We Americans turn every major crisis into a morality tale in which the good guys and the bad guys are identified and praised or vilified accordingly. There’s a political, journalistic, and intellectual imperative to find out who caused the crisis, who can be blamed, and who can be indicted (either in legal courts or the court of public opinion) and, if found guilty, be jailed or publicly humbled. The great economic and financial crisis that began in 2007 has been no exception. It has stimulated an outpouring of books, articles, and studies that describe what happened: the making of the housing bubble, the explosion of complex mortgage-backed securities, the ethical and legal shortcuts used to justify dubious but profitable behavior. This extended inquest has produced a long list of possible villains: greedy mortgage brokers and investment bankers, inept government regulators, naive economists, self-serving politicians. What it hasn't done is explain why all this happened.

The story has been all about crime and punishment when it should have been about boom and bust. The boom did not begin with the rise of home prices, as is usually asserted. It began instead with the suppression of double-digit inflation in the early 1980s, an event that unleashed a quarter-century of what seemed to be steady and dependable prosperity. There were only two recessions, both of them short and mild. Unemployment peaked at 7.8 percent. As inflation fell, interest rates followed. The stock market soared. From 1979 to 1999, stock values rose 14-fold. Housing prices climbed, though less spectacularly. Enriched, Americans borrowed and spent more. But what started as a justifiable response to good economic news—lower inflation—slowly evolved into corrupting overconfidence, the catalyst for the reckless borrowing, overspending, financial speculation, and regulatory lapses that caused the bust.

In some ways, the boom-bust story is both more innocent and more disturbing than the standard explanations of blundering and wrongdoing. It does not excuse the financial excesses, policy mistakes, economic miscalculations, deceits, and crimes that contributed to the collapse. But it does provide a broader explanation and a context. People were conditioned by a quarter-century of good economic times to believe that we had moved into a new era of reliable economic growth. Homeowners, investors, bankers, and economists all suspended disbelief. Their heady assumptions fostered a get-rich-quick climate in which wishful thinking, exploitation, and illegality flourished. People took shortcuts and thought they would get away with them. In this sense, the story is more understandable and innocent than the standard tale of calculated greed and dishonesty.

But the story is also more disturbing in that it batters our faith that modern economics—whether of the Left or Right—can protect us against great instability and insecurity. The financial panic and subsequent Great Recession have demonstrated that the advances in economic management and financial understanding that supposedly protected us from violent business cycles—ruling out another Great Depression—were oversold, exposing us to larger economic reversals than we thought possible. It’s true that we've so far avoided another depression, but it was a close call, and the fact that all the standard weapons (low interest rates, huge government budget deficits) have already been deployed leaves open the disquieting question of what would happen if the economic system again lurched violently into reverse. The economic theorems and tools that we thought could forewarn and protect us are more primitive than we imagined. We have not traveled so far from the panic-prone economies of 1857, 1893, and 1907 as we supposed.

Our experience since 2007 has also revealed a huge contradiction at the center of our politics. Prosperity is almost everyone’s goal, but too much prosperity enjoyed for too long tends to destroy itself. It seems that periodic recessions and burst bubbles—at least those of modest proportions—serve a social purpose by reminding people of economic and financial hazards and by rewarding prudence. Milder setbacks may avert less frequent but larger and more damaging convulsions—such as the one we’re now experiencing—that shake the country’s very political and social foundations. But hardly anyone wants to admit this publicly. What politician is going to campaign on the slogan, “More Recessions, Please”?

In a more honest telling of the story, avaricious Wall Street types, fumbling government regulators, and clueless economists become supporting players in a larger tragedy that is not mainly of their making. If you ask who did make it, the most honest answer is: We all did. Put differently, the widely shared quest for ever-improving prosperity contributed to the conditions that led to the financial and economic collapse. Our economic technocrats as well as our politicians and the general public constantly strive for expansions that last longer, unemployment that falls lower, economic growth that increases faster. Americans crave booms, which bring on busts. That is the unspoken contradiction.

Naturally, it’s unwelcome and unacknowledged. What we want to hear is that we were victimized and that, once the bad actors and practices are purged, we can resume the pursuit of uninterrupted and greater prosperity. So that’s what most crisis postmortems aim to do. They tell us who’s to blame and what we must accomplish to resume the quest for ever greater prosperity. Good policies will replace bad. To simplify only slightly, the theories of the crisis break into two camps—one from the Left, one from the Right.

From the Left, the explanation is greed, deregulation, misaligned pay incentives, and a mindless devotion to “free markets” and “efficient markets” theory. The result, it’s said, was an orgy of risk taking, unrestrained either by self-imposed prudence or sensible government oversight. Mortgage brokers and others relaxed lending standards for home mortgages because they were not holding them but passing them on to investment bankers, who packaged them in increasingly arcane securities, which were then bought by other investment entities (pension funds, hedge funds, foreign banks). These investors were in turn reassured because the securities had received high ratings from agencies such as Moody’s, Standard & Poor’s, and Fitch. All along the financial supply chain, people had incentives to minimize or ignore risks because the volume of loans, securitizations, or ratings determined their compensation. The more they ignored risk, the more they earned. The result was a mountain of bad debt that had to collapse, to the great peril of the entire financial system and the economy.

The Right’s critique blames the crisis mainly on government, which, it is alleged, encouraged risk taking in two ways. First, through a series of interventions in financial markets, it seemed to protect large investors against losses. Portfolio managers and lenders were conditioned to expect bailouts. Profits were privatized, it said, and losses socialized. In 1984, government bailed out Continental Illinois National Bank and Trust Company, then the nation’s seventh-largest bank. In the early 1990s, the Treasury rescued Mexico, thus protecting private creditors who had invested in short-term Mexican government securities. The protection continued with the bailout of the hedge fund Long-Term Capital Management in 1998. After the tech bubble burst in 2000, the Federal Reserve again rescued investors by lowering interest rates.

The second part of the Right’s argument is that government directly inflated the bubble by keeping interest rates too low (the Federal Reserve’s key rate fell to one percent in 2003) and subsidizing housing. In particular, Fannie Mae and Freddie Mac—government-created and -subsidized institutions—underwrote large parts of the mortgage market, including subprime mortgages.

We can test these theories of the crisis against the evidence. Note: Each aims to answer the same questions. Why did the system spin out of control? What caused the surge in borrowing by households and financial institutions? What led to the decline in lending standards and, as important, the misreading of risk, even by supposedly sophisticated players and observers?

Let’s start with the critique from the Left. The presumption is that with adequate regulation, problems would have been identified and corrected before they reached crisis proportions. Although this analysis seems plausible—and has been embraced by many journalists, economists, and politicians, and by much of the public—it rests on a wobbly factual foundation. For starters, many major players were regulated: Multiple agencies, including the Federal Reserve, supervised all the large bank-holding companies, including Citigroup, Bank of America, and Wachovia. Washington Mutual, a large mortgage lender that had to be rescued and was merged into JPMorgan Chase, was regulated by the Office of Thrift Supervision. Fannie and Freddie were regulated. To be sure, gaps existed; many mortgage brokers were on loose leashes. But there was enough oversight that alert regulators should have spotted problems and intervened to stop dubious lending.

The problem was not absent regulation; it was that the regulators were no smarter than the regulated. By and large, they didn't anticipate the troubles that would afflict subprime mortgages or the devastating financial and economic ripple effects. The idea that regulators possess superior wisdom rests mainly on the myth that tough regulation in the 1970s and 80s prevented major financial problems. History says otherwise. In the 1980s, more than 1,800 banks failed, including savings and loan associations. Their problems were not anticipated.

More important, many of the largest U.S. banks almost failed. They had lent billions of dollars to Mexico, Brazil, and other developing countries—loans that could not be repaid. If banks had been forced to recognize these losses immediately, much of the banking system would have been “nationalized,” writes William Isaac, who headed the Federal Deposit Insurance Corporation between 1981 and 1985, in his recent book Senseless Panic. Losses would have depleted banks’ reserves and capital. Instead, regulators temporized. They allowed bad loans to be refinanced until banks’ capital increased sufficiently to bear the losses. Still, regulators weren't smart enough to prevent the loans from being made in the first place.

