The great depression and the second World War not only changed the American economy profoundly, they also changed the discipline of economics. The classical economics first developed by Adam Smith looked on government more as an obstacle to achieving and maintaining prosperity than as a means to it. But Britain’s John Maynard Keynes, the most influential economist since Smith, saw it differently. Keynes was interested in the big picture, aggregate demand and supply in an entire national economy.
In the long run, these two must, obviously, balance out. But as Keynes explained in his famous aphorism, in the long run “we are all dead.” In the short run, demand can outstrip supply, and inflation results. Or demand can lag, and depression occurs. Keynes felt that government should take an active role in regulating supply and demand by manipulating both fiscal policy (how much the government taxes and spends) and monetary policy (how much money creation is allowed). Keynes also held that the size of a country’s internal national debt (debt held by its own citizens, instead of foreigners and their governments) did not much matter, as the pluses and minuses would automatically balance out.
Keynesianism, as it came to be called, quickly dominated the economics profession. It is not hard to see why. Before Keynes, politicians didn’t need economists to help them run the country any more than they needed astronomers. Keynesian economics made them indispensable. By the 1960s, Keynesian thinking would completely dominate in the halls of government, and Richard Nixon would admit that “we are all Kevnesians now.”
The Kennedy administration was the first to wholeheartedly adopt a Keynesian model of the American economy, and Kennedy’s chief economic adviser, Walter Heller, boasted of being able to “fine-tune” the economy by artful policy moves. It was not to be. President Johnson’s attempt to have both guns (the Vietnam War) and butter (his Great Society programs) brought on serious inflation while at the same time the economy stalled. This unprecedented situation, dubbed “stagflation,” was supposedly impossible under Keynesian economic models.
The Nixon administration tried to deal with the inflation by employing a remedy that went back to the Code of Hammurabi. For the first time in peacetime history, the federal government imposed wage and price controls. They dampened inflation temporarily, but they proved impossible to sustain in the long run and were soon abandoned. At the same time, President Nixon unilaterally broke the link between the dollar and gold. Foreign governments would no longer be able to count on converting their dollar reserves into gold should they so choose. Inflation, already bad, became much worse not only in the United States but around the world.
The federal budget, as a consequence, began to slide out of control. The national debt, which had reached $269 billion in 1946, equal to nearly 130 percent of the gross national product, stabilized after the war and, as the economy grew quickly, shrank rapidly as a percentage of gross national product. By 1970 it was only 39 percent of the country’s output of goods and services. But it nearly tripled in the next decade as the government borrowed heavily to maintain social programs. Thanks to the worst inflation since the Civil War, the debt as a percentage of GNP held steady. But inflation, which in 1980 reached a staggering 13.5 percent, ravaged the savings and investments of American citizens and pushed them into ever-higher tax brackets.
The stock market, which had briefly penetrated the 1,000 mark on the Dow in the late sixties and again in the early seventies, entered a ferocious decline. In December 1974, the Dow hit bottom at 577.60, wiping out all the gains since the Eisenhower administration. The Wall Street writer Andrew Tobias, in an article titled “The Bulls of Wall Street (Both of Them),” noted that if greed and fear were the only two emotions known in the stock market, then “I think it’s time we put in a good word for greed.” Although the market recovered in the latter half of the seventies, it remained far below its earlier peaks in real terms.
A major problem besides inflation was the serious erosion of the extraordinary dominance the United States had enjoyed in the world economy right after World War II. The economies of the other belligerents had recovered, and so too had their economic competitiveness. Indeed, they had one advantage over the United States. Having had, in many cases, to start again from scratch, they could incorporate the latest equipment and technology in their new factories and become the low-cost producers.
With world trade expanding, and shipping costs and U.S. tariffs down, these countries could now compete effectively in the American market. Nowhere was this more clear than in the linchpin of the twentieth-century American economy, the automobile industry. American cars had grown ponderously large and thirsty while innovation had faltered in both manufacturing techniques and technology. By the 1960s, the Volkswagen Beetle was commonplace on American roads, and while not a major threat to Ford, Chrysler, or GM, it proved a harbinger.
The United States, where the petroleum industry was born and which remained a petroleum exporter until the 1950s, had become a major importer of the vital fuel by the 1970s. When the Yom Kippur War broke out in the Middle East in 1973 and the Arab countries boycotted exports to the United States, the resulting oil shortages came as a profound shock. Long lines and rising prices at gas stations severely disrupted the economy and produced a surge in demand for more fuel-efficient foreign automobiles.
Foreign cars turned out to be better made too, and the new competitive pressure they introduced forced the domestic auto makers to shape up. It was not an easy or painless process. Many people who had earned good livings for decades found themselves out of jobs as the car industry made itself more efficient. This was repeated in nearly every other major industry. The American steel industry employed 398,000 workers in 1980, and they produced 95.2 million tons. In 1997, steel production had increased to 131 million tons, but with only 112,000 workers.
Many of these jobs went abroad to less developed countries where labor costs were much lower. The communications and air-travel revolutions were allowing companies to operate as unified organizations all around the globe, just as the railroad and telegraph had promoted the growth of national markets a century earlier.
In 1980, the country, wearied of all the inflation and unemployment, unseated an elected President, Jimmy Carter, for the first time since Herbert Hoover, and put Ronald Reagan in the White House. Reagan, together with the chairman of the Federal Reserve, Paul Volcker, proceeded to break the back of the chronic inflation by taking interest rates to unprecedented levels. This induced a severe recession that pushed unemployment over 10 percent for the first time since the Great Depression and caused the stock market to fall below 800. But the medicine, distasteful as it was, worked. Inflation subsided, and the economy took off. The stock market began to move up sharply in 1982, and the Dow crossed 1,000 for the third and so far final time.
But because inflation fell while President Reagan insisted on building up the military and Congress insisted on maintaining social programs, federal budget deficits climbed to levels unknown in peacetime, and the national debt exceeded five trillion by the mid-1990s, 20 times what it had been at the end of World War II.
One major consequence of the globalization of markets has been a severe loss of sovereign governments’ power to control their internal economies. When France elected a socialist government in 1981, the new president, Fran¡ois Mitterrand, tried to implement a traditional socialist program, including nationalizing the banks. Currency traders, who by then operated around the globe as a single unified market, often trading as much as a trillion dollars a day, began dumping the franc until the French government had no choice but to reverse course. It was a pivotal moment in world history. For the first time, a free market had dictated policy to a Great Power.
For the second greatest power in the world, the Soviet Union, the new high-tech, market-driven world economy was a death knell. Its command economy was able to produce a first-rate military, but the repressive Soviet system could not compete with the increasingly high-tech economies that were rapidly developing in the world’s other major nations, which depended on the free flow of information by means of the Internet, faxes, photocopiers, and telephones.
Attempts at reform in the late 1980s proved impossible to control. The Soviet empire in Eastern Europe collapsed in 1989, the Soviet Union itself two years later. Its death ensured that capitalism and, to a greater or lesser extent, democracy were the models for developing nations to emulate.
Japan had already re-established itself as a leading economic power by the 1970s, and many of its East Asian neighbors, including China, Taiwan, Hong Kong, and Singapore, began exponential growth that made them major forces in world markets. The United States, facing both Europe across the Atlantic and the new “Asian tigers” across the Pacific, was uniquely well placed geographically to benefit from the new globalization. In 1993 it signed a treaty with Canada and Mexico, NAFTA , to establish a North American common market that has grown vigorously in the years since. Other nations in the Western Hemisphere will likely join in the future.