The Real Story Behind the 1983 Recovery

I was underwhelmed by Krugman’s recent interpretation of the V-shaped recovery from the 1981-2 recession.  I have written about briefly about the 1983-4 recovery before but this post will be a bit longer.  First is NGDP, GDP, inflation, and 10 year inflation expectations from 1982-1987.

Pretty simple, NGDP is at 4% in 1982, the result is a Fed induced recession to fight inflation.  1983 to 1984, NGDP raises to 12 percent a year, the result is a robust recovery.  Let's compare that with the current recession.


 

 

The 2008 to 2010 period is dismal, with NGDP severely below trend.  Instead of allowing NGDP to grow above the long term average rate and return overall nominal spending to trend since that time, Bernanke put a damper on inflation and growth with passively tight monetary policy.  The result is a long, suppressed recovery, but it need not be so.  Had NGDP been allowed to return to trend, we would have a seen a similarly robust recovery like the one from 1983-1984.

Krugman’s likely response is that monetary policy is ineffective at the ZLB:

The 2007-? slump was brought on by the bursting of a housing and debt bubble, and left the Fed largely pushing on a string.

Krugman, you are right here, monetary policy was pushing on a string, but only because Bernanke refused to communicate outside of  the interest rate channel of monetary policy.   The resulting failure was obvious, a swift drop in nominal expectations of future growth, creating a debt – deflation debacle that could have largely been avoided by setting future nominal expectations.

 

Krugman again, “pushing on a string.”    

In reality however, Matthew Yglesias reminds that you should never bet against a central bank's ability to devalue its currency and consequently increase expectations:

And for all the same reasons that you can always push your exchange rate down, you should always be able to push your medium-term price level expectations up.

But Bernanke continues to communicate through the interest rate mechanism of monetary policy, sowing the seeds for not only the last recession but the next (more on this in my next post).