Yesterday I wrote that causing a recession to correct policy mistakes would reflect the medical wisdom of re-breaking a bone in order to set it correctly. Yes, there is pain in re-breaking a bone. Yes, the patient screams. But the patient is better off in the long-run. I said people would think I was crazy, and Scott Sumner thinks I am crazy.
“PS. Marcus Nunes has a wonderful new post that directed me to a left wing blog that advocates intentionally driving the economy into a recession as a way to reduce inequality. That’s a wonderful idea. I strongly encourage all progressives to read this Angry Bear post, and adopt the “breaking bones to fix bones” model of the economy. Voters will love it and that will finally convince them to adopt all your other socialist ideas.”
Scott Sumner praises the post by Marcus Nunes who basically said that the Volcker recession was unintended. He cites a book by William Barnett…
“Following the inflationary 1970s, Paul Volcker, as chairman of the Federal Reserve Board, decided to bring inflation under control by decreasing the rate of growth of the money supply…The policy succeeded in ending the escalating inflation of the 1970s. but was followed by a recession. That recession, widely viewed as having been particularly deep, was not intended.”
“The chart reveals the cause of the unintended recession. The rates of growth of the Divisia monetary aggregate was much lower than the rate of growth of the official simple-sum aggregate which was the official target of policy. With the Divisia growth so much lower the result was an unintended negative shock of substantially greater magnitude than intended. A deep recession resulted.”
Was the Volcker recession really unintended? Was it an “oops” moment? Well, let’s listen to Milton Friedman and George Shultz talking about the Volcker recession…
First Milton Friedman…
“There is no other president in the postwar period who would have stood by without trying to interfere, to intervene with the Federal Reserve. The situation was this: The only way you could get the inflation down was by having monetary contraction. There was no way you could do that without having a temporary recession. The great error in the earlier period had been that whenever there was a little contraction there was a tendency to expand the money supply rapidly in order to avoid unemployment. That stop-and-go policy was really what bedeviled the Fed during the ’60s and ’70s. That was the situation in 1980, in ’81 in particular. After Reagan came into office, the Fed did step on the money supply, did hold down its growth, and that did lead to a recession. At that point every other president would have immediately come in and tried to get the Federal Reserve to expand. Reagan knew what was happening. He understood very well that the only way he could get inflation down was by accepting a temporary recession, and he supported Volcker and did not try to intervene.”
Reagan and Volcker did exactly what I called “re-breaking the bone” of the economy in order to set inflation straight.
Now George Shultz…
“When President Reagan took office, he had people like Milton Friedman. I was chairman of the economic policy group, Milton was a member, and there were others who said the essence of the inflation problem is monetary policy, and to deal with it effectively, you’ve got to discipline the money supply. Paul Volcker agreed with that, and President Reagan gave him a green light. Now, people worried about that, and many people warned President Reagan that if he did this, there’s likely to be a recession. And obviously who wants a recession? But I can remember President Reagan using those famous words, “If not now, when? If not us, who?”
“And so when he (Reagan) took actions that he thought were right, knowing that there could be difficulties, he stuck with them, he didn’t run away. He had a stiff backbone.”
Reagan and Volcker both knew there would be a recession. Yet they had the backbone (speaking of bones) to push the economy through the screaming pain of a deep recession. And they knew they were risking a political backlash. Milton Friedman said…
“And I know — I can speak with, I think, authority on this — that he (Reagan) realized what he was doing, and he knew very well that he was risking his political standing in order to achieve a basic economic objective. And, as you know, his poll ratings went way down in 1982, and then, when the inflation seemed to be broken enough, the Fed reversed policy, started to expand the money supply, the economy recovered, and along with it, Reagan’s poll ratings went back up.”
Christina Romer is telling us not to worry about recessions. We can recover quickly with proper policy. We could also have a better economy because of a recession, as is the case of beating down inflation during the Volcker recession.
So when Scott Sumner sarcastically says that pushing the economy into a recession to reduce inequality is a “wonderful idea” that voters will love, he is implying that he would have advised against Reagan and Volcker to cause a recession. He is implying that he would not have had the backbone to do what they did. We do not need economists like him. We need economists with backbone.
Voters did not like inflation back then, and they certainly don’t like inequality now. So it follows from the Volcker-Reagan example that a plan to reduce inequality, even if it involves provoking a recession would eventually be appreciated by the voters.
Here is how I see the next recession… (taken from my comments at Mr. Sumner’s post)
To start, there is a growing problem of inequality that is getting more entrenched everyday. Monetary policy is feeding the inequality. We can see who is benefiting and who is not. Just as inflation adversely affected economic decision-making back in the 1970′s, inequality is distorting decisions now to the point that financial stability is again a primary concern. Asset prices are once again becoming distorted. International markets are sensitive to Fed policy. The central bankers are talking seriously about financial stability again.
Yet, the Fed is in a trap. If they tighten to stop this growing financial instability related to inequality, they really do risk a recession. Profit rates have peaked. So what do they do? They choose to push on keeping a hopeful face that a far off full employment will rectify the problems, including inequality and low inflation. That is the only way out of this trap. Basically they underestimated weak demand. They did not understand what a falling labor share meant. They expected the economy would have recovered by now.
The economy healed incorrectly after the crisis, considering the fall in labor share. Then profits increased to great levels with the blessing of monetary policy, while inequality increased. Inflation is staying low globally. There is weak demand from low labor share. The transmission mechanisms of liquidity to middle and low income households is not good enough. Christian Romer acknowledged this in her talk. During the crisis, she didn’t think it proper to help middle incomes. She would help middle incomes in the next crisis. That somehow makes me want a new crisis right away.
The economy is proceeding with a permanent limp related to policies that increase inequality. I foresee progressive mechanisms being engineered in the next recession.
My view is that a recession will happen anyway before their full employment level is reached due to weak effective demand, which monetary policy could not resolve. And the recession will easily be blamed on a monetary policy that benefited the rich at the expense of everyone else. Then as the economy recovers, there will be pressure to make policy more progressive to help the 99%. The new policy will have mechanisms directing liquidity at middle and low incomes.
Larry Summers has already pointed to weak demand causing low production. He has said that policy in the future must be directed at demand. That means labor income in my book. The words of Larry Summers and Christina Romer have influence. So the stage is already set. When the next recession happens, we will see more progressive policies.
So my backbone is ready for the next recession… go ahead and break my bone. Let me scream. I see good economically progressive doctors ready to make the economy better.
To wrap up, Volcker knew what he was doing by re-breaking the economy to correct inflation. Reagan had the backbone to stand by him. We need progressive economists with backbone to correct inequality.