Economic Instability Research Paper

Prior to the twentieth century, the classical school’s reliance on self-correcting private markets, a commodity gold standard, and promotion of free trade broadly defined macroeconomics. Fiscal policy was viewed as the means by which government provided necessary public goods and services, with deficit spending occurring because of either war or weakness in the economy that lowered government tax receipts. Monetary policy for the United States, operating without a central bank until 1914, similarly was not considered a macroeconomic stabilization tool. Financial difficulties before and during the Great Depression were to change that.

The Creation of the Federal Reserve System

Modern study of economic instability in the United States begins with the Great Depression. Prior to the 1930s, economists treated macroeconomic instability as a difficulty best resolved by private markets. Indeed, the U.S. financial system had even operated for most of the pre-Depression period without a central bank. There had been two experiments with a Bank of the United States but, for a variety of reasons, neither survived its initial 20-year charter. During the nineteenth century, the United States had experimented with a number of currency and banking regimes. With the gold standard officially adopted in 1900, the United States entered the new century without a central bank. The next financial panic in 1907 convinced Congress that the economy did need a central banking authority to ensure the soundness of the country’s banking system. The Federal Reserve Act of 1913 created a system of 12 regional Federal Reserve Banks, with the New York bank assuming control of monetary policy. The U.S. banking system now had a lender of last resort.

The Great Depression and the Origin of Macroeconomics

The causes and consequences of the Depression continue to be debated. A recession started in the summer of 1929 that was soon followed by the start of the collapse of the U.S. stock market. In 1930, the United States decided to raise tariffs, soon matched by trading partners, in a mistaken attempt to protect import-competing jobs. More important, the United States experienced a series of financial panics and bank runs that would culminate with a bank holiday in 1933 as the newly elected President Roosevelt closed all banks to end withdrawal of money from the economy. Set up as a result of the financial panic of 1907, the Federal Reserve failed during its first major financial crisis.

This was understood by John Maynard Keynes in Great Britain. The Keynesian approach to dealing with the economic problems of the 1930s, both for Britain and the United States, was to rely on new deficit spending to make up for inadequate private sector spending by consumers and businesses. In the United States, policy emphasis on using fiscal policy was to continue for decades to come. This reflected a major concern with expansionary monetary policy: There might be inadequate demand for newly created bank reserves arising from Federal Reserve open-market bond purchases.

Keynesian theory, originally a depression-economy model, emphasized short-run demand stabilization through fiscal policy using either new government spending or deficit-financed tax cuts. The basic idea was to supplement private consumer sending (C) and business investment spending (I) with either direct government spending (G) or tax cuts (T in dollars or t in tax rates). Keynes explained how a fiscal stimulus, by increasing autonomous spending, would increase GDP by a multiple of the new deficit spending. The year following publication of Keynes’s General Theory, economist John Hicks expanded Keynesian analysis to explicitly include a monetary sector and the interest rate. These additions made the Hicksian IS-LM model a standard part of macroeconomics. As with the Keynesian model, however, it was incomplete. It had no explicit means of analyzing either short-run supply or the price level. Because neither of these were problems in the 1930s, their omission is understandable. Subsequent macroeconomic events would remedy these shortcomings. Following the 1930s, however, the debate over countercyclical macroeconomic policy began in earnest.

The Rise and Fall of the Keynesian Consensus, 1961 to 1973

The 1960 presidential election, at least in then-Vice President Richard Nixon’s view, was determined by the 1960 recession. John F. Kennedy ran that year promising to enact a deficit-financed tax cut that would help restore full employment. Kennedy’s victory brought the Keynesian “new economics” of activist demand management to the United States. The next recession was a decade away. Even the popular media in the 1960s wondered if the Keynesian macroeconomists who came to rise in 1961 with the new Kennedy administration had finally ended the business cycle. While economists debated its meaning and merits, Keynesian macroeconomics seemed to offer the option of fine-tuning the economy. Short-term demand management was explained as making a choice between relatively low unemployment but high inflation or relatively low inflation but high unemployment. This Phillips curve trade-off was the basis for the first ever governmental attempts at macro-economic stabilization. Using the Keynesian spending (C + I + G) and the IS-LM models, Keynesians showed how monetary and fiscal policy could keep the economy on course. The 1960s was the longest economic expansion in U.S. history up to that time. However, as unemployment fell during the decade, inflation began rising and became a major domestic macroeconomic issue in the early 1970s.

