Chapter 1
The American Economy—Historical Overview

It is not what we have that will make us a great nation; it is the way in which we use it.

—Theodore Roosevelt, 1886

The workings of the American economy are complex and often mysterious, even to economists. At its simplest, the economy runs on three major sectors: consumers, businesses, and government. (See Figure 1.1.) Consumers earn money and exchange much of it for goods and services from businesses. These businesses use the money to produce more goods and services and to pay wages to their employees. Both consumers and businesses fund the government sector, which spends and transfers money back into the system. The banking system plays a crucial role in the economy by providing the means for all sectors to save and borrow money. Finally, there are the stock markets, which allow consumers to invest their money in the nation's businesses—an enterprise that further fuels economic growth for all sectors. Thus, the U.S. economy is a circular system based on interdependent relationships in which massive amounts of money change hands. The historical developments that produced this system are important to understand, because they provide key information about what has made the U.S. economy such a powerful force in the world.

DEFINING THE AMERICAN ECONOMY

The term "market economy" describes an economy in which the forces of supply and demand dictate the way in which goods and resources are allocated and what prices will be set. The opposite of a market economy is a "planned economy," in which the government determines what will be produced and what prices will be charged. In a market economy producers anticipate what products the market will be interested in, and at what price, and they make decisions about what products they will bring to market and how these products will be produced and priced.

Market economies foster competition among businesses, which typically leads to lower prices and is generally considered beneficial for both workers and consumers. A planned economy, on the other hand, is directed by a central government that has a far greater degree of influence over prices and production, as well as tighter regulation of industries and manufacturing procedures. The United States has a "mixed economy," which combines aspects of a market economy with some central planning and control to create a system with a high degree of market freedom along with regulatory agencies and social programs that promote the public welfare.

This mixed economy did not develop overnight. It has evolved over more than two centuries and has been shaped by American experiences at various times with hardship, war, peace, and prosperity.

HISTORICAL TRENDS

Colonial Times

When European colonists first came to the "New World," they found a vast expanse of land inhabited by Native Americans. Many of the first colonies were business ventures called "charter companies" that were financed by wealthy English businessmen and landowners. The colonies were granted limited economic and political rights by the king of England. After profits proved to be disappointing, many of the investors turned over the companies to the colonists themselves. These actions were to have far-reaching consequences on the shape of America. A report titled The U.S. Economy: A Brief History published by the U.S. Department of State (http://usinfo.state.gov/products/pubs/oecon/chap3.htm) notes: "The colonists were left to build their own lives, their own communities, and their own economy."

At first the colonists were preoccupied with merely surviving. Eventually they engaged in commerce with Europe by exploiting the natural resources of their new homeland. The main agricultural products of the colonies were tobacco, wheat, rye, barley, rice, and indigo plant. Other important exports were animal furs, products from fish and whales, and timber. Shipbuilding became a major industry in New England.

Political and Industrial Revolution

Frustrated with the political and economic interference of England, the colonists banded together to forge a new nation—the United States of America. The push for independence from Britain, which culminated in the Revolutionary War (1775–83), was driven by economic and political motivations, including the desire for greater self-governance and tax relief.

In 1776 a book was published in England that would have long-reaching effects on the new United States. Scottish philosopher Adam Smith wrote An Inquiry into the Nature and Causes of the Wealth of Nations. The book was remarkable for many reasons. It discussed economic principles in a commonsense, nonmathematical manner and argued that the forces of supply and demand affect prices and wages. It criticized the restrictions and regulations common in European countries, and it advocated free and open trade within and between countries and abolishment of wage and price controls. Smith believed that an "invisible hand" was guiding workers seeking to better their private finances, which in turn helped nations achieve prosperity. In other words, people who work hard for their own gain unconsciously contribute to national wealth. The principles of a competitive marketplace with little government interference were adopted by the new United States and dominated the nation's economic policy for more than a century.

During the late 1700s Britain and the newly formed United States underwent a major social and economic change from agriculture to industry. The Industrial Revolution saw the introduction of the steam engine, cotton gin, and other machines capable of increasing production while decreasing human labor. Farming, in particular, became much less labor-intensive, freeing up people to pursue other forms of employment. Over the next century the United States would change from an agrarian-based nation to one in which the majority of income was generated by manufacturing, trade, and business providing services to consumers. (See Figure 1.2.)

The 1800s—Expansion and Civil War

The 1800s were a period of enormous growth for the United States in terms of territory, population, and economic might. Settlers spread from the East and South across the Midwest to the West Coast. A massive railroad system was built across the country. Gold was discovered in the western territories. More than two dozen states were added to the union. Expansionism was accompanied by violent conflicts with Britain (the War of 1812), Mexico (the Mexican-American War, 1846–48), and Spain (the Spanish-American War, 1896). In addition, the so-called Indian Wars were waged for many years against Native American tribes.

The Northeast developed thriving industries, and cities swelled with hundreds of thousands of European immigrants. Although the South remained largely rural and agricultural, mechanical innovations, like the cotton gin, changed the region's focus. Cotton became a major crop and was exported to textile mills in the North and overseas. Unfortunately, much of the economic success of the South was based on the use of slave labor.

Deep divisions arose between factions in the North and South on the morality of slavery and associated political and economic issues, which led to the devastating American Civil War in 1861. By the time the war ended in 1865 the factories of the Northeast had become extremely important in fueling America's economy.

The Gilded Age

In 1873 American author Mark Twain cowrote with his neighbor Charles Dudley Warner a novel entitled The Gilded Age, which describes an American society in which unscrupulous businessmen and corrupt politicians pursue quick fortunes at the expense of the common people. Indeed, the decades following the Civil War were characterized by scandals involving high-level politicians making money from crooked business deals, as well as an unprecedented boom in business. The resulting social atmosphere was one of decadence among the upper classes contrasted with poverty and labor unrest among the lower classes.

During the late 1800s the U.S. economy surged on a wave of industrialization and mechanized production. Industries boomed in iron, steel, lumber, precious metals, railroading, and petroleum. Some enterprising businessmen became extremely wealthy during the period, including John D. Rockefeller and Andrew Carnegie. Such men were called "captains of industry" by those who admired them and "robber barons" by those who despised them.

The U.S. government had a hands-off approach to business regulation, a tactic described by the French term laissez-faire (leave alone or "do as you please"). It was generally believed that the government should not interfere in economic affairs but should instead allow supply and demand and competition to operate unfettered, resulting in a "free market."

