The Free-Market Turn and After

Part 9 ended with stagflation: inflation and unemployment rising together in the 1970s, which made it look as if governments had grown too big and couldn’t manage the economy. Over the next thirty years, country after country turned the dials back toward markets, in the West, in the communist world and in the developing world, with very different results. Then the free-market era ended in a financial crash, and since 2008 the dials have been turning back toward the state.

This is the last part of the history, and it’s the one I’d lived through without understanding.

As before, I’ve kept the questions I had along the way and what cleared them up.

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The Free-Market Turn (about 1975 to 2008)

Breaking inflation: Volcker (1979 to 1982). By 1980, US inflation was about 13.5%. Everyone expected prices to keep rising, so they built that into wages and prices. Paul Volcker became Fed chair in August 1979 and decided the only way out was to change expectations. He let interest rates soar, with the Fed’s rate reaching about 20% in 1981. Borrowing became brutally expensive. Picture Sam wanting a loan for a second center and being quoted 18%: she wouldn’t build it, and across the economy nobody built much. Unemployment peaked at 10.8% in late 1982. But inflation fell to about 3% by 1983, and people started believing it would stay low.

That shaped central banking for forty years. Central banks became independent of politicians so they could take unpopular steps, and their main job became keeping inflation low and believable. New Zealand adopted the first formal inflation target in 1990, and most rich countries followed.

The ideas. The economists who’d been in the minority since the 1940s now won the argument. Milton Friedman argued that inflation is “always and everywhere a monetary phenomenon,” coming from too much money being created, and argued for floating exchange rates, lower taxes and less regulation. He won the Nobel Prize in 1976. Friedrich Hayek, Nobel 1974, had long argued that no government can gather the information prices carry. And public choice economists like James Buchanan made a new point: economists had studied how markets fail, but governments fail too. Politicians chase votes, agencies grow, and regulated businesses end up steering their regulators. Comparing a messy market with a perfect government isn’t fair; you have to compare it with a real one.

Thatcher and Reagan. Margaret Thatcher, British prime minister from 1979 to 1990, privatized state companies, starting with British Telecom in 1984, British Gas in 1986 and British Airways in 1987, and later water, electricity and rail, selling shares to the public. Right to Buy let council tenants buy their government-owned homes at a discount, turning over a million renters into owners. She faced down the unions in the 1984 to 1985 miners’ strike, which lasted a year and ended in defeat for the miners. She cut the top income tax rate from 83% to 60% and later to 40%, and deregulated the City of London in the 1986 “Big Bang.” Unemployment went above 3 million as old industries closed, and former industrial regions still feel it.

Ronald Reagan, US president from 1981 to 1989, cut the top income tax rate from 70% to 50% and then to 28%, and deregulated airlines, trucking, banking and energy, some of it started under Jimmy Carter. He fired over 11,000 striking air traffic controllers in 1981, a signal to employers that taking on unions was acceptable; US union membership fell from about 20% of workers in 1983 to around 12% by 2008. He also spent heavily on defense, so despite the small-government talk, government debt rose sharply.

China: Deng’s reforms (from 1978). After Mao died in 1976, Deng Xiaoping took control. The Communist Party kept political power, but the economy was opened step by step:

• The household responsibility system. In 1978, 18 farming families in the village of Xiaogang secretly divided their collective land. They agreed to deliver the state’s grain quota and keep whatever they grew beyond it. Each family became the residual claimant: it kept whatever was left after the state’s fixed share, so extra effort now paid it directly. Their harvest jumped. The state soon approved the system nationwide, and China’s grain output rose by about a third between 1978 and 1984.
• Special economic zones, from 1980. Shenzhen, then a small town next to Hong Kong, and three other areas were opened to foreign investment with low taxes and fewer rules. Shenzhen grew into a city of millions.
• Dual-track pricing. State firms still delivered fixed quotas at planned prices, but could sell anything beyond that at market prices. The market grew alongside the plan instead of replacing it overnight.
• Village and township firms, locally owned and neither fully state-run nor private, boomed in the countryside.

Economic opening didn’t mean political freedom: in 1989 the Party crushed the Tiananmen Square protests. After Deng’s “southern tour” in 1992 restarted the reforms, and China joined the World Trade Organization in 2001, it became the world’s factory. It grew about 10% a year for three decades, and by the World Bank’s estimates around 800 million people left extreme poverty, the largest drop in history.

