The American Stagflation Episode of 1981

Symbiosis Institute of Business Management 2011

Table of ContentIntroduction and Features...........................................................................................................................2

Keynesian Theory................................................................................................................................2

Milton Friedman..................................................................................................................................2

Causes of Stagflation...................................................................................................................................2

Stagflation during the 1980’s Recession..................................................................................................2

Supply Side Factors..............................................................................................................................2

Demand Side Factors...........................................................................................................................2

Policy Remedies...........................................................................................................................................2

Statistical Facts and Figures.........................................................................................................................2

Detailed Statistics........................................................................................................................................2

Investment...........................................................................................................................................2

The effects of American Stagflation on the US economy.............................................................................2

The effects of American Stagflation on the world economy........................................................................2

Supply side policies:.....................................................................................................................................2

GDP Gap..............................................................................................................................................2

Industrial capacity...............................................................................................................................2

Unemployment....................................................................................................................................2

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Introduction and FeaturesWell, by the standards of a lot of countries, by Latin American standards, it wasn't so bad.

Paul A. Volcker

So how bad was it that made the then Federal Reserve chairman, Paul Volcker, to make this pacifying statement?

Stagflation [stægˈfleɪʃən]: (Economics) a situation in which inflation is combined with stagnant or falling output and employment

Noun [blend of STAGNATION + INFLATION]

The term was coined by a British politician Iain Macleod as, a situation when the inflation rate as well as the unemployment rate in an economy is constantly high. Both these rates (their sum defined by some as the ‘misery rate’) affect everyone, from the richest to the poor. Thus, the gravity of such a situation cannot be understated. But what makes all the more peculiar is the fact that any policy measure undertaken to arrest one rate usually worsens the other.

Economists offer two principal explanations for why stagflation occurs. First, stagflation can result when the productive capacity of an economy is reduced by an unfavorable supply shock, such as an increase in the price of oil for an oil importing country. Such an unfavourable supply shock tends to raise prices at the same time that it slows the economy by making production more costly and less profitable.

Second, both stagnation and inflation can result from inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply, and the government can cause stagnation by excessive regulation of goods markets and labor markets. Either of these factors can cause stagflation. Excessive growth of the money supply taken to such an extreme that it must be reversed abruptly can clearly be a cause. Both types of explanations are offered in analyses of the global stagflation of the 1970s: it began with a huge rise in oil prices, but then continued as central banks used excessively stimulative monetary policy to counteract the resulting recession, causing a runaway wage-price spiral.

The Gale Encyclopedia refers to stagflation being caused by an overheated economy. In periods of moderate inflation, the usual reaction of business is to increase production to capture the benefits of the higher prices. But if the economy becomes overheated so that price increases are unusually large and are the result of increases in wages and/or the costs of machinery, credit, or natural resources, the reaction of business firms is to produce less and charge higher prices.

Stagflation, first came into use in the mid-1970s, when in the US inflation soared to 12 percent and the unemployment rate nearly doubled to 9 percent. This inflation was the result of the quadrupling of oil prices by the Organization of Petroleum Exporting Countries (OPEC),

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increases in the price of raw materials, and the lifting of Vietnam-era government-imposed Price and Wage Controls. At the same time, the economy went into recession. In 1979 the high inflation rate was sent spiraling upward when OPEC doubled petroleum prices after the Iranian revolution. President Jimmy Carter established the Council on Wage and Price Stability, which sought voluntary cooperation from workers and manufacturers to hold down wage and price increases. The council could not control OPEC, however, and repeated oil-price hikes thwarted the council's efforts. Years of continued inflation and high unemployment were one of the factors that undermined the Carter presidency.

Stagflation at the time was an unexpected phenomenon due to the long held belief based on historical data that both high inflation and high unemployment rates were mutually exclusive events. This relationship was typified in the Phillips Curve, which depicted an inverse relationship between the two. It seemed to suggest a short-run trade-off between unemployment and inflation. The theory behind this was that falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing unemployment to rise. If the Government wanted to reduce the unemployment rate, it could increase aggregate demand but, although this might temporarily increase employment, it could also have inflationary implications in labour and the product markets.