The gilded age is notable for a growth in corporations. A corporation is a legally defined entity that may receive financial support from numerous investors but is treated as an individual under the law. A corporation is granted a state charter including specific rights, privileges, and liabilities. This type of business organization became very popular in the late 1800s. It allowed people to invest in businesses without taking on all of the responsibilities and risks of being a business owner. State charters limited the liability of individual investors, who were paid dividends in proportion to their share of investment in the corporation.

Some corporations grew through mergers or by buying out the companies of their competitors. Then they developed a business structure called a trust, in which the component companies were managed by a small group of people called a board of trustees. These corporations controlled nearly all of the business in their respective industries, a condition known as monopolization. The public feared that trusts squelched competition that helped keep prices in check. In 1890 the U.S. Congress passed the Sherman Antitrust Act. Its stated purpose was "to protect trade and commerce against unlawful restraints and monopolies." But due to court challenges, the law was not successfully applied until the early 1900s.

Panics and Depressions

In economic terms a "panic" is a widespread occurrence of public anxiety about financial affairs. People lose confidence in banks and investments and want to hold onto their money instead of spending it. This can lead to a severe downturn, or depression, in the economic condition of a nation. The U.S. economy suffered from panics and depressions even during the booming growth of the 1800s and early 1900s. Although economists argue about the exact definitions of panics and depressions, in general it is agreed that economic downturns occurred in the United States in 1819, 1837, 1857, 1869, 1873, 1893, and 1907.

The crises were triggered by a variety of factors. Common problems included too much borrowing and speculation by investors and poor oversight of banks by the federal government. Speculation is the buying of assets on the hope that they will greatly increase in value in the future. During the 1800s many speculators borrowed money from banks to buy land. Huge demand caused land prices to increase dramatically, often above what the land was actually worth in the market. Poorly regulated banks extended too much credit to speculators and to each other. When a large bank failed, there was a domino effect through the industry, which caused other banks and businesses to fail.

A panic or depression results in a downward economic spiral in which individuals and businesses are afraid to make new investments. People rush to pull their money from banks. As panic spreads, banks demand that borrowers pay back money, but borrowers may lack the funds to do so. Consumers are reluctant to spend money, which negatively affects businesses. Demand for products goes down, and prices must be lowered to move merchandise off of shelves. This means less profit for business owners. Businesses lay off employees to cut costs and do not hire new employees. As more people become unemployed or fearful about their jobs, there is even less spending in the marketplace, which leads to more business cutbacks and so forth. The cycle continues until some compelling change takes place to nudge the economy back into a positive direction.

The Twentieth Century Begins

The early twentieth century was a time of social and political change in the United States. Public disgust at the corruption and greed of the gilded age encouraged a movement called progressivism. Progressives promoted civic responsibility, workers' rights, consumer protection, political and tax reform, "trust busting," and strong government action to achieve social improvements. The progressive era greatly affected the U.S. economy because of its focus on improving working conditions for average Americans. Successes for the progressives included child labor restrictions, improved working conditions in factories, compensation funds for injured workers, a growth surge in labor unions, federal regulation of food and drug industries, and the formation of the Federal Trade Commission to oversee business practices.

Some people viewed the progressive movement as an attack on capitalism and a prelude to socialism. The American economy was first described as "capitalist" by the German economist Karl Marx (1818–83), who used the term to describe an economy in which a small group of people control the capital, or money available for investment, and, by extension, control the power within the economy. A common criticism of capitalism was that it favored profits over the well-being of workers. Marx advocated a socialist system in which wealth and property were not held by a few individuals but were equally distributed among all workers under a heavily planned economy. The socialist movement gained some momentum during the progressive era, thanks in large part to its ties to organized labor. In the presidential election of 1912 the socialist candidate Eugene V. Debs garnered more than nine hundred thousand votes—around 6% of the popular vote. But socialism soon faded as a serious challenge to American capitalism.

Despite its laissez-faire attitude, in 1913 the federal government took two actions that were to have long-lasting effects on the U.S. economy:

• Establishment of the Federal Reserve System to serve as the nation's central bank, furnish currency, and supervise banking
• Ratification of the Sixteenth Amendment to the U.S. Constitution authorizing the collection of income taxes

World War I and Inflation

In 1914 World War I began in Europe. The U.S. entered the conflict in April 1917 and was engaged until the war ended in November 1918. Although the nation spent only nineteen months at war, the U.S. economy underwent major changes during this period.

It is sometimes said that "war is good for the economy" because, during a major war, the federal government spends large amounts of money on weapons and machinery through contracts with private industries. These industries hire more employees, which reduces unemployment and puts more money into the hands of consumers to spend in the marketplace. This benefits other businesses not directly involved in the war effort. On the surface, these economic effects appear positive. However, major wars almost always result in high inflation rates.

Inflation is an economic condition in which the purchasing power of money goes down because of price increases in goods and services. For example, if a nation experiences an inflation rate of 3% in a year, an item that cost $1.00 at the beginning of the year will cost $1.03 at the end of the year. Inflation causes the "value" of a dollar to go down over the course of the year. In general, small increases in inflation occur over time in a healthy growing economy, because demand slightly outpaces supply. Economists consider an inflation rate of 3% or less a year to be tolerable. During a major war the supply and demand ratio becomes distorted. This occurs when the nation produces huge amounts of war goods and far fewer consumer goods, such as food, clothing, and cars. This lack of supply and anxiety about the future drive up the prices of consumer goods, making it difficult for people to afford things they need or want.

During World War I the federal government intervened in private industry to support war needs and exert some control over supply and demand dynamics. Agencies were created to oversee the production of war goods, food, fuel, and nonmilitary ships. Although the government tried to impose some level of price control in the food and fuel industries, inflation still occurred. According to the U.S. Census Bureau's Historical Statistics of the United States (1975), the prices for many consumer goods nearly doubled between 1915 and 1920. Figure 1.3 shows the average annual inflation rate from 1914 through 1924. The inflation rate was unusually high from 1916 through 1920, peaking at 18% in 1918. Wartime inflation was particularly hard on nonworking citizens, such as the elderly and sick, because there were no large government programs in place at that time to assist needy people.