As for greed and dishonesty, their role in the crisis is exaggerated. Of course, greed was widespread on Wall Street and elsewhere. It always is. There was also much mistaken analysis about the worth of mortgages and the complex securities derived from them. But being wrong is not the same as being dishonest, and being greedy is not the same as being criminal. In general, banks and investment banks weren't universally offloading mortgage securities known to be overvalued. Some of this happened; testimony before the Financial Crisis Inquiry Commission shows that some banks knew (or should have known) about the poor quality of mortgages. But many big financial institutions kept huge volumes of these securities. They, too, were duped—or duped themselves. That’s why there was a crisis. Merrill Lynch, Bear Stearns, and Wachovia, among others, belonged to this group.

If anything, the Right’s critique—Wall Street became incautious because government conditioned it to be incautious—is weaker. It’s the textbook “moral hazard” argument: If you protect people against the consequences of their bad behavior, you will incite bad behavior. But this explanation simply doesn't fit the facts. Investors usually weren't shielded from their mistakes, and even when they were, it was not possible to know in advance who would and wouldn't be helped. In 1984, the shareholders of Continental Illinois weren't protected; when the FDIC rescued the bank, it also acquired 80 percent of the company’s stock. When the Federal Reserve orchestrated a bailout of Long-Term Capital Management in 1998, most of the original shareholders lost the majority of their stake. After the bursting of the stock market bubble in 2000, most investors weren't spared massive paper losses, even with Alan Greenspan’s easy money. From the market’s peak in early 2000 to its trough in October 2002, stock values dropped 50 percent, a wealth loss of about $8.5 trillion, according to the investment advisory firm Wilshire Associates.

Likewise, many investors weren’t protected in the current crisis. The share prices of most major financial institutions—even those that survived—declined dramatically. The stockholders of Bear Stearns and Lehman Brothers suffered massive losses, and their executives and employees were among the biggest losers. Fannie and Freddie’s shareholders met a similar fate. Institutions that were “too big to fail” did fail in a practical sense. It is true that, both before and after the present crisis, some creditors were shielded. Foreign lenders in the Mexican debt crisis of the early 1990s were protected, and most (though not all) lenders to major financial institutions were protected in the present crisis. But to repeat: The protections were not pervasive or predictable enough to inspire the sort of reckless risk taking that actually occurred.

As for interest rates, it is probably true that the very low rates adopted by Greenspan (the one percent rate on overnight loans lasted from June 2003 to June 2004, and even after that, rates remained low for several years) contributed to the speculative climate. Some investors did shift to riskier long-term bonds in an attempt to capture higher interest rates, and the additional demand likely reduced the return on these bonds somewhat. But a bigger effect on long-term rates, including mortgages, seems to have come from massive inflows of foreign money over which the Federal Reserve had no control. Moreover, the fact that housing booms also occurred in England, Spain, and Ireland, among other countries, seems to exonerate the Fed’s interest rates policies as the main cause of the housing bubble.

The central question about the crisis that must be answered is, Why was almost everyone fooled? “Almost everyone” includes most economists (starting with Fed chairmen Alan Greenspan and Ben Bernanke), most investors, most traders, most bankers, the rating agencies, most government regulators, most corporate executives, and most ordinary Americans. There were, of course, exceptions or partial exceptions. Warren Buffett warned against the dangers of financial derivatives—but did not anticipate the problem of mortgages. In 

 (2010), journalist Michael Lewis chronicled the tale of professional investors who were dismissed as oddballs and deviants when they correctly questioned the worth of subprime mortgages. Economist Nouriel Roubini foresaw the connections between fragile financial markets and the real economy, but his early pessimism was a minority view.

People are conditioned by their experiences. The most obvious explanation of why so many people did not see what was coming is that they’d lived through several decades of good economic times that made them optimistic. Prolonged prosperity seemed to signal that the economic world had become less risky. Of course, there were interruptions to prosperity. Indeed, for much of this period, Americans groused about the economy’s shortcomings. Incomes weren't rising fast enough; there was too much inequality; unemployment was a shade too high. These were common complaints. Prosperity didn't seem exceptional. It seemed flawed and imperfect.

The central question about the crisis that must be answered: Why was almost everyone fooled?

That’s the point. Beneath the grumbling, people of all walks were coming to take a basic stability and state of well-being for granted. Though business cycles endured, the expectation was that recessions would be infrequent and mild. When large crises loomed, governments—mainly through their central banks, such as the Federal Reserve—seemed capable of preventing calamities. Economists generally concurred that the economy had entered a new era of relative calm. A whole generation of portfolio managers, investors, and financial strategists had profited from decades of exceptional returns on stocks and bonds. But what people didn't realize then—and still don’t—is that almost all these favorable trends flowed in one way or another from the suppression of high inflation.

It’s hard to recall now, but three decades ago, inflation was the nation’s main economic problem. It had risen from negligible levels of about one percent in 1960 to about six percent at the end of the 1960s and to 12 to 14 percent in 1979 and 1980. Hardly anyone believed it could be controlled, although it was a source of deepening havoc, spurring four recessions since 1969, a stagnant stock market, and rising interest rates. And yet, the pessimists were proven wrong. A wrenching recession—deliberately engineered by then–Federal Reserve chairman Paul Volcker and supported by the newly elected Ronald Reagan—smothered inflationary psychology. It did so in a conventionally destructive way. Volcker tightened credit. Banks’ prime interest rates, the rates they charged on loans to their best customers, averaged 19 percent in 1981. There were gluts of jobless workers (unemployment reached 10.8 percent in late 1982), underutilized factories, and vacant stores and office buildings. But by 1984, inflation was down to four percent, and by 2000 it had gradually declined to the unthreatening levels of the early 1960s.

When Americans think of this inflation—if they think of it at all—they focus on inflation’s rise and ignore the consequences of its fall, disinflation. But these consequences were huge and mostly beneficial. The two recessions that occurred between 1982 and 2007—those of 1990–91 and 2001—each lasted only eight months. Over an entire quarter-century, the economy was in recession for a total of only 16 months, slightly more than a year. By contrast, the four recessions that struck between 1969 to 1982 lasted a total of 49 months, or about four years out of 13. Peak unemployment, 10.8 percent as noted, was much higher than in the following quarter-century, when it topped out at 7.8 percent. Economists called this subdued business cycle “the Great Moderation,” and wrote papers and organized conferences to explore it. But the basic explanation seemed evident: High and rising inflation was immensely destabilizing; low and falling inflation was not.

Declining inflation also stoked stock market and housing booms. By the end of 1979, the Standard & Poor’s 500 index had barely budged from its 1968 level; by year-end 1999, it had risen by a factor of 14. The rise in housing prices was less steep, though still impressive. In 1980, the median-priced existing home sold for $62,000; by 1999, the median price had climbed to $141,000. Declining interest rates propelled these increases. As inflation subsided—and as Americans realized that its decline was permanent—interest rates followed. From 1981 to 1999, interest rates on 10-year Treasury bonds fell from almost 14 percent to less than six percent. Lower rates boosted stocks, which became more attractive compared with bonds or money market funds. Greater economic stability helped by making future profits more certain. Lower interest rates increased housing prices by enabling buyers to pay more for homes.

Millions of Americans grew richer. From 1980 to 2000, households’ mutual funds and stocks rose in value from $1.1 trillion to $10.9 trillion. The 10-fold increase outpaced that of median income, which roughly doubled during the same period, reaching $42,000. Over the same years, households’ real estate wealth jumped from $2.9 trillion to $12.2 trillion. Feeling richer and less vulnerable to recessions, Americans borrowed more (often against their higher home values). This borrowing helped fuel a consumption boom that sustained economic expansion. Disinflation had, it seemed, triggered a virtuous circle of steady economic and wealth growth.

It was not just the real economy of production and jobs that seemed to have become more stable. Financial markets—stocks, bonds, foreign exchange, and securities of all sorts—also seemed calmer. Volatility, a measure of how much prices typically fluctuate, declined in the early 2000s. Sophisticated investors and traders understood this. Studies confirmed it.