According to D. Grubb, R. Jackman & R. Layard in the paper ‘Causes of the Current Stagflation’ (Review of Economic Studies 1982 XLIX) the cause of stagflation (and the failure of the Phillips curve) can be explained by ‘a fall in the feasible rate of growth of real wages unmatched by a reduction in the constant in the Phillips Curve.’

According to the same authors something happened to change the balance in the labour market consistent with stable inflation. They cited, as explanation, the following points:

(i) In the Demand function for labour, the feasible growth rate of real wages consistent with given employment had fallen.

(ii) In the Phillips Curve, there had not been a corresponding downwards adjustment in the target growth rate of wages at the given employment of the 1980s.

(iii) And hence lower real wage growth had to be brought about either by a rise in the unemployment or, since there was some ‘nominal inertia in the system, by a rise in inflation, or by a mixture of the two.’

Thus the fall in feasible real wage growth had worsened the rate of change of inflation that was available.

Keynesian TheoryAs mentioned earlier, Keynesians till the 1960s were still unwilling to accept the possibility of Stagflation, due to their belief in the Phillips Curve holding true universally.

The experiences of the 1970s and 1980s, however, had made it clear that this inverse relationship between inflation and unemployment explained by the Phillips curve could not be taken for granted and that this relationship was volatile. The grounds on which Keynesian theories were based started seeming unstable, and the macroeconomics world began to doubt their consistency, including the Keynesians themselves looking for reasons to explain the stagflation phenomenon.

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Milton FriedmanThey gradually began to accept the views put forth by the great economist Milton Friedman, who suggested a vicious cycle of expectations of inflation giving rise to further inflation and shift in the Phillips curve. According to Friedman, as inflation rose consistently over a period of time, producers began to prematurely expect more inflation and in turn raised their prices, in turn giving way to further inflation. These unrealistically inflated prices hampered revenues, pushing down levels of employment, thus giving rise to twin evils of unemployment and inflation simultaneously.

Friedman also understood that the Federal Reserve wields incredible power to increase or decrease inflation in the U.S. In Friedman's worldview, inflation happens when the Fed allows too much money to circulate in the economy. His formula for inflation: "Too much money chasing too few goods."

The dual mission of the Fed is to keep prices stable and maximize employment. The strategy for achieving this mission is called monetary policy. Modern monetary policy is heavily influenced by Friedman's theories.

When the economy is growing, the Fed raises interest rates to limit the amount of money in circulation. When the economy slows, the Fed lowers interest rates to encourage borrowing and increase the amount of money in circulation. The goal is to strike a precarious balance where the economy grows at a healthy rate without allowing inflation to get out of control.

In the 1960s, in an effort to maximize employment at all costs, the Fed lowered interest rates and flooded the economy with money. This led to increased demand for goods and services and rising prices. When it was clear in the 1970s that inflation was spiraling out of control, the Fed and the federal government took the erroneous approach of pumping more money into the system even as real economic output sagged. This fit Friedman's formula for inflation: too much money chasing too few goods.

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Causes of StagflationThere are two main explanations of why stagnation exists. Firstly, stagflation can occur when the economy is shocked by a sudden decline in supply. For example, stagflation can occur when the price for a commodity (like during the Oil Shocks) rises dramatically in a short period of time. The effect on the rise in the price causes a decrease in economic growth.

The second explanation offered by economists as to why stagflation occurs is simply bad economic policy. For example, allowing too fast of a growth in the money supply or over regulation of markets. Each of these factors lead to a dramatic rise in costs and prices and lead to a loss of jobs.

Whatever the cause, stagflation may take some hard work to correct, and it can be difficult to ride out a period of stagflation.

Stagflation during the 1980’s Recession

Supply Side FactorsIn our report, we will now discuss what caused the strain of Stagflation in the early 1980’s and what caused both the unemployment and inflation to soar. There were several factors that played a role although the principal culprit was rising energy prices.

In 1973, the Organization of Petroleum Exporting Countries (OPEC) quadrupled the price of crude oil. American consumers soon found the prices of gasoline and home heating fuels increasing sharply, and American businesses saw an important cost of doing business, energy prices were rising drastically. OPEC struck again in the period 1979–1980, this time doubling the price of oil. Then the same thing happened again, although on a smaller scale, when Iraq invaded Kuwait in 1990. Most recently, oil prices have been on an irregular up-ward climb since 2002 because of the Iraq war, other political issues such as the recent conflict in Egypt and the rest of the Middle East, problems with refining capacity, and surging energy demand from China.