A lasting legacy of World War I was the assumption of large amounts of debt by the federal government to fund the war effort. Figure 1.4 shows the enormous differences that occurred between government revenues (receipts) and spending during the war years. In 1919 government spending peaked at nearly $18.5 billion; revenues for that year were just over $5 billion. The government made up the difference by borrowing money. One method used was the selling of Liberty bonds. Bonds are a type of financial asset—an IOU that promises to pay back at some future date the original purchase price plus interest.

The Roaring Twenties

The Roaring Twenties began with a whimper; there was a severe economic downturn in 1921. But this crisis was followed by several years of robust economic growth. Mass production and the availability of electricity led to huge consumer demand for household appliances. Installment plans became a popular means for middle-class Americans to purchase expensive long-lasting (durable) goods like refrigerators, washing machines, and automobiles.

Americans also began spending more money on entertainment. They bought radios and went in large numbers to see motion pictures and baseball games. The automobile became a necessity, rather than a luxury, for many people. Booming car sales boosted the petroleum and housing markets and allowed city dwellers to move to the suburbs.

The prosperity of the 1920s was not shared by all Americans. During World War I demand for agricultural goods had skyrocketed, particularly in Europe. Overoptimistic farmers borrowed heavily to pay for tractors and other farm equipment, only to see food prices plummet during the 1920s when supply outpaced demand. Financial problems in the agricultural industry directly impacted a lot of Americans. In addition, banks in rural areas were stressed by farmers who were unable to pay back loans. The agricultural crisis was accompanied by downturns in the coal mining and railroad industries that affected many workers.

In the late 1920s the stock market became a major factor in the U.S. economy. Investors were richly rewarded, as stocks increased dramatically in value. Many people took out loans from banks to pay for stock or purchased stock by "buying on margin." In this arrangement an investor would make a small down payment (as little as 10%) on a stock purchase. The remainder of the balance would be paid (in theory) by the future increase in the stock value. Buying on margin was widely practiced by optimistic investors of the time. University of Wisconsin history professor William Tishler notes: "By 1929, much of the money that was invested in the stock market did not actually exist" ("The Crash and the Great Depression," 2000, http://us.history.wisc.edu/hist102/lectures/textonly/lecture18.html).

Black Tuesday—October 29, 1929

On October 29, 1929, the stock market crashed. For months, President Herbert Hoover and other influential people had warned that there was too much speculation in the stock market and that stock prices were higher than the actual worth of the companies. In the fall of 1929 investors began to get nervous. On October 24, 1929, there was a selling frenzy as people tried to get rid of stocks they thought might be overvalued. The day was dubbed "Black Thursday." The following day the market rebounded somewhat, and stock prices climbed back upward. But the recovery was short-lived.

On Tuesday, October 29, 1929, panic selling took place all day. Stock values dropped dramatically. The drawback to buying on margin was that if a stock value went down by a certain amount, the lender would make a "margin call" asking the buyer for more cash up front. If the margin buyer could not pay, the lender sold the stock to recoup the money. As "Black Tuesday" progressed, desperate margin buyers paid lenders all their cash in savings in hopes of saving their stock for the expected recovery, but no recovery came. As stock values fell further, lenders demanded more money. By the end of the day many margin buyers had lost their life savings and their stock. Those who managed to hold on to their stock found it was worth only a fraction of its former value.

According to economist Harold Bierman, Jr., the American stock market lost almost 90% of its value between 1929 and 1932 ("The 1929 Stock Market Crash," August 11, 2004, http://eh.net/encyclopedia/article/Bierman.Crash).

The Great Depression

The United States economy suffered a devastating downturn following the stock market crash. The depression was so deep and lasted so long—more than a decade—that it is called the Great Depression.

Historically, economic depressions had been short downturns with limited consequences. They were temporary dips in an overall trend of American prosperity. The Great Depression was a completely different experience. It brought long-term unemployment and hardship to millions of people. The unemployment rate soared from 3.2% in 1929 to nearly 25% in 1933. (See Figure 1.5.) It remained more than 10% through the end of the 1930s. The public lost confidence in the stock market, the banking system, and big business.

Like all previous depressions, this one included a downward cycle in which businesses reduced spending and production and laid off employees. Unemployed workers and those fearful of losing their jobs cut back on spending, which forced businesses to lay off more people. The economy underwent "deflation"—a condition where a lack of money among consumers depresses demand and pushes prices downward. Lower prices for agricultural and industrial goods hurt farmers and businesses, particularly those with high debt. Consumers also had assumed high levels of debt during the 1920s.

The Great Depression was aggravated by a crisis in the banking industry. Some banks had invested heavily in the stock market using their depositors' money or loaned large amounts of money to stock market investors. These banks failed after the crash, and the depositors lost their savings. Fear of further failures caused "bank runs," in which large numbers of depositors rushed to withdraw their money at the same time. This caused more bank failures, which perpetuated the cycle. In addition, some economists believe that the banking market became over-saturated during the 1920s with underfunded and loosely regulated banks that loaned money too easily. These institutions were already financially troubled before the crash and could not survive the stress.

America's Great Depression was felt worldwide, particularly in other industrialized countries. By the 1920s the United States played a major role in world commerce by exporting and importing large amounts of goods and investing money in foreign businesses. A prolonged downturn in American production, spending, and investing combined with the banking crisis had international consequences. Europe, in particular, suffered financially as it struggled to recover from the devastation of World War I.

The New Deal

When the Great Depression first began, the laissez-faire attitude still dominated political opinion. Some economists, including Andrew Mellon (1855–1937), who served as Secretary of the Treasury from 1921 through 1932, advised President Hoover not to interfere. These economists took the traditional viewpoint that supply and demand factors would eventually equilibrate, and the economy would recover on its own. Hoover was not convinced. He tried a variety of tax adjustments, asked industry not to cut wages, and pushed for public works projects. But the depression only deepened.

By 1932 Americans were ready for a change in leadership. New York State Governor Franklin D. Roosevelt (FDR) promised "a new deal" for the nation. He was elected in a landslide and developed a government that aggressively acted in economic affairs. The New Deal included a wide variety of programs intended to bring relief to suffering Americans, revive farming and business, and reform the stock market and banking industry. After more than seventy years, economists still argue about whether the New Deal was actually good for the nation. They all agree, however, that it was a turning point in American economic history.