The Great Inflation, 1970 to 1981

From inflation rates of 1% to 2% in the early 1960s, an overheated U.S. economy was experiencing over 5% inflation by the end of the 1960s and into 1970. The U.S. economy had a relatively mild recession in 1970 with unemployment rising from a 1969 low of 3.4% to 6.1% by the end of 1970. As the economy slowed, it seemed reasonable to expect inflation to fall as excess demand was reduced. Somewhat surprisingly, inflation held steady. CPI inflation rose 5.5% in 1969 and was 5.7% in 1970 despite the weakening economy. Facing reelection in 1972, President Richard Nixon decided to impose a temporary 60-day wage and price freeze in August 1971.

The Nixon controls were an experiment with an incomes policy to deal with inflation. Largely voluntary, the Nixon program of two freezes and four phases of lessening degree of price and wage restraint was controversial. Predictably, shortages arose in a variety of markets, most notably in gasoline. However, President Nixon was reluctant to press for an alternative, which seemed to require monetary or fiscal restraint that might finally lower prices with the possibility of a worse recession during a presidential election. Mr. Nixon remembered the role a weak economy played in his 1960 election loss. A positive view of President Nixon’s Phases I-IV controls was that they represented an attempt to help slow the wage-price spiral by signaling to U.S. business and workers that the federal government was going to reduce inflation by in essence making it illegal. Because the program was largely voluntary, it relied on a downward adjustment of inflationary expectations to ensure its success. People had to expect less inflation for a timely reduction in the wage-price spiral.

Unfortunately for U.S. efforts to lower inflation, other events interceded. In 1973, war in the Middle East resulted in an oil embargo engineered by the Organization of Petroleum Exporting Countries (OPEC) that had the economic effect of quadrupling crude oil prices from $3 to $12 a barrel. Because oil is a primary source of energy, this meant demand increases for oil substitutes also pushed their prices upward, creating a major spike in energy prices. This adverse supply shock was a new challenge for U.S. policy makers. While even Mr. Nixon once famously declared “We are all Keynesians now,” it was not clear to Keynesians what should be done about the effects of the adverse supply shock OPEC had created.

Stagflation

In 1974, the U.S. economy did not seem to be operating according to the explanations of economists. The demand-side Keynesian model and its associated Phillips curve predicted two alternative economic states: excess demand (low unemployment and high inflation) or inadequate demand (high unemployment but low inflation)—the Phillips curve trade-off. But 1974 saw inflation rise from 6.2% to 11.0% while unemployment increased from 4.9% to 5.6% as the U.S. economy slipped into a recession. For 1975, the unemployment rate was 8.5%. A new term was coined by Paul Samuelson to describe this seemingly inexplicable situation—stagflation.

As these developments were unfolding in 1974, the previous decade’s claims that the business cycle had been tamed were discarded. For policy makers, there were few options. Fiscal policy was effectively paralyzed in 1974 by the Watergate investigation. That shifted emphasis to the Federal Reserve (the Fed), then chaired by Arthur Burns. Chairman Burns was repeatedly asked by Congress and others to take action to rebalance the economy. Burns knew his options were limited to altering the money supply and credit conditions, which did not, and could not, reverse the impacts of the OPEC oil price shock.

