Forgotten lessons from the Great Stagflation

"We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candor that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step."

This was the confession of James Callaghan, prime minister of the United Kingdom, in a speech at the Labor Party conference in 1976. The Brits had discovered the ruinous consequences of Keynesian policies ahead of the United States, where Jimmy Carter was running for president that year on a promise to end the "Ford recession" with a fiscal stimulus.

When two more years of "priming the pump" failed to deliver the goods, the president became increasingly fatalistic. He blamed the economic hardships on the lack of confidence in his overly materialistic fellow Americans, noting that "for the first time in the history of this country, a majority of our people believe that the next five years will be worse that the past five."

Carter's chief domestic adviser, Stuart Eizenstat, later admitted that the administration had been "blind until it was too late to the rising level of inflation." While the Consumer Price Index was climbing into double digits it was pulling unemployment and interest rates behind it, increasing pessimism and suppressing productivity growth from 3 to 1 percent. Newsweek columnist R. Samuelson observed how inflation "seemed to envelope the future in a thick, impenetrable fog."

For nine years in a row (1973 to 1981), rising prices ranked as the number one concern in the country. Public opinion analysts Seymour Martin Lipset and William Schneider reported, "A high rate of inflation appears to lower the public expectations of the future in all respects."

Only after the monetarist policies of Federal Reserve Chairman Paul Volker and supply-side Reaganomics restored confidence and set the economy on a path of sustained growth for the next 25 years did Americans realize that the "malaise" was not the consequence of imperialist blunders (a lost war in Vietnam or Arab oil embargoes). The real problem was irresponsible domestic fiscal and monetary policies based on flawed theory imported from England. Keynesian econometricians had failed to engineer the full-employment utopia.

The question is: When the financial earthquake of 2008 shook our confidence in the safety of real estate investments, why did we run to the discredited idea of "pump priming" for comfort? British historian Niall Ferguson offers an explanation. The reason this administration picked the wrong tools to get out of the last major recession is the same reason investors picked the wrong strategies in the years leading to the housing bust. Like most Wall Street CEOs, Barack Obama is too young to have any useful first-hand memories of the previous big crisis. His supporters, including economist Paul Krugman, have no interest in an objective investigation of the history of "stimulus" economics. The alpha dogs in our banking system have not studied earlier financial bubbles. Neither has the current occupant of the White House taken time to examine the failures of Keynesian policies around the world and America's Great Stagflation. More on this dreadful mix of ignorance and complacency next week.