India: the 1991 opening. By 1991, India was nearly out of foreign currency. Its reserves covered only a few weeks of imports, and it had to fly gold to London as collateral for emergency loans. Prime Minister P. V. Narasimha Rao and his finance minister, Manmohan Singh, used the crisis to push through reforms that had been debated for years, some of which had started in the 1980s. They abolished most industrial licensing, ending the License Raj for most industries. They devalued the rupee by about 20%, making exports cheaper. They cut tariffs sharply and opened the door to foreign investment. Growth rose to around 6% a year and later higher, and software firms like Infosys and Wipro grew into a global industry. Free entry turned out to matter enormously.

The Soviet collapse (1985 to 1991). Mikhail Gorbachev came to power in 1985 knowing the system was stagnating, and tried two things at once: perestroika, “restructuring,” giving firms some freedom and allowing small private businesses, and glasnost, “openness,” allowing criticism and free speech. The half-reforms broke the old planning system without creating working markets, and shortages got worse. Oil prices, the USSR’s main source of foreign currency, collapsed in 1986. Once people could speak openly, they did. Eastern European countries threw off communist rule in 1989, the Berlin Wall fell that November, and the Soviet Union dissolved in December 1991.

Shock therapy. Russia, under Boris Yeltsin and his reformer Yegor Gaidar, tried to switch to markets all at once. Prices were freed in January 1992, and inflation hit about 2,500% that year. State firms were privatized fast, first through vouchers handed to citizens, then in 1995 through a “loans for shares” deal that gave major companies to a few well-connected bankers at very low prices. They became the oligarchs. Output fell by around 40% over the 1990s, male life expectancy dropped to about 58 by 1994, and Russia defaulted on its debt in 1998.

Poland also used shock therapy, from January 1990, but did much better. It already had a large private farm sector, stronger institutions and the pull of joining Western Europe, and it was the first former communist country to get back above its 1989 output.

The contrast with China is the big lesson. China kept its state and changed the economy gradually, starting where incentives could change quickly, like farming. Russia tore down the state’s economic role before the institutions markets need were in place: courts that enforce contracts, honest regulators, clear property rights. Markets turned out to need much more than getting the government out of the way.

The Washington Consensus. In 1982, Mexico couldn’t repay its foreign loans, and a debt crisis spread across Latin America, whose 1980s became known as the lost decade. The IMF and World Bank lent on conditions, and in 1989 the economist John Williamson summed up the standard advice as the Washington Consensus:

• Keep government budgets under control.
• Let markets set interest rates, and keep exchange rates competitive.
• Lower trade barriers and welcome foreign investment.
• Privatize state firms and deregulate.
• Protect property rights.

Results were mixed. Some countries stabilized: Chile, which under the dictator Pinochet had adopted free-market policies from the mid-1970s, grew strongly. Others privatized in ways that enriched insiders, grew slowly, and saw a backlash in the 2000s. Critics like Joseph Stiglitz argued that one checklist had been applied to very different countries, sometimes in the wrong order.

Globalization. Trade barriers kept falling. NAFTA joined the US, Canada and Mexico in 1994, the WTO was set up in 1995, and China joined it in 2001. Shipping containers and the internet made it cheap to run supply chains across continents: an iPhone could be designed in California and assembled in China from parts made in Korea, Japan and Taiwan.

Output rose, goods got cheaper, and hundreds of millions of people in Asia left poverty. But the gains were uneven. The economists David Autor, David Dorn and Gordon Hanson found that Chinese import competition cost the US somewhere between one and two and a half million jobs from 1999 to 2011, concentrated in particular towns that never really recovered. The economy as a whole gained, but the people who lost were rarely compensated.

Currencies and crises. In the Plaza Accord of 1985, after the dollar had risen about 50% in five years, the five largest economies agreed to sell dollars together to push it down, and it fell sharply. The yen surged, and Japan cut interest rates to protect its exporters. Cheap money inflated a huge bubble in stocks and land: the Nikkei index peaked near 39,000 at the end of 1989. When it burst, Japan entered its lost decade of stagnation and falling prices.

Then pegs broke. Britain was forced out of a European currency system in 1992, and in July 1997 Thailand let go of its peg to the dollar. Investors pulled money out of Indonesia, South Korea and Malaysia too, in the East Asian crisis. Indonesia’s currency lost around 80% of its value, and the crisis helped bring down Suharto’s government in 1998. The IMF lent with strict conditions, like spending cuts and high interest rates, that many economists later judged too harsh. Malaysia defied the advice and imposed controls on money leaving the country. Afterward, Asian countries decided never to run short of dollars again and built up huge reserves.