Keynesian stabilization policies worked only on the demand side. Restrictive monetary policy could lower inflation, but the accompanying output decline would raise unemployment. The reverse was true for easy monetary policy that would push prices higher as unemployment fell. As stagflation pushed both unemployment and inflation higher, economists recognized the need to add short-term supply factors to macro models. These efforts created the aggregate demand and short-run aggregate supply model that illustrated the difficulties of the mid-1970s. The Phillips curve was also reinterpreted to include labor (supply-side) responses to inflation. But the new theory did not resolve the Fed’s dilemma.

Bowing to the inevitable, the Fed first took action against inflation, and by 1975, it had dropped from 11% to 9.1% (5.8% in 1976). One economic cost of the Fed’s action was the worst recession since the Depression. This contraction lasted from the fourth quarter 1973 (1973:4) to 1975:1, a 16-month recession that saw a 1975 monthly unemployment rate of 9.0%. Inflation had been reduced, but faith in fine-tuning the economy was one of the casualties.

Stagflation: Part 2

In 1979, the United States had a new president, Jimmy Carter, but another supply shock. That year, OPEC again exercised its monopoly power and pushed crude oil prices over $30 a barrel. The impact in the United States was now predictable. In 1979, inflation averaged 11.3%, rising to 13.5% in 1980, a presidential election year. Unemployment also rose from 5.8% in 1979 to 7.1% in 1980 as the U.S. economy again slipped into a recession. Once again, the United States faced stagflation, but the numbers were bigger and uncertainty remained about what should be done about this situation.

The difficulty stagflation posed for the U.S. economy in the 1970s arose from its cause. Traditionally, inflation had been viewed as a problem of “too many dollars chasing too few goods.” In the 1960s, the “too many dollars” or “too much spending” had raised demand-side inflation to over 5%. But the inflation problems in the 1970s arose from the supply side or the “too few goods” source of higher prices. It even appeared that causation was running in reverse as high inflation was causing the recession. As the energy price shock worked its way through the economy, nearly all prices were pushed up. U.S. consumers, no better off, could no longer afford what they previously purchased. GDP declined, causing unemployment to rise. By 1980, it appeared necessary to take some type of decisive action against the problem of double-digit inflation.

The 1980 Presidential Election

With double-digit inflation as the major economic issue, incumbent Jimmy Carter and Republican nominee Ronald Reagan offered different policies to voters. Carter had appointed a new Federal Reserve chairman in 1979, Paul Volcker, in part to reestablish the Fed’s credibility in dealing with excess inflation. Volcker knew this was his primary task. However, Mr. Carter did not want to put the economy through another long recession as had occurred during the 1973 to 1975 episode. Fed policy under a new Carter administration would be one of gradual monetary restraint to slow inflation.

Candidate Reagan offered something more appealing to voters. When running for his party’s nomination, Mr. Reagan offered four economic platform promises: lower inflation, more jobs, a balanced federal budget, and an increase in defense spending (higher government spending, G). This was to be accomplished by a variety of initiatives, including market deregulation where possible and a major reduction in federal income tax rates. During the primaries, Reagan’s rival but soon-to-be vice presidential nominee, George H. W. Bush, famously called the promise of a balanced budget with programs of increasing spending while cutting taxes “voodoo economics.” The label that did stick to the Reagan program, however, was supply-side economics. This name came from the prediction that lower federal income taxes would raise after-tax incomes for U.S. workers, thus encouraging additional work and more output. While the details were left unclear, Arthur Laffer produced a famous diagram that seemed to show that tax rate cuts, if they actually could boost work incentives, would eliminate the “too few goods” problem of inflation. The cure for U.S. inflation appeared painless.

