Debates in Macroeconomic Policy Research Paper

The Wealth of Nations integrated eighteenth-century political and economic thinking to present a new framework for economic organization to promote economic well-being. Smith demonstrated that the then prevailing emphasis of government accumulation of specie—gold and silver—was misplaced. For Smith and the following classical school, the correct view of economic progress had nothing to do with money.

Just as in modern views of economic growth, rising living standards depended on increasing the productivity of resources, primarily labor and physical capital. Many factors contribute to rising levels of productivity with the classical tradition favoring reliance on private entrepreneurial activity with essential but limited roles for government.

Smith understood that market or capitalist economies require government oversight and productive contributions. Private markets can fail to operate in society’s interests in a variety of ways, requiring government intervention to reallocate resources as with public goods and externalities and to promote competition where impediments exist. Smith also understood the income distribution or fairness issue and was an early supporter of progressive taxation. However, with respect to the business cycle with contractions and expansions of national production, Smith and the classical economists supported a laissez-faire approach. Thus, if a recession arose, excess output could always be sold through price reductions. Similarly, workers could always find work through wage declines. A general deflation would then gradually move the economy back to its full-employment resting place. Flexible wages and prices would move in the opposite direction, should an economy become overextended in an inflationary boom

This leads to the second tenet of classical macroeconomics—the relevant time frame of interest is the long run. Whatever short-term instability existed was best remedied by the economy’s self-correcting mechanism. The more quickly wages and prices adjusted to economic shocks, the faster the economy would return to its full-employment level of income and output.

Finally, only the supply or production side of the economy mattered for economic growth. Say’s law of markets, namely, that “supply creates its own demand,” meant the demand side was not a concern. Employment of resources automatically generated incomes sufficient to purchase what was produced. Any income not spent was automatically placed back into the economy through business investment spending on the physical capital through the loanable-funds market.

The nineteenth century is also associated with establishment of a global trading system that relied on both free trade and the “classical” gold standard. The case for trade was inherent in Smith’s discussion of specialization and exchange. However, the formal logic for trade was provided by David Ricardo’s principle of comparative advantage. The idea that competition or trade between nations raises living standards remains a principle in modern economics.

The international gold standard served two functions. The first was to create an international payments system to finance trade. The second was to regulate the amount of money in circulation. In a true gold standard, gold circulates both as money and as a commodity and is freely exchangeable between such uses. Because the amount of money was determined by a commodity, the price level was highly correlated with changes in the amount of gold in circulation. Prices rose and fell with new gold discoveries, bullion ship sinkings, and new technologies in gold mining. Such situations produced alternate inflations and deflations as nations allowed their domestic money supplies to be determined by the international gold standard. This system provided two major benefits: it was self-regulating and did not require direct monetary intervention, and it produced long-run price stability. The short-term record, however, was one of instability and unpredictable swings in prices.

David Hume is credited with formalizing this link between the money supply and the price level in the quantity theory of money, MV = PY. The money supply, M, multiplied by its annual turnover rate or velocity, V equaled nominal gross domestic product (GDP), PY. Nominal GDP has two components: the level of prices, P, and real GDP, Y, calculated using prices from a base year. The quantity theory was famously used to explain how a mercantilist country that attempted to block imports, forcing trading partners to pay for exports with gold, must fail. A simple interpretation of the quantity theory shows that an increase in gold, thought to be the source of wealth, puts upward pressure on P, the domestic price level, thereby reducing exports while promoting imports. In the long run, rigging trade to acquire gold must fail. Better policies were free trade, private-market resource allocation, and laissez-faire.

During the nineteenth century, the U.S. economy operated according to classical rules. In the 1890s, the United States experienced several major recessions. Real output actually fell 3 years with the price level declining in 6 years. Real output was higher at the end of the decade by nearly half, but the short-run economic record saw recession and deflation. For macro-economic thinking, this was how the business cycle should operate.

The Panic of 1907 and Creation of the Federal Reserve

The classical hands-off approach also applied to commercial banking and financial markets. Twice, the United States had established a central bank prior to the twentieth century, but neither survived original chartering. In 1907, as had previously happened, a major New York bank failed. This triggered a financial panic that had the impact of producing a sharp drop in the U.S. money supply and subsequent reduction in real output. The panic would have been worse had not John Pierpont Morgan opened his personal fortune to deposit money in banks in a vote of financial support. A century later, a similar but larger crisis would confront the U.S. economy.

