Economics from Scratch · Part 9
Crisis, Revolution and the Mixed Economy
Part 8 ended around 1900, with capitalism absorbing its critics’ demands: antitrust law, factory laws, unions and the first social insurance. The next seventy-five years tested every system at once: two world wars, a revolution that built the first socialist state, and a depression that nearly broke capitalism.
By the end of it, almost every country had turned the dials toward the middle. This was the part of the history where I kept stopping to ask whether a given country was socialist or capitalist, and the answer was usually “both, in different proportions.”
As before, I’ve kept the questions I had along the way and what cleared them up.
Crisis and Revolution (about 1900 to 1945)
By 1900, industrial capitalism had spread across Europe, the US and Japan, and European empires ruled much of the world. Most major currencies were on the gold standard: each could be exchanged for a fixed amount of gold, so how much money a country could create was tied to how much gold it held.
World War I (1914 to 1918): capitalist countries start planning. To fight a total war, Britain, Germany and the US took direct control of much of their economies: deciding what factories made, rationing food and materials, setting prices. Private owners still owned the factories, but the state told them what to produce. Many people concluded that planning could work, at least for one overriding goal. After the war came Germany’s hyperinflation of 1923, partly caused by the reparations it owed.
The Russian Revolution (1917). The Bolsheviks, led by Vladimir Lenin, seized power and set out to build the first socialist state:
| Phase | What they did | What happened |
|---|---|---|
| War Communism (1918 to 1921) | Took over industry, banned private trade, seized grain from farmers by force | Production collapsed; a severe famine in 1921 |
| New Economic Policy (1921 to 1928) | Lenin retreated: farmers could sell surplus grain in markets, and small private businesses were allowed | The economy recovered |
| Stalin’s Five-Year Plans (from 1928) | Central planning of the whole economy, rapid heavy industry, forced collectivization of farms | Huge growth in steel, coal and machinery, but scarce consumer goods, a catastrophic famine in 1932 and 1933 in which millions died, especially in Ukraine, and millions more sent to forced-labor camps |
Lenin himself had to bring markets back to stop the economy collapsing.
The socialist calculation debate. In 1920, the Austrian economist Ludwig von Mises argued socialism couldn’t work rationally: without market prices for factories, machines and raw materials, planners have no way to know which uses are worth more. In the 1930s, Oskar Lange replied with market socialism: planners could simulate prices, raising them when there were shortages and lowering them when there were surpluses. Friedrich Hayek answered that the knowledge needed is scattered across millions of people and changes constantly, so no planner could keep up. This debate shaped economics for the rest of the century.
The Great Depression (1929 to 1939). In the 1920s, US stock prices soared, much of it on borrowed money: people bought shares with loans, called buying on margin. In October 1929, prices crashed, and what followed was the worst collapse in modern history. US output fell by about a quarter between 1929 and 1933, about a quarter of workers were unemployed by 1933, thousands of banks failed, and prices fell by about a quarter.
| What happened | Why it made things worse |
|---|---|
| Frightened depositors pulled money out, and banks failed in runs | A bank only keeps a fraction of deposits on hand, so a run can sink even a sound bank |
| As banks failed and stopped lending, the money supply shrank by about a third | Banks create money when they lend, so when lending collapses, money disappears |
| The Fed didn’t step in as lender of last resort | Nobody stopped the runs |
| Falling prices made debts heavier, causing more defaults | Debt deflation: fixed payments get harder to make as prices and incomes fall |
| People and companies cut spending, so others lost income and cut too | One person’s spending is another person’s income |
| The gold standard spread the collapse and stopped countries creating money | Money was tied to gold, not to what the economy needed |
| The US raised tariffs sharply in 1930 with the Smoot-Hawley Act, others retaliated, and world trade collapsed | Trade makes both sides richer, so cutting it makes both poorer |
Keynes. Classical economics said a slump should fix itself: unemployed workers would accept lower wages, prices would fall, and spending would recover. But the Depression went on for years. John Maynard Keynes, in The General Theory (1936), explained why:
- An economy can get stuck with high unemployment, because the problem is too little total spending, which economists call aggregate demand.
- When everyone is scared, households save more and businesses stop investing. Each is being sensible, but together they cut everyone’s income. Keynes called this the paradox of thrift.
- Falling wages don’t fix it: lower wages mean workers spend even less.
- So when private spending collapses, the government should spend, even by borrowing, to replace it and get the loop running again.
Extra spending turns into more output when there’s slack and into inflation when there isn’t, and in the Depression the economy was nearly all slack. Keynes had earlier written the line still quoted against waiting for markets to fix themselves: “In the long run we are all dead.”
