In developing an economic policy, government officials rely on the recommendations of economists who typically base their analyses on theories of how the economy works or should work. As might be expected, economists often disagree on the cause of a stock market decline or the best solution for curbing inflation.
The first, and for a long time the only, widely accepted economic theory was the laissez-faire theory proposed by Adam Smith in his Wealth of Nations (1776). Laissez-faire roughly translates as "to leave alone," and it means that government should not interfere in the economy. This theory favors low taxes and free trade, and it strongly holds that the market is self-adjusting — whatever happens will be corrected over time without the help of the government.
Keynesian economic theory
John Maynard Keynes, an English economist, published his General Theory of Employment, Interest, and Money (1936) during the Depression. He argued that government should manipulate the economy to reverse the periodic downturns that take place in the market.
Keynes maintained that economic depression was due to a lack of consumer demand. This created excess inventories of goods that forced business to cut production and lay off workers, which led to fewer consumers and even lower demand. The solution was to increase demand by increasing government spending and cutting taxes. This fiscal policy, as it became known, left people with more money after taxes and basic obligations to use for goods and services. Factories increased production to meet the demand and hired more workers.
Franklin Roosevelt used many of Keynes's ideas in the New Deal. The federal government became the "employer of last resort" through such programs as the Civilian Conservation Corps (CCC) and the Works Progress Administration (WPA). These programs did not bring the country out of the Depression, however. The end to the Depression is more attributable to increased defense spending as World War II approached.
In the late 1970s and early 1980s, Keynesian economics fell into disrepute because it did not offer a solution for dealing with unemployment and inflation at the same time. Some economists argued that the Keynesian theory invited excessive government intervention. To monetarists, inflation, unemployment, and stagnation were caused by policies that adversely affected an otherwise stable economy. Led by economist Milton Friedman, they argued that the best way to create a healthy economy is to control the supply of money. The machinery to implement this policy already existed in the Federal Reserve system, which was established in 1913.
The Federal Reserve system consists of 12 banks under a board of governors whose members serve staggered 14-year terms. This long term frees the board from the political influence of any one administration. The Federal Reserve Board controls the supply of money by buying and selling federal government securities, regulating how much money Federal Reserve banks have on deposit, and setting interest rates that member banks pay when they borrow from the Federal Reserve. The purpose is either to stimulate the economy by loosening the money supply or cool it down by tightening the money supply. In other words, the "Fed" lowers interest rates when the economy is sluggish and raises rates when inflation threatens.
Another economic problem of the late 1970s was exploding budget deficits. Because the budget is part of fiscal policy, not monetary policy, monetarism did not speak to this problem directly. Another group, called supply-side economists, offered the surprising suggestion that government could raise more money by cutting taxes. Their argument was fairly straightforward: High taxes were limiting national productivity, so lowering taxes would stimulate economic growth and eventually produce more revenue. The Reagan administration accepted this approach, so much so that supply-side economics became Reaganomics.
Two problems compromised the success of supply-side policies. The Reagan administration increased defense spending dramatically (something the theory did not take into account). Increased expenses combined with the tax cuts to produce a massive budget deficit. Moreover, much of the economic windfall went to buy products manufactured in foreign countries, and so provided little direct stimulus to the U.S. economy. Budget deficits grew even more, and unemployment remained (at least temporarily) high.