Some New Deal programs did not survive court challenges. The National Industrial Recovery Act of 1933 encouraged companies within industries to form alliances and set prices and wages. The companies that participated were exempt from antitrust laws that ordinarily would have forbidden such collusion. In 1935 the U.S. Supreme Court ruled the law unconstitutional. The Agricultural Adjustment Act (AAA) of 1933 paid farmers to reduce production. It was thought that lower supply would raise prices and improve the living conditions of farmers. In 1936 the U.S. Supreme Court invalidated parts of the AAA. But the payment of farm subsidies became a permanent component of U.S. economic policy.

Other legacies of the New Deal include:

• Federal Securities Act (1933)—Regulated the selling of investment instruments (such as stock) to ensure that buyers are better educated about their purchases and to prevent fraudulent practices
• Securities Exchange Act (1934)—Regulated the stock exchanges and created the U.S. Securities and Exchange Commission
• Glass-Steagall Banking Act (1933)—Separated the commercial and investment banking industries and established the Federal Deposit Insurance Corporation (FDIC) to safeguard depositors' money
• National Labor Relations Act (1935)—Guaranteed the right of employees in most private industries to organize, form labor unions, and bargain collectively with their employers; established the National Labor Relations Board
• Social Security Act (1935)—Established a program to provide federal benefits to the elderly and assist the states in providing for "aged persons, blind persons, dependent and crippled children, maternal and child welfare, public health, and the administration of unemployment compensation laws"

Government employment programs under the Public Works Administration, Works Project Administration, and Civilian Conservation Corps put people to work building roads, dams, bridges, airfields, and post offices and developing national parks for tourism. According to economics writer Robert Samuelson, as many as ten to twelve million Americans were employed in these programs at various times during the 1930s ("Great Depression," http://www.econlib.org/library/Enc/GreatDepression.html#biography).

Perhaps the greatest legacy of FDR's New Deal was the new role of the federal government as a manipulator of economic forces and a provider of benefits to the needy. This change in American policy was seen as a wise and compassionate move by some people and as a dangerous shift toward socialism by others. In American history the New Deal is considered the birth of "big government."

By 1940 the unemployment rate was 14.9%. (See Figure 1.5.) Although down from a peak of 25% in 1933, the rate was still very high by historical standards. Nearly a decade of New Deal programs had softened the hardship suffered by many Americans, but had not boosted the country out of the Great Depression. It was going to take a war to accomplish that task.

World War II

During the 1930s Germany, led by the dictator Adolf Hitler (1889–1945), began aggressive military campaigns against its neighboring countries, followed by similar moves by Japan and Italy. Many in the United States were determined to keep the nation out of these international conflicts, but in 1939 Britain, France, and Canada declared war on Germany after Germany invaded Poland. The Germans began a devastating bombing campaign of London called a blitzkrieg ("lightning war"). By 1941 Germany and its Italian and Japanese allies had occupied France and war had spread throughout Europe, North Africa, parts of China, and the North Atlantic and South Pacific seas.

In the United States, FDR publicly adhered to the isolationist sentiment of the American public; but as early as 1939 he began quietly expanding the nation's military capabilities. On December 29, 1940, he gave a radio address in which he reiterated his goal of keeping the United States out of the war, but he warned that the very survival of the United States would be jeopardized if Great Britain were to be defeated. He pledged to provide America's allies with "implements of war," saying "we must be the great arsenal of democracy." FDR believed that American industrial power would save Great Britain and its allies from defeat. In his address FDR noted:

Manufacturers of watches, farm implements, linotypes, cash registers, automobiles, sewing machines, lawn mowers, and locomotives are now making fuses, bomb packing crates, telescope mounts, shells, pistols, and tanks. But all our present efforts are not enough. We must have more ships, more guns, more planes, more of everything. This can only be accomplished if we discard the notion of business as usual.

On December 7, 1941, Japanese forces attacked Pearl Harbor in Oahu, Hawaii, where members of the U.S. Navy, Army Air Corps, and Marines were stationed. The attack killed more than twenty-four hundred American service people and civilians. Within days, the United States was at war with Japan, Germany, and Italy. "Business as usual" was a thing of the past.

Although the U.S. officially entered World War II in 1941, it had been gearing up its industries for war for more than a year. This experience at mobilization (converting civilian industries to produce military goods) proved to be invaluable. The federal government established a host of agencies to oversee wartime production, labor relations, and prices. Efforts were made to avoid the huge inflation increase that had occurred during World War I. Rationing was instituted on some goods to prevent dramatic price increases. By and large, these efforts were successful. Figure 1.6 shows the annual rates of inflation experienced in the United States between 1940 and 1950. Inflation spiked during the early years of the war and immediately after but was not consistently high over the decade.

Businesses rushed to increase production and hire workers to produce the goods needed for the war effort. Unemployment dropped dramatically and wages went up, particularly for workers in low-skilled factory jobs. Laborers found themselves in high demand and joined labor unions in record numbers to consolidate their power and seek better working conditions.

World War II was an expensive endeavor for the United States. But it was believed that the stakes were so high that the war had to be won at any cost. As shown in Figure 1.7, government spending during the war far outpaced revenues. By 1945 the government was spending around $90 billion per year and taking in revenues around half that amount. Once again, the difference was made up by borrowing.

The flood of American goods and military might turned the tide of the war. By early 1945 Germany and Italy had been defeated. In August of that year Japan surrendered after suffering two devastating hits by U.S. atomic bombs. World War II was over, and a new world order had been established. The United States abandoned its isolationist stance and assumed an active role in international affairs.

Keynesian Economics

The Great Depression shook many peoples' beliefs in the laissez-faire approach to economics advocated by Adam Smith in the eighteenth century. During the 1930s and 1940s different approaches to capitalism began to receive serious attention. One of the most famous economists of the time was John Maynard Keynes (1883–1946). Keynes (pronounced "canes") was an English expert in the application of economic theory to real-world problems. He published several influential books, including The Economic Consequences of the Peace (1919) and the General Theory of Employment, Interest and Money (1936). In the latter book Keynes advocated strong government intervention in the economy as a remedy for the ongoing economic depression.