The lesson drawn from this episode was to make clear the need for a central source of reserves for the U.S. banking system. What emerged was the Federal Reserve Act (1913) and the Federal Reserve System that opened in 1914. The System, composed of 12 regional banks, was dominated by the New York Federal Reserve until events in the Great Depression resulted in an overhaul of the U.S. monetary structure.

John Maynard Keynes and the Great Depression

No event in U.S. economic history has had more impact than the Great Depression. Debate continues today as to the causes and consequences of this economic disaster. The collapse that lasted from August 1929 to March 1933 saw real output fall more than 26%. Unemployment rose from 3.5% to over 25% while the price level dropped 26%. The breakdown appeared to mirror past macroeconomic declines in that falling output and rising unemployment were accompanied by deflation. However, this decline seemed to have no end. And at Cambridge University, a new approach to the business cycle was being created to help deal with a global depression.

In The General Theory of Employment, Interest and Money (1936), John Maynard Keynes revolutionized macroeconomics. Classical thinking was discarded as emphasis was changed from the long to the short run and from supply to demand. For Keynes, events in the 1930s required immediate policy response. Furthermore, economies had excess supplies of labor, capital, and other productive resources. Therefore, the key problem was a lack of short-term demand or spending on output. The key question became how to best stimulate total expenditure on GDP. The private sector was in disarray as spending by consumers (C) and businesses (I) fell between 1929 and 1933. Consumer expenditure dropped from $752 to $558 billion (using prices from the year 2000) with private investment spending collapsing from $91 to just $17 billion over this period.

The Keynesian alternative outlined in The General Theory called for the use of deficit spending as a short-term policy to restore full employment. The federal government could either directly raise spending (G) or reduce taxes (T), which through a multiplier process would ultimately raise output and income. Alternatively, the Federal Reserve could pursue expansionary policies that would help lower interest rates to promote new spending. Following publication of The General Theory, however, fiscal policy became the preferred stabilization policy tool. The alternative to this was to wait an indeterminate time period while the economy’s self-correcting forces operated. While U.S. monetary and fiscal authorities took action, unemployment stayed in double digits until the outbreak of World War II. The modern debate over the government’s role in stabilizing the economy had started.

Keynes offered an alternative for ending the Depression. But what had caused the collapse? A recession had started in the summer of 1929, which was soon followed by the Great Crash during the fall of 1929. The negative impact of the 1930 Hawley-Smoot tariff increase contributed. Perhaps the two greatest economists of the twentieth century, John Maynard Keynes and Milton Friedman, both agreed the greatest problem for the United States was a series of policy mistakes made by the Federal Reserve. The Fed failed to contain a series of financial panics between 1930 and 1933. The financial system was so unsound that the newly elected Franklin Roosevelt had to close all banks to help restore financial soundness. This overhaul was accompanied by new laws guaranteeing depositor money (Federal Deposit Insurance Corporation) and a new structure for the Federal Reserve itself in which the Board of Governors and the Federal Open Market Committee (FOMC) were placed in charge of monetary policy and the determination of credit conditions and interest rates. These actions were taken after 1933, after both the nominal money supply and the number of U.S. banks had dropped by one third.

The Postwar Study of Economic Growth

With the Depression behind them, macroeconomists again took up the study of economic growth. Logically, these efforts took Keynesian ideas and developed their implications for growth theory. Evsey Domar and Roy Harrod independently created similar models of economic growth that were familiar to Keynesian economists. The Harrod-Domar growth model emphasized the importance of saving, a major problem for low-income countries, as well as the productivity of the capital stock.

Robert Solow added a fundamental contribution to growth theory that remains the starting point for such analysis. Solow’s model, referred to as the neoclassical growth model, was a supply-side approach to thinking about raising living standards. For the next decade, economic growth theory built on Solow’s model, which gave new life to the classical interest in long-run growth.

Solow’s theory contained two insights. Starting with the simplest model of supply, Solow showed that rising living standards, the goal of economic growth, do not arise from having a relatively high level of national saving. Nations can divert current income to saving and then to investment or real capital formation. This will raise living standards, but only once. Additional saving that can provide workers more capital (machines) with which to work can raise productivity levels. However, additional saving must occur if workers are to become even more productive. In Solow’s model, technological change is the reason why nations can experience continuous improvements in real living standards. When technological advance occurs, workers in affected sectors can become more productive. Modern economic growth is thus a record of technological change.

