Instructions Write a 5-7 page paper (double spaced, 12 point font, standard margins) on one of the following topics. Your title page and bibliography (and any other pages that are not writing) do not

Guide yourself through key concepts with clickable figures, test your understanding with multiple choice questions, look up key terms in the glossary, read full mathematical derivations in the Leibniz supplements, watch economists explain their work in Economists in Action – and much more. 2 Before dawn on Saturday, 7 February 2009, 3,582 firefighters began deploying across the Australian state of Victoria. It would be the day remembered by Australians as Black Saturday: the day that bushfires devastated 400,000 hectares, destroyed 2,029 homes, and took 173 lives.

But when the fire brigades suited up that morning, there had not been any reports of fire. What had mobilised every firefighter in Victoria was the McArthur Forest Fire Danger Index (FFDI), which the previous day exceeded what, until then, was its calibrated maximum of 100—a level that had been reached only during the bushfires of January 1939. When the FFDI exceeds 50, it indicates “extreme” danger. A value above 100 is “catastrophic” danger. On 6 February 2009 it had hit 160.

Later there would be accusations, trials and even a Royal Commission to determine who or what had caused Australia’s worst natural disaster. There were many possible causes: lightning strikes, sparks from farm machinery, faulty power lines, even arson.

A single spark or a lightning strike did not cause Black Saturday. Every day sparks ignite small bush fires, and on that day alone the Royal Commission reported 316 separate grass, scrub or forest fires. This was not a calamity because of any one of these local fires, but because conditions transformed routine, easily contained bushfires into an unprecedented disaster.

Small causes are sometimes magnified into large effects. Avalanches are another natural example. In electricity grids a failure of one link in the network overloads other links, leading to a cascade of failures and a blackout.

This small-causes-with-big-consequences process is found in economics too, for example in the Great Depression of the 1930s and the global financial crisis of 2008.

Although recessions are characteristic of capitalist economies, as we have seen, they rarely turn into episodes of persistent contraction. This is because of a combination of the economy’s self-correcting properties and successful intervention by policymakers. Specifically:

• Households take preventative measures that dampen rather than amplify shocks (Unit 12) • Governments create automatic stabilisers (Unit 13) • Governments and central banks take actions to produce negative rather than positive feedbacks when shocks occur (Units 13, 14) But, like Black Saturday, occasionally a major economic calamity occurs. These calamities raise three sets of questions about how economic crises mirror these natural disasters:

• In economics, what is the counterpart to the dry undergrowth, the small spark, and the positive feedback processes that caused the fire to spread? What creates the raw material for an economic “Black Saturday”?

coreecon | Curriculum Open-access Resources in Economics 3 • Do we wait for the fire burn out, or can we put it out? If so, how?

• How can the lessons of an economic crisis be used to reduce the chance it will happen again? Can a long period without a disaster lead to complacency?

In this unit we look at three crises that have punctuated the last century of unprecedented growth in living standards in the rich countries of the world—the Great Depression of the 1930s, the end of the golden age of capitalism in the 1970s, and the global financial crisis of 2008.

The global financial crisis in 2008 took households, firms and governments around the world by surprise. An apparently small problem in an obscure part of the housing market in the US caused house prices to plummet, leading to a cascade of unpaid debts around the world, and a collapse in global industrial production and world trade.

To economists and historians, the events of 2008 looked scarily like what had happened at the beginning of the Great Depression in 1929. For the first time they found themselves fretting about the level of the little-known Baltic Dry Index ( you can track its current level here ), a measure of shipping prices for commodities like iron, coal and grain. When world trade is booming, demand for these commodities is high.

But the supply of freight capacity is inelastic, so shipping prices rise and the Index goes up. In May 2008 the Baltic Dry Index reached its highest level since it was first published in 1985. But the reverse is also true: by December many more people were checking the Index, because it had fallen 94%. The fall told them that, thousands of miles from the boarded-up houses of bankrupt former homeowners in Arizona and California where the crisis had begun, giant $100m freighters were stuck in port because there was no trade for them to carry.

In 2008 economists remembered the lessons of the Great Depression. They encouraged policymakers globally to adopt a coordinated set of actions to halt the collapse in aggregate demand, and to keep the banking system functioning.

But economists also share some of the responsibility for the policies that made this crisis more likely. For 30 years unregulated financial and other markets had been stable. Some economists incorrectly assumed that they were immune to instability.

So the events of 2008 also show how a failure to learn from history helps to create the next crisis.

How did a small problem in the US housing market send the global economy to the brink of a catastrophe?

• The dry undergrowth: In Unit 16, Figure 16.9 charted the growth in the globalisation of international capital markets by looking at the amount of foreign assets owned by domestic residents. At the same time, the globalisation of banking was occurring. Some of the unregulated expansion of lending by global banks ended up financing mortgage loans to so-called subprime borrowers in the US.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 4 • The spark: Falling real estate prices meant that banks with very high leverage, and therefore with thin cushions of net worth (equity), in the US, France, Germany, the UK and elsewhere quickly because insolvent.

• The positive feedback mechanism: Fear was transmitted around the world and customers cancelled orders. Aggregate demand fell sharply. The high degree of interconnection among global banks and the possibility of massive transactions in a matter of seconds made excessive leverage an increasingly dangerous source of instability.

• The complacent policymakers: With few exceptions most policymakers, and the economists whose advice they sought, still believed that the financial sector was able to regulate itself. The international central bank for central banks—the Bank for International Settlements in Basel—allowed banks great scope to choose their level of leverage. Banks could use their own models to calculate the riskiness of their assets. They could meet the international regulatory standards for leverage by understating the riskiness of their assets, and by parking these risky assets in what are called shadow banks, which they owned but which were outside the scope of banking regulations. All of this was entirely legal. Many economists continued to believe that economic instability was a thing of the past, right up to the onset of the crisis itself. It is as if Australian firefighters had watched the Forest Fire Danger Index hit 160, but did nothing because they didn’t believe a fire was possible.

Some of those involved admitted afterwards that their belief in the stability of the economy had been wrong. For example, Alan Greenspan, who had been in charge of the US central bank between 1987 and 2006, admitted this error to a US government committee hearing.

As the financial crisis unfolded in the summer and autumn of 2008, econo\ mists in government, central banks and universities diagnosed a crisis of aggregate demand and bank failure. Many of the key policymakers in this crisis were economists who had studied the Great Depression.