Following the 1980 election, Congress and Mr. Reagan enacted the Kemp-Roth tax cut and began the defense buildup. The Federal Reserve, however, began ringing alarm bells. Volcker and many others viewed supply-side fiscal policy, whatever its ideological merits, as expansionary. Tax rate cuts coupled with significant government spending increases would increase the “too much spending” problem of inflation. Volcker concluded that expansionary fiscal policy would have to be offset by very restrictive monetary policy. In 1981, the Fed acted. Aggregate demand was reduced, as restrictive monetary policy more than offset the federal fiscal expansion. By 1982, inflation had dropped from 10.3% to 6.2% (3.2% in 1983). The cost of this success was another recession, this time even worse than the 1973 to 1975 slowdown, with unemployment reaching a monthly high of 10.8% in 1982. The 1981:3 to 1982:4 recession was the worst macroeconomic performance since the 1930s. A new term, disinflation, was coined to describe the successful lowering of inflation. Inflation had been lowered to 3% to 4% but would fall no farther in coming decades in part to avoid a repeat of the damage done by the 1981 to 1982 monetary restraint.

The Great Bull Market and the Twin Deficits

As the U.S. economy started recovering from the 1981 to 1982 “Volcker Recession,” the stock market also started to move up. The Dow Jones Industrials reached a low of 777 in August 1982. The subsequent recovery of the economy began a rise in equity values that was twice interrupted in the next 25 years. The first, “Black Monday” (October 19, 1987), occurred just as the Fed chairmanship changed from Paul Volcker to Alan Greenspan. The second and longer retrenchment was associated with the tech stock or dot-com bubble in 2000. From the 1982 low, the Dow rose to 11,722 by 2000, an increase of more than 1,500% over this 18-year period. The market subsequently dropped to 7,286 in October 2002. As the economy recovered from the 2001 recession, both the equity and housing markets moved toward historic highs. The Dow Jones reached this most recent high of 14,146 in October 2007. In the following year, the Dow Jones Industrial Average (DJIA) lost nearly half its value as the U.S. economy began a dramatic slowdown as the financial system entered a crisis period brought on by the housing market collapse.

In 1980, the U.S. national debt was $0.9 trillion, and the United States was the world’s largest creditor nation. By the end of the decade, new deficit spending had raised the national debt to $3.2 trillion, and the United States had become the world’s largest debtor country resulting from a decade of trade deficits. These two deficits are linked to saving rates in both the United States and abroad. Both debts would continue to expand after the 1980s.

The 1990 to 1991 Recession and the Start of the U.S. Housing Boom

The U.S. economy did not fully recover from the 1981 to 1982 recession until the late 1980s. The monthly unemployment rate did not fall below 6% until September 1987 and did not reach 5% until March 1989. In 1990, however, the U.S. economy began to slow. One factor was a decline in the housing market following the collapse of the Savings and Loan banking sector. In the summer of 1990, unemployment started to rise, and by the end of the year, it stood at 6.3%. Officially, the recession started in July (1990:3) and lasted until March 2001, spanning 8 months. There would not be another recession for 120 months, the longest cyclical expansion in U.S. history.

The short-term policy response to the 1990 to 1991 recession was a gradual series of interest rate decreases under the guidance of Fed Chairman Greenspan, who had replaced Paul Volcker in 1987. The Federal Funds (“fed funds”) interbank loan rate stood at 8% when the recession started in 1990. By the summer of 1991, it was 6%, falling to just 3% by the end of 1992. The Fed pursued gradual monetary ease to stimulate spending and help the economy recover.

This expansion also marked an increase in investment spending on the U.S. housing stock. What began as a typical housing recovery would later culminate in a speculative rise in U.S. housing prices. From 1991 through 1996, average U.S. housing prices rose at an annual rate between 2% and 4%, roughly matching inflation. From 1998 through 2006, the rate of increase doubled. At the end of the boom, housing price rises were 9% in 2004 and 2005. Once the bubble had burst, home prices rose a modest 3.3% in 2006 and fell -1.3% in 2007. The bursting of this asset price bubble was to have major macroeconomic consequences that were largely unforeseen.

The Dot-Com Stock Market Bubble and the 2001 Recession

The DJIA reached its 2000 peak of 11,722 on January 14, 2000, falling to a low of 7,286 by October 9, 2002. This loss of financial wealth contributed to weakness in consumer spending. More important was the collapse of business investment spending, especially for computers and software, during 2001.

