The Economist’s Stone

CAMBRIDGE – This year marks the 100th anniversaries of two distinct institutional innovations in American economic policy: the introduction of the federal income tax and the establishment of the Federal Reserve. They are worth commemorating, if only because we are at risk of forgetting what we have learned since then.

Initially, neither the income tax nor the Fed was associated with the explicit concepts of fiscal and monetary policy. Indeed, it wasn’t until after the experience of the 1930’s that they came to be viewed as potential instruments for macroeconomic management. John Maynard Keynes pointed out the advantages of fiscal stimulus in circumstances like the Great Depression. Milton Friedman blamed the Depression on the Fed for allowing the money supply to fall.

Keynes is associated with a belief in activist economic policy aimed at ensuring counter-cyclical responses to economic fluctuations – expansionary policies during recessions and policy tightening during upswings. Friedman, by contrast, opposed discretionary policymaking, believing that government institutions lacked the ability to get the timing right. But both opposed pro-cyclical policy, such as the misguided US fiscal and monetary tightening of 1937: before the economy had fully recovered, President Roosevelt raised taxes and cut spending, while the Federal Reserve raised reserve requirements, prolonging and worsening the Great Depression.

After World War II, students and policymakers internalized the lessons of the 1930’s. But episodes in recent decades – for example, high inflation in the 1970’s – overwhelmed much of what was learned. As a result, many advanced countries today are repeating the mistake of 1937, despite facing similar macroeconomic conditions: high unemployment, low inflation, and near-zero interest rates.