No Mitt, this Recession is Different from the one in 1980-1982

by pdxblake

Well, I though Obama did quite well in the debate tonight.  But, who cares what I think (I am decidedly NOT an undecided voter).  However, I though it was interesting that Romney tried to play the card that things would be better if only Reagan were still president (*shudder*).  Romney compared the recession recovery to the economy Reagan had when he became president, which is fundamentally dishonest because they were two very different economies (something which Carmen Reinhart and Ken Rogoff also want people to stop misleading about).  Going into 1980, the inflation rate was high, and the Fed needed to establish its credibility by lowering inflation expectations into the future.

Look, for example, at the interest rate on the basic 30 year mortgage:

Coming into 1980, it was in the neighborhood of 12.5%.  Even with mortgage interest rates at that level (due in part to the inflation in the economic that was driven by the oil price spikes in 1974 and 1979 (you can see the smaller spike in interest rates in 1974 that led to a recession, marked in the shaded area).  By 1980, inflation was not out of control by any means, but it was far above today’s Fed’s preferred area of around 2%:

So, in 1980, if you are the Fed chairman, newly appointed in August 1979 by Jimmy Carter and your mandate is to get maximum employment in the context of stable inflation are you to do when inflation is above 10% and rising?  Keep in mind that the two inflation spikes in the 1970s are in the periods when the primary driver of inflation is the rise in oil prices (the US was then consuming more barrels of oil for every $1 of GDP than we do today)?

Well, you raise interest rates to force a recession (or two) to slow the economy to get inflation expectations down to lower levels.  And that’s just what Volcker did (yes, the same Volcker who had a rule named after him).  When inflation is increasing >10% per year, the Fed has the tools to bring the expected rate of inflation down.  It just hikes its short-term targeted rate and the recession leads to lower expected rates of inflation.  The Fed knows how to tame high and rising inflation.

But the situation today (and even more in 2009) was that the Fed’s target short-term rate was near zero and the economy was still in recession.  Now, a digression.  There is a relationship between the short-term rates the Fed sets and longer-term rates (like the 10-year Treasury on which many mortgages are based, see above for where that is..).  The yield curve shows the interest rate on bonds of varying maturity (maturity is how far out they are coming due).  Long-term rates, like the 10 year Treasury are essentially summations of what the short-term rates will be for the next 10 years.  So, even if rates are now near zero, if there is expected to be a pickup in inflation starting 5 years from now, that would raise rates on the 10 year.  If, however, deflation (i.e. the economy slides back into recession) is expected, then the longer term Treasuries would have a lower yield.

When the economy is depressed and recovering from a period of debt-built expansion that has now turned into deleveraging, there is a risk that people will forecast a double-dip recession.  This is especially the case when the political system has become so disfunctional that economic growth (which would increase the incumbent’s chances of re-election) becomes anathema and the opposition prefers gridlock or worse (GOP threats to default on the US debt, or imposing calendar-dated fiscal retrenchment pledges in a deleveraging cycle).

As bad as the 1970s may have been for the high inflation and high unemployment (and higher during the period after interest rates were raised by the Fed), there was a recovery around the bend.  When a recession is caused by central bank that is trying to curtail inflation expectations, it can always lower interest rates to ease the pain.  When it gets to near 0% interest rates, it neeeds to do more (and has, thanks to the lessons learned by Ben Bernanke from his study of Milton Friedman and Anna Schwartz’s analysis of the monetary policy factors that intensified the Great Depression).

It is an error and a lie for Mitt Romney to correlate the current recovery (caused by the bursting of the housing and financial bubbles) and the recovery in the early 1980s (which was instead driven by the Fed to lower inflation expectations, even if it was also painful). It is disingenuous at best and a full on lie at worst (I lean toward the latter).