Finally, government economic management seemed more skillful. The gravest threats to stability never materialized. In October 1987, the stock market dropped a frightening 20 percent in a single day, but that did not trigger a deep recession. Neither did the 1997–98 Asian financial crisis (when some countries defaulted on loans) or the bursting of the tech bubble in 2000. In each case, the Federal Reserve seemed to check the worst consequences. Faith in the Fed grew; Greenspan was dubbed the “maestro.”

Well, if the real economy and financial markets were more stable and the government more adept, then once risky private behaviors would be perceived as less hazardous. People could assume larger debts, because their job and repayment prospects were better and their personal wealth was steadily increasing. Lenders could liberalize credit standards, because borrowers were more reliable. Investors could adopt riskier strategies, because markets were less frenetic. In particular, they could add “leverage”—i.e., borrow more—which, on any given trade, might enhance profits.

From 1980 to 2000, households’ mutual funds and stocks rose in value from $1.1 trillion to $10.9 trillion. Feeling richer and less vulnerable to recessions, Americans borrowed more.

So, paradoxically, the reduction of risk prompted Americans to take on more risk. From 1995 to 2007, household debt grew from 92 percent to 138 percent of disposable income. Bear Stearns, Lehman Brothers, and other financial institutions became heavily dependent on short-term loans that underpinned leverage ratios of 30 to 1 or more. (In effect, firms had $30 of loans for every $1 of shareholder capital.) Economists and government regulators became complacent and permissive. Optimism became self-fulfilling and self-reinforcing. Americans didn't think they were behaving foolishly because so many people were doing the same thing. This—not deregulation or investor “moral hazard”—was the foundry in which the crisis was forged.

What now seems unwise could be rationalized then. Although households borrowed more, their wealth expanded so rapidly that their net worth—the difference between what they owned and what they owed—increased. Their financial positions looked stronger. From 1982 to 2004, households’ net worth jumped from $11 trillion to $53 trillion. Ascending home prices justified easier credit standards, because if (heaven forbid) borrowers defaulted, loans could be recouped from higher home values. Because the rating agencies adopted similarly favorable price assumptions, their models concluded that the risks of mortgage-backed securities were low. No less a figure than Greenspan himself dismissed the possibility of a nationwide housing collapse. People who sold a house usually had to buy another. They had to live somewhere. That process would sustain demand. “While local economies may experience significant speculative price imbalances,” he said in 2004, “a national severe price distortion seems most unlikely.”

As time passed, the whole system became more fragile and vulnerable. If the complex mortgage securities held by banks and others began to default—as they did—then the short-term loans that were used to finance the purchase of these securities would be curtailed or withdrawn, threatening the banks’ survival. Because no one knew precisely which banks held which securities (and, therefore, which banks were weakest), this process—once started—could cause a panic within the financial system. Banks, hedge funds, pensions, and corporations would retreat from trading and lending for fear that they might not be repaid. As banks and companies hoarded cash, production and jobs would decrease. Basically, that’s what happened. The initial reaction to disinflation, reflecting its real benefits, had disintegrated into overborrowing, speculation, and self-deception.

It’s worth noting that this explanation of the present crisis is neither widely held nor original. It vindicates Charles Kindleberger, the late economic historian who argued in his 1978 book 

 that financial crises occur in three stages. First comes “displacement”: a favorable development such as new technology, the end of a war, or a change in government that improves the economic outlook. Next is “euphoria”: the process by which a proportionate response to the original development becomes an artificial “bubble.” The last stage is “revulsion”: the recognition of excesses, which leads to panic and a collapse of speculative prices.

Beginning in the 1980s, the U.S. economy followed exactly this pattern. The decline of double-digit inflation was the original “displacement.” The ensuing prolonged prosperity spawned “euphoria,” which culminated in the “revulsion” and panic of 2008. But Kindleberger’s views—which built on those of the economist Hyman Minsky—have never commanded center stage among academic economists. Though widely read and respected, Kindleberger was always something of a renegade. He expressed skepticism and even contempt for the mathematical models and theoretical constructs that have defined mainstream macroeconomics for decades, while paying great attention to historical conditions and events.

If this explanation of the crisis is correct, it raises momentous questions. Since World War II, American democracy has been largely premised on its ability to create ever greater economic benefits—higher living standards, more social protections, greater job and income security—for most of its citizens. The promise has largely succeeded and, in turn, rests heavily on the belief, shared unconsciously by leaders in both parties, that we retain basic control over the economy. Until recently, the consensus among economists was that another Great Depression was unthinkable. We could prevent it. As for recessions, we might not be able to eliminate them entirely, but we could regulate them and minimize the damage. Economic knowledge and management had progressed. These comforting assumptions now hang in doubt.

The great delusion of the boom was that we mistook the one-time benefits of disinflation for a permanent advance in the art of economic stabilization. We did so because it fulfilled our political wish. Ironically, the impulse to improve economic performance degraded economic performance. This happened once before, in the 1960s and 70s, when academic economists—among them Walter Heller of the University of Minnesota, James Tobin of Yale, and Robert Solow of MIT—sold political leaders on an ambitious agenda. Despite widespread post–World War II prosperity, there had been recessions every three or four years. Invoking John Maynard Keynes, the economists said they could—by manipulating budget deficits and interest rates—smooth business cycles and maintain “full employment” (then defined as four percent unemployment) most of the time. They couldn't, and the effort to do so created the inflation that crippled the economy for 15 years.

We still haven’t forsaken the hope for perfected prosperity. After the recent crisis, both liberals and conservatives offered therapeutic visions. Liberals promoted expanded regulation to curb Wall Street’s excesses. Conservatives wanted a less activist government that would let markets perform their disciplining functions. Both may achieve some goals. Liberals have already engineered greater regulation. Banks will be required to hold more capital as a cushion against losses. The new financial reform legislation would allow government to shut large failing financial institutions, such as Lehman Brothers, without resorting to disruptive bankruptcy. Conservatives may take solace from fewer bailouts. They are so unpopular that investors must know that the chances of getting one have diminished. Together, these changes may make the financial system safer.

The trouble is that, like generals fighting the last war, we may be fighting the last economic crisis. Future threats to stability may originate elsewhere. One danger spot is globalization. Economies are intertwined in ways that are only crudely understood. Supply chains are global. Vast sums of money routinely cross borders and shift among currencies. Countries are mutually dependent and mutually vulnerable through many channels: Supplies of oil and other essential raw materials may be curtailed; cyberattacks could cripple vital computer networks; manipulated exchange rates might disrupt trade and investment flows. Economic activity has grown more international, while decision making remains largely with nation-states. Although the global economy has remained basically stable since World War II, there is really no good theory as to why it should stay so—and there are some signs (currency tensions, for instance) that it may not.

Overcommitted welfare states pose another threat. Most affluent nations face similar problems: High budget deficits and government debts may portend a loss of investor confidence, but the deficits and debts have been driven higher by massive social spending—on pensions, health care, unemployment insurance, education—that people have come to expect. Economics and politics are colliding. If the debt and deficits aren't controlled, will investors someday desert bond markets, jolting interest rates upward and triggering a new financial crisis? But if many countries try to control deficits simultaneously, might a tidal wave of spending cuts and tax increases cause a global depression? (The United States, Europe, and Japan still constitute about half the world’s economy.) These are all good questions without good answers. The underlying problem is that economic change seems to have outrun economic understanding and control.

It’s widely believed that the financial panic and Great Recession constitute a watershed for global capitalism, which has been (it’s said) permanently discredited. Around the world, the political pendulum is swinging from unfettered competition toward more government oversight. Markets have been deemed incorrigibly erratic. Greed must be contained, and the greedy must be taxed. These ideas reflect a real shift in thinking, but in time that may not be seen as the main consequence of the economic collapse. These ideas imply that capitalism was unsupervised and untaxed before. Of course, this is not true. Businesses everywhere, big and small, were and are regulated and taxed. Future changes are likely to be those of degree, in part because countervailing forces, mobile capital being the most obvious, will impose limits. Countries that oppressively regulate or tax are likely to see businesses go elsewhere.