Now looking at the stagflation situation from a macroeconomic point of view, we know that higher energy prices, we observed above, shift the economy’s aggregate supply curve inward in the manner shown in the figure below. If the aggregate supply curve shifts inward, as it surely did following each of these “oil shocks,” production will decline. To reduce demand to the available supply, prices will have to rise. The result is the worst of both worlds: falling production and rising prices.

This conclusion is displayed graphically in the figure on the right, which shows an aggregate

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demand curve, DD, and two aggregate supply curves. When the supply curve shifts inward, the economy’s equilibrium shifts from point E to point A. Thus, output falls while prices rise, which is precisely our definition of stagflation.

Stagflation is the typical result of adverse shifts of the aggregate supply curve.

The numbers used in the figure show what the big energy shock in late 1973 might have done to the U.S. economy. Between 1973 (represented by supply curve S0 and point E) and 1975 (represented by supply curve S1 and point A), it shows real GDP falling by about 1.5 percent, while the price level rises more than 13 percent over the two years. The general lesson to be learned from the U.S. experience with supply shocks is both clear and important, namely

The typical results of an adverse supply shock are lower output and higher inflation. This is one reason why the world economy was plagued by stagflation in the mid-1970s and early 1980s. And it can happen again if another series of supply-reducing event takes place.

Demand Side FactorsTo take this model further, let’s add demand factors that caused stagflation as well, which we ignored above: While the aggregate supply curve was shifting inward because of the oil

shock, the aggregate demand was shifting outward. In the figure below, the black aggregate demand curve D0 and aggregate supply curve S0 represent the economic situation in 1973. Equilibrium was at point E, with a price level of 31.8 (based on 2000 = 100) and real output of $4,342 billion. By 1975, the aggregate demand curve had shifted out to the position indicated by the brick-colored curve D1, but the aggregate supply curve had shifted inward fromS0 to the brick-colored curve S1. The equilibrium for 1975 (point B in the figure) therefore wound up to the left of the equilibrium point for1973 (point E in the figure). Real output declined slightly and prices, led by energy costs, rose rapidly.

Therefore in conclusion, the causes behind the stagflation of the 1980’s causing the U.S. economy to performed so poorly in the 1970s and early 1980s, when both unemployment and inflation rose together. The OPEC cartel first flexed its muscles in 1973–1974, when it quadrupled the price of oil, thereby precipitating the first bout of serious stagflation in the United States and other oil-importing nations. Then OPEC struck again in 1979–1980, this time doubling the price of oil, and stagflation returned. We now understand that what was happening was that the economy’s aggregate supply curve was shifted inward by the rising price of energy, rather than moving outward from one year to the next, as it normally does.Unfavorable supply shocks tend to push unemployment and inflation up at the same time. It was mainly unfavorable

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supply shocks that accounted for the stunningly poor economic performance of the 1970s and early 1980s.

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Policy RemediesWhenever the 1980s stagflation is talked about there are two names which come to our mind Reagan and Paul Volcker. Reagan the then president of USA adopted policy measures to pull the economy out of stagflation and was supported in the bid by Paul Volcker the then chairman of Fed.

The Stagflation posed a big question in front of the economists. Until the 1970s, many economists believed that there was a stable inverse relationship between inflation and unemployment. They believed that inflation was tolerable because it meant the economy was growing and unemployment would be low. If the economy slowed, unemployment would rise, but inflation would fall. Therefore, to promote economic growth, a country's central bank could increase the money supply to drive up demand and prices without being terribly concerned about inflation. These beliefs were based on the Keynesian school of economic thought, named after twentieth-century British economist John Maynard Keynes.

In the 1970s, Keynesian economists had to reconsider their beliefs as the U.S. and other industrialized countries entered a period of stagflation. According to the Keynesian economic theories prevalent at the time, inflation should have had an inverse relationship with unemployment, and a positive relationship with economic growth. Rising oil prices should have contributed to economic growth. In reality, the 1970s was an era of rising prices and rising unemployment; the periods of poor economic growth could all be explained as the result of the cost push inflation of high oil prices, but it was unexplainable according to Keynesian economic theory.