Solow’s model makes no attempt to model or to explain a theory of technological change. The neoclassical model assumes that technology changes for reasons that cannot be predicted, or that technological change is exogenous and independent of the model. Somewhat surprisingly, the key to growth is not explained. The Solow model nonetheless remains the starting point for the economic growth studies.

The Arrival of Keynesian Macropolicy in the United States

Keynesian macroeconomics came to the United States in the 1960 presidential election. A recession was under way in 1960, and John F. Kennedy proposed a deficit-financed tax cut to stimulate the economy and end the recession. The Kennedy tax plan was not enacted until 1964 and was accompanied by two contemporaneous fiscal shocks. The first came from the new President Lyndon Johnson’s Great Society program and its War on Poverty. The second was the Vietnam War. These three demand shocks produced an overheated economy that by the end of the decade had produced a very low unemployment rate of 3.5% but an accelerating inflation rate that topped 5%. Two points stood out to economists in 1969. First, there had been no recessions during the 1960s, and Keynesian-style demand management was given credit for the longest period of economic expansion in U.S. history up to that time. Second, the economy was behaving precisely as had been expected. Excess demand had resulted in higher prices, or the increase in inflation, while driving down unemployment. In macroeconomic books, the Phillips curve inflation-unemployment trade-off emerged as the tool economists used to explain how the U.S. economy operated.

The ascendancy of the original Keynesian model was challenged by macroeconomic events of the 1970s. The decade began with a recession that produced higher unemployment but without any decline in inflation. This surprised Keynesian economists, who had come to rely on the Phillips curve to portray an inverse relationship between inflation and unemployment. In the early 1970s, however, the trade-off seemed to be weakening. Then President Nixon resorted to wage and price freezes and controls in 1971 to slow the 5% inflation, then viewed as a major macroeconomic problem. President Nixon, remembering his loss to Kennedy in 1960, did not want to risk another recession in 1972, a presidential election year. While the U.S. experiment with wage and price controls seemed to initially produce positive results with inflation starting to fall, international events would overtake the attempt to slow inflation.

Stagflation and the Reemergence of Conservative Macroeconomics

War in the Middle East in 1973 lead the Organization of Petroleum Exporting Countries (OPEC) oil cartel to quadruple crude oil prices that year. As this energy price shock spread through the global economy in 1974, it produced a phenomenon that required a new word— stagflation—to describe the simultaneous occurrence of both higher inflation and unemployment. The Phillips curve seemingly could not account for this event. For U.S. policy makers attempting to deal with what was a new macroeconomic crisis, the choices were few. Fiscal policy was effectively paralyzed by the Watergate investigation, and Fed chairman Arthur Burns was asked repeatedly by Congress and a growing number of U.S. citizens to do something about double-digit inflation and rising unemployment.

The Fed’s dilemma, which also directly applies to fiscal policy action, had to do with the basics of the Keynesian model. Developed for a country suffering from very high unemployment, the Keynesian model was concerned only with short-run demand or spending issues and what government might do to make up a spending gap should private (C +1) spending be too low to produce full employment. Supply was not part of this framework. This omission was correct for the 1930s, as there were abundant quantities of labor, capital, and other scarce resources. But this omission was to undermine the Keynesian consensus in the early 1970s.

Edmund Phelps and Milton Friedman explained why the original Phillips curve—spending approach to understanding countercyclical stabilization policy—was wrong. The fatal omission was on the supply side. How would the economy respond to changes in the unemployment (out-put)-inflation (price level) mix as these two variables changed? The Friedman-Phelps idea was that the rising demand-side inflation in the late 1960s caused a supply-side reaction. U.S. workers saw prices rising for commodities they purchased, but without an increase in nominal wages, their real purchasing power or living standards fell. To prevent this, workers would demand a nominal wage increase at least equal to what they expected inflation to be. The increase in wages would prompt another round of price increases. Once set into motion, this wage-price spiral seemingly took on a life of its own. Wage increases boosted the cost of doing business, as workers received higher wages to offset inflation, thereby helping to perpetuate the upward rise in prices. All this was missing from the original interpretation of the Phillips relation.

The new Friedman-Phelps interpretation, termed the expectations-augmented Phillips curve, was revolutionary.