What looms as the most significant legacy of the crisis is a loss of economic control. Keynes famously remarked that “practical men” are “usually the slaves of some defunct economist.” By this he meant that politics and public opinion are often governed by what economists (living and dead, actually) define as desirable and doable. In the years after World War II, the prevailing assumption among economists, embraced by much of the public, was that we had conquered the classic problem of booms and busts. Grave economic crises afflicted only developing countries or developed countries that had grossly mismanaged their affairs. This common view is no longer tenable. It has been refuted by events.

Our economic knowledge and tools came up short. Either they were overwhelmed by change or their power was always exaggerated. This does not mean that economic growth will cease. Chances are that the United States and the other prosperous nations of the developed world will, over time, get wealthier as a result of technological changes that are now barely glimpsed. But the widespread faith—and the sense of security it imparted—that economic management would forever spare us devastating disruptions has been shattered. Just as there has never been a war to end all wars, there has yet to be an economic theory that can end all serious instability.

The Great Inflation and Its Aftermath: The Past and Future of American Affluence

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In embracing a victims-and-villains explanation of the recession, Americans are missing important lessons about the future of the U.S. economy. 

Rethinking the Great Recession

The Great Depression cast a dark shadow over the 20th century. 

It arguably led to World War II, because without the Depression, Adolf Hitler might never have come to power. It discredited unfettered capitalism—which was blamed for the collapse—and inspired the expansion of government as the essential overseer of markets. This economic catastrophe has long fascinated historians and economists, but for decades serious reflection on the Depression didn’t extend much beyond the scholarly world. It couldn’t happen again. We knew too much. There were too many economic and regulatory controls. But the Great Recession has made us wonder. Can we learn from the Depression? Are there parallels between then and now? Most ominously, could we suffer another depression? The conventional wisdom still says no. Unfortunately, the conventional wisdom might be wrong.

There is no precise definition of a depression; it’s a term of art. Generally speaking, it’s a broad economic collapse that produces high unemployment from which there is no easy and obvious escape. The crucial difference between recession and depression is that recoveries from run-of-the-mill recessions occur fairly rapidly in response to automatic market correctives and standard government policies. Businesses work off surplus inventories or repay excessive debt. Governments reduce interest rates and allow budgets to swing into deficit. A depression occurs when these mechanisms don’t work, or don’t work quickly. The pivotal question becomes: Why?

One answer is that powerful historical, social, and political changes overwhelm the normal market and policy responses. Modern depressions are not ordinary business cycles susceptible to routine remedies, because their origins lie in institutions and ideas that have been overtaken by events. But letting go of or modifying these powerful attachments is a painfully slow process, precisely because the belief in them is so strong and the alternatives are often unclear. Hence, adjustment occurs slowly, if at all. Change is resisted or delayed, or wanders down dead ends. Economies languish or decline. The Great Depression was one of those moments. We may now be in another.

There are parallels between then and now, largely unrecognized. Then, the forces suffocating economies stemmed from a jarring historical rupture: the end of the gold standard. In the late 1920s and early ’30s, countries clung to the gold standard—backing paper currencies with gold reserves—as a defense against hyperinflation. Gold was thought to be the foundation of sound money, which was deemed necessary for prosperity. Most simply, gold regulated economic activity. When gold drained out of a country, supplies of money and credit tended to shrink; when a country accumulated gold, they tended to expand. But defending the gold standard caused country after country to suffer banking runs and currency crises. These fed each other and deepened the economic collapse. By 1936, more than two dozen countries had reluctantly jettisoned gold. Once this happened, expansion generally resumed.

Something similar is happening today, with the welfare state—the social safety net of wealthy democracies—playing gold’s destructive role. In Europe, government spending is routinely 40 percent or more of national income. In the United States, it exceeds a third. Like the gold standard 80 years ago, these protections command broad support. They mediate between impersonal market forces and widely shared norms of fairness. The trouble is that many countries can no longer afford their costly welfare states. Some nations have already overborrowed; others wish to avoid that fate. Their common antidote is austerity: spending cuts, tax increases, or both. The more austerity spreads, the greater the danger it will feed on itself. What may make sense for one country is disastrous for many—just as in the 1930s.

The exhaustion of economics is another parallel between our time and the Depression. Then, as now, economists didn’t predict the crisis and weren’t able to engineer recovery. “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate,” said President Herbert Hoover’s Treasury secretary, Andrew Mellon. In the 1930s, this “liquidationist” view dominated. Let wages, stocks, and land values fall until prices are attractive, it said; recovery will occur spontaneously as businesses hire and investors invest. It didn’t work. Today’s orthodoxy is Keynesianism (after John Maynard Keynes), and governments responded to the 2007–09 financial crisis with its textbook remedies. The Federal Reserve and other central banks cut interest rates; governments ran huge budget deficits. Arguably, these measures did prevent a depression. But, contrary to expectations, they did not promote a vigorous recovery. As in the 1930s, economics has disappointed.

Of course, analogies shouldn’t be overdrawn. We’re still a long way from a second Great Depression, even if such an economic disaster is conceivable. Compared to what happened in the 1930s, the present distress—here and abroad—is tame. From 1929 to 1933, the output of the U.S. economy (gross domestic product) dropped almost 27 percent. The recent peak-to-trough GDP decline, from the fourth quarter of 2007 to the second quarter of 2009, was 5.1 percent. From 1930 to 1939, the U.S. unemployment rate averaged 14 percent; the peak rate, in 1932, was 23 percent. Rates elsewhere in the world were as bad or worse. Unemployment among industrial workers had reached 21 percent in the United Kingdom a year earlier; it hit 44 percent in Germany in 1932. The social protections we take for granted barely existed. Congress didn’t enact federal unemployment insurance until 1935.

Still, the economy’s present turmoil resembles the Great Depression more than anything since. As this is written, Europe is sinking into recession. In the United States, unemployment stayed above nine percent for 21 consecutive months, and then another seven after a short period slightly below that level. The longest previous stretch was 19 months, in the early 1980s. Against this backdrop, it’s natural to reexamine the Depression and search for parallels.

The Depression is usually dated from late 1929 to the eve of World War II. But people didn’t immediately recognize that they had entered uncharted economic waters. “Down to the last weeks of 1930, Americans could still plausibly assume that they were caught up in yet another of the routine business-cycle downswings that periodically afflicted their boom-and-bust economy,” David Kennedy writes in his 2001 Pulitzer Prize– winning history

Freedom From Fear: The American People in Depression and War, 1929–1945

. Unemployment, for example, reached nearly 12 percent in the recession year of 1921 and was 8.9 percent in 1930. The riddle is: What caused the Depression to defy history? Over the years, many theories have been floated and discredited.

Chief among the fallen is the stock market crash of 1929. True, it was terrifying. From October 23 to November 13, the Dow Jones Industrial Average dropped almost 40 percent, from 327 to 199. Fortunes were lost; Americans were fearful. But steep market declines, before and since, have occurred without causing a depression. The most obvious connection would be the “wealth effect.” Shareholders, being poorer, would spend less. However, very few Americans (about 2.5 percent in 1928) owned stocks. Moreover, stocks rebounded, as historian Maury Klein has noted. By March 1930, the Dow had recovered 74 percent from their December level. Stocks later fell, but that was a consequence of the Depression, not the cause.

Another familiar villain is the Smoot-Hawley tariff. It has “become synonymous with an avalanche of protectionism that led to the collapse of world trade and the Great Depression,” writes Dartmouth economist Douglas Irwin. But 

shes the conventional wisdom. The tariff’s direct effects were modest, and its timing also argues against its significance. President Hoover signed the Smoot-Hawley Tariff Act in June 1930, well after the Depression had begun. Average U.S. tariffs on imports did rise from 40 percent in 1929 to 59 percent in 1932, but two-thirds of U.S. imports had no duties at all. Europe did retaliate with higher tariffs, but only six percent of Europe’s exports came to the United States. Trade did collapse in the Depression, but (again) that was consequence, not cause.

