The Carter Recession and the Natural Rate of Unemployment

As James Hamilton weighed in on when the most recent recession began, he also takes us back to the late 1970’s:

For example, most of us would agree that the slowdown in inflation in the 1980s (for which President Reagan is sometimes credited) was due to Fed Chair Paul Volcker, who was in fact appointed by President Carter. Moreover, the primary reason that Volcker was able to bring inflation down was his willingness to contribute to an economic recession in 1980, for which Carter was blamed. Perhaps the real error was allowing inflation to accelerate as much as it did prior to Volcker, for which much of the blame would logically go to Fed Chair Arthur Burns, appointed by President Nixon in 1970, and G. William Miller, Carter’s pick in 1978. But even here there is a separate interesting question as to the contribution that bad real-time data may have made to those policy errors.

Dr. Hamilton provided a link to an important paper by Athanasios Orphanides on how the tradeoff between using timely data versus reliable data makes policy choices more difficult.

The “stagflation” of the late 1970’s presented the Federal Reserve with certain chooses that would have been difficult even if they had better real-time data. I view the Carter years as being composed of three distinct periods as far as policy actions and the policy debates. During the first year and a half, macroeconomic policy seemed to be designed on generating an investment led recovery by using monetary expansion – especially given Carter’s tendency towards fiscal conservatism. By late 1978, unemployment had declined to just below 6% and with inflation accelerating, there was a period when Keynesians were split on what monetary policy should be. Dr. Hamilton is making the case that monetary restraint should have been imposed well before Volcker became Federal Reserve chairman.

While some Keynesians were saying the same thing in late 1978, others were arguing that we were still well below full employment as we really had little consensus on whether the natural rate of unemployment was 5% or 6%. Those Keynesians who believed that the natural rate was between 5% and 5.5% were arguing that the acceleration of inflation was due to oil price increases, dollar devaluation, or other cost-plus factors. Even when the Volcker FED decided to adopt a Friedman type approach and ride us along the short-run Phillips curve to reduce inflation at the pain of a recession – these more liberal Keynesians strongly objected.

This episode has a parallel in today’s debate. While some of us still think the labor market is weak, other economists have applauded the FED for raising interest rates on the fear that excess aggregate demand would lead to an acceleration of inflation. And for those of us who recall Volcker’s second round of monetary restraint, which was driven by Reagan’s fiscal insanity, it is hard to criticize today’s FED in light of the current fiscal insanity. But there have some macroeconomists who are better forecasters than this Bear (I don’t discuss forecasts as I’d only make the weatherman look good) who are concerned that the tight monetary policy is about to lead to another recession. On this score – the recent debates as to the natural rate of the employment to population ratio may be secondary to the issue raised by Dr. Hamilton and Athanasios Orphanides.