Politicians of the 1930s were not completely convinced by Keynes's arguments, particularly in regards to government spending. Maintaining a balanced federal budget was considered so sacred that the governments of Hoover and Roosevelt were reluctant to veer far from that precedent. But following World War II it appeared obvious that huge government spending had helped fuel recovery from the Great Depression. Keynes's theories on capitalism, unemployment, and business cycles became highly regarded, and he is credited with inventing macroeconomics. This is a "big picture" approach that measures broad trends in an economy, such as employment and inflation, and the way these trends interact. In contrast, microeconomics analyzes the economy on a smaller scale—for example, by studying the supply and demand factors at work in individual markets or industrial segments.

Keynesian economics became the operating principle of the U.S. government in the post-World War II era. Although Keynes had his critics, and his methods have been revised over time, he is considered by many to be the father of the mixed economy system used in the United States to this day.

The National Income and Product Accounts

One innovation of the 1940s was the National Income and Product Accounts (NIPAs), which are compilations of national economic data. Prior to that time there was a lack of comprehensive macroeconomic data on the nation's inputs and outputs, such as labor and production of goods and services. This problem became apparent during the Great Depression when the Hoover and FDR administrations were forced to make decisions based on fragmented and incomplete data on the nation's financial condition. As a result, the federal government asked researchers at the National Bureau of Economic Research (NBER) at the City University of New York to begin estimating national income (wages, profits, rent, etc.). The NBER had been founded in 1920 as a private nonprofit organization dedicated to economic research.

During World War II the federal government began compiling another macroeconomic measure called the gross national product (GNP). The GNP is the amount in dollars of the value of final goods and services produced by Americans over a particular time period. For example, the GNP for 1945 was nearly $212 billion (Historical Statistics of the United States, September 1975). GNP is calculated by summing consumer and government spending, business and residential investments, and the net value of U.S. exports (exports minus imports).

At first GNP estimates were made annually; eventually they were calculated on a quarterly basis. The GNP provides a valuable tool for tracking national productivity over time. By the end of the 1940s an entire set of NIPAs had been developed to report macroeconomic data on the state of the U.S. economy.

A Postwar Spending Spree

Following World War II many U.S. industries demobilized from producing military goods and returned to producing consumer goods. Well-paid workers who had been frustrated by wartime shortages were ready to spend money. Returning soldiers received government incentives to buy houses and start businesses. Postwar euphoria drove a spending spree and a baby boom. The birth rate increased from an average of 19.2 births per one thousand population in the 1930s to 24.8 births per one thousand population in the 1950s. (See Figure 1.8.)

Growing families purchased bigger houses, many of which were built in the suburbs. The suburban population shift was accompanied by a growth in shopping centers, supermarkets, and car ownership. According to the U.S. State Department's Outline of U.S. History, annual production of automobiles quadrupled between 1946 and 1955. Television and air conditioning became widely available following World War II. Air conditioning spurred migration from the Northeast and Midwest to the Southeast and Southwest. By the end of the 1950s three-fourths of all American families owned at least one television set. Television advertising reached a large audience and promoted more consumer spending.

New industries in aviation and electronics arose after World War II. Many existing industries underwent consolidation and growth as corporations merged into giant conglomerates. Figure 1.9 shows the national income produced by the business sector for 1953 to 1957. Manufacturing accounted for nearly a third of the national income during this period.

The 1950s also experienced a boom in business franchises. In this arrangement an individual could purchase permission from a company in one geographic area to sell the company's products or services in another area. Franchising proved to be a very effective means of spreading brand recognition and was widely practiced in the surging "fast food" industry. In 1955 Des Plaines, Illinois, became the site of the first McDonald's franchise after businessman Raymond Kroc became a franchisee for the McDonald brothers, who owned a small chain of restaurants in California. By 1959 there were more than one hundred McDonald's franchises around the country. Over the next decade franchising was practiced in a number of other businesses, many of which grew into major corporations.

Dwight D. Eisenhower was president from 1953 through 1961. His administration is associated with a growing economy that experienced low inflation rates and general prosperity. But the prosperity of the 1950s was not shared equally in American society. Once again, farmers found themselves in trouble due to overproduction. Oversupply of agricultural goods meant lower prices (and lower profits). Agriculture became increasingly an industry in which large "factory farms" run by corporations were able to survive, while many smaller farmers could not compete.

Minority populations (largely African-American) also suffered financial hardship during this era. Figure 1.10 shows the dramatic difference between the unemployment rates for whites and minorities during the postwar decades. By the mid-1950s unemployment among minorities was twice as high as it was among white workers, a disparity that lingered well into the 1960s. It was in this atmosphere that the civil rights movement gained in strength and urgency. In 1954 segregation was ruled unconstitutional by the U.S. Supreme Court. A year later African-American seamstress and activist Rosa Parks was arrested in Alabama for refusing to move from the "white" section of a public bus. This incident spurred a bus boycott and ultimately brought Martin Luther King, Jr., and other leaders of the movement to national prominence.

The Cold War, Korea, and Vietnam

The United States left World War II in sound economic shape. All other industrialized nations had suffered great losses during the war in their infrastructure, financial stability, and populations. The United States invested heavily in the postwar economies of Western Europe and Japan, hoping to instill an atmosphere conducive to peace and the spread of capitalism. U.S. barriers to foreign trade were relaxed to build new markets for American exports and to allow some war-ravaged nations to make money selling goods to American consumers.

The Soviet Union had been a wartime ally of the United States, but relations became strained after World War II ended. The Soviet Union had adopted communism following a period of revolution and civil war in the late 1910s and early 1920s. During World War II the Soviet Union "liberated" a large part of Eastern Europe from Nazi occupation. Through various means the Union of Soviet Socialist Republics (USSR) assumed political control over these nations. The USSR had been largely industrialized prior to World War II and quickly regained its industrial capabilities. It soon took a major role in international affairs, placing it in direct conflict with the only other "superpower" of the time—the United States. A "cold war" began between two rich and powerful nations that had completely different political, economic, and social goals for the world.

The cold war was fought mostly by politicians and diplomats. A direct and large-scale military conflict between U.S. and Soviet forces never occurred. But an expensive arms race began in which both sides produced and stockpiled large amounts of weapons as a show of force to deter a first strike by the enemy. In addition, both sides provided financial and military support to countries around the world in an attempt to influence the political leanings of those populations. Communist China joined the cold war during the 1950s and often partnered with the USSR against U.S. interests.