The lessons they had learned from the Great Depression in the US—cut interest rates, provide liquidity to banks and run fiscal deficits—were applied. In November 2008, ahead of the G20 summit in Washington, British Prime Minister Gordon Brown told reporters:

“We need to agree on the importance of coordination of fiscal and monetary policies. There is a need for urgency. By acting now we can stimulate growth in all our economies. The cost of inaction will be far greater than the cost of any action.” coreecon | Curriculum Open-access Resources in Economics 5 HOW ECONOMISTS LEARN FROM FACTS “I MADE A MISTAKE” On 23 October 2008, a few weeks after the collapse of the US investment bank Lehman Brothers, former US Federal Reserve chairman Alan Greenspan admitted that the accelerating financial crisis had shown him “a flaw” in his belief that free, competitive markets would ensure financial stability. In a hearing of the US House of Representatives Committee on Oversight and Government Reform, Greenspan was questioned by chair of the House Committee, Rep. Henry Waxman:

Waxman Well, where did you make a mistake then?

Greenspan I made a mistake in presuming that the self-interest of organisations, specifically banks and others, was best capable of protecting [the banks’] own shareholders and their equity in the firms… So the problem here is that something which looked to be a very solid edifice, and, indeed, a critical pillar to market competition and free markets, did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened and, obviously, to the extent that I figure out where it happened and why, I will change my views. If the facts change, I will change.

Waxman You had a belief that [quoting Greenspan] “free, competitive markets are by far the unrivalled way to organise economies. We have tried regulation, none meaningfully worked.’’ You have the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. [Did you] make decisions that you wish you had not made?

Greenspan Yes, I found a flaw… Waxman You found a flaw?

Greenspan I found a flaw in the model… that defines how the world works, so to speak.

Waxman In other words, you found that your view of the world was not right, it was not working.

Greenspan Precisely. That’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 6 A direct comparison between the first 10 months of the Great Depression and the 2008 financial crisis shows that the collapse of industrial production in the world economy was similar (compare January 1930 and January 2009 in Figure 17.1a). But lessons had been learned: in 2008, monetary and fiscal policy responses were much larger and more decisive than in 1930, as shown in Figures 17.1b and 17.1c. 05101520253035404550 60 65 70 75 80 85 90 95 100 105 110 Months into crisis Index of world industrial production April 2008 = 100 June 1929 = 100 Jan 1931 Jan 1932 Jan 1933 Jan 2009 Jan 2011 Jan 2012 Jan 2010 Jan 1930 Figure 17.1a The second Great Depression that did not happen: Comparing industrial production in the Great Depression and the global financial crisis.

Source: Almunia, Miguel, Agustín Bénétrix, Barry Eichengreen, Kevin H. O’Rourke, and Gisela Rua. 2010. ‘From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons.’ Economic Policy 25 (62): 219–65.

Updated using CPB Netherlands Bureau for Economic Policy Analysis. 2015. ‘World Trade Monitor.’ Months into crisis 05 1015202530354045500 1 2 3 4 5 6 Central bank policy interest ra tes, % (7 c ountry aver age) Jan 2009 Jan 2010 Jan 2011 Jan 2012 Jan 1930 Jan 1931 Jan 1932 Jan 1933 From April 2008 Fr om June 1929 Figure 17.1b The Great Depression and the global financial crisis: Monetary policy.

Source: As in Figure 17.1a updated using national central bank data.

coreecon | Curriculum Open-access Resources in Economics 7 Years from st art of period 012345678-8 -7 -6 -5 -4 -3 -2 -10 1 Government bud get balanc e (as a % of GDP) 1925 1926 1927 19281929 1930 1931 19321933 2004 2005 2006 2007 2008 2009 2010 2011 2012Fr om 1925:

GDP -weighted aver age for 21 c ountries Fr om 2004: world Figure 17.1c The Great Depression and the global financial crisis: Fiscal policy.

Source: As in Figure 17.1a updated using International Monetary Fund. 2009. World Economic Outlook: January 2009; International Monetary Fund. 2013. ‘IMF Fiscal Monitor April 2013: Fiscal Adjustment in an Uncertain World, April 2013.’ April 16. 17.1 THREE ECONOMIC EPOCHS In the past 100 years the economies we often refer to as advanced (meaning, basically, “rich”), including the US, Western Europe, Australia, Canada and New Zealand, have seen average living standards measured by output per capita grow six-fold. Over the same period hours of work have fallen. This is a remarkable economic success, but it has not been a smooth ride.

The story of how rapid growth began was told in Units 1 and 2. In Figure 12.2 we contrasted the steady long-run growth rate from 1921 to 2011 with the fluctuations of the business cycle, which go from peak to peak every three to five years.

In this unit we will study three distinctive epochs. Each begins with a period of good years (the light shading in Figure 17.2 below), followed by a period of bad years (the dark shading).

• 1921 to 1941: The crisis of the Great Depression is the defining feature of the first epoch, and opened the way for Keynes’ concept of aggregate demand to become standard in economics teaching and policymaking.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 8 • 1948 to 1979: The golden age epoch stretched from the end of the second world war to 1979, and is named for the economic success of the 1950s and 1960s. The golden age was brought to an end in the 1970s by a crisis of profitability and productivity, and saw the emphasis in economics teaching and policymaking shift away from the role of aggregate demand toward supply-side problems such as productivity and decisions by firms to enter and exit markets.

• 1979 to 2013: In the most recent epoch, the world was caught by surprise by the global financial crisis. The potential of a debt-fuelled boom to cause havoc was neglected during the preceding years of stable growth and seemingly successful macroeconomic management, which had been called the great moderation. 0 5 10 15 20 25 30 1914 192219301938194619541962197019781986199420022010 -1 -2 0 1 2 3 4 5 6 5 10 15 20 Great Depression epoch:

1921-29; 1929-41 Dashed lines show period aver ages of the series Golden ag e epoch:

1948-73; 1973-79 Fr om st agflation to financial crisis epoch:

1979-2008; 2008-13 Unemployment rate, % Inc ome share of top 1% Annual productivity growth, % Productivity growth (right axis) Unemployment ra te (lef axis) Figure 17.2 Unemployment, productivity growth and inequality in the United States (1914- 2013).

Source: United States Bureau of the Census. 2003. Historical Statistics of the United States: Colonial Times to 1970, Part 1. United States: United States Govt Printing Office; Alvaredo, Facundo, Anthony B Atkinson, Thomas Piketty, Emmanuel Saez, and Gabriel Zucman. 2016. ‘The World Wealth and Income Database (WID).’ ; US Bureau of Labor Statistics; US Bureau of Economic Analysis.

The term crisis is routinely applied to the first and the last of these episodes because they represented an unusual but recurrent cataclysmic divergence from the normal ups-and-downs of the economy. In the second epoch the end of the golden age, too, marked a sharp deviation from what had become normal. The three unhappy coreecon | Curriculum Open-access Resources in Economics 9 surprises that ended the epochs are different in many respects, but they share a common feature: positive feedbacks magnified the effects of routine shocks that under other circumstances would have been dampened.

What does Figure 17.2 show?

• Productivity growth: A broad measure of economic performance is the growth of hourly productivity in the business sector. Productivity growth hit low points in the Great Depression, at the end of the golden age epoch in 1979 and in the wake of the financial crisis. The golden age got its name due to the extraordinary productivity growth until late in that epoch. The dashed blue lines show the average growth of productivity for each sub-period.

