Friday, January 21, 2022

How the 2020s economy might resemble the 1980s

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It is easy to recall the 1980s as being a boom time for the United States economy – a time of gleaming excess that, among other things, powered Ronald Reagan to a landslide reelection in 1984.

But the decade didn’t start out quite so sunny. And understanding the history of how the economy went from bust to boom in the early 1980s offers a surprising model for optimism about how the US economy could progress in the next couple of years.

All it would take is for the Federal Reserve to pull off a delicate economic pivot that is the mirror image of the one it managed four decades ago.

Now, high inflation and a seemingly never-ending pandemic are depressing Americans’ attitudes about the economy. By contrast, in December 1981 — when Mr Reagan had been president for 11 months, just as President Joe Biden has now — conditions were by most measures substantially worse. The unemployment rate was 8.5 per cent would keep rising throughout 1982. Inflation was 8.9 per cent and indexes of consumer sentiment were abysmal.

In an issue of time magazine published this month 40 years ago, if you flip past a cover story that ranks the performance of Reagan’s Cabinet and an advertisement pitching a Smith-Corona typewriter as a holiday gift for your child, you see just how bad the vibes were.

“Gathering Gloom for Workers,” goes the headline, reporting that “A spreading slump swells the long gray line of the unemployed.” The article said joblessness was so high in Detroit that community leaders “fear that they are sitting on a smouldering powder keg of urban unrest.”

If nothing else, this chronology is a reminder that conditions can change surprisingly quickly. By the time Mr Reagan was reelected in 1984, the jobless rate was 7.2 per cent and falling and inflation was down to 4.2 per cent.

Some commentators have argued that Mr Biden has the opportunity to be an inverse of Mr Reagan politically (much of this commentary, it should be noted, came before Senator Joe Manchin pulled his support from the president’s signature Build Back Better bill ). And there is of course no telling what the next three years will bring politically, regardless of what happens to the economy.

But in terms of the economic backdrop, it is important to understand the “why” of the Reagan economic reversal.

Those gloomy unemployment numbers in Mr. Reagan’s first two years were a consequence of aggressive tightening of monetary policy by Fed Chair Paul Volcker, who was aiming to end the high inflation of the 1970s.

Across the government, including in the Reagan administration, there was a concerted focus on breaking inflation, even as the job market worsened. “What I find startling about this downturn is that so few politicians are calling for federal job training or the extension of unemployment benefits,” said Alan Greenspan, a former presidential adviser who would go on to succeed Mr Volcker, in the 1981 time article. “Five years ago, politicians would have been stumbling all over themselves to demand anti-recession spending.”

By late 1981, there were signs it was starting to work. That same article, for example, notes that Teamsters who had managed a 31.5 per cent pay raise in 1979 promised to be “reasonable” in the next negotiations, and that employees at major airlines had agreed to a 10 per cent wage reduction.

With this progress against inflation, Mr Volcker was ready to relent and begin lowering interest rates. This enabled a speedy recovery from the recession, powering the Reagan boom and a period in which both unemployment and inflation were steadily falling.

As the Fed chair now, Jerome Powell has until recently faced the opposite problem.

For most of the 2010s, inflation was lower than the Fed aimed for and the job market was persistently weak. And for the first nine months or so of the pandemic, too-low inflation and too few jobs appeared to be the predominant economic problem. Just one year ago, in December 2020, bond market prices implied that inflation would remain below the Fed’s 2 per cent target for years to come, and the jobless rate was still 6.7 per cent.

Mr Powell and the Fed organized their strategy for monetary policy around building the Fed’s credibility that it would no longer allow a persistently too-low inflation and a too-weak job market. A new “flexible average inflation targeting” strategy introduced in 2020 was built on allowing inflation to sometimes overshoot 2 per cent.

That, in turn, helps explain why the Fed has been slow to move toward tighter money this year, even as inflation soared and the job market recovered quickly. Only this month, after year-over-year inflation reached a whopping 6.8 per cent, did Mr Powell undertake a clear shift toward tighter money. He signaled the Fed would speed up the end of its bond-buying program and could begin raising interest rates in the first part of 2022.

Just as Mr Volcker was willing to allow a recession to take hold to break the high-inflation cycle of the 1970s, Mr Powell has, until recently, emphasized that an inflationary surge that started earlier this year was likely to be temporary and that the urgency of achieving full employment was paramount.

The Powell pivot to tighter money in 2021 is the equivalent of Mr Volcker’s 1981 move: By then Mr Volcker was ready to relent and, in effect, declare victory, cutting interest rates and setting the stage for the economy to recover. The signs that inflationary pressures were shifting downward was sufficiently compelling that the psychology had broken.

“It was a nasty, nasty fall, but Volcker stuck the landing to the point that many parts of the macroeconomic landscape could be changed and tilted toward prosperity and markets,” said Paul McCulley, an economist and senior fellow at Cornell Law School.

The New York Times

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