In 1950 North Korean forces backed by the Soviet military invaded South Korea, setting off the Korean War (1950–53). The United States was caught off guard by the invasion, but rushed to defend South Korea from a communist takeover. Over the next three years U.S. and allied forces under the United Nations fought against North Korean and Chinese troops supported by the Soviet Union. The war ended in a stalemate with both sides back where they had started—on either side of the thirty-eighth parallel (a line of latitude). In 1953 a cease-fire agreement ended the armed conflict in Korea. North Korea remained under communist control, while South Korea became a democracy protected by United Nations troops (primarily U.S. forces).

Also during the 1950s, the U.S. military became involved in a conflict between communist North Vietnam and noncommunist South Vietnam. The United States sent thousands of "military advisors" to South Vietnam during the late 1950s and early 1960s in an effort to bolster the defenses of the country. In 1964 the conflict escalated into full-scale civil war. Once again, the U.S. found itself in a remote Asian country trying to prevent the spread of communism.

The fight in Vietnam turned out to be a long and difficult one in which U.S. forces, assisted by a handful of other countries, were pitted against highly motivated forces equipped and backed by the USSR and China. The U.S. was engaged in the Vietnam War for more than a decade before withdrawing its last troops in 1975 and leaving South Vietnam to a communist takeover. According to Outline of U.S. History, the total cost of the Vietnam war exceeded $150 billion.

In both the Korean and Vietnam wars the U.S. chose to fight in a limited manner without using its arsenal of nuclear weapons or engaging Chinese or Soviet troops directly for fear of sparking another world war. Full-scale mobilization of U.S. industries was not required for these wars, as it had been during World War II. Instead, a defense industry developed during the cold war to supply the U.S. military on a continuous basis with the arms and goods it wanted. In a 1961 speech, outgoing President Dwight D. Eisenhower described this arrangement to the American public:

We can no longer risk emergency improvisation of national defense; we have been compelled to create a permanent armaments industry of vast proportions. Added to this, three and a half million men and women are directly engaged in the defense establishment. We annually spend on military security more than the net income of all United States corporations.

Figure 1.11 shows the percentage of the national budget that was devoted to national defense between 1940 and 1970. Spending on national defense soared during World War II and then declined dramatically following the war's end. But military spending quickly climbed again as the cold war heated up, remaining above 40% for nearly two decades.

The Birth of the Modern Fed

The nation's central bank—the Federal Reserve System—was formed in 1913 to furnish currency and supervise financial institutions. Gradually it took on other roles that affected the amount of money circulating in the United States and the interest rates charged by banks to their customers. The Federal Reserve System comprises twelve regional banks located around the country and overseen by a seven-member board of governors headquartered in Washington, D.C.

The Fed, as it came to be called, was designed to be as independent as possible from political pressures from the U.S. president and the Congress. This safeguard was included to prevent the Fed from having to bow to demands for short-term economic fixes requested by politicians seeking reelection. The Fed was charged with taking a big-picture, long-term approach to economic policy for the good of the nation as a whole.

From its inception until the early 1950s the Fed was influenced by the policies of the U.S. Department of the Treasury, a federal agency created in 1789. During the late 1940s Fed and Treasury officials disagreed about how best to handle the large debt accumulated by the United States during World War II. This conflict and other contentious issues led to a new agreement, or accord, between the two agencies about the roles of each in the U.S. economy. This accord is considered the birth of the modern Fed, an organization that has grown to exert great power in the U.S. economy (Robert L. Hetzel and Ralph F. Leach, "After the Accord: Reminiscences on the Birth of the Modern Fed," Economic Quarterly, volume 87/1, winter 2001, http://www.richmondfed.org/publications/economic_research/economic_quarterly/pdfs/winter2001/leach.pdf).

The chairman of the board of governors at the time of the accord was William McChesney Martin, Jr. (1906–98). Martin was a dynamic leader who maintained his post for nearly two decades. Under his leadership the Fed assumed greater control over the nation's financial policies. This control was exercised primarily by influencing interest rates on loans. Lowering interest rates encouraged borrowing, which put more money into circulation for spending or investing. However, if demand outpaced supply, price inflation became a problem. Then, the Fed would raise interest rates to make borrowing less attractive and dampen demand. Martin reportedly summed this up as follows: "You have to take away the punch bowl when the party is warming up." His policy proved to be fruitful during the prosperous decades of the 1950s and 1960s.

The 1960s—Social Upheaval and Economic Growth

The 1960s were a time of social and economic change for the United States. The decade began with the election of President John F. Kennedy, who promised to ensure economic growth and address America's growing social problems. In 1963 Kennedy's efforts were cut short by his assassination. Lyndon B. Johnson took over as president and dramatically enlarged the federal government and its role in socioeconomic affairs. Johnson's administration initiated large-scale programs for the needy, including the health care programs Medicare (for the elderly) and Medicaid (for the poor), jobs programs, federal aid to schools, and food stamps for low-income Americans. The so-called "war on poverty" and the escalating war in Vietnam proved to be very expensive. At the same time, the United States was pursuing a costly (but ultimately successful) endeavor to land astronauts on the moon before the end of the decade.

Consumer and government spending drove the nation's GNP during the 1960s. It grew to $977 billion by 1970. But inflation became a problem (as it often does in a fast-growing economy) in the late 1960s. At the macroeconomic level there was too much money in the hands of consumers, which resulted in consumer demand that was higher than supply. By 1970 the inflation rate had reached 5.7%.

The nation was preoccupied with the explosive social problems of the time. During the mid- to late 1960s the country was plagued by protests against the Vietnam War and riots in blighted urban areas populated by poor African-Americans. By 1968 there were half a million American troops in Vietnam. Nightly television coverage provided a bleak picture of the war's progress and helped turn public opinion against the war and President Johnson. In 1968 Johnson announced he would not seek reelection. That same year Martin Luther King, Jr., and Robert Kennedy—John Kennedy's brother and an aspiring presidential candidate—were assassinated.

The United States left the 1960s having experienced the longest continuous stretch of positive GNP growth in history—the first quarter of 1961 through the last quarter of 1969 (National Bureau of Economic Research, http://www.nber.org/cycles.html/). But high inflation was about to become a major problem.

The 1970s: Stagflation and Energy Crises

Stagflation is a word coined during the 1970s to describe an economy suffering stagnation, high inflation, and high unemployment all at the same time. This combination of economic problems was unprecedented in U.S. history. Previously, high inflation had occurred when the economy was growing quickly, such as during World War II. But high production had meant high employment levels. By contrast, economic downturns were associated with higher unemployment but lower inflation (and even deflation). These relationships had been considered natural and certain.

