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The 'New Economists' and the Great Depression of the 1970s

May 7, 2004Mark Thornton

Tags The FedU.S. EconomyU.S. HistoryFiscal Theory

During the 1960s when Keynesian economics came to truly dominant the economics profession, there was a large influx of these "new economists" into government. The disastrous results included the "keynesianisation" of the economy and what is best described as an economic depression lasted throughout the 1970s and into the early 1980s.

Like the 1920s and 1990s, the decade of the 1960s was a period of remarkable prosperity in the U.S. as measured by such statistics as GNP and the unemployment rate. While the 1950s included several periods of stagnation and recession, the following decade was a period of nearly unblemished prosperity. The economy grew at a brisk pace and employment and wages grew at good rates. America was able to fight the Cold War, the Vietnam War, the war against poverty, and win the space race, simultaneously. The only noticeable negative effect was a mild uptick in price inflation.

Credit for the expansion was given to two primary factors. The first factor was scientific management of the economy by the "new economists"1 who were brought to Washington to help fine-tune the economy with fiscal and monetary policy. The second factor was the new technology that was introduced into the economy, particularly computer technology, consumer electronics, and technological advances related to space exploration.

Academic economist Arthur Okun was a prominent member of President Johnson’s Council of Economic Advisors. Right before the crash he described the economic expansion as "unparalleled, unprecedented, and uninterrupted." Okun believed that the economy was on a new "dramatic departure" from the past:

The persistence of prosperity has been the outstanding fact of American economic history of the 1960s. The absence of recession for nearly nine years marks a discrete and dramatic departure from the traditional performance of the American economy.2

​After declaring the business cycle dead, he went on to demonstrate that research on the business cycle was now a thing of the past and that a "new" approach to the economy had replaced it. In fact, he even took the dangerous step of ridiculing those who stubbornly stuck to the old economics, where business cycles were viewed as an inevitable feature of the market economy and that recession could even be placed in the positive role of correcting past excesses.

When recessions were a regular feature of the economic environment, they were often viewed as inevitable. Indeed, the Doctor Panglosses saw them as contributors to the health of our best of all possible economies, correcting for the excesses of the boom, purging the poisons out of our productive and financial systems, and restoring vigor for new advances. And the latter-day Machiavellis saw potentially great political significance in the timing of turning points. They spun out fantasies, suggesting or suspecting—depending upon whether their party was in or out of office—that the business cycle would be controlled so that the inevitable recession would come between elections and would be replaced by a vigorous economic recovery during the campaign period.3

He confidently declared that the death of the business cycle is "proof par excellence" that economic controversies can be solved. How was the business cycle killed? Okun found that the slayer was not new theories or policy tools, but simply a more confident and scientifically rigorous implementation of existing tools that resulted in the efficient scientific management of the economy.

More vigorous and more consistent application of the tools of economic policy contributed to the obsolescence of the business cycle pattern and the refutation of the stagnation myths. The reformed strategy of economic policy did not rest on any new theory.4

For Okun, the New Deal had employed fiscal stimulus of the economy a la Keynesian economics. He considered those experiments successful and as far as he was concerned they provided evidence of the success of countercyclical fiscal policy. In his view, the much older "fiscal religion" of limiting the size of government and keeping its budget in balance was based mostly on myth and superstition. Overthrowing the superstitions of the past and embracing scientific management of the economy had allowed economists to fully grasp and subdue the business cycle. "The activist strategy was the key that unlocked the door to sustained expansion in the 1960s." All remaining errors could be dealt with by fine-tuning of the activist strategy.5

It was unfortunate for Okun that the publication of his book was not delayed because an economic recession began the following month. Civilian unemployment increased from well below 4% to just over 6% by the end of 1970. The rate then retreated to 5% in 1973 only to skyrocket to 9% by mid-1975—the highest rate since the Great Depression. The unemployment rate remained above the normal level of 5% for the next two decades, including ten double-digit months during 1982-83. 

The experiments of the new economists also resulted in higher price inflation, as would be expected from the "stimulating" fiscal and monetary policy of the 1960s. From the beginning of 1946 to the beginning of 1965 the consumer price index increased by 71.4%, but then increased 20% by the end of the decade. From 1965—when the experiment began in earnest—to the end of 1980 the CPI increased by 176.6%. The experiment had tripled the rate of inflation experienced by consumers.

More importantly, revolutionary changes occurred in money and banking. The U.S. Treasury stopped issuing silver coins in 1964 and Gresham’s Law insured that Americans were soon using nothing but clad coins that only looked like the old silver coins. Silver certificate notes were recalled in 1968 and replaced by Federal Reserve notes. In August of 1971, Nixon initiated a "new economic policy" that closed the international gold window. The U.S. had printed too much money during the 1960s and had caused a "run" on the dollar by foreign central banks who sought to cash in their dollar holdings for gold. Despite his promises to the contrary, Nixon also instituted comprehensive wage and price controls in an attempt to block the rising price inflation before his reelection campaign. The Bretton Woods system, where currencies had fixed values in terms of gold, inevitably collapsed. Thus the last links between gold and U.S. money were broken and a completely fiat money was established.