The rise of finance. From the mid-1980s to 2007, rich economies had steady growth and low inflation, which economists called the Great Moderation, and many believed the business cycle had been tamed. Underneath, finance grew enormously:

• Its share of US corporate profits rose from around 10 to 15% in the early 1980s to as much as about 40% in the early 2000s.
• Rules separating ordinary banking from riskier investment banking were loosened, and in 1999 the old Glass-Steagall separation from the New Deal was largely repealed.
• Banks increasingly bundled mortgages into bonds and sold them on, a process called securitization. A bank that sells a loan on doesn’t suffer if the borrower defaults, so it cares less about who it lends to, which is the principal-agent problem again.
• Banks and investors borrowed heavily against thin capital.

Inequality rose too. In the US, the share of income going to the top 1% roughly doubled between 1980 and 2007, with similar rises in Britain. Most continental European countries and Japan saw much smaller increases, which suggests policy and institutions mattered, not just technology and trade.

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Crisis and Backlash (2008 to now)

The 2008 financial crisis. Through the early 2000s, US house prices kept rising and lending got looser. Banks gave mortgages to borrowers with weak credit, called subprime loans, often with low starter rates that would jump later. They bundled the mortgages into bonds and sold them on, and ratings agencies, paid by the banks issuing the bonds, gave many of them top ratings.

Investment banks borrowed heavily to hold these bonds. Lehman Brothers had roughly $30 of debt for every $1 of its own money. A bank’s capital is the cushion of its owners’ own money that absorbs losses before lenders get hurt. At 30 to 1, a 3% fall in the value of what you own wipes the cushion out.

When house prices started falling in 2006 and 2007, borrowers defaulted, the bonds lost value, and nobody knew which banks held the bad ones. Banks stopped lending to each other: a bank run among institutions instead of depositors. In March 2008, Bear Stearns collapsed and was sold to JPMorgan with Fed support. On September 15, 2008, Lehman Brothers went bankrupt; the government decided not to rescue it. Within days, the insurer AIG needed a huge government rescue, a major money market fund lost money, which was supposed to never happen, and credit froze worldwide.

The response: Congress passed TARP, a $700 billion program to put capital into banks. The Fed cut its rate to 0 to 0.25% by December 2008, and with rates already at zero, it created new money to buy trillions of dollars of bonds, pushing down long-term rates: quantitative easing. The US passed a $787 billion stimulus in 2009, and China a stimulus of about 4 trillion yuan, mostly infrastructure. The Dodd-Frank Act of 2010 and the international Basel III rules required banks to hold much more capital, so the cushion would be thicker next time.

US unemployment peaked at 10% in October 2009. Millions lost their homes, while bank executives mostly kept their jobs and bonuses. That anger fed the next decade’s politics: Occupy Wall Street in 2011, and Thomas Piketty’s 2013 bestseller Capital in the Twenty-First Century, which argued that when the return on wealth exceeds the economy’s growth rate, wealth tends to concentrate in fewer hands.

The eurozone crisis (2010 to 2015). In late 2009, Greece revealed its budget deficit was far bigger than reported. Investors demanded very high interest rates to lend to Greece, then to Ireland and Portugal, then Spain and Italy.

A country with its own currency could let it fall, or have its central bank buy its bonds. Eurozone members shared the euro and the European Central Bank, so they couldn’t do either. They had to cut spending and wages instead, an internal devaluation. Greece’s economy shrank by about a quarter, and unemployment peaked around 27%.

In July 2012, ECB president Mario Draghi said the bank would do “whatever it takes” to preserve the euro, and that promise alone calmed markets: traders didn’t want to bet against a central bank that could create unlimited euros. Greece nearly left the euro in 2015, but stayed.

The long, slow 2010s. After 2008, growth in rich countries stayed weak while interest rates stayed near zero. Larry Summers revived the term secular stagnation: people want to save more than businesses want to invest, so rates stay very low and growth stays sluggish. The ECB and Bank of Japan even set negative interest rates. Low rates had a predictable effect. What something is worth is its future earnings discounted to today, so when the rate used to discount them falls, everything that pays in the future is worth more today. Stocks, houses and startups all rose. Those who owned assets got richer, and those who didn’t fell further behind.

