Thursday, June 3, 2010

Can Krugman Explain the 1983 Recovery?

The last time the United States saw double-digit unemployment was during the recession of 1982, which seemed to spell huge problems for then-President Ronald Reagan. He had pushed through a cut in tax rates (across-the-board) with the top rate dropped from 70 percent to 50 percent, and the federal deficit was skyrocketing to record nominal levels (past $200 billion in 1983).

There are two ways to look at that recession and the subsequent recovery. The first is through the standard Keynesian lens with a few twists. I remember reading an editorial in the Atlanta Constitution entitled "Tax Hike or Recession" in which the writer claimed that unless the government raised the top rates back to 70 percent, interest rates would continue to rise, and the economy would move into recession. Congress did not raise income tax rates (although it did pass a tax increase in other areas which Austrian Economists believe had a stifling effect on the economy).

Now, no self-respecting Keynesian economist would argue for a tax increase during a recession, although they do have a "balanced-budget multiplier" in the Keynesian arsenal that "proves" a tax increase will stimulate the economy more than letting individuals keep their earnings. (This raises the question as to whether or not a 100 percent tax would really do the trick, although most Keynesians have not willingly taken their "balanced-budget multiplier" to its logical conclusion.)

Nonetheless, the Keynesian analysis is fairly simple in its causality: recessions come about because people spend less money. Furthermore, Keynesians believe that higher interest rates are a cause of recessions, as was the case in 1982, and any decrease in the rate of inflation also will have negative economic effects, as economic growth cannot occur without inflation.

If I can characterize the Keynesian position from an Austrian point of view, it is that Keynesian economics is based upon the following fallacy: post hoc ergo propter hoc, or "after this, therefore, because of this." For that matter, Keynesians employ the same fallacy in order to explain economic recoveries, which could be explained in the following form: "After federal budget deficits, therefore, because of federal budget deficits."

There is no doubt that federal budget deficits grew during the early 1980s, and the government borrowed huge sums to paper over the differences. However, the question as to whether or not the borrowed expenditures fueled the real economic recovery of the 1980s is legitimate. Government statistics tell us that before and during the recession, expenditures as percentage of U.S. GDP rose in military spending, and in Social Security and Medicare, along with net interest on the federal debt.

Furthermore, during the recession huge portions of what might be called the "old economy" simply disappeared. Cities like Cleveland and Pittsburgh lost industries to the point where the term "Rust Belt" was used to describe the swath of northern states steel mills and other factories became little more than scrap metal. Unlike previous economic recoveries, hundreds of thousands of laid-off workers were not called back to their old jobs because those production facilities disappeared. (One might remember that Billy Joel's song "Allentown" was a major hit in 1982.)

Yet, the economy clearly recovered and it is obvious, in hindsight, that this recovery was different than what had been the case during the 1970s and before. First, this was a recovery that was not accompanied by high rates of inflation. Second, the recovery was centered not in the traditional manufacturing areas, but rather in the development of computers and telecommunications.

Third, financing was made available through the short-lived methods pioneered by Michael Milken, the so-called Junk Bond King, who helped bring about a lot of corporate restructuring that needed to take place. Fourth, the ending of the transportation cartel (i.e. "deregulation") enabled goods to be shipped more quickly, cheaply, and efficiently. (The cost-saving "Just-in-Time" methods of production simply would not have been possible had the old regulations governing trucking and railroads.)

So, despite the fact that inflation went down and interest rates stayed high, the United States had a robust economic recovery in the mid-1980s. This recovery defied the Keynesian rules; indeed, it was the closest thing one will see to an Austrian recovery in our lifetimes.

The so-called founder of the Austrian School, Carl Menger, wrote in his groundbreaking 1871 book, Principles of Economics, "All things are subject to the Law of Cause and Effect." Indeed, we begin with causality. Unfortunately, Keynesians consistently (at least they ARE consistent) confuse effect with cause, and that makes all of the difference.


Jesse Narveson said...

Excellent post. I love this blog! Keep up the good work!

bjlee said...

Bill, if you want to see a real laugh piece, check out Krugman and Larry Summers letter to the Fed in 1983 predicting a return of double digit inflation due to the economic recovery.

Thisguy said...

I think the problem here is that you still think Keynesians still use the Philips Curve in its old form.

Andrew said...

I wonder how many times Kenseians will be proven wrong before they give up....

michael said...

Wow, that was great! I'm very new to all of this. Looking to go into business economics after I finish my gen ed. This is so incredibly interesting to me, I can't wait to see more.

Thisguy said...

I don't think anyone has made the argument that the deficits fueled the economy of the 80s. Keynsians believe large deficit spending is only appropriate when we're in a liquidity trap and interest rates are zero bound, as it was in the Great Depression and it is now. Interest rates were purposely set by high by Volcker to stop massive inflation causing high unemployment, but lowering it after is what caused the majority of the recovery.

The Philips curve only works in the short run, but not in the long run. This distinction wans't made in the 70s.

Look up NAIRU.

William L. Anderson said...

Thanks for the letter. Hmm, I think it might be useful for a future post.

I have written some long and detailed pieces on the Tonya Craft case on my other blog, which is why I have not posted on here in a few days.