It correctly predicted that the short-run trade-off between inflation and unemployment lasted only as long as the actual and expected or perceived inflation rates differed. In 1969, actual inflation was above 5%, but expected inflation, reflecting inflationary expectations, lagged. Once inflationary expectations rose to match reality, the economy had restored balance to price, or inflation, and wage growth. This is the logic that underlies the modern natural rate hypothesis that identifies full-employment real GDP as that rate of output where inflation tends to remain constant. Inflation tends to remain fixed at the natural rate because actual and expected inflation are the same. Workers are not expecting prices to grow faster than their wages, and managers are not expecting labor costs to grow faster than prices. Corresponding to the natural rate of real GDP is the natural rate of unemployment at which the economy has reached this inflation and output balance point. Milton Friedman famously said that there is no way to quantify this natural rate of unemployment, but other economists have tried to do this for the United States and other economies, and current views allow for the natural rate of unemployment to vary over time.

If the Phillips curve trade-off lasted only as long as there was a difference between actual and expected inflation, it appeared to make little sense to attempt stabilization policy that required the presence of “fooling,” using Friedman’s term, on the supply side. For Friedman, the short-run Phillips trade-off required workers to not correctly understand what was happening to prices. In other words, there had to be unanticipated inflation for policy makers to exploit the trade-off. In rebuttal, Keynesians identified a wide variety of both nominal and real rigidities in the economy that prevent relatively quick matching of actual and expected inflation. This debate is an ongoing area of interest and research.

Also during the early 1970s, Robert Lucas and Thomas Sergeant extended the conservative rebirth by broadening the role of “rational expectations” and going well beyond the Friedman-Phelps contribution. Friedman and Lucas provided the cornerstone for a macroeconomic counterrevolution. For both, the task of stabilizing the U.S. economy was a goal not worth pursuing.

Friedman explained that macroeconomic stabilization policy was doomed to fail because it was too difficult to achieve. Four beliefs were offered as proof. First is the challenge posed by time lags with obtaining economic information, forming policy, policy implementation, and policy effects, all of which are “long and variable.” For example, the 1964 Kennedy-Johnson tax cut was enacted to help end the 1960 recession. Next is the frank admission that we do not understand the U.S. economy well enough to effectively stabilize it. Contemporary difficulties with stagflation seemed to clearly make this point. The rational expectations revolution seemed to emphatically make this point. In the Lucas critique, Lucas also pointed to the naive approach to understanding and modeling expectations in the original Keynesian model.

Third is the miserable past performance of stabilization efforts, particularly with monetary policy. The three major economic contractions of the twentieth century were caused or made far worse by restrictive monetary policies. Finally, there is the issue that leads to Friedman’s policy recommendation—policy rules are inherently superior to discretionary policy. While the Congress and the president are elected and answer to voters, the Fed and monetary policy are effectively shielded from the ballot box.

Friedman’s macroeconomic school was monetarism. To deal with the rules-discretion problem, Friedman proposed a simple monetary rule of matching monetary growth to real GDP growth. Thus, as the economy grew, the Fed would simply add enough money to the economy to finance the additional transactions. During the 1970s, faced with rising inflation, this type of approach made sense to a growing number of people. Friedman (1992) famously stated that “inflation is everywhere and always a monetary phenomenon” (p. 193), and his monetary rule was based on this view. In essence, Friedman proposed lowering inflation, or the growth of prices, by matching money growth to no more than an expanding economy needed to finance additional transactions. Inflation arose when “too many dollars, or too much spending, chased too few goods.” Monetarism dealt directly with the too many dollars issue, leaving the supply-side, or “too few goods,” to the private economy where it belonged. For Friedman, all the Fed had to do was add sufficient reserves to the U.S. banking system to allow the money supply to expand as fast as real output. People had known for centuries that excess creation of money by resorting to the printing press could produce hyperinflation, and modern examples of this can still be found. On the other hand, the Depression clearly demonstrated the consequences of large monetary reductions.

Friedman’s constant growth rate rules (CGRR) offered a secure return to the laissez-faire macroeconomics of the past. Its popularity was ended, however, in the early 1980s with the deregulation of U.S. commercial banking and financial markets. The high inflation of the 1970s and the new opportunities for managing cash holdings created in the early 1980s had a major impact on the demand for money.