The 1970s were unique, because both unemployment and inflation were high, by historical standards. Economist Robert Barro invented a new term called the Misery Index to describe this condition. The Misery Index is computed by summing the unemployment rate and inflation rate. Figure 1.12 shows the annual Misery Index calculated for 1968 through 1983. By the mid-1970s each rate exceeded 5%.

There were three presidents during the 1970s—Richard Nixon, Gerald Ford, and Jimmy Carter. Each tried a variety of measures to stem stagflation, but none was considered effective. Nixon implemented wage and price controls and increased government spending. In 1973 he resigned under threat of impeachment for his role in the Watergate scandal. Vice President Gerald Ford assumed the presidency. Economic problems continued, and in 1976 the country elected Jimmy Carter as the new president. Carter had emphasized the high Misery Index during his presidential campaign, but his administration was unable to turn the tide. By 1980 the Misery Index had climbed to 20%.

FOREIGN OIL AND COMPETITION

America's economic problems were aggravated by its dependence on foreign oil and competition from foreign industries. In 1973 Middle Eastern members of the Organization of Petroleum Exporting Countries (OPEC) halted oil exports to the United States in retaliation for U.S. support of Israel. The oil embargo lasted five months. When shipments resumed, the price of oil had dramatically increased. Americans faced high prices, long lines, and shortages at the gas pumps. Figure 1.13 shows that the average retail price of gasoline surged from around thirty-five cents per gallon in 1972 to $1.35 per gallon in 1981. A fifty-five mile per hour speed limit was imposed on the nation's interstates to save fuel. The federal government called on Americans to conserve energy and provided an example by not lighting the White House Christmas tree. During the late 1970s a revolution in oil-rich Iran brought a second wave of shortages to U.S. energy supplies.

The "energy crisis" of the 1970s had a ripple effect through the U.S. economy, causing the prices of other goods and services to increase. Lower profits and uncertainty about the future caused businesses to slow down and reduce their workforces. At the same time, American industries in steel, automobiles, and electronics endured stiff foreign competition, particularly from Japan. Small energy-efficient Japanese cars became very popular in the United States. By 1980 gasoline cost more than $1.00 per gallon, which was quadruple the price in 1970. American car makers struggled to compete, having always relied on consumer demand for large automobiles—now considered "gas-guzzlers."

DEREGULATION

One of the measures that President Carter took to combat stagflation was deregulation. For decades certain industries in the United States had been given government immunity from market supply and demand factors. The railroad, trucking, and airline industries were prime examples. Companies in these industries were guaranteed rates and routes and were allowed to operate contrary to antitrust laws. In 1978 the airline industry was deregulated; airlines began to compete with each other over fares and routes, and new companies entered the industry. Some of the large, well-established companies were unable to compete in the new environment and went out of business. But demand increased as prices came down and flying became available to many more Americans. By 1980 deregulation had been completed or was underway for the railroad, trucking, energy, financial services, and telecommunications industries.

The 1980s—Recession and Reaganomics

In November 1980 the American people elected Ronald Reagan as the new president. Inflation was at 13% that year—incredibly high for a peacetime economy. Unemployment was at 7%, meaning that millions of people were unemployed and faced with rapidly increasing prices in the marketplace. The economic situation was dire, and drastic measures would be required to turn the economy around.

SLAYING THE INFLATIONARY DRAGON

In late 1979 President Carter had appointed a new governor of the Federal Reserve, Paul Volcker, who promised to "slay the inflationary dragon." Volcker began by tightening the nation's money supply. This had the effect of making credit more difficult to obtain, which drove up interest rates. The government knew that rising interest rates would probably trigger a production slowdown (a recession) that would push unemployment even higher. It was a trade-off that policymakers during the previous decade had been unwilling to accept.

Volcker forged ahead with his policies, and by the early 1980s interest rates had reached historical highs. Figure 1.14 shows that the prime loan rate—the interest rate that banks charge their best customers—peaked at 21.5% in December 1980. In 1981 the average interest rate for a conventional thirty-year mortgage soared to 18.45%, the highest rate ever recorded by the Federal Home Loan Mortgage Corporation (http://research.stlouisfed.org/fred2/data/MORTG.txt).

Lack of credit caused a business slowdown—a reduction in GNP growth (or recession). As expected, the recession put more people out of work. Unemployment climbed at first, averaging 10% in 1982 and 1983, but then began to decline. By the end of the decade it was down around 5%. The inflation rate dropped from a high of 13% in 1980 to less than 5% by 1989. Although the spike in unemployment had been painful for Americans, the inflationary dragon was finally dead.

REAGANOMICS

When Reagan took office in 1981 he brought a new approach to curing the nation's financial woes: supply-side economics. Traditionally, the government had focused on the demand side—the role of consumers in stimulating businesses to produce more. Reagan preferred economic policies that directly helped producers. Professor Paul Johnson of Auburn University describes the philosophy this way: "Supply-side policy analysts focus on barriers to higher productivity—identifying ways in which the government can promote faster economic growth over the long haul by removing impediments to the supply of, and efficient use of, the factors of production" (http://www.auburn.edu/∼johnspm/gloss/supply_side).

One of the cornerstones of supply-side economics is reducing taxes so that people and businesses have more money to invest in private enterprise. Reagan enacted tax cuts through two pieces of legislation: the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986. The result was a much lower number of tax brackets (the various rates at which individuals are taxed based on their income), a broader tax base (wealth within a jurisdiction that is liable to taxation), and reduced tax rates on income and capital gains (the profit made from selling an investment, such as land).

At the same time, Reagan pushed for greater national defense spending as part of his "peace through strength" approach to the Soviet Union and selective cuts in social services spending. But no cuts were made to the largest and most expensive programs within the social services budget. The combination of all these factors resulted in high federal deficits during the 1980s. In other words, the federal government was spending more than it was making each year. As shown in Figure 1.15, the federal deficits of the mid-1980s were more than twice what they had been during the mid-1970s. In 1981 the national debt (the sum of all accumulated federal deficits since the nation began) reached $1 trillion.

