The Volcker Recession: The Good, the Bad and the Ugly

Krugman does his best to maintain a descriptive rather than normative tone in this book, though his dominant thesis is that the American people are largely content with lackluster economic performance, via their diminished expectations, so long as there is no crisis that shakes up their world. People can live with a little inflation, deficit-spending and/or unemployment so long as the costs in the short term seems relatively low. Given this argument, I want to explore if a crisis can ever be considered “worth it” under Krugman’s account if the economy is “better off” afterward. In particular, I will look at the in’s and out’s of the Volcker Recession of the early 1980’s, considered by many to be a boon rather than blight.

Carter appointed stern old Paul Volcker as chairman of the Fed in the late 70’s and he quickly took to attacking inflation by choking the economy with high interest rates. Both parties knew full well of the devastating effects this would have and agreed to the draconian contractionary monetary policy. By raising the Federal Funds rate as high as 20% in June 1981, Volcker squeezed inflation out of the US economy from 10.3% in 1981 to 3.2% in 1983, a remarkable drop that predictably caused a temporary recession and unemployment rates peaking at 10.8%. Once inflation was under control, Volcker took his foot of the brake and the economy boomed with the help of Reagan’s deficit spending. Though Volcker has been hailed as an economic hero by some, I think it’s important to take a closer look at his policies, perhaps through Krugman’s colored spectacles.

First of all let’s entertain the counterfactual. The impetus for this drastic manipulation of interest rates was that inflation was spiraling out of control. It seems, though, that this “spiraling” effect was an illusion due in large part to the massive oil shocks of the 70’s. Inflation spiked during the oil shock of 1973 but returned to around 5% in 1975, and spiked yet again in 1979, though this time drastic measures were taken. If Volcker had not acted, it is likely that inflation would have dropped via lower oil prices during the early to mid 80’s either way – an important point to consider. Another phenomenon in this era contributing to inflation was the wage-price feedback loop, often perpetuated by unions. However, during the late 70’s and early 80’s unionization was largely decreasing, and highly unionized industries such as manufacturing were facing competition from export-oriented Asian economies, would effectively reduced the feedback loop as well. This driver of inflation would have dropped significantly in the 80’s as well. The point is that drastically combating inflation in this era of unprecedented stagflation may have been more psychological than of necessity in hindsight.

Krugman makes the argument in this book that the real holy grails of economic well-being are productivity, income distribution and unemployment. He gives inflation a second-class and “neutral” status, a thorn in the side that can pose problems for the more “real” measures. Therefore, it would seem that he would prima facie oppose a recession that trade inflation for massive unemployment and loss of productivity, even if these ills were temporary in nature.

The argument can be made that most accounts of the Volcker recession view the US in a vacuum, and fail to consider its impacts more broadly. First of all, the residual effects of high interest rates were a leading factor in the Savings and Loans crisis that took place shortly after in the 1980’s. The high interest rates destroyed the ability of savings and loan associations to attract capital, and people fled to higher-earning commercial banks. Concurrently, the high interest rates hurt mortgages, which these S&L organizations used as underlying assets.

Often overlooked is the Volcker Recession’s effect on the rest of the world, which helped trigger and worsen the debt crisis in the Third World, in particular in Latin America. This is not unlike the recent global financial crisis, where US was the epicenter. Volcker visited the CMC Athenaeum, and asked by Bill Ascher if he considered the impact of his policies in this era on the international community he responded “Not at all”. While this may have been acceptable in the stagflated 80’s, it does not hold up to scrutiny today. Before we go trumpeting the success of aggressive monetary policy, we need to have a more serious look at these historical examples, and think seriously about the more long-term effects in the tradeoff between inflation and unemployment.