To get the economically devastating effects of inflation under control in the 1970s, the Federal Reserve Chairman Paul Volcker put the monetarist theory into practice. Monetarists strong believe that the economy's performance is determined almost entirely by changes in the money supply. Volcker and Reagan together tried to reduce the inflation by reducing money supply in the economy.Ronald Reagan promised an economic revival that would affect all sectors of the population. He proposed to achieve this goal by cutting taxes and reducing the size and scope of federal programs. Critics of his plan charged that the tax cuts would reduce revenues, leading to large federal deficits, which would lead in turn to higher interest rates, stifling any economic benefits. Reagan and his supporters, drawing on the theories of supply-side economics, claimed that the tax cuts would increase revenues through economic growth, allowing the federal government to balance its budget for the first time since 1969. The four pillars of Reagan's economic policy were to

Reduce government spending Reduce income and capital gains marginal tax rates Reduce government regulation Control the money supply to reduce inflation

In his stated intention to increase defense spending while lowering taxes, Reagan's approach was a departure from his immediate predecessors. Reagan enacted lower marginal tax rates in conjunction with simplified income tax codes and continued deregulation. Much of the credit for

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the resolution of the stagflation is given to two causes: a three year contraction of the money supply by the Federal Reserve Board under Paul Volcker, initiated in the last year of Carter's presidency, and long term easing of supply and pricing in oil during the 1980s oil glut. The Keynesian interpretation of Reaganomics is that the economic expansion is primarily or entirely due to these factors, and not due to Reagan's policies. Reagan declared spending cuts for the Social Security budget, which accounted for almost half of government spending, off limits due to fears over an electoral backlash, but the administration was hard pressed to explain how his program of sweeping tax cuts and large defense spending would not increase the deficit. President Reagan lifted remaining domestic petroleum price and allocation controls on January 28, 1981 and lowered the oil windfall profits tax in August 1981, helping to end the 1979 energy crisis. He ended the oil windfall profits tax in 1988 during the 1980s oil glut. With the Tax Reform Act of 1986, Reagan and Congress sought to broaden the tax base and reduce perceived tax favoritism, for which he was sharply criticized.

Reagan's policies are recognized by some as bringing about one of the longest peacetime expansions in U.S. history. By early 1982, Reagan's economic program was beset with difficulties as the recession that had begun in 1979 continued. In the short term, the effect of Reaganomics was a soaring budget deficit. Government borrowing, along with the tightening of the money supply, resulted in sky high double digit interest rates. Reagan allowed the Federal Reserve to drastically reduce the money supply to cure inflation, but it resulted in the recession deepening temporarily. The economy recovered in 1983 and 1984. A factor in the recovery from the worst periods of 1982-83 was the radical drop in oil prices due to increased production levels of the mid 1980s, which ended inflationary pressures on fuel prices.

By the middle of 1983, unemployment fell from 11 percent in 1982 to 8.2 percent. GDP growth was 3.3 percent, the highest since the mid-1970s. Inflation was below 5 percent. When the economy recovered, Ronald Reagan declared it was Morning in America. Reagan and Paul Volcker thus stabilized the ship which was otherwise wavering in the sea and established America as a super power back again.

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Statistical Facts and Figures1982 Recession and Recovery (in percent)

1980 1981 1982 1983 1984

Nominal Interest Rate (Three month

treasury bill rate)

11.5 14.0 10.7 8.6 9.6

Real Interest Rate 2.0 4.0 4.5 4.5 5.2

Full Employment Deficit 0.4 0.0 1.1 2.1 3.0

Unemployment Rate 7.0 7.5 9.5 9.5 7.4

GDP Gap 6.4 7.1 11.6 10.4 6.2

Inflation 9.5 10.0 6.2 4.1 4.4

In October 1979, the Fed acted, turning monetary policy in a highly restricted direction. The monetary squeeze was tightening in the first half of 1980, at which point the economy went into a mini recession. The reason for the sharp decline in activity was tight money. Because inflation was still above 10% and the money stock was growing at only 5.1% in 1981 the real money supply was falling. Interest rates continued to climb. Investment especially construction collapsed.

Over the period 1981-1984, the real interest rate increased sharply even as the nominal rate declined. The real cost of borrowing went up although the nominal cost went down. Investment spending responded to both the increased interest rates and the recession, falling 13 percent between 1981 and 1982 and investment subsidies and prospects of recovery, increasing 49 percent between 1982 and 1984. Also, the full employment deficit increased rapidly from 1981 to 1984.

