian victory?
With the spread of COVID-19, we face a recession that is even worse than the Great Recession of 2008.
Faced with a fall in global demand, all developed countries seem convinced by the need to deploy Keynesian policies. Interest rates are lowered to 0% by most central banks, as in the last recession. The difference is that this time, most rich countries also use massive fiscal stimuli.
But as always in Europe, things are more complicated. Most countries want to implement fiscal stimuli, but those who are heavily indebted do not dare use it too much, for fear of falling again into a debt crisis. Unfortunately, these at-risk countries are precisely those which have been most affected by the recession, like Italy. Faced with this situation, the European Union made the historic decision to carry out loans for the first time at the federal level, and is preparing a large-scale fiscal stimulus policy in Europe.
Does this period mark a permanent victory for the Keynesians? How to prevent fiscal policy from being used as a means to favor national companies and thus distort competition? Will interest on government debts remain low, or will there be a new debt crisis? Will central banks lose their independence? This period raises many questions which the future will answer…