In the 19th century, before liberalism became the unmentionable "L" word, it used to denote an economic ideology that was rather like Reaganomics. Defending the inalienable right of citizens to own property and the freedom to enter contracts, classical liberals wanted the government to stay out of private enterprise and the market.
Even though it originated in Great Britain, economic liberalism found a responsive audience in the United States, a country founded on the then-novel idea of limited government. In the 19th century, liberalism proved highly successful in spurring economic development in the early stages of capitalism. Guided by liberal principles, the United States, Britain and Northern and Central Europe experienced rapid economic growth and industrialization in the run-up to World War I.
But unbridled capitalism, while extremely efficient, had its flaws. It created excessive cyclical volatility and, therefore, social dislocations. Left to their own devices, industrialists and captains of industry tended to get giddy in good times, over-investing and over-expanding and then precipitously going bust. Periods of rapid growth before World War I alternated with steep corrections, or depressions as they were then known.
In addition, capitalism, when run on liberal principles, entailed enormous income disparities and low wages. Laissez-faire economists believed that higher wages only encouraged workers to have larger families and did nothing to pull them out of poverty. Low wages not only stoked class warfare, encouraged growth of socialist movements and triggered frequent riots and revolutions, but it began to harm capitalism once industry adopted mass-production methods. In an increasingly competitive environment, profit margins decreased and producers needed vast markets to increase volumes. Without higher wages and disposable income, a growing supply of goods and services threatened to overwhelm demand.
This was the problem faced by Henry Ford, who in 1914 more than doubled the daily wage of his workers, to $5. Other employers were forced to follow suit and, as a consequence, demand for Ford vehicles increased. While this could be seen as an example of market self-regulation, in truth it can only work in a restricted market. In a free market, another producer could pay workers half as much and sell his cars to Ford workers for half the price. That was how Japanese carmakers nearly put their Detroit competitors into bankruptcy in the 1970s.
After the experience of the Great Depression, it became accepted wisdom that business needed government guidance to avoid similar debacles. The New Deal in the United States and welfare states in Europe regulated business both directly and by means of active monetary policy. The job of the central banks was, to paraphrase one former Fed chairman, to make sure that businesses and consumers don't party too hard during good times, hiking interest rates to prevent economic overheating and irrational exuberance in financial markets.
In addition, the government played a key role in sustaining aggregate demand in the economy. It taxed individuals and businesses and redistributed wealth to the poor, who tend to spend a far larger share of every extra dollar of income. Governments in the industrial world got themselves into the business of paying pensions, stipends, subsidies, unemployment insurance, etc. Governments also came down on the side of trade unions, supporting their demands for higher pay and legislating minimum wages. Finally, governments themselves expanded, becoming major employers and consumers of goods and services.
Classical liberalism was replaced with Keynesian economics, which promised fool-proof tools for fine-tuning the economy and ensuring stable growth with only mild recessions. Such claims seemed to be vindicated by the prosperity of the 1950s and 1960s, generating great respect for economics. In 1968, it became grouped with hard sciences when the Nobel Prize in economics was established.
But Keynes proved no panacea -- far from it. By the early 1970s, Western economies began to lose momentum. Regulation reduced competition and stifled innovation. High wages and union contracts stunted productivity and spurred inflation. Taxes sapped private initiative, whereas taxpayer money was usually misspent by government agencies. Businesses became bureaucratized and choked by superfluous layers of management. When faced with the Arab oil embargo in 1973, this ungainly structure responded by sinking into stagflation, a hitherto unimaginable combination of no growth and rising prices.
Reaganomics to the Rescue
The pendulum swung back in the 1980s. In the United States, three straight Republican Administrations enacted market reforms, cut taxes and eased regulatory burdens -- policies that were mirrored in Britain by Margaret Thatcher. The new business climate was first felt in financial markets and the financial services industry, where the groundwork for two decades of robust economic growth was originally laid.
In the early 1990s, the U.S. economy went through a short, sharp retooling recession, when companies slashed costs, eliminated layers of management and emerged ready to compete. The success of pro-business policies caused even the Democrats in the United States and the Labor Party in Britain to change. Bill Clinton's eight years in the White House were, on balance, the continuation of the pro-business policies of his predecessors. Alan Greenspan, a Reagan appointee, continued to provide laissez-faire economic supervision at the Fed.
The contrast between government-directed and private sector-driven growth has been stark. To be sure, technological development took place in the early postwar decades, too, with the space program and the development of the computer as prime examples. But, partnership between the government and large industrial behemoths was ponderous, and commercial applications of new products were slow. Contrast this with the breakneck pace of innovation, new products and new global brands that have popped up since the early 1990s. Competition intensified and prices were pushed lower as capitalism spread its reach around the globe in search of cheaper production venues and new markets.
However, even in the early 1990s, the same challenges that faced Henry Ford nearly a century ago became apparent. While supply could be increased at will, demand didn't always follow. In a global economy labor is plentiful, and companies can relocate easily in search of lower production costs, keeping average wages under downward pressure. Inflation stayed low, but served as an alarm bell, an early signal that supply was outstripping demand.
The United States provided the only global source of demand, but at the cost of going deep into debt. During the 1990s Internet boom, households leveraged their appreciating stock portfolios and, when that bubble burst, they shifted to their homes. By the end, leveraging became the rule throughout the U.S. economy, and sophisticated credit markets allowed consumers and businesses to monetize any asset, converting even their future value into cash in hand.
However, Reaganomics was not classical liberalism. It freed up business, but its talk of smaller government never translated into action. On the contrary, government involvement in the economy continued to grow, even accelerating under the pro-business Bush Administration. Over the past decade, for example, government jobs rose from 15 percent of payroll employment to 16.6 percent. Layoffs since the start of the recession, measuring close to 4 million people, hit only the private sector, boosting the proportion of government employment further.
Add to this a growing number of government dependents -- military personnel, civilian and military contractors, lawyers and lobbyists, and an army of retirees and medical professionals paid by Medicare. Government consumption jumped from 17.2 percent of GDP in 1998 to 20.4 percent just before the advent of the crisis.
This should be kept in mind in the ongoing debate about boosting government spending to stimulate the flagging U.S. economy. It is not only that a government-dominated economy is likely to be ponderous and inefficient. More troubling, the government has been a full participant in the debt-finance excesses of the recent past. While the financial services industry is being restructured and consumers are curbing consumption, boosting savings and repaying debt, an increase in government spending could end up perpetuating the credit bubble that got us into trouble in the first place.
Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at email@example.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past five years, 2004-2008.