• Unemployment: High unemployment, shown in red, dominated the first epoch.

The success of the golden age was marked by low unemployment as well as high productivity growth. The end of the golden age produced spikes in unemployment in the mid 1970s and early 1980s. In the third epoch, unemployment was lower at each successive business cycle trough until the financial crisis, when high and persistent unemployment re-emerged.

• Inequality: Figure 17.2 also presents data on inequality for the US: the income share of the top 1%. The richest 1% had nearly one-fifth of income in the late 1920s just before the Great Depression. Their share then steadily declined until a U-turn at the end of the golden age restored the income share of the very rich to 1920s levels.

We saw in earlier units that continuous technological progress has characterised capitalist economies, driven by the incentives to introduce new technology. Based on their expected profits after tax, entrepreneurs make investment decisions to get a step ahead of their competitors. Productivity growth reflects their collective decisions to invest in new machinery and equipment embodying improvements in technology. Figure 17.3 shows the growth rate of the capital stock and the rate of profit of firms in the non-financial corporate sector of the US economy before and after the payment of taxes on profits.

The data in Figure 17.3 illustrates that capital stock growth and firm profitability tend to rise and fall together. As we saw in Unit 13, investment is a function of expected post-tax profits and expectations will be influenced by what has happened to profitability in the recent past. Once a decision to invest is taken, there is a lag before the new capital stock is ordered and installed.

As profitability was restored following the collapse of the stock market in 1929 and the banking crises of 1929-31, investment recovered and the capital stock began to grow again. During the golden age, profitability and investment were both buoyant.

A closer look at Figure 17.3 is revealing: investment depends on post-tax profitability and we can see that the gap between the pre-tax (red) and post-tax (green) rate of profit declined during the golden age. The lower panel shows the effective tax rate on corporate profits explicitly.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 10 192719371947195719671977 1987 19972007 -50 5 10 15 20 0 2 4 6 8 10 12 14 Annual perc entage r eturn on ne t capital stock/ annual growth r ate o\f net capital stock , % E\bective t ax rate on c orporate pro\fits \f or US non-\financial\h c orpor ations, % Great Depression downswing:

1929\f41 Golden ag e epoc\b:

1948\f73; 1973\f79 From st agflation to financial crisis epo\2c\b:

1979\f2008; 2008\f13 E ective t ax ra te on profits St art of WWII:

1939 St art of Korean W ar: 1950 St art of Vie tnam W ar: 1961 Pre-t ax profit rate Po st-tax profit rate Growth of capit al stock Figure 17.3 Capital stock growth, profit rates and effective tax rate on profits for US non- financial corporations (1927-2013).

Source: US Bureau of Economic Analysis.

Wars have to be financed and the tax on businesses increased during the second world war and the Korean war, and more slowly over the course of the Vietnam war.

The effective tax rate on profits fell from 8% to 2% over the 30 years from the early 1950s. This helped to stabilise the post-tax rate of profit. In the late 1970s and early 1980s, taxes on profits were cut sharply; thereafter the pre-tax profit rate fluctuated without a trend. But in spite of the stabilisation of profitability in the third epoch, the growth rate of the capital stock fell.

On the eve of the financial crisis, Figures 17.2 and 17.3 show that the richest Americans were doing very well. But this did not stimulate investment, with the capital stock growing more slowly than at any time since the second world war. The onset of the financial crisis also coincided with a peak in debt (shown in Figure 17.4).

Debt in financial firms and in households was at postwar highs (relative to the size of GDP). The swelling in the amount of debt was clearest for financial firms—but households also increased their debt ratio steadily through the 2000s.

coreecon | Curriculum Open-access Resources in Economics 11 0 50 100 150 200 250 300 3501945 1950195519601965197019751980198519901995200020052010 Debt as a % of GDP Golden ag e epoch:

1948-73; 1973-79 Per c ent of GDP for e ach categ ory Financial firms Households Non-financial firms Government Fr om st agflation to financial crisis epoch: 1979-2008; 2008-13 109 94 75 70 Figure 17.4 Debt as a percentage of GDP in the United States: Households, non-financial firms, financial firms and the government (1945-2013).

Source: US Federal Reserve. 2015. ‘Financial Accounts of the United States, Historical.’ December 10; US Bureau of Economic Analysis.

The three epochs of modern capitalism are very different, as Figures 17.5a and 17.5b show. We need to use the full range of tools of analysis we have developed in previous units to understand their dynamics, and how one epoch is related to another.

By 1921, the US had been the world productivity leader for a decade, and the world’s largest economy for 50 years. The three epochs are more clearly defined in the US than in other countries, even other rich countries, although they had a profound influence on the economic history of the rest of the world. Its global leadership in technology and its global firms help explain rapid catch-up growth in Europe and Japan in the golden age. On either side of the golden age, the crises tha\ t began in the US in 1929 and 2008 became global crises too.

So why, apart from its productivity leadership, were these epochs centred on the US? Figure 17.5b summarises important differences between the US and other rich countries.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 12 NAME OF PERIODDA TES IMPORTANT FEA TURES OF THE US EC ONOMY 1920s GREA T DEPRES SION GOLDEN AG E ST AGFLA TION 1980s & THE GREA T MODERA TION FINANCIAL CRISIS 2008-2013 1979-2008 1973-1979 1948-1973 1929-1941 1921-1929 High unem\floymen\b Low infla\bion Rising inequali\by\m L ow unem\floymen\b and inf\mla\bion F alling grow\bh r a\be of business ca\fi\m\b al s\bock Shar\fly rising in\mequali\by Rising indeb\bednes\ms of households and b\m anks High unem\floymen\b a\mnd infla\bion L ow \froduc\bivi\by grow\bh L ower \frofi\bs L ow unem\floymen\b Unusually high \fr\moduc\bivi\by grow\bh Unusually high gr\mow\bh r a\be of ca\fi\bal s\bock F alling e ec\bive \b ax ra\be on c or\fora\be \frofi\bs F alling inequali\by High unem\floymen\b F alling \fric es Unusually low grow\m\bh r a\be of business ca\fi\m\bal s\bock F alling inequali\by L ow unem\floymen\b High \froduc\bivi\by gr\mow\bh Rising inequali\by\m Figure 17.5a The performance of the US economy over a century. GREA T DEPRES SION GOLDEN AG E FINANCIAL CRISIS US : Large , sustained downturn in \f\wDP st arting fro\b 1929 UK : Av oided a b anking crisis, expe\wrienc ed a \bodest fall in \fDP US : T echnology le ader Outside US : Di \w usion of technology\w cr eates catch-up growth,\w i\bproving produc\wtivity US : Housing bub\wble cr eates banking crisi s \fer\bany , Nordic countries, Jap an, Canada, Austr alia : Did not \w experienc e bubble, larg ely avoided financi\wal crisis INTERNATIONAL OPENNES S (ALL THREE PERIODS) More i\bport ant in \bost c ountries than in t\whe US Figure 17.5b The Great Depression, the golden age, and the financial crisis in cross-national comparison: Distinctive features of the United States.

coreecon | Curriculum Open-access Resources in Economics 13 17.2 THE GREAT DEPRESSION, POSITIVE FEEDBACKS, AND AGGREGATE DEMAND Capitalism is a dynamic economic system and, as we saw in Unit 12, booms and recessions are a recurrent feature even when weather-driven fluctuations in agricultural output are of limited importance in the economy. But not all recessions are equal. In Unit 13, we saw that in 1929 a downturn in the US business cycle similar to others in the preceding decade transformed into a large-scale economic disaster— the Great Depression.