Finally, there’s Herbert Hoover. The anti-Hoover indictment is that he passively let the Depression deepen and, by trying to balance the budget, made it worse. This argument is unfair and inaccurate. After the crash, Hoover urged businesses to maintain wages and continue investment projects. In three years, he nearly doubled federal public works spending and pushed the states to do likewise. In 1932, he did successfully propose a tax increase—Roosevelt also advocated balanced budgets, a widely shared goal—but the federal budget still ran a large deficit: four percent of GDP. “It would be hard to find an economic historian to argue that fiscal [budgetary] tightness was a significant factor in worsening the Great Depression,” 

writes Timothy Taylor, managing editor of 

None of these familiar scapegoats solve the puzzle: Why did the economy continue getting worse? Some other force or forces must have been responsible. Scholarship on this question has proceeded in spasms.

Just as the Gold Standard amplified the effects of the Depression, so the modern welfare state is magnifying the effects of the recession.

In 1933, Irving Fisher of Yale, then one of the nation’s most prominent economists, published an article titled “The Debt-Deflation Theory of Great Depressions.”

 The chief causes of the Depression, he argued, were “over-indebtedness to start with and deflation following soon after.” Debts were written in fixed dollar amounts, and so deflation—falling prices, wages, and profits—made it harder for farmers, businesses, and households to repay loans. Defaults dumped more land and jobless workers onto the market, causing prices and wages to fall further and worsening the slump. It was a vicious circle. Still widely accepted, Fisher’s analysis explains why modern economists dread deflation. From 1929 to 1933, prices for wheat, corn, and other farm products dropped 54 percent; those for building materials fell 25 percent. But Fisher didn’t explain precisely what caused the 1930s’ deep deflation.

The General Theory of Employment, Interest, and Money

. The culprit was insufficient “effective demand”— what economists now call “aggregate demand.” People and firms weren’t spending enough. Keynes rejected the “classical” economists’ view that spontaneous shifts in wages and interest rates would generate recovery. Wages might be rigid. Low interest rates might not stimulate new investment in plants or products, because businessmen’s “animal spirits” had deadened. The economy “seems capable of remaining in a chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse,” he wrote. Keynes’s remedy was to boost “effective demand” through more government spending.

But his argument, like Fisher’s, was abstract. It lacked a detailed explanation of the Depression itself. Since then, scholars have scoured the historical record to obtain a fuller answer. A breakthrough occurred in 

A Monetary History of the United States, 1867–1960

 by Milton Friedman (a subsequent Nobel Prize winner) and Anna Jacobson Schwartz

. Friedman and Schwartz argued that the Federal Reserve caused the Depression by failing to rescue the banking system. From 1929 to 1933, more than two-fifths of the nation’s 24,970 banks disappeared through failure or merger. The nation’s money supply—basically, bank deposits plus currency in circulation—shrank by a third. This steep decline, said Friedman and Schwartz, drove prices and production down. The irony was that Congress created the Fed in 1913 to backstop the banking system.

What would have been a normal, if severe, recession became a depression. Friedman and Schwartz blamed the Fed’s passivity on the death in 1928 of Benjamin Strong, head of the New York Federal Reserve Bank, who had been the Fed’s most forceful figure and would have, they contended, acted aggressively to limit bank failures. By contrast, economist Allan Meltzer cites the “real bills” doctrine as the cause of the Fed’s passivity. Under “real bills” (bills are a type of loan), the Fed lent to banks only against collateral they presented. During the Depression, they didn’t present much; the supply of money and credit shrank. Whatever the truth, these accounts had the Depression starting in the United States and spreading abroad. It was an American story with global side effects.

economic historian Charles Kindleberger in his 1973 book 

. The collapse was international and reflected the inability of a Britain weakened by World War I to continue to stabilize the world economy. Among other things, Kindleberger wrote, Britain’s leadership role had required it (a) to act as “lender of last resort” to stem banking crises, (b) to keep its markets open to sustain trade, and (c) to maintain stable exchange rates. After the war, Britain couldn’t perform these tasks. It lacked sufficient gold reserves to make loans to stop foreign banking crises. High joblessness weakened its commitment to free trade. Consequently, it couldn’t stabilize exchange rates.

The gold standard transmitted the breakdown around the globe, argue economic historians Barry Eichengreen and Peter Temin in, respectively, 

Golden Fetters: The Gold Standard and the Great Depression, 1919–1939

. Countries that backed their paper currency with gold sacrificed much economic independence. For example, gold outflows through trade deficits might trigger recessions, because the loss of gold could automatically contract the supply of money and credit. But countries could not respond by devaluing their currencies to boost exports; gold fixed currency rates. Gold’s straitjacket was its supposed virtue. By eliminating inflation and currency fluctuations, it reduced uncertainty and encouraged commerce. This was the theory and belief.

After World War I, countries sought to restore the gold standard, which had been widely suspended during the fighting. Because the reliance on gold had delivered prosperity, this was understandable. But there were daunting problems: Prices had exploded during the war; gold was relatively scarce; exchange rates had shifted; countries were saddled with large debts. As a result, the restored gold standard was unstable. Skewed exchange rates meant that two countries, the United States and France, ran large trade surpluses and accumulated disproportionately large gold stocks. By 1930, they owned nearly 60 percent of the world’s gold.

The resulting gold scarcity—for most countries—created a fatal interdependence. If one country raised interest rates, it might drain gold from others. Depositors and investors, foreign and domestic, would withdraw their money or sell their bonds, convert the receipts into gold, and transfer the gold to the country with higher interest rates. There, the process would be reversed: Gold would be converted into local currency and invested at the higher rates. The gold standard created a potential domino effect of tighter credit that would make the Depression feed on itself. While credit was plentiful, the danger was theoretical. Once economies turned downward, the scramble for gold intensified the slump.

Germany’s Reichsbank, the Bank of England, the Fed, and other central state financial institutions were handcuffed in their efforts to aid their countries’ banks. The Depression weakened banks by increasing their customers’ loan defaults; loan losses then made the banks more vulnerable to depositor runs. But a central bank couldn’t inject too much money and credit into the system without raising doubts about its country’s commitment to gold. Politics compounded the effect by closing another avenue of escape: international rescues to stop bank runs. In May 1931, Austria’s largest bank, Credit-Anstalt, faced a panic. The Bank of England’s reserves were too meager for it to provide an adequate loan on its own, and France—still scarred by World War I—insisted that Austria renounce a customs union with Germany before providing funds. The rescue was delayed. Panic spread and confidence fell.

Gold’s oppressive consequences ultimately caused countries to abandon it. Austria, Germany, and Britain did so in 1931. (The United States left two years later, while France hung on until 1936.) The process was long and punishing because faith in gold was so pervasive. It was hard to let go. But once countries did let go, they could spur their economies. Eichengreen writes, “They could expand the money supply. They could provide liquidity [cash] to the banking system at the first sign of distress. They could increase the level of government expenditure. They could take these actions unilaterally.” By 1937, world manufacturing output was 71 percent above its 1932 level and had exceeded its 1929 level.

Why was the Depression so deep and long? All this scholarship provides a crude answer. Whether the cause was the gold standard, the “real bills” doctrine, Benjamin Strong’s death, Britain’s postwar weakness, or rancor from World War I—or all of these factors—government economic policies perversely reinforced the original slump. Banks were not rescued. Defaults and bankruptcies fed deflation. Unemployment spiraled up, production down. Prevailing economic doctrine was suicidal. The good news, it’s said, is that we understand what happened and can prevent a repeat. Heeding Fisher, we can avoid deflation. Following Keynes, we can prop up aggregate demand. Per Friedman and Schwartz, we can defuse financial panics. Learning from Kindleberger, Eichengreen, and Temin, we can practice international cooperation.

UNFORTUNATELY, THESE REASSURANCES OMIT AN OBVIOUS AND MORE DISCOURAGING LESSON

: The Depression couldn’t end until people changed their beliefs and behavior—a lengthy and tortuous process, because people cling to what’s familiar. Here is where the parallel with the present becomes relevant and sobering. Just as the gold standard amplified and transmitted the effects of the Depression, so the modern welfare state is magnifying the effects of the recession. The United States, Europe, and Japan, together representing about half of the world economy, face similar pressures: aging societies, high government spending, and soaring debt levels. These pressures impose austerity on country after country—just as the gold standard did. The cumulative effect is to make it harder for the world to recover from what started as an ordinary, though severe, recession—just as happened under the gold standard.

