Misremembering history
The Week has an article by Jeff Spross, which tries to rewrite the history of the early 1980s:
The story of how Volcker fulfilled his mission is complicated. But it boiled down to a massive hike in interest rates: The Fed’s primary target for those rates reached an astronomical 19 percent in 1981.
Actually, during 1979-82 the Fed switched from targeting interest rates to targeting the money supply. (Although there is debate about whether they actually were targeting the money supply.)
The basic problem, as economist Dean Baker explained to The Week, is there’s no way to tame inflation that doesn’t involve inflicting damage on the economy. But using interest rate hikes to spark recessions is a methodology that loads the bulk of the pain onto everyday workers, and people who are marginalized in our society. The national unemployment rate (the blue line below) briefly reached 10.8 percent — higher than it got even in the Great Recession — and it didn’t get back to 5 percent until 1989. Which was bad enough. But the unemployment rate for lower class workers is always much higher than for upper class ones. Ditto racial minorities: The unemployment rate for African-Americans (the red line below) topped 20 percent by 1983.
And that’s not all:
The Volcker recession also roughly coincides with a remarkable inflection point in the American economy. Before the mid-1970s, labor markets were often tight and full employment was common. After the Volcker recession, full employment — when there are more jobs available than workers, so employers have to bargain up wages and work conditions — basically disappeared. Union membership had already fallen 5 percentage points from roughly 1960 to 1980. But after the Volcker recession, its decline accelerated, falling another 10 percentage points from 1980 to roughly 1995.
Most strikingly, the Volcker recession falls almost right atop the moment when inequality took off:
So what’s the alternative?
All of that raises the obvious question: Could we have done things differently?
The 1970s were actually a relatively straightforward version of standard Keynesian macroeconomic theory, in which an overheating economy drives up the inflation rate. The real economic growth rate was actually quite strong that decade, bouncing around near 5 percent.
This alternative doesn’t get off to a promising start. Real growth was closer to 3%, not 5%. And even that was mostly due to very fast labor force growth (boomers like me, plus women entering in large numbers). In fact, the 1970s was the decade when the Keynesian model basically collapsed, and had to be replaced by New Keynesianism, which, as Brad DeLong later pointed out, was to a substantial extent monetarism.
Keynesianism says that hiking taxes and balancing the budget, or even driving it into surplus, will put a drag on economic growth and slow down inflation. So we could’ve raised taxes and returned to the mid-century model of lots of brackets and really high rates at the top. That would’ve inflicted most of the damage on richer Americans who can afford to absorb it, rather than the workers and the poor who can’t.
Where to start? Even if this were true, the old Keynesian (Phillips curve) model says the slowdown in inflation would have produced mass unemployment, regardless of whether it was caused by fiscal austerity or tight money. And of course the model is not true. LBJ tried to control inflation with tax increases in 1968, and failed. That was one of the key policy experiments (along with Volcker’s later success in controlling inflation, during a period of fiscal stimulus under Reagan) that led economists to abandon old Keynesianism. The theory simply does not work. Even worse, the left-wing solution of high taxes was tried in Sweden during the 1970s and 1980s, and had to be abandoned in the early 1990s, as Sweden was rapidly losing ground relative to other developed countries.
On top of that, inflation was exacerbated by several historical flukes. The most obvious was the rise in oil prices over the 1970s, driven by OPEC’s oil embargo against the U.S., and then by the shutdown in Iranian oil exports brought on by the Iranian revolution.
This is a common myth, at least for the decade as a whole (perhaps true for 1974 and 1979). During the period from 1972-81, NGDP growth averaged 11%, divided into 3% RGDP growth and 8% inflation. Oil shocks may impact inflation, but they don’t impact NGDP. Even if we had had no oil shocks during the 1970s, an 11% NGDP growth rate was enough to generate 8% inflation. Even with 4% RGDP growth, inflation would have averaged 7%.
All these problems would’ve likely worked themselves out regardless of what Volcker did. The error in the CPI was corrected in 1982. The run-up in oil prices from the Middle East drove a massive surge in oil production in other parts of the world, and a big uptick in energy efficiency, all of which would’ve naturally pushed inflation back down. And as mentioned, unions were losing their clout, with membership already on a downslide.
“We could’ve expected inflation to fall in any case,” Baker continued. “Probably not as quickly and not as much.”
“But suppose it took us 6 years to get down to 4 percent inflation? What would’ve been the problem with that?”
The real problem was different; the short 1980 recession was a complete waste, accomplishing nothing. Volcker got cold feet in the summer of 1980 and adopted an extremely expansionary monetary policy (the Fed was worried about Carter’s chances in the fall election). For those who like “concrete steps”, the Fed drove real interest rates sharply negative in mid-1980. This pushed NGDP growth up to an astounding 19.2% in 1980:4 and 1981:1. Thus the Fed had to tighten again in mid-1981. The recession from mid-1981 to the end of 1982 should have started at the beginning of 1980, in which case it would have been over by mid-1981. And it would have been milder than the actual 1981-82 recession, because inflation expectations were even more deeply entrenched after the 19.2% spurt in NGDP after the brief 1980 recession.
Plus, Ronald Reagan would have looked far more heroic if the recession had ended in mid-1981.