The New Deal (from 1933). Franklin Roosevelt’s response built much of the system the US still runs on:
| Reform | What it did | What it fixed |
|---|---|---|
| Federal deposit insurance (FDIC, 1933) | Insured bank deposits, ending most bank runs | Instability |
| Separating ordinary banking from investment banking | Kept riskier activities apart from depositors’ money | Instability |
| The SEC (1934) | Required companies to disclose information to investors | Hidden information |
| Social Security (1935) | Old-age pensions and unemployment insurance | Worker insecurity |
| Public works programs | Government hired millions to build roads, dams and schools | Too little spending |
| Labor laws (1935, 1938) | Protected union organizing, set a minimum wage and maximum hours | Bargaining power |
The US also loosened its link to gold in 1933, which let the money supply grow again. Countries that left the gold standard earlier generally recovered faster.
Fascism: private ownership, state control. Italy under Mussolini and Germany under Hitler kept private ownership but put it under the state’s direction. Independent unions were abolished, and businesses and workers were organized into state-controlled bodies. Nazi Germany spent massively on rearmament, which cut unemployment quickly, aimed for self-sufficiency, seized property from Jews and others it persecuted, and used forced labor on an enormous scale during the war. Private ownership alone doesn’t guarantee freedom or voluntary exchange: under fascism, owning a business was conditional on serving the state.
Gandhi: an alternative from India. In colonial India, Mahatma Gandhi offered a very different vision: swadeshi, buying Indian goods and boycotting British ones, especially the British cloth that had wiped out India’s handloom industry; khadi, hand-spun cloth, both an economic and a political act; village self-sufficiency rather than big factories and cities; and trusteeship, the idea that the wealthy should hold their wealth as trustees for society. He was skeptical of machinery that put people out of work, close to the Luddites’ concern. His 1930 Salt March, protesting Britain’s tax and monopoly on salt, echoes the Han dynasty’s salt debate two thousand years earlier.
World War II (1939 to 1945) ended the Depression. Governments spent on a scale never seen before, unemployment vanished, and economies, including the US, were run largely by central direction.
| What this era teaches | Where it shows up |
|---|---|
| Planning can mobilize resources fast for one goal | The world wars; Stalin’s industrialization |
| Without market prices, planners struggle to know what’s worth making | Mises and Hayek; the New Economic Policy’s retreat |
| Economies can get stuck if total spending collapses | The Depression; Keynes |
| Bank failures destroy money and deepen slumps | The shrinking money supply |
| Rigid money rules can turn a slump into a disaster | The gold standard |
| Protectionism spreads hardship | Smoot-Hawley |
| Private ownership without voluntary exchange isn’t freedom | Fascism |
| Most of today’s fixes were built in response | Deposit insurance, disclosure rules, Social Security, labor laws |
By 1945, almost nobody believed in pure, hands-off capitalism. The question became how much the state should manage the economy.
The Mixed-Economy Era (about 1945 to 1975)
Bretton Woods (1944). The Allies met in Bretton Woods, New Hampshire, to design rules between countries that would avoid the 1930s trade wars and currency chaos. Other currencies were fixed to the US dollar, and the dollar was fixed to gold at $35 an ounce, for central banks. The IMF and World Bank were created to lend to countries in trouble and fund rebuilding. Trade barriers came down through agreements under the GATT, from 1947. And countries kept controls on money flowing across borders, so they could set their own interest rates without money rushing in and out. The US also funded the Marshall Plan, from 1948, giving Western Europe billions of dollars to rebuild.
The West: the Golden Age. From the late 1940s to the early 1970s, Western Europe, the US and Japan grew faster than ever before, and the gains were shared more widely than in almost any other period. France calls it les Trente Glorieuses, “the thirty glorious years,” and West Germany the Wirtschaftswunder, the economic miracle. The recipe was markets and private ownership plus a much bigger state:
| Country | What they built |
|---|---|
| Britain | Following the 1942 Beveridge Report, which set out to fight “five giants,” want, disease, ignorance, squalor and idleness, Britain created the National Health Service in 1948, free at the point of use, and nationalized coal, railways and steel |
| West Germany | The social market economy: free markets and private firms, plus strict competition law, social insurance, and co-determination, with workers on company boards. Its architect, Ludwig Erhard, saw strong competition and a safety net as working together. |
| Nordic countries | High taxes, generous universal welfare, strong unions bargaining with employers nationally, and open, competitive markets |
| United States | Strong unions, the GI Bill paying for veterans’ education and homes, and later Medicare and Medicaid (1965). Top income tax rates were around 90% in the 1950s. |
Governments followed Keynes: when the economy slowed, spend more or cut taxes; when it overheated, do the opposite. Many economists believed in a stable trade-off called the Phillips curve: accept a bit more inflation, get less unemployment.
