Often, historical knowledge is just as useful for understanding economic issues as economics itself.

We are currently in dangerous waters in our politics, our economy and the international situation, and yet we are caught in an intellectual malaise that keeps us ignoring the problems that are looming in our faces.

Congress is broken and no one is talking about fixing it. Economic inequality in the U.S. and the world has reached levels not seen in a century.

A wealthy class has political and economic power not seen since the 1890s. Moreover, some politicians or political observers believe, contrary to all theory and history, that the Federal Reserve can and should solve all of the United States’ economic problems.

For some insight into history, read Barbara Tuchman’s The Proud Tower, a book about the recklessness, irresponsibility and willful blindness to looming dangers in the 25 years before World War I. The similarities to our own time are enormous. We too are reckless, irresponsible, deeply divided, blind to enormous problems and both unwilling and seemingly unable to act.

The reaction of the markets, experts, politicians and the public to the economic developments of the last few weeks highlights the problem.

July’s labor market indicators released this month showed lower than previous job growth and a rise in the unemployment rate. Stock markets fell worldwide and there were loud calls for the Fed to loosen the money supply to lower interest rates. Two days before the release of this data, the Fed had met and left interest rates unchanged at their highest level since 2008. Experts immediately pounced on it, complaining that the Fed had messed up, waited too long to ease and was now risking a recession in the US.

Market indices have since recovered.

The real value of total economic output, measured by real gross domestic product, grew by 2.8% annually in the April-June quarter. This growth was double the previous quarter and above the two-decade average from 2000 to 2020 of 2% annually. And last week, consumer inflation figures were released. The consumer price index for July was 0.155% higher than June. This one-month change accumulates to 1.9% over 12 months. Compared to July 2023, prices rose by 2.9%. So it seemed like we were reaching a “soft landing” with tamed inflation and no recession.

The markets and pundits have gone mad again! Inflation is weakening, so interest rates must fall! The “head of global investment strategy” of a major bank called for a half-percent rate cut at the next Fed meeting in four weeks, and further cuts at the other two meetings this year. Stock prices would soar, he predicted. A newspaper article summarizing his remarks was headlined: “Stock prices will see a rise not seen in 30 years.”

Never mind that the market has largely priced in an expected rate cut in September. If the Fed doesn’t act as expected, should we expect a 30-year sell-off?

Friends, this is madness and willful blindness. That these views are so widespread reflects the failure of economists to educate the business community, let alone the press and the general public. This will come at a high cost. This madness is also the result of two decades of desperate “terrible but better than the alternative” interventions by the Fed in times of crisis. What was abnormal, if not self-destructive, a generation ago has now become the norm.

Our current dilemmas have a historical context.

From the 17th century to the late 18th century, economists believed that government should play a major role in economic activity. However, with the publication of Scottish philosopher Adam Smith’s The Wealth of Nations in 1776, this view changed dramatically. For decades, the prevailing view was that government should only interfere minimally in markets.

In the face of the unprecedented global Great Depression of the 1930s, British economist John Maynard Keynes made a compelling case for the need for government intervention to reduce the destructive swings between boom and bust and back again – associated with high inflation at the end of the boom phase and high unemployment in times of crisis.

Since then, the philosophical pendulum has swung in different directions: towards more or less state intervention in the markets, depending on which economic theory was dominant at the time and was adopted and adapted to the political philosophies of those in power.

The role of the central bank, the Federal Reserve, had always remained the same, with a few exceptions. When faced with a recession, slow and negative growth, and rising unemployment, it should increase the money supply and lower interest rates to reduce corporate costs and stimulate the economy. But when rapid growth stimulates inflation, it should restrict the money supply and raise interest rates. This apparent wisdom was accepted by all, eagerly by Democrats and grudgingly by Republicans.

After World War II, the world economy boomed for a quarter of a century. It was a glorious and wonderful three decades of unprecedented growth, during which the economy recovered from both the depression and the destruction of war and raised living standards to levels never before dreamed of. France experienced its “Trente Glorieuses” and Germany its economic miracle. Japan, Taiwan, South Korea, Hong Kong and Singapore made the leap from poverty to prosperity within a generation. Brazil and Iran also seemed to be on this path.

But by the mid-1970s, the party was over. Despite Keynesian “stabilization,” which alternately tightened and loosened taxation, spending, money supply, and interest rates, all of the world’s major economies experienced “stagflation,” a period of low output, high unemployment, and high inflation—conditions that Keynes thought should not exist simultaneously.

Keynesian theory seemed to be a dead end. A new generation of economists developed an intellectually coherent refutation of Keynes. These new theories, proudly titled “New Classical Economics,” reflected a return to the 19th-century precept of minimal government control of the economy. Not everyone in the discipline agreed, but even skeptics recognized that micromanagement often led to disaster. After harsh adjustments under Margaret Thatcher in the United Kingdom and Ronald Reagan in our country, and a period of exceptionally high interest rates, the 1990s were a year of prosperity.

Following the moderate and prudent tax increases called for by Presidents George HW Bush and Bill Clinton, the United States enjoyed four years of budget surpluses. While these were modest and based on a decline in defense spending after the fall of the Berlin Wall, if one were to use a ruler to project the U.S. national debt, it could be zero by 2012.

Then we threw it all away. The self-defeating tax cuts of 2001 and 2003, the attacks of September 11, 2001 and the associated reduction in defense spending to Cold War levels, the Fed opening the money taps and lowering its benchmark interest rate from 6% to 1%, all brought the U.S. economy back to Cold War levels.

Then, after a self-inflicted mortgage crisis erupted in late 2007, the Fed cut its benchmark interest rate to zero and kept it there for five years. That was unprecedented in the history of central banking. Fed policymakers then slowly raised the benchmark interest rate to half the long-term average. Then COVID hit, and the money supply grew 39% from March 2020 to May 2022.

Again, there was no precedent in our country’s history. Yes, it was a well-intentioned attempt in a pandemic the likes of which have not been seen in a century. But it led to a 19% increase in consumer prices in 18 months.

And that’s exactly where we are today: We are stuck in the illusion that everything that happens in the economy is the Fed’s fault – praise when times are good, blame when things go wrong.

Central banks can keep prices stable and prevent financial crises from turning into meltdowns. That’s all. They have only one policy tool, the money supply, and that translates into various interest rates. It’s insane to expect it to keep stock prices going up. It’s insane to expect we can somehow avoid bipartisan policy action to solve federal finances. It’s insane to expect the Fed to address youth unemployment, monopoly power, poverty, or regional economic decline.

The money supply remains unprecedentedly higher than it was four years ago. It and the stock indices remain unprecedentedly high relative to the real value of our products. Yes, the target interest rates are higher than the averages of the last 25 years, but that was a quarter century of follies. They remain in the range that prevailed over half a century of greater caution.