Wednesday, August 12, 2009

How Bad was the 1970s Economy?

The Great Depression and the failure of classical economics to provide a solution led to the rise of Keynesian economics. In particular, an active fiscal policy to maintain full employment was a key element of the post war consensus.

However, many felt that the 1970s, proved the failure of Keynesian economics. Against a backdrop of stagflation, neo-classical economists such as Milton Friedman came back into fashion and this led to the adoption of Monetarist policies in the early 1980s - in both US and UK.


Graph showing combination of high inflation and falling output.

However, was the 1970s such as failure?

Inflation did rise significantly. This was a combination of
  • An external shock - rise in oil prices
  • Monetary policy too loose
  • Wage price spiral magnified by relatively powerful trades unions.
Despite the high inflation, living standards did rise during the decade.

Unemployment did rise in the 1970s, but, it was much lower than the unemployment experienced during the 1980s.

There was a break down in the simplistic Phillips curve showing a trade off between inflation and unemployment. However, given the external supply shocks this is only to be expected. You could argue the Phillips curve merely shifted giving a worse trade off.

In response to the inflation of 1979, governments in both UK and US adopted Monetarist policies - tight monetary and fiscal policy. This caused a deep and long last recession 1979-81, with rising unemployment. In the UK, unemployment rose to over 3 million.

According to the rational expectation, real business cycle models advocated by Monetarists, the recession should have been much more short lived. But, it wasn't, in the UK unemployment rose to over 3 million for a considerable time.

Despite this failure of Monetarism in the early 1980s, the ideological strength of laissez faire remained untarnished and this led to the widespread growth of financial deregulation which has caused so many problems in the current climate.

Many commentators refer to the current downturn as the worst economic situation of the 1970s. But, this is incorrect, the current economic downturn is far worse than anything witnessed in the 1970s. Unemployment is rising at a much faster rate. Output is falling far deeper and for longer. True, we don't have the instability of high inflation, but, inflation is not the most pressing concern at moment.

There were many structural weaknesses in the 1970s - powerful unions, reliance on oil imports from OPEC. But, the inflation of the 70s was not 'proof' that free markets will provide optimal solution. To say the 1970s 'proves' the failure of Keynesian economics and government intervention in the economy is very lazy analysis.

1 comment:

averagejoe said...

Good post, despite the fact it was years ago is still relevant. Given that the BoE hows now confirmed that the money supply is created as debt by banks creating loans, surely this means that the key source of inflation is the rate of growth of the money supply, not workers demand large pay rises. In essence high pay rises are simply a reallocation of the money supply. Any views?