Casting the welfare state in this role will strike many as outrageous. After all, the welfare state—what Americans blandly call “social spending”—didn’t cause the 2007–09 financial crisis. This dubious distinction belongs to the huge credit bubble that formed in the United States and elsewhere, symbolized by inflated real estate prices and large losses on mortgage-related securities. But neither did the gold standard directly cause the 1929 stock market crash. Wall Street’s collapse stemmed, most simply, from speculative excesses. Stock prices were too high for an economy that was already (we now know) entering recession. But once the slump started, the gold standard spread and perpetuated it. Today, the weakened welfare state is perpetuating and spreading the slump.

What has brought the welfare state to grief is not an excess of compassion, but an excess of debt. After World War II, governments in most advanced countries grew enormously, a reaction to the suffering of the Depression coupled with early postwar optimism about the power of social engineering. By 2007, government spending totaled 53 percent of GDP in France, 44 percent in Germany, 45 percent in Britain, and 37 percent in the United States, 

. Most spending represented income transfers. Even in the United States, with its sizable military budget, “payments for individuals” (which means entitlements such as Social Security and Medicare) amounted to two-thirds of federal spending in 2010, up from a quarter in 1960.

But this system required favorable economics and demographics—and both have moved adversely. A younger population was needed to lighten the burden of supporting the old, the largest claimants of benefits. Rapid economic growth was needed to generate the tax revenues to pay for benefits. Indeed, the great expansion of benefits started in the 1950s and ’60s, when annual economic growth in Europe and the United States averaged about four percent or more, and the expectation was that this would continue indefinitely. Long-term economic growth is now reckoned closer to two percent a year, a little more for the United States, a little less for Europe. Meanwhile, older populations are exploding. In 2010, the 65-and-over population in Italy was 21 percent, and heading toward 34 percent by 2050; for the United States, the figures were 13 percent and 20 percent.

The means of escape from these unhappy trends was to borrow. Some countries with extensive welfare systems that didn’t borrow heavily (examples: Sweden and Finland) have fared well. But most governments became dependent on bond markets. Until the financial crisis, they coexisted in a shaky equilibrium. Most European governments could borrow cheaply. Their bonds were considered safe investments. Perhaps inevitably, the financial crisis shattered this equilibrium. Economic growth fell from already low levels; government debt rose. Suddenly, financial markets—banks, pension funds, insurance companies, wealthy investors—turned skittish. Perhaps debts wouldn’t be repaid. Greater risk translated into higher interest rates on government bonds.

Once this happened, welfare states became an engine of international austerity. Countries’ choices were constricted. To maintain existing levels of spending, they needed to borrow. But lenders demanded higher interest rates, and to keep these down, governments had to resort to austerity, which meant cutting social programs and raising taxes. Some countries were completely shut out of private markets and had to rely on international financial bailouts; but these bailouts (i.e., loans) came with a string attached: austerity. First Greece, then Ireland and Portugal submitted to this logic. But almost all advanced countries, including the United States, are potentially subject to it. Countries embrace austerity to keep their credit worthiness. Or they embrace it because they lose their credit worthiness.

What this means is that governments, against their will, are being forced to reconsider some basic post–World War II premises around which their economies and societies are organized, much as countries in the 1930s were forced to reconsider economic premises based on the gold standard. Now as then, the process is unwelcome, painful, and agonizingly slow. It involves a balancing of political and economic imperatives: not dismantling the welfare state, but shrinking it to a size that is politically acceptable and economically viable. Social protections and benefits must be reduced so that the resulting obligations don’t impose crippling levels of debt or taxes. It is not clear where this point is and whether wealthy democracies are capable of identifying and reaching it. It will differ for different countries, depending on their underlying economic vitality and political culture.

The ultimate danger is that the welfare state will go into a death spiral. The political impetus to provide promised benefits keeps taxes and debt high, to the point that economic growth suffers; but slower growth or longer recessions make it harder to pay promised benefits, an outcome requiring still further cutbacks. As political leaders grapple with these problems, they are constantly reacting to events—doing too little too late. The fact that many governments are caught in this trap simultaneously means that their collective actions exert a drag on the world economy that makes it harder for all of them to reconcile political and financial- market pressures. The further fact that Europe’s banks are large holders of government debt means that a debt crisis could become a banking crisis—with failures and runs—or a credit squeeze, as banks suffer large losses on their bond portfolios.

Governments are losing control over their economic fates, because high debt also undermines standard Keynesian anti-recessionary tools, a.k.a. “stimulus,” spending more and taxing less in times of economic weakness. The prospect of more debt simply sends interest rates up, nullifying some or all of any “stimulus” and, for some countries, closing access to private credit markets. It’s true that some major debtor countries, notably the United States and Germany, have so far escaped this squeeze. Their interest rates (at this writing) remain low, about two percent on 10-year bonds. But there’s no ironclad reason why these countries should remain immune forever. If investors come to believe that the United States can’t control its debt, they might dump Treasury bonds and other dollar securities. Interest rates would rise; on foreign exchange markets, the dollar would fall.

So it’s not preposterous to compare the gold standard then with the welfare state now. In both cases, a framework is imposed that impedes recovery from what might otherwise be a recognizable recession. The obstacles lie in institutions and beliefs that are deeply woven into the social, political, and intellectual fabric of societies. It takes time to adjust—and sometimes adjustment doesn’t happen at all—because the status quo has established stubborn habits of thought and strong vested interests that can be dislodged only by powerful, incontestable evidence and experience to the contrary. Even then, the destruction of the old does not ensure replacement by the new. There may simply be a void.

This does not mean we are condemned to a second Great Depression. The messy process of grappling with overcommitted government may lead to slow growth, long recessions, or stagnation—but not the dramatic collapse of the 1930s. China, India, Brazil, and other developing countries, representing about half of the world economy, don’t face the dilemmas of mature welfare states. Their economic growth may provide a safety net for the “old world” of Europe, North America, and Japan. But here, too, there are cautionary comparisons. China’s rise and America’s problems have fragmented economic power. Cooperation is strained. The analogies with Britain’s post–World War I weakness and the paralyzing rancor between Germany and France are obvious. Another parallel with the 1930s is the euro, which, as the gold standard once did, has created a straitjacket that makes recovery harder.

All of these challenges suggest that a second depression or some prolonged period of economic disappointment and hardship is no longer implausible, as it seemed for most of the past half-century. The mastery of economic activity we thought we had achieved—not in the sense that we could eliminate all business cycles or financial panics, but in the more limited way that we could avoid pervasive instability—can no longer be taken for granted. The mistake, popularized largely by economists, was to believe that regulation of the economy could be derived from theory and converted into practical precepts for policy. The reality is that economic life is not solely described or dictated by rhythms suggested by economic models. It moves in response to institutions, technologies, beliefs, and cultures that follow their own logic, sometimes with completely unexpected, mystifying, and terrifying consequences.

The Great Inflation and Its Aftermath: The past and Future of American Affluence

Bank_of_the_United_States_failure_NYWTS.jpg

The role of the welfare state in today’s economic crisis recalls the part played by the gold standard in the calamitous 1930s.

Revisiting the Great Depression

The future of affluence is not what it used to be.

 Americans have long believed — it’s part of our national character — that our economic well-being will constantly increase. We see ourselves as a striving, inventive, and pragmatic people destined for higher living standards. History is a continuum of progress, from Robert Fulton’s steamboat to Henry Ford’s assembly line to Bill Gates’ software. Every generation will live better than its predecessors.

For millions of younger Americans — say, those 40 and under — living better than their parents is a pipe dream. They won’t. The threat to their hopes does not arise from an impending collapse of technological gains of the sort epitomized by the creations of Fulton, Ford, and Gates. These advances will almost certainly continue, and per capita income — the average for all Americans and a conventional indicator of living standards — will climb. Statistically, American progress will resume. The Great Recession will be a bump, not a dead end.

The trouble is that many of these gains will bypass the young. The increases that might have fattened their paychecks will be siphoned off to satisfy other groups and other needs. Today’s young workers will have to finance Social Security and Medicare for a rapidly growing cohort of older Americans. Through higher premiums for employer-provided health insurance, they will subsidize care for others. Through higher taxes and fees, they will pay to repair aging infrastructure (roads, bridges, water systems) and to support squeezed public services, from schools to police.