The tech giants. In 2008, the most valuable US companies included Exxon, GE and Walmart. By the 2020s it was Apple, Microsoft, Alphabet, Amazon, Meta and Nvidia, and their economics differ from a steel mill’s:

• Network effects. A platform gets more valuable as more people use it, which pulls in still more users, so these markets tend to have one or two winners.
• Near-zero marginal cost. Once software is built, serving one more user costs almost nothing, so the firm with the most users can undercut everyone.
• Intangible capital. Their value is in code, data, brands and know-how rather than factories.

Economists started talking about superstar firms, a few companies in each industry capturing a growing share of sales and profits, and labor’s share of income, the part going to wages rather than owners, fell in many countries.

China’s state capitalism. Under Xi Jinping, in power from 2012, China’s model became more state-directed:

• State-owned firms stayed dominant in banking, energy and telecoms, with the state steering credit to priority sectors.
• Made in China 2025, launched in 2015, set out to lead in chips, electric vehicles, batteries and robotics. China now dominates EV, battery and solar panel production.
• The Belt and Road Initiative, from 2013, lent to and built infrastructure in dozens of countries.
• Control over private firms tightened. In November 2020, regulators halted the stock market listing of Ant Group, Jack Ma’s financial company, and a broad crackdown on tech firms followed.
• The property bubble burst, with the developer Evergrande defaulting in 2021.

Growth slowed from about 10% to around 5%. China is a new kind of case: markets and private firms working under a state that sets the direction and can overrule any company, the developmental state of Korea and Japan at continental scale and without democracy.

The backlash against trade. The losers from globalization pushed back through politics. In June 2016, Britain voted to leave the European Union. Donald Trump won the US presidency in 2016 promising to bring back manufacturing jobs, and in 2018 imposed tariffs on Chinese goods and on steel and aluminum; China retaliated. The Biden administration kept most of those tariffs and added industrial policy, the government picking industries to support, which had been out of fashion since the 1970s: the CHIPS Act of 2022, with about $52 billion to bring chipmaking to the US, and the Inflation Reduction Act of 2022, with large clean-energy subsidies. Since 2025, Trump’s second term has raised tariffs much further, across most trading partners, taking average US tariffs to their highest level since the 1930s.

Security became an economic question too. After Russia invaded Ukraine in February 2022, Western countries froze about $300 billion of Russia’s central bank reserves. Every country holding reserves noticed that dollars held abroad could be frozen. Central banks bought gold at a record pace, and supply chains are being rebuilt around allies, called friend-shoring, rather than simply the cheapest supplier.

The pandemic and the return of inflation. In spring 2020, COVID-19 shut down much of the world economy, and US unemployment hit 14.7% in April. The response was much bigger and faster than in 2008: about $5 trillion of US relief including checks to households, and the Fed back at zero with QE on a massive scale.

Households stuck at home bought goods, and supply chains couldn’t keep up. Then the invasion of Ukraine sent energy and food prices soaring. US inflation reached 9.1% in June 2022, the highest in four decades.

The Fed raised rates from near zero to 5.25 to 5.5% by July 2023, the fastest increase since Volcker. Rising rates cut the value of existing bonds, and Silicon Valley Bank, which had put depositors’ money into long-term bonds, failed in March 2023 when depositors, mostly startups, pulled their money out in a couple of days.

Unlike under Volcker, inflation fell without a recession, a soft landing. The Fed began cutting in late 2024. Inflation has stayed above the 2% target since, and tariffs have added to prices.

The AI boom. Since ChatGPT launched in November 2022, the largest tech companies have been spending hundreds of billions of dollars a year on data centers and chips, Nvidia became the world’s most valuable company, and much of recent US stock market growth has come from a handful of AI-linked firms. The open questions are the ones this series has been building toward: whether AI raises productivity across the economy, whether the gains go mostly to the firms that own the models and chips or to workers and consumers, and whether today’s investment is justified by future earnings or is partly a bubble.

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What’s Next

From 1975, the dials turned toward markets: Volcker broke inflation, Thatcher and Reagan privatized and deregulated, China and India opened up and grew fast, and the Soviet system collapsed. Gradual reform with working institutions did far better than shock therapy, and globalization raised overall output while leaving concentrated losers. Finance grew, inequality rose in some countries, and the calm hid risk until 2008. Since then the dials have turned back: bailouts and QE, industrial policy, tariffs, security-driven trade, and a return of inflation. Through all of it, the same lessons from thousands of years of history kept reappearing.

Next is where the debate between capitalism, socialism and the mixed systems stands now, what each side gets right, the main proposals for fixing capitalism’s weaknesses, and how AI changes those questions. After that come central banks and governments in depth, the global system, and finally the capstone: understanding AI through the lens of economics.