Episodes in Macro History

The worst slump in modern history. After the 1929 stock-market crash, spending dried up across the United States and the wider world. Banks failed, factories closed, and US unemployment peaked near 25 percent — one in four workers had no job.

The shock to economists was that it did not fix itself. The old belief was that a market economy snaps back quickly on its own. Instead, output stayed low for a decade.

The lesson. Total spending in an economy — what economists call aggregate demand (the combined demand for goods and services from households, firms, and government) — can collapse and stay collapsed. Markets do not always self-correct quickly. This built the case for the government stepping in: spending and tax changes (fiscal policy) and central-bank action on money and interest rates (monetary policy). The economist John Maynard Keynes made that argument and reshaped the field.

For decades, the rule of thumb was simple: when unemployment is high, inflation is low, and the other way round. You could trade one for the other. The 1970s blew that up.

Oil-producing countries cut supply and oil prices jumped. This was a supply shock — a sudden rise in the cost of producing almost everything. Inflation climbed to about 13 percent while unemployment also stayed high. Both bad things happened at once. People named it stagflation: a stagnant economy plus inflation.

The lesson. An adverse supply shock pushes up prices and unemployment together. The neat trade-off between inflation and unemployment is not a law — a cost shock can break it.

By the late 1970s, high inflation had become a habit. People expected prices to keep rising, so workers demanded big raises and firms kept marking up — a self-feeding loop.

Paul Volcker, head of the US central bank (the Federal Reserve, or the Fed), broke the loop the hard way. The Fed raised its policy interest rate — the rate it controls, which steers all other borrowing costs — to about 20 percent. Borrowing collapsed, a deep recession followed, and unemployment shot up. But it worked: inflation fell from about 13 percent to about 3 percent.

The lesson. Beating inflation that people have come to expect takes credible, painful tightening. There is usually no cheap way out once high inflation is entrenched.

Then came two decades of calm. Inflation stayed low and stable — around 2 percent — and recessions were short and mild. Economists called this stretch the Great Moderation.

Many credited better monetary policy. Central banks had learned from the 1970s and 1980s and seemed to have tamed the business cycle — the repeating swing of the economy between boom and slump.

The lesson. Good policy really can steady an economy. But the long calm had a dark side: it bred complacency. With slumps looking like a thing of the past, banks, households, and regulators underrated the risk piling up inside the financial system.

The calm ended hard. A boom in house prices and risky mortgage lending turned to bust. Banks that had bet on rising house prices faced huge losses, lending froze, and the slump spread worldwide.

Central banks slashed their policy interest rate — the rate they control — to fight the slump. They cut all the way to the zero lower bound (about 0 percent): interest rates cannot go far below zero, so the usual tool ran out of room. So central banks tried something new: quantitative easing, which means creating new money to buy bonds and push other borrowing costs down.

The lesson. The financial system itself can trigger a deep recession. And conventional interest-rate policy hits a wall at the zero lower bound, forcing central banks to improvise.

When the pandemic hit, governments shut down large parts of daily life. The fall in output was the fastest on record — and so was the rebound. In the United States, unemployment spiked to 14.7 percent in a single month, a jump that once would have taken years.

This was both a supply shock (factories and supply chains stopped) and a demand shock (people could not go out and spend) at the same time. Governments and central banks responded with huge fiscal and monetary support — big spending, cheap credit, direct payments. That support prevented a second Great Depression.

The lesson. A joint supply-and-demand shock is possible. Massive stimulus stopped the slump, but it also helped fuel the inflation surge of 2021–22 that came after — a reminder that even successful rescues carry a bill.