The 1990s—Sparkling Economic Performance

The 1990s were a time of phenomenal economic growth for the United States, even amid the shadows of war and an ever-increasing federal deficit. In August 1990 the military forces of Iraq under President Saddam Hussein invaded the small neighboring country of Kuwait. President George H. W. Bush had taken office in 1989 and quickly acted to put together a coalition of international forces that successfully forced Iraq out of Kuwait. The Gulf War, as it came to be known, was short-lived and would be seen as a triumphant, if incomplete, victory by allied forces. Although his military strength was weakened, Hussein was not removed from power in Iraq and continued to pose foreign relations problems for the United States for many years.

President Bush had been elected in large part because of his promise not to raise taxes. During the campaign he famously said, "Read my lips: No new taxes." But the promise was not one he could keep given the economic realities of the time. During the late 1980s there had been a severe financial crisis in the savings and loan industry, which had been recently deregulated. A series of unwise loans and poor business decisions left most of the industry in shambles and necessitated a government bailout. According to the U.S. Department of State, by 1993 the cost of the bailout had exceeded $500 billion ("Outline of U.S. History," November 2005, http://usinfo.state.gov/products/pubs/histryotln/order.htm). At the same time, the government faced rapidly rising expenditures on health care programs for the elderly (Medicare) and the needy (Medicaid). Bush reluctantly agreed to a tax increase, a move that was politically damaging. In 1992 he lost his reelection bid to Arkansas Governor Bill Clinton, who was reelected in 1996.

By and large the 1990s were a period of peace and prosperity for America. The cold war ended when the Soviet Union disintegrated into individual republics. Technological innovations, particularly in the computer industry, helped push the economy to new heights. Sterling business success led to robust investor confidence in the stock markets. Figure 1.16 shows the portion of household assets invested in real estate and corporate equity (stocks) between 1945 and 1998. Although real estate was the preferred investment through nearly all of this period, the 1990s witnessed tremendous increases in the holdings of corporate equity by the average American. In the mid-1980s the average household had only 10% of its assets in corporate equity. By 1998 this percentage had reached nearly 30%, roughly equal to the percent held in real estate. The Dow Jones Industrial Average is a stock market index—a measure used by economists to gauge the value (and performance) of the stock of thirty large companies. Between the late 1970s and the late 1990s the index soared from around one thousand points to eleven thousand points—reflecting the tremendous value gained by these companies over that time period.

The combination of low interest rates, low unemployment, and high investment rates and business growth combined to greatly expand the U.S. economy. In a 1999 speech, Chairman of the Federal Reserve Board Alan Greenspan described the expansion as "America's sparkling economic performance."

The 2000s—Hardship, War, Peace, and Prosperity

In January 2001 George W. Bush was inaugurated as the nation's new president. He entered office with plans to overhaul many federal programs and enacted a tax cut within the first few months of his administration. On September 11, 2001, four commercial airliners were commandeered by hijackers. Two of the planes were flown into the twin towers of the World Trade Center in New York City. A third plane was flown into the Pentagon in Washington, D.C. The fourth plane crashed in a field in Pennsylvania after passengers likely struggled with their hijackers. The attacks killed more than twenty-nine hundred people and stunned the world. Intelligence revealed that the hijackers were Middle Eastern terrorists associated with the group al-Qaida, led by Osama bin Laden. The U.S. believed that bin Laden was being harbored by the Taliban government of Afghanistan and demanded that he be turned over to authorities. After the Taliban refused to do so, the United States military invaded Afghanistan. Although the military operations were technically a success, the U.S. was not able to capture bin Laden and found itself in a lingering guerilla-type conflict with Taliban and al-Qaida fighters.

The so-called 9/11 attacks dramatically altered the priorities of the U.S. government. The president called for a worldwide war against terrorism and created a new Department of Homeland Security to strengthen national security. In 2003 an allied military force comprised mostly of American and British troops invaded Iraq. The allied forces met little resistance from Iraqi forces, and the war was declared over in less than a month. But, as in Afghanistan, the United States found itself trying to establish order in a country in which pockets of insurgents (well-armed and determined guerillas and terrorists) managed to wreak havoc and kill American soldiers and innocent civilians. As of the fall of 2006 the U.S. military continued its presence in Afghanistan and Iraq. Both nations were trying to rebuild with U.S. assistance. Fox News reported in September 2005 that the Afghanistan and Iraq campaigns had cost the United States more than $300 billion at that time (September 10, 2005, http://www.foxnews.com/story/0,2933,169035,00.html).

The 9/11 attacks had numerous direct effects on the U.S. economy. Investor nervousness brought a short-lived dip in the stock markets. The tourism industry suffered a major setback, and insurance companies had to make massive payouts to settle claims. There were also costs to the government for rescue and recovery operations. Longer-term effects include the financial repercussions of new national security and antiterrorism measures implemented at home and abroad.

THE INTERNET BUBBLE BURSTS

During the late 1990s the stock market witnessed tremendous growth, driven in large part by investor enthusiasm for Internet-related businesses. Access to the Internet became widespread in America and much of the developed world, creating many new market opportunities for entrepreneurs. Investors enthusiastically poured money into the stock of these new businesses. NASDAQ is U.S.-based stock market on which the stock of many technology companies is traded. The NASDAQ composite index is a measure of the performance of many of the stocks on NASDAQ. In 1990 the index was less than five hundred. In early 2000 it peaked above four thousand during the height of the Internet stock craze. Many of the stocks had become overvalued; their high prices could not be sustained based on the actual financial results that the companies were producing. What followed was a sharp market correction, as investors sold off many Internet-based stocks and the prices plummeted. By late 2002 the NASDAQ composite index was around twelve hundred, from which it slowly began to climb again.

In economics a "bubble" is a phenomenon in which investors overzealously invest (speculate) in a particular commodity or market sector that becomes overvalued. Excitement about possible gains overrules frank analysis of the underlying financial factors. Unfortunately, the very existence of a bubble is not evident until after the fact, when the bubble has burst and much value has been lost in the investments and the businesses involved.

THE DECADE SO FAR

The early 2000s have proved to be expensive years for the U.S. economy, with the 9/11 attacks, the wars and rebuilding efforts in Iraq and Afghanistan, the bursting of the Internet bubble, corporate scandals, devastating hurricanes that hit the U.S. Gulf Coast in 2005, and rising energy costs. But relatively prosperous conditions have continued for the U.S. economy, as witnessed by continuing growth in the gross domestic product (GDP), relatively low unemployment rates, and moderate rates of inflation.