The 8-month 2001 recession ran from March until November of that year. In January 2001, the unemployment rate was a low 4.2%. Following the end of the recession, it peaked at 6.3% in June 2003. In response to this relatively slow recovery, the Fed once again adopted a policy of monetary ease. 2001 started with the fed funds rate at 6%. It was progressively lowered to 1% by the summer of 2003 as the Greenspan Fed tried to move the economy back to full employment. By the summer of 2005, the unemployment rate had reached 5% as the Fed ended its policy of easy monetary policy. As 2005 began, the fed funds rate was 2.25% and would reach 5.25% in late 2006.

The Collapse of the Housing Bubble

The National Bureau of Economic Research (NBER), established in 1920, dated a recession as starting in December 2007. The recognition of this downturn came in December 2008. This somewhat unusual delay was caused by the mixed signals being generated by macro-economic aggregates. While real GDP grew for the first two quarters of 2008, total employment had peaked in December 2007 and fell thereafter. The employment data, and other economic indicators, convinced the NBER’s Business Cycle Dating Committee that the actual recession had started December 2007.

As noted, the U.S. housing market began expanding following the 1990 to 1991 recession. The housing boom continued even during the 2001 recession with residential investment declining only in 2001:4, after the trough of the recession was reached. Home prices kept rising and even accelerated through 2005. Such asset price trends cannot be maintained, and the inevitable slowdown began in 2006. Home prices began falling as that sector was now characterized by both excess supply and falling demand. This had a variety of negative impacts on the economy, including a major decrease in financial wealth as the stock market plunged. The Dow Jones peaked at 14,164 on October 9, 2007. During 2008, the market lost one third of its value by this measure. Not only was financial wealth cut as equities dropped, but many now saw the value of their home falling as well. With this twin wealth shock, consumer confidence in the economy dropped to historic lows.

The business and financial sectors were also adversely affected. The construction industry was among the first casualties as new residential construction stalled. Worse, the financial system seemed unable to cope with the magnitude of the financial distress the collapsing housing bubble had produced.

The list of factors associated with the rise and fall of the U.S. housing market is remarkably long. Alan Greenspan acknowledged he had placed too much confidence in the self-regulatory character of complex financial markets and financial derivatives. While the boom unfolded, money was drawn to the United States from around the world. To finance the levitating housing market, first investment banks then government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac developed new sources of funding. First, this process relied on the selling of bundles of mortgages, or securitized mortgage debt, to investors eager to benefit from the housing boom. Given the demand for these mortgage-backed securities (MBS), it was not surprising loan standards were loosened as “subprime” or risky lenders were given mortgages that were quickly resold into an ever-growing mountain of paper wealth.

This expansion of housing credit occurred against a backdrop of financial deregulation, questionable rating of the risks associated with MBS and related financial contracts, complex financial investments that were usually marketed through in a lightly regulated “shadow banking system,” charges of predatory lending and borrowing, and an apparent belief that the housing price rise was too good an opportunity to miss. There was also a government commitment to promote home ownership. Thus both Fannie Mae and Freddie Mac were encouraged to help provide the financing necessary to help people buy a home while the boom was in progress. Perhaps one positive, if transitory, benefit of the bubble was a 69.2% home ownership rate in 2004, the highest in U.S. history.

As the housing collapse started to have macroeconomic effects in late 2007, the economic impacts were historic. In 2008, the economy experienced the largest corporate bankruptcy in history (insurance company AIG), the largest bank failure in U.S. history (Lehman Brothers), and the largest Savings and Loan failure in U.S. history (Washington Mutual). All major investment banks failed, merged, or converted themselves into traditional deposit banks. Major U.S. commercial banks asked for Treasury funding support through new fiscal programs.

Monetary Policy and the 2007 Recession

The macroeconomic policy response to this recession was unprecedented in its size and scope. Monetary policy in 2008, under Chairman Bernanke, was the most expansionary since World War II (WWII). The Fed’s emphasis remained on the stability of the banking sector and to a lesser extent on inflationary concerns as total spending in the economy declined. As with Japan during the 1990s, concern was expressed over the appearance of deflation further reducing Fed worries over inflation.

