Thursday, August 05, 2010

Krugman Misleads About Reagan

Responding to people who note (See Dan Mitchell's take here, see my own here) that the recovery we have seen so far after the 2007-09 recession is a lot weaker than the recession of 1981-82, Paul Krugman claims that the vigorous recovery in the 1980s was simply a case of the Fed fueling a housing boom with interest rate cuts.

"The 1981-2 recession was a very different kind of event from the 2007-9 recession: basically, it was a recession deliberately created by the Fed to bring down inflation. The Fed raised interest rates sky-high, causing a plunge in home construction, which was the main driver of the slump. When Paul Volcker believed that we had suffered enough, he cut rates, housing sprang back — and it was housing that mainly drove the recovery. Reaganomics was basically irrelevant."

It is interesting that he assigns to monetary policy such a great role in driving the housing sector. When discussing the 2001-06 housing boom, Krugman and other Keynesians have denied that interest rate policy played a significant role and instead claimed that "lax regulation" caused the bubble.

Anyway though, while Krugman is right to argue that Volcker's dramatic interest rate reduction certainly fueled a strong boom in housing, it is clearly not true that it was "mainly housing". GDP rose by 4.5% in 1983, and 7.2% in 1984, for a cumulative 12% (as I showed in my post about the Reagan recovery, the numbers are even more impressive when comparin fourth quarters than when comparing full years). While residential investments rose the most, a cumulative 62.3%, consumer spending also rose, by a cumulative 11.3% while business investments rose by 16.1%.

And since residential investments was only 3.2% in 1982, and 4.6% in 1984, this means that GDP excluding residential investments rose by 10.4% in 2 years (at an average annual rate of 5.1%). The boom was thus very broad based.

Furthermore,in the 5 following years (1985-89) when GDP rose by an average of 3.7% , per year, the share of GDP going to housing fell from 4.6% to 4.4%.

It is thus false to say that the Reagan boom was simply driven by housing. It is true that the impact of monetary policy isn't limited to housing, the unusual strength of the boom clearly suggests that other factors, meaning the tax cuts, also played a role in fueling the boom.