The unemployment rate peaked at over 11 percent in the last quarter of 1982 and then steadily declined under the impact of the huge fiscal expansion. Further fiscal expansion in 1984 and 1985 pushed the recovery of the economy forward, and the expansion continued throughout the 1980s.

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Detailed Statistics

Let’s look at the graph of the levels of quarterly real Gross Domestic Product (GDP) levels, seasonally adjusted and in billions of chained 2000 dollars.

As can be seen in the above graph, the real GDP from 1980 onward was fluctuating up and down and on average not trending in either direction. It is perhaps best to refer to this condition as an economic malaise rather than a recession because the economy was in difficulty more than a year before it was officially an economic recession. The graph below shows what was happening to investment purchases in 1979 through 1982.

This was the picture of investment conditions seen by economists and politicians in 1982. It was not a comforting picture. The profile for mid-1981 to 1982 was especially disturbing. It is the classic picture of a catastrophic collapse in progress. Although recessions are defined in terms of output (GDP) they are felt in terms of the unemployment rate. Here are the unemployment statistics from the Bureau of Labor Statistics of the U.S. Department of Labor.

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U.S. Unemployment Rates Month-by-Month for the Period 1978-1984

Year Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec

1978 6.4 6.3 6.3 6.1 6.0 5.9 6.2 5.9 6.0 5.8 5.9 6.0

1979 5.9 5.9 5.8 5.8 5.6 5.7 5.7 6.0 5.9 6.0 5.9 6.0

1980 6.3 6.3 6.3 6.9 7.5 7.6 7.8 7.7 7.5 7.5 7.5 7.2

1981 7.5 7.4 7.4 7.2 7.5 7.5 7.2 7.4 7.6 7.9 8.3 8.5

1982 8.6 8.9 9.0 9.3 9.4 9.6 9.8 9.8 10.1 10.4 10.8 10.8

198310.4

10.4 10.3 10.2 10.1 10.1 9.4 9.5 9.2 8.8 8.5 8.3

1984 8.0 7.8 7.8 7.7 7.4 7.2 7.5 7.5 7.3 7.4 7.2 7.3

If we analyse the above statistics we see a perceptible rise in the unemployment rate in 1980. Second the unemployment rate rose as the period of no growth in output persisted while the labor force grew. Third the peak unemployment rates persisted after the economy began to grow again in 1983 because of the backlog of unemployed workers that had accumulated during the period of no growth. Fourth, and perhaps most important, after the recovery of growth the unemployment rate stayed at a higher level than it had been at before the recession.

So far there has been no mention of the cause of the recession or malaise or whatever one wants to call it. The cause clearly was Paul Volcker's tight money policy which the Fed carried out to kill the chronic inflation that had developed in the U.S. economy during the 1970's. To show this one needs the statistics on the nominal interest rate, the rate of inflation and the real interest rate. The real interest rate is the key variable because it determines the level of investment. However, the level of investment is an accumulation of work on past inititated investment projects as well as the current ones so the level of investment has a lagged response to the real interest rate.

A subsidiary issue is the impact of the Reagan administration's fiscal policy. Some taxes were cut, government expenditures in some fields were also cut and the net impact has to be evaluated. There was also a trade deficit that worried politicians. The trade deficit was an effect of the high value of the dollar relative to other currencies and this in turn was the result of the high real interest rates in the U.S. compared to other countries.

Investment

The key variable affected by the high real interest rates was the level of investment purchases.

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It is to be noted that the deficits of the Federal Government did not "crowd out" private investment. On the contrary, the expectations of economic recovery and growth induced higher levels of investment purchases. In other words, private borrowing was enticed in. Where did the funds come from for businesses to borrow? They came from the increased savings generated by the recovery of the economy. It is also to be noted that the increased deficits of the Federal government did not lead to increased inflation. On the contrary during the time of the increased deficits the chronic inflation of the 1970's collapsed and did not re-emerge.