In the GDP version of the quantity theory, MV = PY. Expressed as rates of growth, the quantity theory is written as follows: money growth + velocity growth = inflation + real GDP growth. Friedman had linked money growth to real GDP growth, assuming the growth of both V and P would be modest at best. If V is interpreted as the amount of money people choose to hold as a fraction of nominal income, PY, then instability in the growth of velocity ruins the CGRR. If velocity grows or declines in an unpredictable fashion, a fixed monetary growth policy would be destabilizing.

Robert Lucas and Thomas Sergeant had prepared the way for another attempt to restore laissez-faire macroeconomics while attempting to increase understanding of the U.S. economy. It was first common to refer to their approach as the rational expectations school. The label soon changed to the new classical school, both to reflect the ties back to pre-Keynesian economics that placed emphasis on long-run supply issues and to indicate that there was something new being studied.

The Lucas approach was pioneering in that it appeared to restore the primacy of microeconomics in the effort to comprehend macroeconomic aggregates. In microeconomics, economic agents—consumers and producers—are modeled as being rational decision makers. Consumers maximize utility; producers maximize economic profit. Macroeconomics should reflect this microfoundation. The theory of the business cycle that first emerged from this approach was initially quite similar to other macroeconomic schools. In Friedman’s natural rate hypothesis, demand disturbances had caused workers to be “fooled” when demand-side inflation pushed prices above wages. In the new classical school, the presumption was the divergence that occurred between what economic agents expected prices, or inflation, and actual values arose because of “expectational errors.” More formally, explanations of the business cycle presumed that there would be “price surprises,” as happened in the late 1960s, for the economy to move away from its natural rate of output.

The logical conclusion to draw from this approach was that attempts to stabilize the economy could not be productive. Successful stabilization policy would have to generate a price surprise for it to matter for the real economy, but rational economic agents will always be able to divine macropolicy direction. The national economy would operate more effectively if stabilization policies were eliminated. Monetary policy would also be directed to operate more or less along Friedman’s lines so that there would be no surprises that would contribute to macroeconomic instability.

The new classical school added microeconomic rigor to the debate about macroeconomic stabilization policy. As with monetarism, it ran into difficulties. Few economists had difficulty accepting the idea that expectations about macroeconomic variables, especially inflation and nominal interest rates, were formed rationally using available information. However, the claim that monetary and fiscal policy could not affect output and employment in the short run seemed incorrect. As mentioned earlier, Keynesians pointed to a variety of potential impediments to price and wage adjustments that delay movement from one equilibrium to the next. There may indeed be no surprise in the Fed’s actions with the money supply, but those actions will have real impacts in the macroeconomy. In macroeconomic jargon, money mattered and was not “neutral” in the short run. In the long run, the quantity of money does not matter for living standards, excluding small gains from avoiding barter. The quantity of money does affect nominal magnitudes, prices, nominal wages, nominal interest rates, and nominal GDP. It does not affect real macroeconomic values. The new classical school seemed to be saying that it was also neutral in the short run unless some type of surprise occurred.

The idea that there must be uncertainty about future actions had unexpectedly widespread impacts in macroeconomics. This introduced the idea that game theory could be applied to the decision made concerning monetary policy. One of the difficulties of the 1960s and 1970s was that there was little coherence in actions taken by the Federal Reserve when economic conditions deteriorated. Improved policy response required actions to be credible and consistent with no attempts to pursue conflicting goals. This was clearly a step beyond the original promises of fine-tuning made by economists in the 1960s. This issue became especially important in the debate over the U.S. macroeconomic policy in response to the collapse of the U.S. housing and financial markets in 2009.

The Great Inflation and the Volcker Recession: Disinflation in the 1980s

In 1979, OPEC pushed crude oil prices over $30 per barrel, producing the second energy price shock of the decade. The economy slowed as prices rose even faster with a minor recession in 1980. That was also a presidential election year, and voters wanted to know what was to be done to fix the economy. President Carter had just appointed a new Fed Chair, Paul Volcker, in 1979, with a clear order to bring double-digit inflation under control. In 1980, some measures of inflation were approaching 15% with interest rates moving over 20%. Ronald Reagan’s approach to the inflation problem presented a new approach to the stagflation problem. If supply problems had created the difficulties, supply-side policies had to be the remedy.

The supply-side school that emerged in the early 1980s shared the laissez-faire philosophy of the more academic monetarists and new classical schools. This was interpreted to lend support to federal income tax rate reductions as a means to lower inflation. The logic was that lower income tax rates would increase work incentives and therefore supply. Because part of the inflation problem is “too few goods,” the tax cut was an anti-inflationary program. The Reagan platform also included expansion of government spending as part of a defense buildup. Added with the income tax reductions, this led many economists to conclude that fiscal expansion was being adopted that would only add to current inflationary pressures.