The story of how the Great Depression happened is dramatic to us, and must have been terrifying to those who experienced it. Small causes led to ever-larger effects in a downward spiral, like the cascading failures of an electricity grid during a blackout. Three simultaneous positive feedback mechanisms brought the American economy down in the 1930s:

• Pessimism about the future: The impact of a decline in investment on unemployment and of the stock market crash of 1929 on future prospects spread fear among households. They prepared for the worst by attempting to save more, bringing about a further decline in consumption demand.

• Failure of the banking system: The resulting decline in income meant that loans could not be repaid. By 1933, almost half of the banks in the US had failed, and access to credit shrank. The banks that did not fail raised interest rates as a hedge against risk, further discouraging firms from investing and curbing household spending on automobiles, refrigerators and other durable goods.

• Deflation: Prices fell as unsold goods piled up on store shelves.

Deflation affects aggregate demand through several routes. The most important channel operated through the effect of deflation on those with high debts. This positive feedback channel was new because in earlier episodes of deflation levels of debt had been much lower. Households stopped buying cars and houses, and many debtors become insolvent, creating problems for both borrowers and the banks. A survey showed that one-fifth of those in owner-occupied and rented accommodation was in default. Farmers were among those with high levels of debt: prices of their produce were falling, pulling down their incomes directly and pushing up the THE GREAT DEPRESSION The period during the 1930s in which there was a sharp fall in output and employment, experienced in many countries.

• Countries that left the gold standard earlier in the 1930s recovered earlier.

• In the US, Roosevelt’s New Deal policies accelerated recovery from the Great Depression, partly by causing a change in expectations.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 14 burden of their debt. They responded to this by increasing production, which made the situation worse. When prices are falling, people also postpone the purchase of durables, which further reduces aggregate demand. DISCUSS 17.1: FARMERS IN THE GREAT DEPRESSION The response of farmers may have made sense from an individual point of view, but collectively it made the situation worse. Use diagrams, for example the model of a firm in a price-taking market for an individual farm and diagrams for supply and demand for the industry (for example wheat), to show why.

Few understood these positive feedback mechanisms at the time, and the government’s initial attempts to reverse the downward spiral failed. This was partly because the government’s actions were based on mistaken economic ideas. It was also because, even if they had pursued ideal policies, the government share of the economy was too small to counter the powerful destabilising trends in the private sector.

Figure 17.6 shows the fall in industrial production that started in 1929. In 1932 it was less than 60% of the 1929 level. This was followed by a recovery, until it fell again by 20% in 1937. Unemployment did not fall below 10% until 1941, the year the US entered the second world war. Consumer prices fell with GDP from 1929 to 1933 and remained stable until the early 1940s. 1928 1929193019311932193319341935193619371938193919401941 40 60 80 100 120 140 160 0 5 10 15 20 25 30 Index (1929=100) Unemployment ra te (%) Stock mark et cr ash: 1929 Roosevelt elected President : 1932 Unemployment rate (right axis) US entered WWII: 1941 Real GDP (lef axis) Indust\fial p\foduction (lef axis)\t \bonsume\f p\fices (lef axis) Figure 17.6 The effect of the Great Depression on the US economy (1928-1941).

Source: United States Bureau of the Census. 2003. Historical Statistics of the United States: Colonial Times to 1970, Part 1. United States: United States Govt Printing Office; Federal Reserve Bank of St Louis (FRED).

coreecon | Curriculum Open-access Resources in Economics 15 17.3 POLICYMAKERS IN THE GREAT DEPRESSION Australia experienced a Black Saturday. The origin of the Great Depression can be dated to a day now known as Black Thursday. On Thursday 24 October 1929 the US Dow Jones Industrial Average plunged by 11% during the day, starting three years of decline for the US stock market. Figure 17.7 shows the business cycle upswings and downswings from 1924 to 1941. -25 -20 -15 -10 -50 5 10 15 Annualised chang e over period (re al 1972 $bn) Recession Consumption of nondur able goods and ser vices Government purchases Net exports Household and business investment Recession Recession Q3 1924 - Q3 1926 Q3 1926 - Q4 1927 Q4 1927 - Q3 1929 Q3 1929 - Q1 1933 Q1 1933 - Q2 1937 Q2 1937 - Q2 1938 Q2 1938 - Q4 1941 Figure 17.7 Changes in the components of aggregate demand during upswings and downswings (Q3 1924 to Q4 1941).

Source: Appendix B in Gordon, Robert J. 1986. The American Business Cycle: Continuity and Change. Chicago, Il: University of Chicago Press.

The long downswing from the third quarter of 1929 until the first quarter of 1933 was driven by big falls in household and business investment (the red bar) and in consumption of non-durables (the green bar). Recall that in Figure 13.6 we used the multiplier model to describe how this shock created a fall in aggregate demand, and in Figure 13.8 we described a model of how households had cut consumption to restore their target wealth, to understand the observed behaviour of households and firms in the Great Depression.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 16 In Unit 13, we showed how government policy could both amplify and dampen fluctuations. In the opening years of the Great Depression, government policy both amplified and prolonged the shock. Initially, government purchases and net exports hardly changed. As late as April 1932 President Herbert Hoover told Congress that “far-reaching reduction of governmental expenditures” were necessary, and advocated a balanced budget. Hoover was replaced by Franklin Delano Roosevelt in 1932, at which point government policy changed.

Fiscal policy in the Great Depression Fiscal policy made little contribution to recovery until the early 1940s. Estimates suggest that output was 20% below the full employment level in 1931, for example, which means that the small budget surplus in that year would have implied a large cyclically adjusted surplus, given the decline in tax revenues in the depressed economy.

Under Roosevelt, from 1932 to 1936 the government ran deficits. When the economy went into recession in 1938-39, the deficit shrank from its peak of 5.3% in 1936 to 3% in 1938. This was another mistake that reinforced the downturn. The big increase in military spending from early 1940 (well before the US entered the second world war in late 1941) contributed to the recovery.