A minority disagreed. Hayek, Milton Friedman and others, who founded the Mont Pelerin Society in 1947, warned that the state was growing too large. In 1968, Friedman argued that the Phillips curve wouldn’t last: once people expected inflation, they’d build it into wages and prices, and you’d get inflation without the extra jobs.
East Asia: the developmental state. Japan, and later South Korea and Taiwan, took a different route: capitalism with the state actively steering it. Japan’s trade and industry ministry, MITI, guided which industries got support, credit and protection, and pushed companies to export, while high household savings funded heavy investment. South Korea, in 1960 about as poor as many African countries, grew explosively after General Park Chung-hee took power in 1961. The state controlled the banks and directed cheap credit to big family-run conglomerates, the chaebol, like Samsung and Hyundai, but only if they hit export targets. Taiwan began with a major land reform that broke up large estates, then built export industries.
The difference from planned socialism: firms were privately owned and had to compete in world markets.
India: planning in a democracy. After independence in 1947, Prime Minister Jawaharlal Nehru chose a mixed economy with heavy planning. Five-Year Plans began in 1951, and the second, from 1956, shaped by the statistician P. C. Mahalanobis, focused on heavy industry like steel. The state ran the “commanding heights”: steel, heavy machinery, power and later banks. Private companies needed government licenses to start, expand or change what they made, a system nicknamed the License Raj. High tariffs protected domestic industry, a strategy called import substitution: make at home what you’d otherwise import.
India avoided the disasters of Mao’s China and built a real industrial base, but growth was slow, around 3.5% a year, which the economist Raj Krishna called the “Hindu rate of growth.” One big success was the Green Revolution of the late 1960s: new high-yield seeds and fertilizer, championed by scientists including M. S. Swaminathan, greatly increased grain output and ended India’s dependence on food aid.
China under Mao. After the Communist victory in 1949, China redistributed land from landlords to peasants, then moved to collective farms and state industry. Then came two catastrophes.
In the Great Leap Forward (1958 to 1962), Mao tried to industrialize overnight. Peasants were organized into huge communes and pushed to make steel in backyard furnaces, much of it useless. Local officials, afraid to report failure, wildly exaggerated harvests, so the state took grain that didn’t exist. The famine killed tens of millions of people, one of the deadliest in history. It’s the knowledge problem at its most extreme: when the only information flowing upward is what officials think leaders want to hear, planning goes blind.
The Cultural Revolution (1966 to 1976) then threw the country into political chaos, closing universities and persecuting experts.
The Soviet Union: success, then stagnation. The USSR grew quickly through the 1950s and launched Sputnik, the first satellite, in 1957, which shocked the West. By the 1970s growth slowed sharply. Adding more workers and factories had run its course, and productivity barely improved: growth from more inputs runs into diminishing returns, and only productivity keeps it going. A 1965 attempt to give firms profit incentives was largely abandoned, and the Brezhnev years became known as the era of stagnation.
The end of the era (1971 to 1975). Two shocks broke the postwar system. In 1971, with US inflation rising and foreign central banks holding more dollars than the US had gold to back, President Nixon ended the dollar’s conversion into gold. Fixed exchange rates collapsed within two years, and major currencies began to float. In 1973, Arab oil producers embargoed oil to the US and others, and oil prices roughly quadrupled.
The result was stagflation: high inflation and rising unemployment at the same time. The Phillips curve trade-off broke, just as Friedman had warned, and Keynesian tools seemed to have no answer.
| What this era teaches | Where it shows up |
|---|---|
| Markets plus a strong state can produce fast, widely shared growth | The Western Golden Age |
| State guidance works best when it’s disciplined by competition | Japan and South Korea’s export tests |
| Blocking free entry slows growth, even in a democracy | India’s License Raj |
| Planning without honest information can be catastrophic | The Great Leap Forward |
| Growth from adding inputs runs out without productivity | Soviet stagnation |
| Expectations break the inflation and jobs trade-off | Friedman’s warning; stagflation |
| Fixed exchange rates break when underlying conditions change | The end of Bretton Woods |
What’s Next
From 1900 to 1975, planning mobilized economies for war, the first socialist state industrialized at enormous human cost, and capitalism nearly collapsed in the Depression before Keynes explained why it got stuck. Afterward, almost every country built a mixed economy: the West with welfare states, East Asia with state-guided exporters, India with planning and licenses, the communist world with full central planning. The mixes that kept competition and honest information did best. Then stagflation broke the postwar consensus.
Part 10 covers 1975 to now: Volcker and the free-market turn, China’s reforms and India’s 1991 opening, the Soviet collapse, globalization and its crises, the 2008 crash, and the backlash that followed.