The hit to their disposable incomes would matter less if the young were major beneficiaries of the resultant spending. In some cases — outlays for infrastructure and local services — they may be. But these are exceptions. By 2025 Social Security and Medicare will simply reroute income from the nearly four-fifths of the population that will be under 65 to the older one-fifth. And health care spending at all age levels is notoriously skewed: Ten percent of patients account for 65 percent of medical costs, reports the Kaiser Family Foundation. Although insurance provides peace of mind, the money still goes from young to old: Average health spending for those 45 to 64 is triple that for those 18 to 24.

The prospect of downward mobility is not just dispiriting. It assails the whole post–World War II faith in prosperity.

The living standards of younger Americans will almost certainly suffer in comparison to those of their parents in a second crucial way. Our notion of economic progress is tied to financial security, but the young will have less of it. What good are higher incomes if they’re abruptly revoked? Though it wasn’t a second Great Depression, the Great Recession was a close call, shattering faith that modern economic policies made broad collapses impossible. Except for the savage 1980-82 slump, post-World War II recessions had been modest. Only minorities of Americans had suffered. By contrast, the Great Recession hurt almost everyone, through high unemployment, widespread home foreclosures, huge wealth losses in stocks and real estate — and fears of worse. A 2012 Gallup poll found that 68 percent of Americans knew someone who had lost a job.

The prospect of downward mobility is not just dispiriting. It assails the whole post–World War II faith in prosperity. Beginning in the 1950s, commentators celebrated the onrush of abundance as marking a new era in human progress. In his 1958 bestseller 

, Harvard economist John Kenneth Galbraith announced the arrival of a “great and unprecedented affluence” that had eradicated the historical “poverty of the masses.”

Economic growth became a secular religion that was its own reward. Perhaps its chief virtue was that it dampened class conflict. In 

The Great Leap: The Past Twenty-Five Years in America

 (1966), John Brooks observed, “The middle class was enlarging itself and ever encroaching on the two extremes” — the very rich and the very poor. Business and labor could afford to reconcile because both could now share the fruits of expanding production. We could afford more spending on public services (education, health, environmental protection, culture) without depressing private incomes. Indeed, that was Galbraith’s main theme: Our prosperity could and should support both.

To be sure, there were crises of faith, moments when economic progress seemed delayed or doomed. The longest lapse occurred in the 1970s, when double-digit inflation spawned pessimism and frequent recessions, culminating in the 1980-82 downturn. Monthly unemployment peaked at 10.8 percent. But after Federal Reserve chairman Paul Volcker and President Ronald Reagan took steps to suppress high inflation, faith returned.

Now, it’s again imperiled. A 2011 Gallup poll found that 55 percent of Americans didn’t think their children would live as well as they did, the highest rate ever. We may face a crimped and contentious future.

Let’s be clear: The prospect is not national impoverishment; it is of relative deprivation. Even if disposable per capita incomes fell 10 percent — an extreme outcome — Americans would remain wealthy by any historical standard. Such a change would entail a decline in the annual disposable income from $37,000 to $33,300 (in 2011 inflation-adjusted dollars), probably over many years. People might adjust in ways that barely affected daily routines. They might live in slightly smaller houses, drive more fuel-efficient vehicles, or eat out a bit less. These are inconveniences, not tragedies.

But popular expectations would be dashed. Even assuming a full recovery from the Great Recession — possible, though not certain — the resulting prosperity will be qualified by greater competition for scarce economic resources. Massive federal budget deficits are only the most conspicuous sign of a society that has promised itself more than it can afford. To resurrect a familiar metaphor: A more slowly growing economic pie will face more claimants for slices. Some will receive bigger slices, others smaller.

Generally speaking, there are two types of economic mobility, though they’re often confused.

 The first is intergenerational mobility (also called “relative mobility”). It involves children moving up or down the economic ladder from their parents’ position — do they rise to the top, stay where they started, or fall toward the bottom? Call the second type “national” mobility (specialists refer to it as “absolute mobility”). It concerns whether or not most members of each succeeding generation live better than their predecessors. If they do, then the whole society can be upwardly mobile even if all children occupy the same position relative to others as their parents on the social ladder. To take an obvious example, the poorest third of Americans lived much better in 1980 than in 1930.

In the United States, both types of mobility abound. For starters, birth is not fate. Americans do not automatically match their parents’ position on the economic ladder. A report by the Pew Economic Mobility Project finds that 61 percent of children born to parents in the richest fifth of Americans fall from that stratum, while 58 percent of children born in the poorest fifth rise above to a higher stratum. There’s not much movement from the very bottom to the very top. Only six percent of children make that journey. But in between, there’s much shifting.

Similarly, economic growth since World War II has allowed most Americans to live better than their parents did — even if they haven’t moved up the economic ladder. In the first two postwar decades, household incomes roughly doubled. Despite slower growth since then, about two-thirds of today’s Americans have higher incomes than their parents at a similar age, Pew finds. Even this understates the extent of the achievement, because some of those who lost ground still have relatively high incomes. They’re children of well-to-do families who don’t match their parents’ status, but their fall has been modest. Among the poorest fifth of Americans, about four-fifths have incomes higher than their parents’.

Even if the United States fully recovers from the Great Recession, Americans will endure greater competition for scarce economic resources.

Both types of mobility have contributed to America’s success. Although studies suggest that intergenerational mobility — again, children moving up or down the economic ladder — is greater in some other countries, the United States has enough of it to foster the bedrock belief that striving and talent are rewarded. That is important because societies in which economic status is rigid discriminate against individual ability and effort and discourage parents from striving to help their children succeed. As for national (or “absolute”) mobility, it affects social peace and satisfaction, because intergenerational mobility is a zero-sum game. For everyone who climbs the ladder into a higher stratum, someone else must fall down into a lower one. By contrast, a rising tide does lift all boats.

But there’s a rub: Upward national mobility requires strong economic growth — and U.S. growth is weakening. Growth comes from two sources: more labor (more workers or longer hours) and improved efficiency (or labor productivity, measured in output per hour). Unfortunately, slower labor force expansion virtually guarantees a decline in overall U.S. economic growth.

As economist Brink Lindsey of the Kauffman Foundation notes, two powerful trends boosted labor force growth for many years: the influx of baby boomers from the late 1960s to the mid-1980s, and the flood of married women into jobs starting in the late 1950s. Both trends have ended. Baby boomers are retiring; the oldest ones, born in 1946, turned 65 in 2011. And women’s participation ebbed a decade ago, well before the recession, with some women deciding to stay home or retire early. (From 1960 to 1999, the labor force participation rate of women 16 and over rose from 38 percent to 60 percent; in 2011, it was 58 percent.)

As a result of these trends, the number of new workers barely exceeds the number of those retiring. Barring major pleasant surprises, the slower labor force increases reduce projections of overall economic growth from a postwar average of slightly more than three percent to slightly more than two percent, as the table below shows. (The table shows “potential” economic growth under assumed conditions of “full employment,” but actual results are also affected by business cycles.)

Ideally, we would raise productivity to offset slower labor force growth. Realistically, we don’t know how to do this. What creates higher productivity is a murky mixture of new technologies, industry organization, government policies, management competence, worker abilities, and market pressures. Economists don’t fully understand the process and can’t manipulate it. Future rates of productivity growth could as easily fall as rise. In the table, the assumed annual gains average 1.7 percent, near the post–World War II rate of 1.8 percent. But gains might be two percent, one percent, or who knows what. Large deficits and higher taxes may crowd out investment or discourage risk taking, slowing productivity increases. That would further trim future economic growth, making it even harder for the young to achieve upward mobility.

It’s already hard enough. The mounting number of retirees increases pressure to move money from workers to the elderly. Consider that in 1960 the worker-to-retiree ratio was 5:1; in 2010 it was 3:1, and the projection for 2025 is nearly 2:1. At the federal level, the pressures stem from higher spending on Social Security, Medicare, and Medicaid. At the state and local levels, they stem from Medicaid (states pay about 40 percent of its costs) and pensions for government workers. In 

The Predictable Surprise: The Unraveling of the U.S. Retirement System

 (2012), Sylvester Schieber, an actuary and former chairman of the Social Security Advisory Board, estimates that state and local public employee pensions are 20 to 25 percent underfunded.

