The Ten Biggest Economic Policy Mistakes from the Depression to the Recession
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I have just finished teaching a graduate course on the management of the U.S. economy from the Great Depression to the Great Recession. Given that economic crises bookended the syllabus, student interest in the review session unsurprisingly focused on discussing macroeconomic policy errors more than successes.
This set me thinking as to what I would adjudge the ten greatest economic policy errors from the late 1920s to the present. My list and rationale appear below. But first some caveats.
Such a listing tends to focus on short-term rather than long-term consequences because the latter are more difficult to track and link to specific policies. It can also be difficult to separate policy effects from broader structural movements in the U.S. and world economies that would have produced similar outcomes anyway. Furthermore, judgements about whether policy outcomes are good or bad reflect the values of the assessor -- people with different political views to mine would likely produce a different list.
Finally, a list of failures has a pathological focus on economic sickness. It tends to overlook the reality that the American economy has been broadly healthy for a good many of the last eighty-plus years.
But maybe a list of policy successes that generated and sustained prosperity can be a subject for a future blog. In the meantime, here’s my take on policy failures in ascending order of magnitude:
10) Eisenhower’s drive for a balanced budget 1959-60
This is included to demonstrate that the Eisenhower economy was not as strong as historical opinion often makes it out to be. There were three recessions in eight years, the worst of them in 1957-58, but Eisenhower’s excessive concern about creeping inflation caused him to insist on balancing the Fiscal 1960 budget in the immediate wake of the large Fiscal 1959 deficit. Denied fiscal adrenaline, the economy slipped back into double-dip recession just before the 1960 election. The Eisenhower administration failed to recognize that chronic slack rather than creeping inflation was the main economic problem of the late 1950s.
9) LBJ’s refusal to raise taxes to fund the Vietnam War
Lyndon Johnson opted for guns and butter rather than risk conservative congressional retrenchment of the Great Society if he asked for a tax increase to pay for the Vietnam War in the Fiscal 1966 budget. The consequence was the overstimulation of a full-employment economy and the doubling of consumer price inflation from a 2 percent annual average in 1963-65 to 6 percent in 1969. The Great Inflation had been set in train. Why is this error not higher in the list? It’s mainly because other factors contingent to the 1970s had more effect in producing the runaway inflation of that decade.
8) Nixon’s economic mismanagement
Nixon was determined that the economy would not be his Achilles heel in the 1972 presidential election in the way it had been in 1960. Accordingly he threw a big-spending fiscal party to boost recovery from the 1970 recession, even going so far as to announce, ‘I am now a Keynesian in economics.” He achieved his political goal of a second term but at cost of greatly aggravating the price instability inherited from the Johnson political economy. Nixon implemented the first-ever peacetime wage-price controls to hold inflation in check while fiscal stimulus boosted employment. However their eventual removal released a stockpile of inflationary pressures just as the termination of the Bretton Woods agreement, which sent the dollar plummeting on the world money markets, made for dearer imports. Nixon’s economic mismanagement squandered the opportunity to choke off inflation before oil shocks, productivity decline, and currency fluctuation made matters much worse. In his defense, however, contemporary Democrats had no better idea of how to deal with the stagflation conundrum.
7) Stop-go economic policies of 1974-80
The Ford and Carter administrations and the Federal Reserve found it impossible to break the worsening cycle of stagflation. Economic policy oscillated between anti-inflation restraint and employment stimulus in this period before Jimmy Carter eventually settled on a politically disastrous and economically ineffective austerity program that did much to make him a one-term president. On Election Day 1980, he faced the voters with inflation at 13 percent and unemployment at 7 percent, making for a misery index of 20 percent. Policymakers of this era underestimated the inflationary significance of a decline in productivity, whose cause economists still dispute but which a futile quest for fiscal discipline could not cure.
6) Hoover’s drive for a balanced budget in 1932
Britain abandoned the gold standard and devalued sterling in response to the worsening international depression in 1931. Its actions provoked money-market concern that the United States would follow suit. The resultant run on America’s gold deposits posed a threat to its reserves. The Federal Reserve consequently raised interest rates in an effort to promote confidence in the dollar. Having tolerated sizeable deficits as the economy declined, Herbert Hoover now shifted fiscal course to seek a balanced budget so that government borrowing would not crowd out scarce credit needed by business. The Revenue Act of 1932, then the largest peacetime tax increase in American history, was his instrument for doing so. However, its main effects were to diminish purchasing power in an already devastated economy and thereby further hurt business confidence. The enhanced loss of tax revenue as economic decline accelerated served to increase rather than diminish the deficit. In defense of Hoover, he had acted in accordance with the monetary logic of the time rather than out of outdated anti-deficit dogma.