President Reagan followed through on his electoral program: Defense spending rose while federal taxes were lowered by the Kemp-Roth tax cut. Paul Volcker and others at the Fed tried to make clear that fiscal policy was too expansionary. In 1981, the Fed acted to slow total spending in the economy, thereby creating the worst recession since the Depression. Unemployment was pushed over 10% in some months in 1982, but the Fed’s commitment to lower inflation seemed to take hold. By 1983, the inflation rate fell from 12% to 4%, adding the term disinflation to the U.S. economic vocabulary. Faced with no alternative, the Fed had to slow the economy sufficiently to reduce both actual and expected inflation. In the spirit of the rational expectations movement, this meant that the Fed had to make clear its commitment to restrictive policies until its inflation target was achieved.

Real Business Cycle Models

The new classical school had based its price surprise model on concepts imported from microeconomics, including near-perfect flexibility of wages and prices. While this is a standard assumption in microeconomics, it appeared to many economists that it is demonstrably not the case in macroeconomics. The new classical assumption of wage and price flexibility was necessary for its business cycle model to operate as its supporters explained it. When this assumption was challenged, along with its prediction of short-run monetary neutrality, the new classical school changed.

Edward Prescott moved past the new classical school in the early 1980s when he combined the Lucas rational expectations approach with evidence from the economy’s growth record. In Solow’s neoclassical model, higher real GDP per capita arose from capital accumulation and technological change. Any growth in living standards that could not be accounted for by increases in the capital and labor must be due to exogenous or autonomous change in technology. This approach of measuring technological change as a residual from a basic growth equation produced a surprising result. Solow’s technology residual seemed to be highly correlated with detrended changes in real GDP. Could technological change, a supply-side phenomenon, be the source of the business cycle? If this were true, and if strict microfoundations applied, then all government stabilization effort should be focused on promoting creation and application of technological change, understood to be a relatively broad concept.

This new real business cycle (RBC) model completely changed the interpretation of the business cycle. If short-run microconsumer and producer markets are continuously in equilibrium, their aggregates should also display this result. The macroeconomy is subject to external shocks, but growth evidence pointed to technology or supply-side factors as the cause. The business cycle arose from real shocks to the growth process, and the resulting cyclical disturbances must be optimal responses to these changes. Because micro-decision making is optimal, in the absence of market failure, macrodisturbances could be interpreted as movements from one equilibrium state to another.

The case for laissez-faire had seemingly been reestablished. Macroeconomics returned to its starting point. The task of raising living standards was confirmed as being a supply-side, long run (or short run, as they could be interpreted as being equivalent), with little discretionary role for government.

While the RBC model was being developed, new Keynesian macroeconomists also built on rational expectations and microfoundations, but with the goal of making stabilization policy’s foundations even stronger. Distinctions are still made between the long and short run (and a medium term) in which stabilization policy efforts can be useful. For a variety of market imperfections and rigidities, both monetary and fiscal actions have short-term real impacts.

The Savings and Loan Crisis

Macroeconomic policy debates in the 1980s covered a variety of issues, from the growth of the “twin deficits” to interest-rate targeting by the Federal Reserve. Major macroeconomic events of the 1980s included the 1981 to 1982 recession, the stock market crash on October 19, 1987, and the collapse of Savings and Loan (S&Ls) banks. S&Ls originally provided fixed, 30-year mortgage financing for the U.S. housing market. This traditional role was discarded during the economic turmoil of the late 1970s and 1980s. With the hope of fostering more competition, regulations were relaxed as S&Ls moved financial activities into new higher return but much riskier markets. The S&Ls, in a scenario to be repeated 15 years later, ignored risk in the pursuit of short-term profit opportunities. Speculative investments in commercial and residential real estate, lax and ineffective regulation, and outright fraud finally bankrupted the industry. The federal government took over the failed S&Ls in 1989 at significant taxpayer cost. A regulatory commission was established to reform and restructure both S&Ls and their regulation. S&L assets were sold off over time, but a precedent had been set. Overextension in the banking sector appeared to have a new lender of last resort: the U.S. taxpayer. In addition, federal policies now gave additional responsibility to private corporations, or government-sponsored enterprises (GESs), to support the goal of promoting homeownership. These agencies, in particular Fannie Mae and Freddie Mac, would play a major part of the next major wave of banking failures.

