Recession of 1981-82 Not a Useful Comparison (posted 3/8/09)

Comparisons of the current economic problems with the recession of 1981-82 are appearing frequently in the media. Such comparisons are meaningless, and may be misleading. True, we have not yet reached the unemployment rate of that recession…….so far; nor has GDP declined as much… far. But the character of that period was completely different from this one.

The current economic decline is complex in both causes and effects. It is the aftermath of years of rapid debt expansion, and overindulgence in risk and speculation that inflated asset prices to unsustainable levels. Now wealth has been erased by an amount not seen since the Great Depression, with the consequences of badly impaired financial health of both individuals and institutions. Even at the stage, 16 months into the recession, we’re not sure where we are or what will turn us around. But let’s not compare today with 1981-82.

The 1981-82 recession was self-inflicted by monetary policy as a way to bring serious inflation and inflationary psychology under control.

Following the oil price shock of the mid-70’s, which fed inflationary expectations, inventories of raw materials and just about everything else were accumulated as a way to hedge against further price increases. The Federal Reserve, led by Arthur Burns, and worried about the effect of higher oil prices on economic activity, maintained an easy money policy that further fed the inflationary fire. Needless to say, it was not one of the bright spots in the history of central banking. Inventory accumulation at all levels, including consumer pantry shelves, was overdone, and there followed a recession caused primarily by inventory liquidation.

But the recession did nothing to cure inflationary psychology. Monetary policy remained timid at best under a new Fed Chairman, William Miller, a corporate executive with a sparse knowedge of economics and central banking. The Economist joked that Miller’s most oustanding accomplishment was to ban smoking at Board of Governors’ meetings. Inflation, which had doubled after the oil shock to 7.7%, then climbed to 9.1% in 1975, and after a brief respite went to 11.3% in 1979 and 13.5% in 1980.

Paul Volcker came to the rescue in August 1979 and courageously went to work tightening the monetary screws. The federal funds rate, which was about 11% in 1979, was raised to 20% by June 1981. The prime interest rate, at the time an important monetary measure, eventually reached 21.5% in June 1982. Economic activity was strangled. The recession began in July 1981 and lasted until November 1982. Inflation fell almost continuously from 1981 through most of the 1980’s.

Volcker’s mission was accomplished. The price paid was the worst recession since the 1930’s, but its cause was there for all to see. Nothing complex about it.


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