Traditionally, monetary policy is first seen as the Federal Reserve Board, acting through the Federal Open Market Committee (FOMC), altering credit conditions in the economy using open-market operations. Predictably, following 9/11 and the 2001 recession, the Fed lowered the fed funds rate to 1% by mid-2003. Alan Greenspan, Fed chairman, made clear his policy goal was overall stimulus of the economy. However, 30-year fixed rate mortgage rates, which had been 8% in 2000, fell below 6% during the same period. Therefore, further stimulus was given to the U.S. housing market, whose growth appeared to be feeding on itself. By mid-2006, monetary restraint had pushed the fed funds rate back to 5.25%. Against this background, Greenspan was criticized for following traditional easy monetary policy in a weak economy that nonetheless was experiencing a residential and commercial real estate boom.

When the housing price bubble began to lose air in 2005 and 2006, the Fed began to take new and dramatic action. In December 2007, new Fed Chairman Ben Bernanke created the Term Auction Facility (TAF), the first of seven completely new lending operations that would provide liquidity (money) to a variety of financial institutions and markets that had stopped working efficiently. Lenders had decided to significantly reduce traditional lending as the “credit crunch” spread. There was no longer any market for MBS or other high-risk alternatives. The Fed even allowed short-term borrowing by financial institutions that were able to use some higher grade MBS as collateral and finally agreed to purchase some MBS itself. All through 2008, the Fed kept creating new auctions and programs of providing credit to the economy. The Fed also pursued traditional easy monetary programs. At the end of 2007, the Fed funds rate was 4.25%. By the end of 2008, it was 0% (officially a range of0%to0.25%).

The immediate question this zero-interest rate policy posed was, had the United States run out of monetary policy options just as the NBER announced a recession had started in December 2007? Certainly fiscal policy could be used to stimulate spending, but had monetary policy run aground?

While the Fed was lowering the nominal fed funds rate to zero, it simultaneously pursued a program of “quantitative” monetary ease. The Fed accomplished this in two ways. The first was continuation of traditional monetary expansion. The monetary base doubled in 2008, increasing from $855 billion in December 2007 to over $1,728 billion by December 2008. This expansion was not needed to lower the fed funds rate to zero; rather, its aim was to help recapitalize the U.S. banking system. Inflationary concerns were put on hold as the Fed kept adding to bank reserves. For the banking sector, this dramatically increased the bank holdings of excess reserves as the Fed kept adding liquidity to the economy.

The second policy still available to the Fed was to alter its holdings of U.S. Treasury securities. The Fed could provide additional monetary stimulus to borrowers by also lowering long-term interest rates. Buying long maturity Treasury bonds pushed up their prices, which pulled their yields or rates down, putting downward pressure on related long-term rates, mortgage rates in particular.

The issue of policy credibility was also important for the Fed’s commitment to recovery. All through 2008, the Fed signaled that low interest rates and market support programs would be used as long as required by the economy. With support from fiscal policy actions, the Fed had embarked on the most expansionary policy in its history.

Fiscal Policy and the 2007 Recession

Fiscal ease was viewed as an inevitable policy response to the same problems that preoccupied the Fed. Fiscal policy was used to help both the overall economy and financial markets and institutions. In early 2008, the Economic Stimulus Act of 2008 sent $150 billion into the private economy as temporary tax rebates. The worsening economy and the fact the tax change was temporary meant that much of this additional income was not spent by consumers. By the fall of 2008, fiscal action moved into new country as the Treasury Department asked for a total of $700 billion to assist the economy.