Monetary policy in the Great Depression 19211923192519271929193119331935193719391941-15 -10-50 5 10 15 20 25 30 Unemployment rate (%) Consumer pric e inflation (%) Short -term nominal interest rate (%) Short -term re al interest rate (%) F eder al government budget b alanc e (as a % of GNP) UK lef Gold Standard: 1931 (Se\ftember) US lef Gold St andard:

1933 (\b\fril) President Roosevel\(t’ s New Deal Policies:

1933 onwards P olicy v ariables Rec essions Background dat a Figure 17.8 Policy choices in the Great Depression: United States (1921-1941).

Source: Friedman, Milton, and Anna Jacobson J. Schwartz. 1982. Monetary Trends in the United States and the United Kingdom, Their Relation to Income, Prices, and Interest Rates, 1867-1975. Chicago, Il: University of Chicago Press; United States Bureau of the Census. 2003. Historical Statistics of the United States: Colonial Times to 1970, Part 1. United States: United States Govt Printing Office; Federal Reserve Bank of St Louis (FRED).

coreecon | Curriculum Open-access Resources in Economics 17 Monetary policy prolonged the Great Depression. The real interest rate data in Figure 17.8 suggest that monetary policy was contractionary in the US economy from 1925 onwards: the real interest rate increased, reaching a peak of 13% in 1932. Once the downturn began in 1929, this policy stance reinforced, rather than offset, the decline of aggregate demand. But note that the nominal interest rate was falling after its peak in 1929; the real interest rate went up because prices were falling too. Interest- sensitive spending on buildings and consumer durables decreased sharply.

The gold standard The US was still on what was known as the gold standard. This meant that the US authorities promised to exchange dollars for a specific quantity of gold (the promise was to pay an ounce of gold for $20.67). Under the gold standard, the authorities had to continue to pay out at the fixed rate and, if there was a fall in demand for US dollars, gold would flow out of the country. To prevent this, either the country’s tradable goods must become more competitive (boosting gold inflows through higher net exports) or gold must be attracted through capital inflows by putting up the nominal interest rate, or keeping it high relative to the interest rate in other countries. As a result, policymakers were reluctant to push the interest rate down to the zero lower bound to avoid contributing to the gold outflow.

Unless wages decline rapidly to raise international competitiveness and boost the inflow of gold through higher exports and lower imports, sticking to the gold standard in a recession is destabilising: it will amplify the downturn. There was a very large outflow of gold from the US after the UK left the gold standard in September 1931. One reason for speculation against the US dollar—that is, investors selling dollars for gold—was that there were expectations that the US would also abandon the gold standard and devalue the dollar. If it did, those holding dollars would lose.

Countries that left the gold standard earlier in the 1930s recovered earlier.

A change in expectations In 1933 Roosevelt began a programme of changes to economic policy:

• The New Deal committed federal government spending to a range of programmes to increase aggregate demand.

• The US left the gold standard in April 1933, which meant the US dollar was devalued to $35 per ounce of gold, and the nominal interest rate was reduced to close to the zero lower bound (see Figure 17.8).

• Roosevelt also introduced reforms to the banking system following the bank runs of 1932 and early 1933.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 18 The change in people’s beliefs about the future was just as important as these policy changes. On 4 March 1933, in his inaugural address as president, Roosevelt had told Americans that: “the only thing we have to fear is fear itself—nameless, unreasoning, unjustified terror”.

We have seen that the terrors of consumers and investors in 1929 had been justified.

But a combination of Roosevelt’s New Deal policies and the beginnings of recovery in the economy that were already underway before he became president, households and firms began to think that prices would stop falling and that employment would expand. Debt Home equity Financial wealth Expected future e arnings from employment Ta rget wealth Net worth Incre ase in savings to restore target wealth Reduction in savings to restore target wealth To tal wealth To tal wealth To tal wealth Early 1929 Late 1929-31 Late 1933 A BC Figure 17.9 The Great Depression: Households cut consumption to restore target wealth.

Figure 17.9 adds a third column to the model that we first encountered in Figure 13.8.

Column C shows the household’s perspective from late 1933. By that time output and employment were growing. With much of the uncertainty about the future resolved, households re-evaluated their expected wealth (including their expected earnings from employment). They reversed the cutbacks in consumption because they saw no need to make additional savings. To the extent that they now expected their income prospects and asset prices to return to pre-crisis levels, consumption would be restored. Any increase in wealth above target due to the increased savings during the Depression years (shown by wealth above target in column C) would create an additional boost to consumption.

The slow path to recovery had begun. But the US economy would not return to pre- Depression levels of employment until Roosevelt was in his third term as president and the second world war had begun.

coreecon | Curriculum Open-access Resources in Economics 19 17.4 THE GOLDEN AGE OF HIGH GROWTH AND LOW UNEMPLOYMENT The years from 1948 until 1973 were remarkable in the history of capitalism.

In the US, we saw in Figure 17.2 that productivity growth was more rapid and unemployment was lower than in the other periods. But this 25-year golden age was not confined to the US. Countries across western Europe, Japan, Australia, Canada and New Zealand experienced a golden age as well. Unemployment rates were historically low (see Figure 15.1). Figure 17.10 shows data from 1820 to 1913 for 13 advanced countries, and for 16 countries from 1950. 0 1 2 3 4 5 6 A ver ag e annual growth (%) 1820-70 1870-1913 1913-501950-73 Real GDP per capita Capital stock 1.0 1.4 1.2 3.8 2.9 1.7 5.5 Figure 17.10 The golden age of capitalism in historical perspective.

Source:

Table 2.1 in Glyn, Andrew, Alan Hughes, Alain Lipietz, and Ajit Singh. 1989. ‘The Rise and Fall of the Golden Age.’ In The Golden Age of Capitalism: Reinterpreting the Postwar Experience, edited by Stephen A.

Marglin and Juliet Schor. New York, NY: Oxford University Press.

The growth rate of GDP per capita was more than two-and-a-half times as high during the golden age than in any other period. Instead of doubling every 50 years, living standards were doubling every 20 years. The importance of saving and investment is highlighted in the right panel, where we can see that the capital stock grew almost twice as fast during the golden age as it did between 1870 and 1913.

The story of how the large western European countries and Japan (almost) caught up to the US is told in Figure 17.11. In the figure, the level of GDP per hour worked in the US is set at the level of 100 throughout, and so the figure tells us nothing about the performance of the US itself (we have to use Figure 17.2 for that). However, it is a striking way to represent the starting point of these economies relative to the US immediately after the second world war and their trajectories in the years that followed. This was known as catch-up growth.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 20 1950195519601965197019751980198519901995200020052010 0 20 40 60 80 100 120 GDP per hour relative to the US (US=100) Fr anc e United St ates Germany United King dom Sp ain It aly Jap an Figure 17.11 Catch-up to the US during the golden age and beyond (1950-2013).

