When World War II ended, there was a widespread fear that the Great Depression would return, but fear soon gave way to optimism when the expected economic collapse failed to materialize. Academic economists were especially optimistic because of the belief that John Maynard Keynes, the famous British economist, had shown how a modern industrial economy could be kept on even keel through the judicious use of fiscal policy. The confidence of economists that the business cycle could be tamed reached its peak during the Kennedy-Johnson years, but then the weakness of the Keynesian regimen (as it was applied in practice), inflation, began to make itself felt (see Figure 28.1).
Instead of unemployment, inflation became the primary problem. Inflation tended to fall and unemployment tended to rise in each recession (see Figure 28.2), but inflation did not fall as much in each recession as it had risen in the previous expansion, so that the core rate of inflation moved steadily upward during the 1960s and 1970s. Similarly, the unemployment rate did not fall as much in each expansion as it rose in each recession; the core, or natural rate of unemployment as some called it, also increased during these years. By the late 1970s, “stagflation” (high unemployment combined with high inflation) seemed to be as perplexing as depression had been to an earlier generation.
Stagflation presented a fundamental challenge to Keynesian economics. As a result, economists and policymakers began to pay more attention to the ideas of Milton Friedman, the free market economist at the University of Chicago. Friedman stressed several points that profoundly influenced policy from the 1970s through the remainder of the century: (1) the trade-off between inflation and unemployment was temporary, (2) inflation was a monetary problem best solved by reducing the rate of growth of money to a slow and stable rate, and (3) freely floating exchange rates worked better than fixed exchange rates. The attempt to apply monetarist ideas (as the school of thought established by Friedman came to be called), although not always faithful to the original doctrine, became the basis for monetary and fiscal policy in the 1980s and early 1990s. Inflation was arrested in the early 1980s, but at the cost of a severe recession. Although inflation was never reduced to zero, it was kept under control for the remainder of the century.
At the turn of the century, optimism about the economy among policymakers, economists, and the general public was high. Financial innovation seemed to be creating vast amounts of new wealth. But then in 2008 this optimism was shattered by financial panic the likes of which had not been seen in the United States since the early 1930s. The crisis ushered in a long period of persistently high unemployment.
World History
