Throughout this financial crisis, I have been approached repeatedly by people from all walks of life asking the question, Is this the end of America as we know it? Is the American Dream dead? Are we finally at the point where our nation and its economy have begun a downward spiral that will end the hegemony the United States has enjoyed since World War II? And if so, how will that affect the standard of living for the vast majority of Americans?
I am 46 years old and this is at least the third bout of self-confidence we have seen our nation struggle with. Both of those earlier struggles coincided with relatively long and deep recessions, 1973-75 and 1981-82. The current recession shares a great many similarities with those earlier downturns. In fact, we would go as far to say that the current recession incorporates the worst qualities of the two deepest prior postwar recessions. Given this scenario, the hit to consumer confidence and the nation's psyche are understandable.
Not only were those two earlier downturns the longest and deepest recessions in the postwar period, but both were also transformational events that dramatically changed the way our economy has operated since. What drove economic growth prior to the recession essentially got hammered in the downturn, and the economic landscape looked vastly different in the ensuing recovery. Fear of the unknown is palatable, and the unknowns today are many.
The purpose of this essay is to show that today's economic troubles did not occur in isolation. Our nation has faced similar challenges before and overcome them. How we overcame those earlier downturns has important implications for policymakers and business leaders today. Recessions are essentially caused by excesses that build up during the boom times, which cause capital to be misallocated. These imbalances are ultimately brought into check by a reduction in risk tolerances. The reduction in risk tolerances is typically brought about by some key policy change or external shock, which causes businesses, consumers, investors and regulators to become more cautious.
Most postwar recessions were ended by aggressive monetary easing and fiscal policy expansion. Monetary policy has been the more effective tool in recent cycles, as fiscal policy has been too slow. Moreover, persistently large federal budget deficits have tended to constrain fiscal policy alternatives in recent years, with actions being too small to make a meaningful change.
While policy intervention has been successful at reversing the downward trend in economic activity, it has rarely done anything to reverse the underlying long-run imbalances that brought about the recession itself. Some of these imbalances, such as low productivity growth and the persistent lack of national saving, were rolled over into the next business cycle, where they continued to build and eventually evolved into the monumental credit bubble we are dealing with today. Fully unwinding these imbalances will require significant policy actions on both the monetary and fiscal fronts and will ultimately take several years to complete.
Recessions Are Caused by Imbalances and Policy Mistakes
Recessions are essentially caused by the intersection of imbalances that build up during the boom years and some sort of exogenous shock or policy mistake. Back in the 1970s and the early 1980s, imbalances were concentrated in the nation's industrial heartland where cheap and abundant energy allowed much of American industry to prosper, even against a rising tide of overseas competition, particularly from Japan and other emerging economies. In addition, the early 1970s saw a tremendous housing boom, as consumers rushed into the only meaningful inflation hedge available. These imbalances were ultimately brought into check by a pair of oil shocks and sharply higher interest rates, which dramatically transformed the competitive landscape and ushered in a credit crunch like none other seen since the Great Depression.
History Has Lessons for Today's Economy
The most defining characteristic of the 1973-75 recession is that it marked the end of the era of cheap and abundant energy. Prior to 1973, oil prices averaged around $2 - $3 a barrel for the previous 20 years. Low energy prices provided little incentive to find ways to use energy more efficiently. Entire industrial processes were built around the premise that energy would remain cheap and abundant. Buildings, homes and automobiles were built more for comfort and convenience than energy efficiency.
Low energy prices also helped sow the seeds of the housing boom and bust of the early 1970s. The persistence of low oil prices allowed monetary and fiscal policies to be far looser than they otherwise would have been, particularly at a time when both were stretched to the max by the twin burdens of the Vietnam War and Great Society programs. Inflation became problematic in the late 1960s and briefly reached six percent. Higher inflation led to a weakening in confidence in the dollar and the ultimate breakdown of the Bretton Woods monetary system. President Nixon ended the final link to the gold standard in 1971 and later that year imposed wage and price controls.
The problematic inflation of the late 1960s and early 1970s drove up demand for hard assets. Gold could not be purchased privately back then, and interest on savings accounts were limited by law. Consumers turned to the next best alternative, real estate. Sales of homes surged during the 1969 to 1973 period and home prices increased substantially both in nominal and real terms as an increasing share of the nation's resources were allocated to housing.