Higher taxes to pay for Social Security and Medicare will undermine after-tax wages. So will mounting employer costs for health insurance and pensions; these expenses limit what companies would otherwise pay in wage increases. Schieber estimates that all these factors could absorb two-thirds of compensation growth from 2015 to 2030. Other studies reach similar conclusions. Economist David Auerbach and physician Arthur Kellermann, both of the Rand Corporation, find that 80 percent of median-family income gains from 1999 to 2009 went to higher health spending in the form of employer-paid premiums, out-of-pocket costs, and taxes. And these studies don’t count the cost of infrastructure repair.

The future of today’s young has been heavily mortgaged. The grimmest prospect is a death spiral for the welfare state. That could happen if we continue to pay for promised benefits by increasing taxes or deficits, further retarding economic growth and thus spurring still more tax and deficit increases to sustain benefits. But to all of these unsettling possibilities, there’s a ritualistic, upbeat response: We shall overcome. We’re a can-do people. The U.S. economy adapts to change. It creates new technologies and industries. Its long-term resilience is incontestable. As Vice President Joseph Biden once put it, “No one’s ever made money betting against America.”

Unfortunately, that isn’t true. Many people have made money betting against America: those who sold stocks in August 1929 or sold the dollar in the late 1970s, and those who bet against the U.S. mortgage market in 2006. The list goes on. It’s true that over long stretches — decades — the U.S. economy has generated higher living standards for most citizens. But even this truth is selective. Banking panics occurred regularly in the 1800s. In the mid- to late 19th century, disease and poor diets lowered living standards of urban workers. Then came the Great Depression, the Great Inflation, and now the Great Recession.

So: America is not entitled to economic success. What actually happens depends on private markets and public policies. To be sure, the future is not etched in stone. Uncertainties abound, as any prediction must acknowledge. Here are three caveats.

First, forecasts of the future as an extension of the present are suspect. Unforeseen events — for good and ill — intervene. History is littered with false prophets. Consider Harvard economist Alvin Hansen (1887–1975). In 1938, when unemployment was still 19 percent, he sought to explain why the U.S. economy couldn’t shake the Depression. His answer was “secular stagnation.” There was no engine of expansion. Slower population growth meant fewer new consumers and less reason for businesses to invest. Technology was not advancing, dampening investment in new industry. And decades earlier the “frontier” had effectively ceased to exist, so there was no longer any spending on new settlements to boost the economy.

It was all plausible — and wrong. After World War II, the baby boom created a population explosion. Countless technologies spawned new industries in television, aviation, synthetic fibers, and plastics, to name a few. And there was a new frontier to settle — suburbia.

The second caveat is that economic progress may be overrated. Younger Americans may be less obsessed with material goods as the be all and end all of a satisfying life. Moreover, many Americans will enjoy rising incomes over their lifetimes, reflecting experience and seniority. In 2009, for example, the median income of working men aged 45 to 54 was 40 percent higher than for their counterparts aged 25 to 34. Viewing their own lives, most Americans might feel upwardly mobile. The difference would be that tomorrow’s 45-year-olds might have less than today’s.

Finally, we are not helpless. We might mitigate the forces that assail a broad-based affluence. Just because health spending hasn’t been tamed in the past doesn’t mean it won’t be tamed in the future. As society ages, Americans may recognize that longer life expectancies justify longer working lives and that wealthier retirees deserve fewer (or no) subsidies from less affluent younger workers. That could lead to steps that would reduce the burdens of the old on the young.

Though the future will doubtlessly differ from how anyone now imagines it, the trends fostering downward mobility are insistent, because they are rooted in demographics, politics, and global economics.

We are at a symbolic turning point. The coincidence of the Great Recession with baby boomers’ retirements marks the eclipse of the post–World War II social compact, formed in the 1950s and ’60s. That arrangement promised that business cycles would be mild, because economic policy could moderate booms and busts. Technological change would be gradual, because dominant firms such as General Electric, AT&T, and General Motors controlled it and had a stake in gradual change. Large institutions were mostly benign. Major corporations provided career jobs and generous fringe benefits (health insurance, pensions) for most of their workers. There were reciprocal loyalties and obligations between employee and employer. Greater wealth enabled government to create a safety net for the old, the disabled, and the poor.

The props underlying this unspoken compact have been weakening since 1980. Technological changes are no longer gradual; they’re abrupt and disruptive, driven largely by computer hardware and software companies, or Web-based enterprises such as Google and Facebook. Career jobs still exist but are dwindling in number. The reciprocal loyalties between workers and their employers have weakened. The promise of overall economic stability seems hollow. The fundamental lesson of the 2007–09 financial crisis is that economists overestimated their ability to prevent calamitous boom-bust cycles. Globalization has increased economic complexity faster than economists’ capacity to keep up. The social safety net — actually, the welfare state — is popular, but huge government deficits put its affordability in doubt.

The premise of the post–World War II affluent society, that we were or would soon become so rich that we could afford almost anything, was never true,

 but we often acted as if it were. We avoided unpleasant choices, especially in government, accepting routine federal budget deficits (46 out of 51 years since 1961). Now, limits are painfully evident. There are more promises than can be fulfilled. Meeting all of government’s spending commitments would require higher, broad-based taxes, which both liberals and conservatives reject, or perpetually large deficits, which both parties consider unsustainable and undesirable.

What looms is a future of more distributional struggles between young and old, rich and poor, different regions, and many interest groups. Each will defend subsidies, work to avoid tax increases, and maneuver for regulatory advantage.

The role of economic growth in advanced nations is less to make people richer than to reduce conflict. If most people feel that they’re “getting ahead,” they’re less resentful of others who are doing better or hold different views. “Periods of economic expansion in America and elsewhere, during which most citizens had reason to be optimistic, have also witnessed greater openness, tolerance, and democracy,” writes Harvard economist Benjamin Friedman in 

The Moral Consequences of Economic Growth

 (2005). If, however, people fall behind — or fear they will — they become more resentful. Until the Great Recession, three decades of growing economic inequality had inspired little popular backlash. This changed after unemployment rose. The Tea Party and Occupy Wall Street movements reflect the fallout of feared downward mobility.

Lower economic growth will have broad consequences. Already, defense spending is headed toward claiming the lowest share of GDP since 1940. In effect, the welfare state is defeating the Pentagon. Some will cheer, others complain. Either way, America’s global role will change.

The prospect of downward mobility could discourage younger Americans from marrying and having families — a development that would accelerate America’s aging. Although people marry and have children for many reasons, their economic outlook is an important influence. Low-income men are not prime candidates for marriage. Birthrates collapsed in the 1930s because families worried that they could not support new offspring. It is surely no coincidence that in the wake of the Great Recession the number of marriages fell five percent in 2010 and births three percent.

As it is, the generations are in an undeclared war. Americans in their late forties, fifties, and sixties believe that the contract made with them should be kept. They want their Social Security and Medicare benefits. They are angry when what they thought were career jobs are unexpectedly terminated; corporate buyouts and firings weren’t part of the bargain. Meanwhile, their children and grandchildren are befuddled and frustrated. Their unemployment rates are high, and their wage levels — compared to those of the past — are low. Yet they feel guilty advocating trims to Social Security and Medicare, even when the transfers go from the struggling young to the comfortable old.

The Affluent Society was more a state of mind than an explicit economic target or threshold level of income. It announced the arrival of an era when traditional economic concerns were being overwhelmed by a seemingly unstoppable flood of abundance. Prosperity was a panacea. We could afford a decent society as well as a wealthy society. Many traditional social, political, and economic choices could, with a little patience, be evaded. There was enough for almost everything. We have been, in historian David Potter’s apt phrase, a “people of plenty.” What happens when there is less plenty than we expected? We are about to find out.

, a columnist for The Washington Post, is the author, most recently, of 

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Though Americans see upward mobility as their birthright, that assumption faces growing challenges, with consequences not just for the size of our wallets, but for the tenor of our politics.

Robert J. Samuelson