The Rebirth of the Economic Growth Theory

As the liberal-conservative debate over the usefulness or even wisdom of stabilization policy was under way, macroeconomics returned to the study of economic growth and Solow’s neoclassical growth model. While the new classical model’s explanation of the business cycle had run into difficulties, interest in the creation of macromodels derived directly from the rational world of microeconomics expanded into the study of economic growth.

The new growth theory sought to explain changes in Solow’s residual or exogenous technological change. Using the microfoundations approach, technological change was analyzed as the result of profit-maximizing business activity. Firms engage in developing new technologies, which can include development of labor skills or human capital, when economically profitable. In private markets, patent protection and government subsidies were ways in which individual firms could gain from developing new products and markets. The importance of competition—even if imperfect—trade, property rights, and other necessary factors for growth were emphasized as key underpinnings for promoting change and higher living standards. However, the goal of modern growth theory to help narrow the gap between average living standards between nations is still being pursued.

Activist Macroeconomic Policy: The Great Depression and the Great Recession of 2007

The 1990s saw two macroeconomic milestones. The first was the “Long Boom,” the longest cyclical expansion in U.S. history. This period lasted 120 months from March 1991 (trough) to March 2001 (peak). Following the 1990

to 1991 recession, the Fed followed countercyclical expansionary monetary policy, pushing the fed funds rate from a prerecession high of 8% to a 1992 low of 3%. Fed policy was even more expansionary during the 2001 recession. The fed funds rate was 6% at the beginning of 2001, but by late 2003, it was 1%. By 2009, the Fed moved even farther by lowering the target fed rate to essentially 0% following the start of the 2007 recession. In an old macroeconomic phrase, the Fed was actively “leaning against the wind.”

The second was the emergence of another boom in the U.S. housing market. This boom and rising home prices encouraged financial markets to create bundles of real estate assets or mortgage-backed securities (MBSs) that allowed buyers to participate in the ongoing housing boom. Supporters of these new financial instruments thought that they diversified risks associated with investing in real estate markets. However, the opposite happened when the bubble began to collapse in 2006. Home prices began falling and home foreclosures rose markedly. MBSs and other widely marketed financial instruments became unmarketable, crippling U.S. credit markets. The economy began slowing with a recession starting in 2007 that also triggered a major retreat in stock prices. Many U.S. households saw significant reductions in personal wealth as the value of both real estate and equity holdings were significantly lowered.

The 2007 recession posed a new set of challenges for the conduct of monetary and fiscal policies. Both the U.S. Treasury and the Fed were called on to deal with a banking crisis that was much larger than the S&L crisis but not as severe as during the Depression.

In the 1930s, fiscal policy was characterized by deficit spending arising from both the weak economy and New Deal spending programs. The federal deficit in 1934 was 5.9% of GDP, but it fell to just 0.1% in 1938. In 2009, projected deficits were on the order of 10% of GDP.

Monetary policy differences between the 1930s and 2009 were even more dramatic. Between 1929 and 1933, the nominal money supply fell by one third. This drop arose from Fed inaction, as successive waves of financial panics crippled the banking system. In 2009, the Fed was actively pursuing the opposite course through conventional monetary expansion supplemented with an array of new lending and asset-purchasing programs unprecedented in Fed history. Interest rates have been pushed to historic lows, and Fed Chair Ben Bernanke has made it clear that expansionary policy will continue until financial market health is restored.

The Current Debate: Activism Versus Laissez-Faire

As this central debate about stabilization policy continues, the Great Depression of the 1930s continues to affect this macroeconomic debate. In the Keynesian view, problems in private spending coupled with the near collapse of the banking and financial sector produced the worst economic crisis in U.S. history. Through Keynes, a new approach was developed to mitigate the worst consequences of cyclical instability. Ironically, it had been the failure of the Federal Reserve to help the banking sector that contributed to the depth of the Depression. The possibility of such failures remains.

In the twenty-first century, these events are being studied again as economies struggle with financial, banking, and credit crises. The new consensus requires that action be taken to reduce adverse impacts arising from either demand or supply shocks. There will always be debate about how much and how far these actions should be taken. Macroevents and theoretical developments have clearly shown, however, that neither simple laissez-faire nor fine-tuning are sensible approaches to follow.

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