5) The fiscal-monetary mix of the early 1980s
Selecting this as a policy error will doubtless raise some hackles because the Reagan-Volcker economic policies are generally lauded for restoring economic growth and conquering inflation in the wake of 1970s economic misery. The Volcker Fed can be credited with winning the battle for price stability but at cost of the deep recession of 1981-82 that resulted in partial de-industrialization of the old industrial heartland. Another victim of the downturn was the Reagan administration’s "rosy scenario" that its massive 1981 tax cuts would generate economic growth that would in turn produce a harvest of budget-balancing revenue. Instead, the outcome was a string of record deficits that would eventually have to be funded through the maintenance of high real interest rates long after the recession ended in order to attract foreign purchasers for U.S. Treasury securities. This transformed America from the world’s largest creditor to the world’s largest debtor between 1980 and 1985, saddled it with a chronic trade gap, and made it dependent on foreign lenders to sustain its borrowing habit.
4) The Bush tax cuts of 2001 and 2003
George W. Bush promised that his tax cuts would deliver huge productivity gains, bumper employment growth, and a harvest of surplus-producing revenues. Instead, the main consequences of a tax program skewed towards the rich were widening income inequality, massively loss of government revenue, and anaemic job growth. With fiscal policy proving so ineffective, cheap credit had to bear the main burden for post-2001 recovery from the dot.com recession and the economic shocks of the 9/11 terrorist attacks. But that particular cure had dangerous side effects that would eventually lead to the financial crisis of 2007-08.
3) The Roosevelt Recession of 1937-38
In 1937 Franklin Roosevelt prematurely moved to balance the budget in the mistaken belief that full recovery from the Great Depression was nigh and that inflation would soon replace unemployment as the main economic threat. The Federal Reserve also tightened credit out of the same concern. At this juncture, too, the initial collection of the new Social Security taxes reduced purchasing power in the economy. The combined effect produced an abrupt termination of the economy’s steady post-1933 recovery and precipitated one of the sharpest recessions in American history. This prompted FDR to make a modest turn towards Keynesian policies that he had hitherto spurned, but he did not operate sufficiently large deficits in 1938-40 to bring about robust recovery. The New Deal never conquered the Great Depression. It was the stimulus of defense spending in World War II that finally restored the U.S. economy to full health.
2) The Greenspan bubbles
The monetary ‘Maestro’ of the 1990s boom eventually struck out -- twice! If only Alan Greenspan had ended his tenure as Federal Reserve chair in 1999 rather than in 2006, his reputation in history might have been so different. However, Greenspan’s faith in the rationality of the market proved his undoing. Having kept monetary policy relatively tight as an anti-inflation safeguard during recovery from the recession of 1990-91, he decided that the productivity improvements associated with the increasingly high-tech economy merited a reversal of course in 1995. Cheap credit led to a Wall Street boom as investors stocked up on debt to buy shares in the belief that their value would rise indefinitely. Greenspan’s rhetorical warnings of ‘irrational exuberance’ did nothing to prevent the boom turning into a bubble. The Fed’s eventual raising of interest rates in 1999-2000 precipitated the collapse of the dot.com share boom and a brief recession in early 2001. Greenspan then mitigated the effects of the downturn and the economic shocks from the 9/11 terrorist attacks with an even stronger dose of cheap credit. The result was another bubble, this time in real estate values. Greenspan’s reversal of monetary course to douse house price inflation in 2005 had more devastating consequences than his earlier U-turn. It proved the critical link in the chain of events that led to the implosion of the subprime mortgage market, the collapse of real estate values, and the financial crisis of 2007-08.
1) Converting a recession into the Great Depression, 1929-1933
The Wall Street Crash need not have precipitated the Great Depression. Bad monetary policy was to blame for the worst economic crisis in American history. The Federal Reserve System had been established to prevent what actually happened. It was set up in 1913 to avoid bank closures but its 1929-1933 policies produced the very opposite of this goal. Fed officials seemingly subscribed to Treasury Secretary Andrew Mellon’s ‘liquidationist’ theory that weeding out weak banks was a necessary response to the financial crisis precipitated by the stock market collapse of late 1929. Central bank policies accordingly resulted in a decline of one-third in the money quantity in the banking system between the Wall Street crash and the end of the Hoover presidency. During this period, a total of 5,750 banks failed with the loss of over nine million savings accounts. As Milton Friedman and Anna Schwarz later documented, this was an entirely avoidable economic tragedy. In 2002, then Federal Reserve Governor Ben Bernanke voiced agreement with their thesis: “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” It was a lesson that he put into practice as Federal Reserve chair during the Great Recession.