The effects of American Stagflation on the US economyThe monetary authorities in the US made little effort to reassure Financial Markets. Instead due to the gap between their behaviour and the stated intensions resulted in uncertainly less trust. Monetary targets routinely announced and missed which causes movement in reaction to such changes from the financial markets to protect themselves. This reaction in turn complicates the Federal Reserve’s task of money control. The authorities and the markets simply chased each other up and down the interest-rate gamut, each blaming the other for the trouble. This process of mutual frustration by the authorities and the markets has damaging effects on the general economy. This resulted in low confidence in business investments and consumers’ willingness to spend. This according to the Macroeconomics theory resulted in a slow down.

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The effects of American Stagflation on the world economy

The huge fluctuations in the US interest rates induced large fluctuations in the exchange rate of the currencies of other nations and US dollars. Increasing US rates attracted huge financial flows into US Dollar Investment. The resulting upward pressure in exchange markets pushed the dollar up against the German mark from 1.71 marks in early January to 1.98 marks in early April. The behaviour of the other European currencies against the dollar was similar, except in the case of sterling, which remained high against the dollar right through the year 1980.Also dollar’s unwarranted strength against sterling had undesirable consequences. German and Japan had been faced with major outflows of financial capital attracted by high real interest rate available on dollar assets. The resulting downward pressure on the mark and the yen has tended to raise the domestic prices of oil and other imports, thus speeding inflation in both countries. In response, the German and Japanese authorities sought to strengthen their currencies by abolishing controls on capital inflows and by tightening their domestic monetary policies and supporting their currencies on the exchanges. Such moves had a restrictive effect on monetary conditions in the two countries, tending to worsen the business slowdown already developing there. The world price of oil spurted from an average of $12.91 a barrel in the fourth quarter of 1978 to $23.54 in the fourth quarter of 1979 to an estimated $33.00 in the final quarter of 1980. Once again the authorities in all the industrial countries responded by tightening money supply more or less simultaneously. The result was a second business slowdown after 1974.Thus, the fluctuations in the rates in US impacted the exchange rates and domestic policies in countries like Japan and Europe. Flexible rates provided countries with more independence but in real or business cycle terms this wasn’t true. It was so because of the simultaneous oil shocks and parallel policy responses to them but also because flexible exchange rates force other countries’ central banks to respond quickly rather than with a lag to shifts in Fed Reserve’s policy.In 1980 dollars’ swift arise in exchanges in anticipation of Fed’s tightening and higher interest rates forced the German Government to tighten the domestic credit, this caused a mild slow down in business to become a recession of 1980-81. In Britain's case, though, the synchronization with the European and U.S business cycles was more accidental. The British recession was mainly the result of the financial markets' belief that Prime Minister Margaret Thatcher means business and that she may yet succeed in making the Bank of England bring down money growth and reduce inflation. This state of mind has led not only to the pound's exaggerated strength on the exchange markets but also to an increase in the public's willingness to hold pounds, which has reduced the velocity of circulation of money in Britain, thereby slowing spending and lowering business activity.

Recovery from Stagflation

The American Stagflation lasted from 1970 till 1987. Stagflation was eradicated during the Reagan era. It was done under Paul Volcker who was the Fed Chairman at the time. By eliminating stagflation Volcker made the American economy swallow the bitter pill of recession.

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Volcker’s solution to reducing high inflation was to slow down growth and force the economy into a recession. The recession that followed was severe and lasted till 1984.

The first priority of the Fed was to lower inflation which stood at 13.5% in 1981. This was done by effecting two changes. First was to slow down the rate of growth of money supply. It was achieved through increasing the federal funds rate (interbank rate) from 11.2 % in 1979 to an average of 20%. Second was to increase the prime rate to 21.5% in 1981 as well.

The role of the government is also very critical. Ronald Reagan’s policies later came to be known as Reaganomics. He is said to have eliminated the causes of stagflation by instituting supply side economics. His policies as per the Economic Recovery Tax Act of 1981 were as follows

Supply side policies:1) Lower government spending by reducing expenditure on social programs2) Reduce government regulation3) Reduce personal and corporate taxes

Keynesian economics would show that lower taxes would increase the levels of inflation, but that did not happen. But economist Arthur Laffer disagreed.

Lowering the tax rate to X’ would increase tax revenue. Lower tax rate would lessen avoidance of taxes. Fewer transfer payments (reduced govt. spending) would result in greater number of people working and greater number paying taxes. Hence the result is greater productivity and therefore increasing GDP.