Source: The Conference Board. 2014. ‘Total Economy Database.’ The three large defeated countries (Germany, Italy and Japan) were furthest behind in 1950. Japan’s GDP per hour worked was less than one-fifth the level of the US. Clearly, growth of all of these economies was faster than the US during the golden age: all moved much closer to the level of US productivity.

What was the secret of golden age performance in the productivity leader— the US—and in the follower countries?

• Changes in economic policymaking and regulation: These resolved the problems of instability that characterised the Great Depression • New institutional arrangements between employers and workers: These created conditions in which it was profitable for firms to innovate. In the US, the technology leader, this meant new technologies, while the follower countries often adopted improved technology and management already in use in the US. Because workers’ trade unions and political parties were now in a stronger position to bargain for a share of the productivity gains, most supported innovation—even when it meant temporary job destruction. THE GOLDEN AGE OF CAPITALISM The period of high productivity growth, high employment and stable inflation extending from the end of the second world war to the early 1970s.

• The gold standard was replaced by the more flexible Bretton Woods System.

• Employers and employees shared the benefits of technological progress thanks to the postwar accord .

• The golden age ended with a period of stagflation in the 1970s.

coreecon | Curriculum Open-access Resources in Economics 21 After the second world war governments had learned the lessons of the Great Depression. This affected national and international policymaking. Just as Roosevelt’s New Deal signalled a new policy regime and raised expectations in the private sector, postwar governments provided reassurance that policy would be used to support aggregate demand if necessary.

Government was now larger in all of these countries after the second world war, and the size of government grew throughout the 1950s and 1960s. Figure 13.1 showed the decline in output fluctuations after 1950, and the much larger size of government in the US. In Unit 13, we saw how a larger government provides more automatic stabilisation for the economy. The modern welfare state was built in the 1950s, and unemployment benefits were introduced. This also formed part of the automatic stabilisation.

Given the cost of adherence to the gold standard during the Great Depression, it was clear that a new policy regime for international economic relations had to be put in place. The new regime was called the Bretton Woods System after the ski resort in New Hampshire where representatives of the major economies, including Keynes, created a system of rules that was more flexible than the gold standard. Exchange rates were tied to the US dollar rather than gold and, if countries became very uncompetitive—if they faced a “fundamental disequilibrium” in external accounts, in the words of the agreement—devaluations of the exchange rate were permitted. When a currency like the British pound was devalued (as occurred in November 1967) it became cheaper to buy pounds. This boosted the demand for British exports and reduced the demand of British residents for goods produced abroad. The Bretton Woods System worked fairly well for most of the golden age. 17.5 WORKERS AND EMPLOYERS IN THE GOLDEN AGE High investment, rapid productivity growth, rising wages and low unemployment defined the golden age.

This seems too good to be true. We saw a model of the wage and profit curve in Unit 15 which highlighted the conflict of interest between workers and employers: at low unemployment, workers must get high wages so that they will work effectively. This depresses profits and reduces investment. The golden age does not seem to follow this model: we saw low unemployment, high profits and high investment at the same time.

How did this virtuous circle work?

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 22 • Profits after taxes in the US economy remained high: This persisted from the end of the second world war through the 1960s (look again at Figure 17.3) and the situation was similar in other advanced economies.

• Profits led to investment: The widespread expectation that high profits would continue in the future provided the conditions for sustained high levels of investment (refer back to the model of investment spending in section 13.4).

• High investment and continued technological progress created more jobs:

Unemployment stayed low.

• The power of workers: Trade unions and political movements allied with employees had high bargaining power, which allowed a sustained increase in wages.

As the last bullet suggests, trade unions were important in this process, as well as governments. Between 1920 and 1933 trade unions lost two-fifths of their members, most of the losses occurring immediately after the first world war. During the 1930s changes in the laws affecting trade unions, as well as the hardship of the Great Depression, reversed this decline. High demand for labour during the second world war strengthened labour’s bargaining power: trade union membership as a fraction of total employment peaked in the early 1950s. There was a subsequent steady decline during the next 50 years. 1913 19231933 19431953 196319731983 19932003 20130 5 0 15 20 25 30 35 Union membership as a % of employed / Government re venue as a % of GNP Great Depression epoch: 1921-29; 1929-41 Golden ag e epoch:

1948-73; 1973-79 Government size Union membership Fr om st agflation to financial crisis epoch:

1979-2008; 2008-13 Figure 17.12 Trade union membership and the size of government in the United States (1913-2013).

Source: Wallis, John Joseph. 2000. ‘American Government Finance in the Long Run: 1790 to 1990.’ Journal of Economic Perspectives 14 (1): 61–82; Mayer, Gerald. 2004. Union Membership Trends in the United States.

Washington, DC: Congressional Research Service; US Bureau of Economic Analysis.

Figure 17.12 shows both the growth of the government and the historically high level of trade union membership in the US. As we have seen, larger government partly reflected the new unemployment insurance entitlement. From the wage and profit coreecon | Curriculum Open-access Resources in Economics 23 curve model, we know that higher unemployment benefits and stronger trade unions shift the wage curve upwards, allowing employees to bargain for a share of increasing productivity.

In the golden age employees had sufficient bargaining power to claim a share in the gains that technological progress made possible. Both employers and employees realised that there was more to be gained in cooperating to increase the size of the pie than in wasting resources in futile efforts to claim most of the pie for themselves.

Policies, business practices and trade union strategies during this period reflected this insight.

When translated into the labour market model (in Figure 17.13) the four bullets explaining of the golden age can be translated into shifts in the profit curve and the wage curve:

• The profit curve shifted up: This happened because productivity increased rapidly • The wage curve shifted up: Low unemployment, strong unions and favourable government policies increased labour’s bargaining power, but the resulting upward shift in the wage curve was modest, allowing for high profits, high investment (the basis of continuing productivity growth) and low unemployment. Upward shif of profit cur ve due to techno\fogica\f changeProfit cur ve, late 1950s/60s Profit cur ve, early 1950s Wa ge cur ve, post -war acco rd, late 1950s-mid 60s Wage cur ve, e arly 1950s Labour forc e U=5\b A B U=4\b Real wage Employment rate (%) Lower unemployment ra te (%) Figure 17.13 The golden age: Using the wage and profit curves.

Recall from Unit 15 that the profit curve shows the real wage consistent with employers maintaining investment at a level to keep employment constant. This means that a real wage above the profit curve will drive firms to leave (relocate to some other economy) or cut back on their investment, and employment falls.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 24 The profit curve will shift up when worker productivity rises, or when taxation on profits is reduced, or when investors and owners have optimistic expectations about future profits. It will shift down when employers have to pay higher prices for imported raw materials, such as oil.

In the US, technological progress was rapid in the golden age as the innovations developed during the Great Depression and the second world war were embodied in new capital equipment.

