The impact of the Great Depression on economic policies

The Great Depression, starting in 1929 in the US and spreading globally, involved declining production, falling prices, and widespread job losses that continued into the late 1930s. This period highlighted flaws in existing economic strategies and led to shifts in government approaches worldwide.

Effects of the Great Depression on UK policy

As the downturn affected Britain, income from taxes dropped while expenses for jobless support increased, creating pressure for a growing budget shortfall. Influenced by classical economics, which prioritised a balanced budget, the government adopted contractionary fiscal measures, including reductions in public wages and benefits for the unemployed.

Impact of these policies:

• These actions worsened the situation, with joblessness continuing to climb and the economy remaining in decline.
• Monetary policy was also restrictive due to participation in the Gold Standard, a system where money could be exchanged for a set quantity of gold, limiting the currency supply and preventing measures like increasing money availability or reducing interest rates.
• Fixed exchange rates under the Gold Standard kept the pound at a high value, making British goods less attractive abroad.

Path to recovery:

• Recovery started after Britain exited the Gold Standard in 1931, allowing interest rate cuts and currency devaluation.
• This encouraged spending and investment, such as in housing construction that generated employment.
• Rising military expenditure, prompted by events in Europe, further supported expansion.

Policies during the Great Depression in the US

Under President Hoover, strategies followed a hands-off approach, relying on market forces with limited state involvement. Taxes were typically low to promote business investment and consumer purchases, but as revenues declined, they were raised to prevent a budget deficit, similar to UK actions. Criticism grew as the government failed to assist those without work or in poverty.

In 1932, President Roosevelt introduced the New Deal, shifting to interventionist measures with increased state funding for job creation and major public works. These initiatives lowered joblessness and hardship, though unemployment rose again later in the decade before dropping due to wartime defence outlays.

The US faced comparable Gold Standard issues, with improvement seen after leaving it in 1933.

The rise of Keynesian fiscal policy in the mid-20th century

Experiences from the Great Depression boosted support for ideas from economist John Maynard Keynes, who suggested that state expenditure could revive economies during slumps.

Features of Keynesian demand management

• Governments adjusted spending and taxes to regulate economic expansion, aiming to stabilise cycles.
• In Britain, the focus was on achieving low unemployment, using fiscal tools to influence overall demand.
• This connected to the multiplier effect, where state outlays generate a larger rise in overall income.
• The 1950s and 1960s saw consistent growth, near-full employment, and controlled price rises, with milder fluctuations than before.

Keynesian versus classical views on economic adjustment

Different economic schools hold varying opinions on how economies respond to disruptions and the need for government action.

Keynesian perspective on economic recovery

• Keynesians argue for state involvement to approach maximum employment and capacity, as seen on the upright section of their long-run aggregate supply curve.
• They believe recoveries from demand drops, like recessions, are slow due to gradual changes in wages and prices, leaving the economy underperforming without intervention to increase demand.

Classical and monetarist perspectives on economic recovery

• Classical thinkers, including monetarists, view the economy as typically operating at peak capacity and employment without help, aligned with their vertical long-run aggregate supply curve.
• They suggest quick rebounds from demand falls because wages and prices adapt easily.

Reasons for questioning Keynesian policies in the 1970s

By the late 1960s, rising prices and economic instability in Britain challenged Keynesian methods.

Economic challenges in the 1970s

• Price increases accelerated, driven by surging energy costs (oil prices tripled between 1973 and 1974) and wage pressures, reaching 25% inflation by 1975.
• A downturn occurred in 1973-1974, with sharp rises in joblessness.
• This stagflation contradicted the Phillips curve idea of trading higher prices for low unemployment, leading to doubts about demand-focused strategies.

Criticisms of demand-side fiscal policy

• The spending multiplier is limited, as outlays funded by taxes remove funds from circulation.
• State spending can displace private activity, reducing innovation.
• Ongoing borrowing for expenditure risks higher prices, budget shortfalls, and growing national debt.
• Precise control is challenging, needing exact data; errors can cause alternating booms and busts.
• Focusing only on demand creates tensions among key goals like growth, low unemployment, stable prices, and trade balance.

For instance, stimulatory policies might cause overheating and high inflation, prompting restrictive measures that trigger slumps.

Modern uses of fiscal policy and responses to the 2008 financial crisis

Since the 1970s, fiscal approaches have shifted from pure demand management, though elements returned during major crises.

Contemporary applications of fiscal policy

• Supply-side measures boost overall supply, aiding all main objectives, such as tax reductions for new ventures to expand capacity.
• Micro-level tools influence actions, like taxing harmful goods to cut use or subsidising beneficial ones to increase it.
• Environmental goals are supported, e.g., taxes on fossil fuels or aid for green energy.
• Targeted spending helps struggling areas, like investing in regions with job losses to create employment or attract firms via incentives.
• Graduated taxes redistribute income from wealthier to poorer groups.

Policy responses to the 2008 financial crisis in the UK

Stimulatory measures:

• Stimulatory fiscal actions included a short-term VAT reduction from 17.5% to 15% to encourage purchases and advancing infrastructure projects to lift income.
• Automatic mechanisms, like higher welfare payments, also increased outlays.
• Monetary steps lowered the base rate to 0.5% and used quantitative easing.
• Unlike the Great Depression, banks were rescued with public funds to avoid collapses and maintain money flow.

Results and subsequent policies:

• These helped limit the downturn, but led to large deficits and debt.
• Post-crisis, policy turned restrictive with spending cuts and a VAT rise to 20%, contributing to slower growth from 2010-2012 alongside factors like energy price hikes.

Policy responses to the 2008 financial crisis in the US

• Similar initial actions reduced rates, used quantitative easing, and funded banks and industries like vehicles.
• Stimulatory policies were withdrawn more gradually than in Britain.
• This may have aided faster recovery, though other elements like less EU exposure and milder oil price rises played a role.