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.
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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