Therefore a tight monetary policy by the Fed led to two recessions between 1980-83. The short term results were good

1) Inflation drops dramatically2) Unemployment eventually came down3) The longest expansion in peacetime history. (Known as the “Seven Fat Years”)

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But some results were perceived to be bad. They are

1) Large deficit resulted (as inflation fell faster than expected). These deficits were expected to crowd out investments

2) Trade deficit increased. High interest rates with low inflation made US a good investment hub for international investors. This pushed up the value of dollar making imports cheaper & exports expensive.

Even today there are different takes on whether the policies used were pure Keynesian or not. But the fact is that now people agree with the policy decisions taken then. The argument is that when Reagan left office the average US citizen earned about 25% more than the average citizen of Germany & Japan.

Comparison between current and 1981-82 recessions

The early 1980s recession was a severe recession in the United States which began in July 1981 and ended in November 1982. The primary cause of the recession was a contractionary monetary policy established by the Federal Reserve System to control high inflation. The double dip recession of the early 1980s as it is called was actually two separate recessions interrupted by a very short (two quarter) expansion. Since the expansion was so short and the causes of both recessions were the same it is considered to be one for most of the analyses.

According to the NBER, a non- profit body which decides the recession the current recession is considered the longest recession so far. It started in December 2007 continued till June 2009, for a period of 19 months as compared to the 16 month duration of the 1981-82 recessions.

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However, just considering that the recession of 1980 is worse than the current recession because it was a combined effect of two subsequent recessions won’t be right and needs a deeper insight. A comparison between the two recessions can be done on the basis of GDP Gap between the actual real GDP gap and the potential GDP, industrial capacity, unemployment rate and the payroll job losses

GDP GapThe best way to look at the depth of the recession and see how much excess capacity the double 1980-82 recession created compared to the current recession is to look at the GDP Gap or the gap between actual Real GDP and Potential Real GDP as shown in the chart:

In the chart, we can see how the recovery from the 1980 recession was incomplete and the economy was significantly below potential real GDP when the 1981-82 recession began. But we had something similar in this cycle. If we observe we will find that the 2002 -2009 expansion was so weak that real GDP never got back to potential just as it did not in 1981. But if we assume that second quarter real GDP falls at a 4% annual rate it creates a GDP Gap of -8.4% as compared to -8.3% at the 1982 bottom. So even when we build into the comparison that the 1980 -82 recessions was really two recession, we still come to the conclusion that the depth of this recession was about the same as the combined 1980-82 recessions.

Industrial capacityA second way of measuring the depth of a recession is to compare how much excess industrial capacity is created which we can do by comparing the manufacturing capacity utilization during both the durations:

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The chart shows how in both the 1981 recovery and the 2002-2008 expansions the economy failed to recover to prior peaks and entered the recessions with significant excess capacity already existing. But during the recession of 2007 manufacturing capacity utilization is at 65.7% (as on Jan 2009 data) versus 68.6% at the 1982 bottom. So again this measure shows the depth of the current recession to be greater than the combined 1980-82.

UnemploymentDuring the recession of 1981-82 the employment conditions deteriorated throughout the year. The unemployment rate in the U.S. reached 10.8% in December 1982 much higher than at any time in post-war era. Job cutbacks were particularly severe in housing, steel and automobiles. By September 1982, the joblessness / unemployment rate had reached 10.8%. Twelve million people were unemployed, an increase of 4.2 million people since July 1981.

Talking about the current recession, from the start of the recession to the end of May 2009, total nonfarm payroll employment declined by about 6 million, or 4.3 percent. In the same period, the unemployment rate jumped from 4.9 percent to 9.4 percent, amounting to almost 6.9 million additional unemployed workers.

The following chart shows that the unemployment rate of the 2007 recession is going steep in the negative direction.

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In a typical business cycle, the unemployment rate starts to increase right around the beginning of the recession and does not show any sign of decline until the recession is over. The rate at which the unemployment rate increases over the course of the recession is a good measure of how severe a downturn is

It can be said that the job losses associated with this recession already have been deeper because the downturn started with a lower unemployment rate than in the 1981-82 slump as. The rise in employment in this particular recession is of the fact that the companies are over cautious about hiring and also the growth of the economy has come to a standstill with absolutely no investment. Capital spending and inventory policies had also been conservative.

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The American Stagflation Episode of 1981