CAUSES OF RECESSIONS AND RECOVERIES
Economists do not know the deeper causes of recessions.
However, there is a prevailing theory which partially explains them, and
it was first articulated by John Maynard Keynes before World War II. According
to Keynes, recessions occur when individuals start hoarding money because
times are tough - but times become tougher when everyone starts hoarding
money. To get the circular flow of money restarted in the economy, Keynes
suggested that government expand the money supply (accomplished by the
Treasury printing money and buying U.S. debt, thus putting more bills in
circulation). The greater supply of money permits people to start spending
again. In worst case scenarios, Keynes suggested "priming the pump"
of the stalled economy by having government borrow and spend itself. Indeed,
America only came out of the Great Depression when it began massive borrowing
and spending on defense in 1939, in anticipation of World War II.
The success of Keynesian policies inspired nations around the world
to adopt them. In fact, Keynesianism appears to have eliminated the economic
depression from the human experience! Before World War II, eight U.S. recessions
worsened into depressions (1807, 1837, 1873, 1882, 1893, 1920, 1933, and
1937). Since World War II, there have been nine recessions (1945-46, 1949,
1954, 1956, 1960-61, 1970, 1973-75, 1980-83, and 1990-92) -- and not a
single one has turned into a depression.1
This is eloquent testimony of the power of Keynesian economics.
Expanding the money supply is the job of the Chairman of the Federal
Reserve Board. His influence on the economy is immediate and profound.
With a few phone calls, he can raise or drop interest rates 10 percent
overnight, and induce either crushing unemployment or runaway inflation
by doing so. Finding the right balance calls for considerable discretion,
and although many chairmen have succeeded, some have not. But almost all
economists agree that controlling the money supply exerts a powerful, measurable
and easily-observed influence on the economy.
The President of the United States, by contrast, has only gradual and
long-term influence over the economy. Education programs, highway construction
and child vaccination may produce results years after he leaves office.
Even borrow-and-spend programs take considerable time to draw up, promote,
debate, pass through Congress, field bids and put into effect. In other
words, the President is the tortoise to the Fed's jack rabbit.
It follows that presidents deserve very little blame for recessions,
or credit for recoveries. Proper responsibility goes to the Chairman of
the Federal Reserve Board. Most economists consider it an injustice that
voters often hold the president responsible; Carter was evicted for a "misery
index" (high unemployment and inflation) that was really beyond his
control. Bush was fired after a lingering recession had immortalized James
Carville's election slogan: "It's the economy, stupid." However,
if presidents really knew how to prevent recessions, they would be on the
short list for the next Nobel Prize.
A review of the Fed during the 70s and 80s is valuable in confirming
this observation. During the 70s, inflation and unemployment grew together,
forming "stagflation." The fact that it was predicted as early
as the 60s makes it difficult to pin the blame for stagflation on Carter.
As we shall see, all presidents battled it; it just happened to peak on
Carter's watch. By 1980, the "misery index" reached 20 percent.
Fed Chairman Paul Volcker was committed to fighting inflation before unemployment,
and he kept interest rates high to wring inflationary expectations out
of the economy. By the summer of 1982, the economy was threatening to free
fall, but by then inflation looked defeated. Abruptly, Volcker slashed
interest rates and flooded the economy with money. A few months later the
economy roared to life, in a recovery that would last seven years. The
reason why the recovery was so healthy and prolonged was because the recession
had been so deep. And with record numbers of women joining the labor force,
the labor pool was large enough to fuel a long recovery.
In October 1987, the stock market crashed, partly in response to reports
of economic mismanagement in the White House. The 508-point drop was even
worse than the Crash of '29, which led to the Great Depression. This time,
learning from its mistakes, the Fed sharply expanded the money supply.
And the recovery continued without a bump.
Return to Overview
1 "Recession," The 1995
Grolier Multimedia Encyclopedia, CD-ROM.