The new technologies and new management techniques already in use in the US could also be used in the catch-up economies if the innovators expected high enough profits. In many of these countries golden age growth was even faster than at the technology frontier as defined by the US in Figure 17.11.

Taking the example of the US, we can represent the economy as at point A at the beginning of the golden age, with unemployment of 5%. Technological progress shifts the profit curve up (to the one labelled “late 1950s/60s”).

Unless wages adjust upwards or the economy expands, the result initially is a wage much below the profit curve. This stimulates high investment, consistent with the data for the growth of the capital stock in the US shown in Figure 17.3.

But wages eventually did rise and at the same time the economy expanded, moving towards point B in the figure.

The strength of unions in wage setting and the improvement in unemployment insurance during the 1950s and 60s are illustrated as an upward shift of the wage curve in Figure 17.13. To get the outcome observed, with wages growing in line with productivity at low unemployment such as point B , unions and employers need to agree about the scope for wage increases. This would be the case if the wage curve shifted to the one labelled “Wage curve, postwar accord, late 1950s-mid 60s”.

Unions would refrain from using the full extent of their bargaining power (for example, in firms or plants where they had a very strong position) and cooperate in an economy-wide bargain designed to keep wage growth consistent with the constraint imposed by the profit curve. In return, employers would maintain investment at a level sufficient to keep unemployment low. This unwritten but widely observed pattern of sharing the gains to technological progress between employees and employers is termed the postwar accord. In Unit 15, we also referred to this process as fair-shares bargaining.

Different countries had different postwar accord relationships among employers, unions and governments to create high productivity growth, high real wage growth and low unemployment. In Scandinavia, Austria, Belgium, Netherlands, Switzerland and West Germany, wage setting was either centralised in a single union, or coordinated among unions or employers’ associations, resulting in wage restraint. In coreecon | Curriculum Open-access Resources in Economics 25 technologically advanced sectors in France and Italy, governments intervened to set wages in dominant state-owned firms, creating wage guidance across the economy.

The outcome was similar to the result in the countries with centralised wage setting.

Where there was little cooperation between employers and unions, a country’s performance in the golden age was worse. In Figure 17.11, the UK’s relatively poor golden age performance shows up clearly: it started with higher productivity than the other large countries shown (that is, its productivity level in 1950 was the closest to that of the US) but was overtaken by France, Italy and Germany in the 1960s.

Compared to Sweden, Norway and many continental European nations, where the postwar accord underwrote rapid growth in productivity, the British industrial relations system made an accord difficult. It combined very strong union power at the factory level with fragmented unions, which were unable to cooperate in the economy as a whole. The strength of local union shop stewards (representatives), in a system of multiple unions per plant, led unions to attempt to outdo each other when negotiating wage deals, and created opposition to the introduction of new technology and new ways of organising work. The problems of British firms were compounded because markets in former British colonies were protected from competition.

Competition is important in the Schumpeterian creative destruction process because it creates incentives for firms to get a step ahead of the competition, and reduces the number of low-productivity firms. When competition is weak, existing firms and jobs are protected. The employers and workers in these firms share the monopoly rents, but the overall size of the pie is reduced because technological progress is slower.

Postwar accords succeeded in the US and the successful catch-up countries in creating the conditions for a high profit and high investment equilibrium. It delivered rapid productivity and real wage growth at low unemployment, but the British experience during the 1950s and 1960s (Figure 17.11) emphasises that there is nothing automatic about achieving this outcome. 17.6 THE END OF THE GOLDEN AGE The virtuous circle of the golden age began to break down in the late 1960s, as a result of its own successes. The postwar accord and its rationale of enlarging the pie gave way to a return to contest over the size of the slice that each group could get. This set the stage for the period of combined inflation and stagnation called stagflation that would follow. Employers eventually won the contest, but at a substantial cost to the economy.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 26 Australia can go many years without a major bush fire. But fewer small fires means there will be more flammable undergrowth, which increases the chance of a major fire. Years of low unemployment (fewer small fires) convinced workers that they had little fear of losing their jobs. Their demands for improvements in working conditions and higher wages drove down the profit rate.

They also demanded policies to redistribute income to the less well off and to provide more adequate social services, making it difficult for governments to run a budget surplus. In the US, additional military spending to fund the Vietnam war added to aggregate demand, keeping the economy at unsustainably high levels of employment. 19501955196019651970197519801985199019952000 0 1 2 3 4 5 0 100 200 300 400 500 Days on strik e per 1,000 industrial work ers A ver age wag es relative to share pric es Averag e wag es relative to share pric es (right axis) Days on strik e (lef axis) Figure 17.14 The end of the golden age: Strikes and wages relative to share prices in advanced economies (1950-2002).

Source: Glyn, Andrew. 2006. Capitalism Unleashed: Finance, Globalization, and Welfare. Oxford: Oxford University Press.

Greater industrial strife in the late 1960s signalled the breakdown of the golden age accords. Figure 17.14 plots the days on strike per 1,000 industrial workers in advanced economies from 1950 to 2002. As strike activity peaked, wages measured relative to share prices increased rapidly. The postwar accords that helped create the golden age collapsed.

The process is represented in Figure 17.15 by an upward shift in the wage curve (to the one labelled “late 60s/early 70s”). At the same time, economy-wide productivity growth slowed (see Figure 17.2 for the US data). In the catch-up countries in western Europe, it was becoming more difficult to get easy gains from technology transfer, because the gap between US technology and the technology used by followers narrowed (see Figure 17.11). In 1973, the first oil price shock occurred. In the Figure 17.15, this pushes the profit curve down (see the profit curve labelled “1973-79”).

coreecon | Curriculum Open-access Resources in Economics 27 Downward shif of p\erofit curve due to productivit\f\e slowdown and oil shock , partiall\f o\bse t b\f reduction in t ax rate Barg aining g ap: inconsistent claims of work ers and emplo\fers on output per work er in late 60s/ e arl\f 70s at unemplo\fm\eent of 4% Profit cur ve, late 1950s-mid 60s Profit cur ve, late 60s/ e arly 70s Wa ge cur ve, post -war acco rd, late 1950s-mid 60s Wage cur ve, late 60s/ early 70s Labour forc e U=7% D BC U= 4% Real wage Employment rate (%) Lower unemployment ra te (%) The combination of a downward shift in the profit curve and an upward shift in the wage curve meant that the sustainable long-term unemployment rate increased to 7%, shown at point D. The double-headed arrow at low unemployment shows the situation in the early 1970s.

Figure 17.15 The end of the golden age: Using the wage and profit curves.

In the early 1970s the claims of employers given their bargaining power compared to consumers (the profit curve) and the claims of workers given their bargaining power compared to their employers were no longer consistent. Something had to give. The golden age was over.

What happened?

Wages did not rise to the level of point C. Under the impact of the upward pressure on wages and the oil price shock, the economy contracted and unemployment began to rise. But even a significant reduction in the employment rate (short of increasing the unemployment rate to 7%) did not eliminate the bargaining gap shown in the figure.