Fiscal policy embarked on programs that would produce $1 trillion deficits. Both stabilization policies tried to slow the economy’s retrenchment following the collapse of the housing market. As in the 1930s, the major problem facing the U.S. economy was the potential collapse of its banking and financial sectors. The evolution of financial intermediation in the United States was thought to have been one of increasing sophistication that reduced risk while generating income. As noted previously, this view, widely expressed prior to the collapse of the housing market, was incorrect. Rather than reducing risk, debt securitization, related financial derivatives, and inadequate market supervision magnified the temptation to assume ever-growing risk. After all, the economy had grown for 25 years with no major economic difficulties. As with previous asset bubbles, the U.S. housing market boom did finally come to an end. The macroeconomic costs of repairing the damage done by this largest ever bubble will take years to complete.

The U.S. National Debt and Foreign Trade Debt

While both monetary and fiscal policy were being used to offset spending declines arising from the 2007 recession, the twin deficits that emerged in the 1980s remain unresolved. Deficit spending, except for 3 years at the end of the 1990s, has continued. Given the combination of a weak economy and expansionary fiscal policy, deficit growth will accelerate. Thus, the short-term projection for the national debt is significant growth until full employment is restored.

The cause of the persistent trade deficits over the past quarter century arise from another domestic macroeconomic imbalance, here between saving and investment. U.S. national saving is so low that the United States must finance domestic investment spending with the help of foreign savings. Given expanding federal budget deficits, there is additional pressure on the trade deficit despite reductions in private investment spending for buildings and equipment. Most observers therefore conclude that U.S. trade deficits, and their financial liabilities, will continue until the U.S. saving rate can be increased. This adjustment can be done in an orderly fashion by promoting both private and public sector saving. It could also happen as a matter of economic necessity should the United States no longer be in a position to finance substantial federal debt and private investment spending. That undesirable outcome is being considered if only to promote thinking about more desirable resolutions. Debt does not have to be zero, but it must be manageable.

The Future of Macroeconomic Policy

The debate over stabilization policy displays its own cyclical features. The classical tradition of laissez-faire was displaced by the Great Depression and the demand management policies of The General Theory. Such countercyclical policies were applied in the 1960s when it almost seemed that the business cycle had been managed away. Theory lapses and supply shocks demonstrated the weaknesses of the Keynesian consensus in the 1970s. At best, “coarse tuning” was the new standard. A variety of new conservative macroeconomic schools emerged that encouraged reconsideration of the wisdom of laissez-faire policies for the business cycle. Despite academic debates about such issues, stabilization efforts continued after the 1970s. Volcker’s Fed acted to slow inflation in the early 1980s, and Alan Greenspan’s first challenge, the October 1987 stock market crash, saw the Fed act to prevent additional damage from this event. Greenspan continued to purse countercyclical policies in the two recessions that occurred during his tenure. Greenspan was even criticized for pursuing overly expansionary policies in 2003 to 2004 as the housing market boom continued. However, Greenspan said the error he made was in misjudging the stability and risk-management capabilities of financial markets. Furthermore, it was not clear that it was the Fed’s responsibility to prevent the occurrence of asset price bubbles.

If anything, Bernanke’s Fed has been the most active ever in dealing with the difficulties the U.S. economy was facing. Along with the recession, the Fed had to operate in an economy that was hit by a major equity-price shock as stock markets around the world dropped dramatically. For 2008, U.S. stock prices, as measured by the level of the Dow Jones Industrials, fell by one third. Across all equity markets, trillions of dollars of financial wealth were erased. This negative wealth effect affected private-sector consumer and business spending. Further eroding consumer confidence was the apparent fear of the federal government as it pushed for new emergency deficit spending to keep collapsing financial markets operating. The fiscal policy response was initially one of additional spending and tax cuts, and in relatively large amounts, before taking on regulatory reform. The combination of remarkably expansionary fiscal and monetary policy with structural reform of financial markets is being counted on to repair the damage from the greatest financial bubble in history. Macroeconomic events of the 1930s were somewhat similar, with financial turmoil, falling equity prices, and rising unemployment. It took the expansionary macro policies of WWII to finally pull the economy back to full employment. In 2009, such spending policies are in place because of the lessons of that era.

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