The bubble of the 1960s and subsequent collapse have been well chronicled by John Brooks in his book, The Go-Go Years. The "go-go 60s" refers to the market for technology stocks during the 1960s when the "Nifty Fifty" emerged as a list of "one decision" stocks that could be bought and held forever. This list of stocks included Coca-Cola and IBM as well as troubled companies of today, such as Xerox and Polaroid. Like the investment trusts of the 1920s, mutual funds were touted as the fastest path to riches for the common man. As the bubble expanded, investment gurus such as Gerald Tsai used aggressive investment techniques to generate huge increases in the value of their mutual fund shares, while others made millions building the conglomerate corporations that spanned many industries and nations.

Brooks well captured the euphoria that emanated from this new-era stock market: "As mutual-fund asset values went up, new money poured in. Tsai and others like him seemed to have invented a money-making machine for anyone with a few hundred or several thousands of dollars to invest."6 He even labeled Tsai "the first big-name star of the new era."7 Unfortunately, Brooks was unable to properly diagnose the cause of the mania, attributing it largely to greed and irrationality.

Where were the counsels of restraint, not to say common sense, in both Washington and on Wall Street? The answer seems to lie in the conclusion that in America, with its deeply imprinted business ethic, no inherent stabilizer, moral or practical, is sufficiently strong in and of itself to support the turning away of new business when competitors are taking it on. As a people, we would rather face chaos making potsfull of short-term money than maintain long-term order and sanity by profiting less.8

Brooks is correct to note that "man’s apparent capacity to learn from experience is an illusion." Man is able to benefit from experience, but our collective ability to learn and pass knowledge on to future generations depends on our ability to formulate correct theories regarding our experiences. Like many others, Brooks seems oblivious to the role of economic theory.

However, Brooks is correct and quite methodical in showing the similarities between the 1920s and the 1960s. In each case there was a new era and a new way of economic thinking. Both episodes had their investment stars that fell to disgrace and cases of corruption and malfeasance that led, after the fact, to attempts at reform via legislation. At the heart of both eras—the vehicle of mania and deception—was technology. By presenting his history of Wall Street, Brooks was able to show that the initial collapse in the market was actually much worse than the Dow index indicated (many of the best-performing stocks of the decade were not in the Dow index) and spelled trouble for the many years to come.

A better indication is to be found in the fact that in May 1970, a portfolio consisting of one share of every stock listed on the Big Board was worth just about half of what it would have been worth at the start of 1969. The high flyers that had led the market of 1967 and 1968—conglomerates, computer leasers, far-out electronics companies, franchisers—were precipitously down from their peaks. Nor were they down 25 percent, like the Dow, but 80, 90, or 95 percent. This was vintage 1929 stuff, and the prospect of another great depression, this one induced as much by despair as by economic factors as such, was a very real one.9

The stock market as measured by the Dow did decrease 25% between 1969 and 1971 and then (after the publication of Brooks’ book) lost another 20% by mid-1975. However, the real losses in the stock market were larger and longer lasting than an ordinary chart of the Dow might suggest. In the graph below, the Dow index shows that stocks tended to trade in a wide channel for much of the period between 1965 and 1984. However, if you adjust the value of stocks by price inflation as measure by the Consumer Price Index, a clearer and more disturbing picture emerges. The inflation-adjusted or real purchasing power measure of the Dow indicates that it lost nearly 80% of its peak value. When Brooks drew out the similarities between 1929 and 1969, he stops short of declaring a second great depression. However, this graph indicates that the economic pain of the 1970s and early 1980s may have more closely resembled that of the Great Depression of the 1930s than previously thought.

The decade that began with recession and the abandoning of the gold monetary system saw the emergence of stagflation (stagnation + inflation) and ended with the coining of the "misery index" (inflation rate + unemployment rate) by presidential candidate Ronald Reagan. While not recognized in the statistical senses as a decade of depression, and certainly not as a great depression, the decade was nonetheless a period of economic gloom and despair that was compounded by Watergate and defeat in Vietnam.

Also, the statistical evidence clearly demonstrates that the 1970s was a turning point, in the wrong direction, for the American economy. Gold was abandoned, prices increased, and the dollar rapidly depreciated. Unemployment and underemployment increased, and both the duration of unemployment and the unemployment rate set post-WWII highs in the early 1980s. The federal government abandoned a long standing tradition of balanced budgets for the current regime of ever-increasing deficits and escalating national debt while the personal saving rate of Americans, which had been on an increasing trend, flattened out and began its current declining trend toward a zero savings rate. It was the 1970s when the trade balance first destabilized and then began the trend of escalating trade deficits (naturally when the people are saving less and the government is borrowing more, the new loans have to come from foreigners).

All of these problems were not due to the laziness of the American people. Females moved into the workforce in record numbers and the two-income family was established, mostly to try and maintain their standards of living. Unfortunately, the 1960s and 1970s were two decades when government employment expanded the most, so that much of this increased labor effort produced little of value. Working for government can even be on net negative for the economy in that government employees can do actual harm to the production of useful goods and services. Economists in the service of the state are a good example of that.

  • 1. As labeled by Okun (1970, p. 57).
  • 2. Okun, p. 31.
  • 3. Okun (1970, p. 32).
  • 4. Okun, p. 37.
  • 5. Okun, p. 43.
  • 6. Brooks, p. 139.
  • 7. Brooks, p. 137.
  • 8. Brooks, p. 187.
  • 9. Brooks, p. 4.
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