A result was an increase in the rate of inflation, as is shown in Figure 17.16.

Because of the strong bargaining position of workers in the early 1970s in most of the high-income economies, the oil price shock primarily hit employers, redistributing income from profits to wages (Figure 17.15). The era of fair-shares bargaining was coming to a close.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 28 In the US, where trade unions were less powerful, workers nevertheless managed to defend their share of the pie even after the oil price increase. In countries with inclusive and powerful trade unions (as described in Unit 15), the accord survived. In Sweden, for example, the powerful centralised labour movement restrained its wage claims to preserve profitability, investment and high levels of employment.

But in virtually all countries including the US, wages remained above the new profit curve, so investment fell and the rate of productivity growth slowed. As predicted by the model in Figure 17.15, the outcome was rising inflation (Figure 17.16) falling profits (Figure 17.3), weak investment (Figure 17.3), and high unemployment (Figure 17.16). 196019651970197519801985199019952000200520100 2 4 6 8 10 12 14 16 18 Unemployment ra te (%) Consumer pric e inflation (%) St agflation:

1970s Figure 17.16 After the golden age: Unemployment and inflation in advanced economies (1960-2013).

Source: OECD. 2015. ‘OECD Statistics.’ The end of the golden age set off a new economic crisis—one that was very different from the Great Depression. The economic downturn of the 1930s had been propelled by problems of aggregate demand and for this reason it has been called a demand-side crisis. The end of the golden age has been called a supply-side crisis, because those problems on the supply side of the economy depressed the profit rate, the rate of investment and the rate of productivity growth.

The period that ensued came to be called stagflation because it combined high unemployment and high inflation. If the golden age was an unusual time during which everything went right at once, stagflation was the unusual time when everything went wrong.

According to the Phillips curve model of Unit 14, inflation goes up when unemployment goes down; this is a movement along the Phillips curve. Figure 17.16 summarises the unemployment and inflation data for the advanced economies from 1960-2013.

coreecon | Curriculum Open-access Resources in Economics 29 Just as the Phillips curve predicts, for most of the period, inflation and unemployment were negatively correlated: as unemployment rose, inflation fell and vice versa. But the entire Phillips curve shifted upward during this period period, as a bargaining gap opened and expected inflation increased. Look at the shaded part of Figure 17.16: inflation and unemployment rose together, giving this period its name. 17.7 AFTER STAGFLATION: THE FRUITS OF A NEW POLICY REGIME The third major epoch during the last 100 years of capitalism began in 1979. Across the advanced economies, policymakers focused on restoring the conditions for investment and job creation. Expanding aggregate demand would not help: what would have been part of the solution during the Great Depression had now become part of the problem.

Arrangements based on accords between workers and employers continued in northern European and Scandinavian countries. Elsewhere, employers abandoned the accord, and policymakers turned to different institutional arrangements as the basis for restoring the incentives for firms to invest.

The new policies were called supply-side reforms, aimed to address the causes of the supply-side crisis of the 1970s. The policies were centred on the need to shift the balance of power between employer and worker in the labour market, and in the firm.

Government policy at this time achieved this goal in two main ways:

• Restrictive monetary and fiscal policy: Governments showed that they were prepared to allow unemployment to rise to unprecedented levels, weakening the position of workers and restoring the consistency of claims on output as the basis of modest and stable inflation.

• Shifting the wage curve down: As we saw in Unit 15, these policies included cuts in unemployment benefits and the introduction of legislation to reduce trade union power.

Figure 17.16 illustrates the new policy environment. Unemployment increased rapidly from 5% to 8% in the early 1980s. This was the price of restoring conditions for profit and investment, and for reducing inflation from greater than 10% to 4%. Policymakers were prepared to depress aggregate demand and tolerate high unemployment until inflation fell.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS 30 DISCUSS 17.2: WORKERS’ BARGAINING POWER After the Great Depression most advanced economies adopted policies that strengthened the bargaining power of employees and labour unions. After the golden age, by contrast, the policies weakened workers’ bargaining power.

1. Explain the reasons for these contrasting approaches.

2. With hindsight, do you think the economic logic behind each set of policies makes sense?

The increased unemployment beginning with the first oil price shock in 1973 had two effects:

• It reduced the bargaining gap in Figure 17.15, bringing down inflation (shown in Figure 17.16).

• It put labour unions and workers on the defensive as the cost of job loss rose and employees’ bargaining power eroded.

Figure 17.17 shows the development of productivity (output per hour) and real wages in manufacturing in the US from the beginning of the golden age. Index numbers are used for each series to highlight the growth of real wages relative to that of output per hour worked. Real wage growth in line with output per hour is not inevitable: in Unit 1, when looking at the growth of real wages in England since the 13th century, we saw that institutions (social movements, changes in the voting franchise and in laws) played a vital role in translating productivity growth into real wage growth.

The figure shows two dramatically different periods:

• Before 1973: Fair-shares bargaining meant that wages and productivity grew together.

• After 1973: Productivity growth was not shared with workers. For production workers in manufacturing, real wages barely changed in the 40 years after 1973.

By the mid-1990s, the effects of the new supply-side policy regime were becoming clear. The period from this time until the global financial crisis of 2008 was called the great moderation because inflation was low and stable, and unemployment was falling. Although wage growth fell well below productivity growth, policymakers no longer thought of this as a bug; it was a feature of the new regime. The third oil shock that occurred in the 2000s was a good test of the regime. As we saw in Unit 14, it created none of disruption of the two oil shocks in the 1970s. coreecon | Curriculum Open-access Resources in Economics 31 1949195719651973198119891997200520130 100 200 300 400 500 600 700 Index (1949=100) Golden ag e epoch:

1949-73; 1973-79 From st agflation to financial crisis epoch: 1979-2008; 2008-13 Productivity Real wages Figure 17.17 The Golden Age and its Aftermath: Real wages and output per production worker in manufacturing in the United States (1949-2013).

Source: US Bureau of Labor Statistics. Note: “production workers” exclude supervisory employees such as foremen and managers.

In virtually all of the advanced economies the new supply-side policies redistributed income from wages to profits. In the US (Figure 17.3) the after-tax profit rate gradually increased between the 1970s and 2008. But investment responded only weakly to the profit incentives, so that the rate of growth of the capital stock declined. The economy had settled at some point below the profit curve in Figure 17.15, with more than sufficient profits to motivate an expansion to the higher employment equilibrium, but with investment not fully responding.

Supply-side policy advisors could not recreate the improbable package of high employment, high investment and growing wages of the golden age. The growth of profits unmatched by investment in new equipment would also help to cause the next crisis.

UNIT 17 | THE GREAT DEPRESSION, THE GOLDEN AGE OF CAPITALISM AND THE GLOBAL FINANCIAL CRISIS