The Volcker Disinflation and the Volcker Recovery Were Both Primarily the Work of… Volcker: Macroeconomic History Things That Really Should Not Need to Be Said Department
Paul Krugman corrects the record:
Postmodern Business Cycles: Noah Smith finds John Taylor claiming that the V-shaped recovery from the 1981-2 recession proves that Reagan roolz. Kind of sad, really: I find it hard not to believe that Taylor actually knows better.
But anyway, this gives me an occasion to talk about why the sluggish recovery was predictable — and predicted. This is not an after-the-fact rationalization, I was explaining very early on that this wasn’t going to be like the 1981-2 recession.
As I said then, there’s a definite change in the character of recessions after the mid-1980s. Before then, recessions were basically brought on by the Fed, which raised interest rates sharply to curb inflation, causing a slump in housing. When the Fed decided that we had suffered enough, it let rates fall again, and there was a surge from pent-up housing demand. Morning in America!
Since then, however, inflation has been well under control, and booms have died of old age — or more precisely, they have died because of overbuilding and an excessive level of debt. The Fed is then in the position of trying to goose housing (which is the principal channel for monetary policy) even though housing may already be overbuilt (which was the point I was making, sarcastically, when I said long ago that the Fed has to create a housing bubble), and it is cutting rates from an initial level which isn’t that high. So the odds of running up against the zero lower bound are high, and recovery can be a long time in coming….
The early-80s slump was brought on by a huge rise in the Fed funds rate, which left lots of room for cuts, and was driven by a deep slump in housing, which meant that there was lots of pent-up demand when rates fell again. The 2007-? slump was brought on by the bursting of a housing and debt bubble, and left the Fed largely pushing on a string.
Noahpinion: Standard Republican narrative of history (John Taylor edition): According to John Taylor, the reason that the recovery from the 2008-9 recession has not been as rapid as the recovery from the 1981-2 recession is that Reagan's policies were better than Obama's policies:
We are not really recovering from the recession, at least not compared to the period after previous big recessions such as the early 1980s…. The reason is pretty clear. In the Wall Street Journal piece I refer to and quote from a memo written by President Reagan’s economic adviser George Shultz and others after the 1980 election. It laid out the long run economic strategy they recommended and which Reagan followed. Contrast that with the memo Larry Summers sent to President-elect Obama after the 2008 election, which is making the internet rounds. It laid out the short-run Keynesian policy Summers recommended and which Obama has followed. The big policy differences largely explain the big economic performance differences.
And what are those big policy differences? In the WSJ article, Taylor spends a lot of time making a general case for "economic freedom," but names only one concrete policy difference between Reagan and Obama: Reagan enacted permanent tax cuts, while Obama enacted temporary tax rebates (in the ARRA). Taylor argues that Reagan's permanent tax cuts represent policy based on predictability and stability, while Obama's policies represent short-term, unreliable interventions.
This is a very standard intellectual-Republican narrative of economic history. Which, again, does not mean it is wrong. But I do see some big problems with Taylor's analysis.
Problem 1: Reagan's permanent tax cuts were enacted in early 1981, before the steep recession. This means that any effect that those tax rates had on the 1983 recovery had to have come not from the policy change, but from the low tax rates that were in place. However, in 2010, thanks to the Bush tax cuts, stable permanent long-term income tax rates were lower under Obama than they were under Reagan. If low permanent tax rates caused a rapid recovery in 1983, why didn't even lower permanent tax rates cause a rapid recovery in 2010?
In other words, if the 1981-2 recession was fundamentally the same kind of event as the 2008-9 recession, then Taylor is concluding that Obama's temporary tax cuts (or other actions, such as saying bad things about "business") substantially prolonged the current slump. I suppose that is possible - it's a claim that many Republicans have repeated - but it seems like a difficult case to make. A lot harder of a case, in fact, than simply saying "Reagan's policies were better than Obama's."
Problem 2: There are other historical examples of deep recessions besides the one in the early 80s. When we compare policies and results between now and the Great Depression, for example, especially in Britain, we are tempted to reach conclusions very different from Taylor's. I'll outsource this part of the argument to Brad DeLong:
This many months after the start of the Great Depression, the British economy was rapidly converging back to its pre-depression level of production under Chancellor of the Exchequer Neville Chamberlain's policy of using stimulative policies to restore the price level to its pre-Great Depression trajectory.
By contrast, the Cameron-Osborne policies of expansion-through-austerity have produced a flatline for real GDP, and the odds are high that British real GDP is headed down again.
In less than a year, if current forecasts come true, the Cameron-Osborne Depression will not be the worst depression in Britain since the Great Depression, but the worst depression in Britain… probably ever.
So if you want to ascribe economic outcomes to broad differences in economic policy, why only look at the Reagan years? Why not look at the Depression? And why look only at the U.S. instead of at other countries as well?
Problem 3: The 2008-9 recession does not seem very comparable to the 1981-2 recession. For one thing, the early 80s recession immediately followed (and, most believe, was precipitated by) a huge hike in interest rates by the Federal Reserve (which was trying to beat inflation). That meant that as soon as rates were allowed to fall, the force that had spiked U.S. GDP growth would be removed. In contrast, the 2008-9 recession occurred during a period of historically low interest rates, which were dropped to zero shortly after the recession began. This left the Fed without its usual method of boosting GDP growth. Even more importantly, the difference also indicates that the "shocks" that caused the two recessions were fundamentally different - a policy shock in the case of the early 80s recession, but some other kind of shock in the case of the 2008-9 recession.
In other words, I think this simple standard Republican narrative does not fit the facts. It is tempting, especially for politically conservative economists, to conclude that Reagan's tax cuts made everything about the U.S. economy awesome, and that something done or said by the left-leaning Obama made everything go wrong. But that conclusion just doesn't square with the evidence that we see when we look out the window. I think a more complex narrative is needed.