Edward Lotterman

Many times knowledge of history is as useful to understanding economic situations as economics itself.

We are in dangerous waters right now in terms of our politics, our economy and the international situation. Yet we are gripped in an intellectual malaise in which we ignore problems looming in all our faces.

Congress is broken and no one talks of fixing it. Economic inequality in the U.S. and the world is at levels not seen for a century.

A wealthy class wields political and economic power not seen since the 1890s. Moreover, against all theory and history, some in politics, or who follow politics, believe that the Federal Reserve can and should solve all U.S. economic ills.

For insights from history, consider Barbara Tuchman’s “The Proud Tower,” a book about the recklessness, fecklessness and willful blindness to looming perils in the 25 years leading up to World War I. The similarities to our day are enormous. We too are reckless, feckless, sharply divided, blind to enormous problems and both unwilling and apparently unable to act.

The reaction of markets, pundits, politicians and the public to economic hews in recent weeks exemplifies the problem.

Labor market indicators for July released this month showed lower growth in jobs than before and an uptick in the unemployment rate. Stock markets fell globally and there were strident calls for the Fed to loosen the money supply to lower interest rates. Two days before that data were released, the Fed had met and left interest rates unchanged at the highest they’ve been since 2008. Pundits immediately pounced, complaining that the Fed blew it, waited too long to ease, and thus now risked a U.S. recession.

Market indexes have since recovered.

The real value of all economic output, measured by real Gross Domestic Product, grew at a 2.8% annual rate in the April to June quarter. That growth was twice the prior quarter and above the two-decade average of 2% annually from 2000 to 2020. And last week, consumer inflation numbers were released. The July Consumer Price Index was 0.155% above June. That one-month change cumulates to 1.9% over 12 months. Compared to July 2023, prices were up 2.9%. So, it seemed, we would achieve a “soft landing” with tamed inflation and no recession.

Markets and pundits again went wild! Inflation was slowing so interest rates must fall! The “head of global investment strategy” at a major bank called for a half-percent cut in the next Fed policy meeting four weeks from now and additional ones on the other two meetings remaining this year. Stocks would soar, he predicted. One news article summarizing his remarks was headlined: “Stocks will embark on a run of gains unseen in 30 years.”

Never mind that the market has largely priced in an expected September rate cut. If the Fed doesn’t act as expected, can we expect a 30-year selloff?

Friends, this is madness and willful blindness. That these views are so widely held reflect failings of economists to educate the business community much less the press and general public. This will have high cost. Such madness also comes from two decades of desperate “terrible-but-better-than-the-alternative” Fed interventions when faced with crises. What was abnormal if not self-destructive a generation ago has become the norm.

There is historical context for our current dilemmas.

From the 1600s to the late 1700s, economists thought government should play a large role in economic activity. That reversed sharply with the publication of Scottish philosopher Adam Smith’s 1776 opus “The Wealth of Nations,” and for decades the prevailing wisdom was for minimal government “interference” in markets.

Then, in the face of an unprecedented worldwide Great Depression in the 1930s, British economist John Maynard Keynes made a convincing argument for government action to reduce destructive swings from boom to bust and back again, with high inflation at the boom end and high unemployment in busts.

The philosophical pendulum has swung in different directions since, towards more or less government interference in markets, depending on the dominant economic theory du jour as adopted by — and adapted to — the political philosophies of those in power.

The constant, with some exceptions, had been the role of the central bank, the Federal Reserve. In the face of recession, slow and negative growth and rising unemployment, it should increase the money supply and lower interest rates, thus reducing the cost of doing business and stimulating the economy. But when rapid growth stimulates inflation, it should crimp down on available money and thus raise rates. This apparent wisdom was accepted by all, Democrats eagerly and Republicans grudgingly.

The world economy boomed for a quarter-century after World War II. These were glorious and miraculous three-decade periods of unprecedented growth, recovering both from Depression and wartime destruction and raising living standards to levels never dreamed of. France had its “trente glorieuses” and Germany its Wirtschaftswunder. Japan, Taiwan, South Korea, Hong Kong and Singapore leapt from poverty to prosperity in one generation. Brazil and Iran seemed on the path also.

But the party came to an end in the mid-1970s. Despite Keynesian “stabilizing,” alternately pressing and relaxing pedals on taxing, spending, money supply and interest rates, all major world economies began to experience “stagflation,” a period low output plus high unemployment with high inflation — conditions that, under Keynes’ thought, were not supposed to exist at the same time.

Keynesian theory seemed a dead end. A new generation of economists forged an intellectually coherent refutation of Keynes. Proud to claim the title of “New Classical Economies,” these new theories reflected a return to the 19th century prescription of minimal government management of economies. Not all in the discipline agreed, but even skeptics saw that micromanagement often led to disaster. After harsh adjustments under Margaret Thatcher in the United Kingdom and Ronald Reagan in our nation, and a period of exceptionally high interest rates, the 1990s were prosperous.

After moderate and prudent tax increases requested by Presidents George H.W. Bush and Bill Clinton, the U.S. had four fiscal years with budget surpluses. These were modest and dependent on a fall in defense spending after the Berlin Wall collapsed, but if projected with a ruler, the U.S. national debt might be zero by 2012.

Then we threw it all away. The self-harming tax cuts of 2001 and 2003 combined with the attacks on 9/11 returning defense spending to Cold War levels and the Fed opening money taps and lowering its target interest rate from 6% to 1%.

Then, after a self-inflicted mortgage crisis exploded in late 2007, the Fed dropped its target rate to zero and kept it there for five years. This was unprecedented in the history of central banking. Fed policy makers then inched up half-way to long term averages. Then COVID broke and the money supply grew 39% from March 2020 to May 2022.

Again there was no precedent for this in our nation’s history. Yes, it was a good faith effort in a pandemic unseen for a century. But it did cause a 19% rise in consumer prices over 18 months.

And this is where we are today: stuck in the delusion that anything that happens in the economy is pinned to the Fed — credit when times are good, blame when things go bad.

Central banks can provide stable prices and keep financial crises from turning into collapse. That is all. They have only one policy instrument, the money supply, and that shows up in sundry interest rates. It is madness to expect it to maintain ballooning stock prices. It is madness to expect that we can somehow avoid bipartisan political action to deal with federal finances. It is madness to expect the Fed to cure youth unemployment or monopoly power or poverty or regional economic decline.

The money supply remains unprecedentedly higher than it was four years ago. It and stock indexes remain unprecedentedly high relative to the real value of what we produce. Yes, target rates are higher than averages for the last 25 years, but those were a quarter century of much folly. They remain in the range that prevailed over a half century of greater prudence.

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St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.