Why the recession won't last long

SYNOPSIS: Krugman shows why the 1991 recession would be mild

The FED To The Rescue. We are clearly sliding into a recession -- even the White House agreed with that assessment last week. Now the debate is between those who think that the economy will bounce back quickly and those who think that a slack economy will persist for years to come. The best bet is for a swift recovery engineered by the Federal Reserve.

The economy will probably shrink by about 2 percent during 1991, pushing unemployment close to 8 percent. But then things will turn around, with 5 percent growth in 1992 and 3 percent growth in 1993. This will bring unemployment back down to around 6 percent by the beginning of 1994.

The rapid revival will occur because this recession, unlike the three previous big slumps since the Depression, is unnecessary. As a result, the Federal Reserve can move aggressively to end the downturn. Both the 1974-75 recession and the back-to-back recessions of 1979-82 were essentially planned: The Fed imposed economic slumps through tight money in order to curb inflation. By contrast, this recession is unplanned, the result of a vicious circle in which battered banks, consumer pessimism (further fueled by war fears) and plunging real-estate prices caused a sudden downward spiral in demand that took the Fed by surprise.

The Fed was caught off guard, but it remains immensely powerful. Monetary policy always seems like magic. By adding to or subtracting from the amount of money in circulation, the central bank exerts massive leverage over economic activity. As the depth of the recession becomes apparent, the Fed will buy Treasury bills, cutting interest rates sharply -- perhaps by as much as 3 percentage points. Housing markets will recover; the dollar will fall, making U.S. exports more competitive, and the economy will rebound.

In the last recession, the Fed was cautious at first about expanding credit because of fear of inflation. Faced with skyrocketing oil prices, the central bank felt that it needed to accept prolonged recession to bring inflation under control.

Reduced Inflation Fears. Today's crisis in the Middle East has again brought soaring oil prices. But this time, we enter recession with lower inflation and lower inflationary expectations. In the year before the fall of the Shah of Iran in 1979, U.S. consumer prices rose 11 percent -- and the experience of the late '70s had convinced most people that inflation had nowhere to go but up. In the year before the Kuwait invasion, the consumer price index rose only 5.6 percent -- and the '80s were a decade of falling inflation.

The early returns on the present oil shock are encouraging. Consumer price inflation surged briefly this fall, to more than 9 percent, but it has already subsided. In addition, the so-called core inflation rate, which excludes food and energy, has remained stable at around 5 percent.

Finally, U.S. labor markets are now more flexible. Five years ago, many thought we could not have an unemployment rate below 6.5 percent or even 7 percent without accelerating inflation; in the past few years, unemployment closer to 5 percent has been sustained with stable inflation.

Driving Down Interest Rates. With inflation under control, the Fed is free to move to end the current recession. Pessimists say that fearful bankers will not increase credit regardless of what the Fed does. But our beleaguered financial institutions will not prevent the real industrial economy from reviving. Even with banks on the rocks, the Fed can still drive down interest rates as much as it likes. It is possible that the central bank will have to print more money to end this recession than it took to end the last one that monetary policy will get less bang for the buck. Luckily, the Fed has an unlimited supply of bucks. Soon it will begin to use them -- and the recession will end with a strong recovery.

Then vs. Now

Prices rose more slowly in the years before the Iraqi invasion of Kuwait than they did prior to the 1979 Iranian oil shock

Percent change in the Consumer Price Index:


1977 6.5 pct.

1978 7.6 pct.

1979 11.3 pct.


1988 4.0 pct.

1989 4.7 pct.

1990 5.6 pct.

Energy vs. Other Price Hikes

The Persian Gulf crisis has failed to send inflation spiraling upwards, and "core" prices -- which exclude energy -- have remained flat

Percent change in Consumer Price Index:

All items All items less food and energy


J 4.7 pct. 4.9 pct.

J 4.8 pct. 5.0 pct.

A 5.6 pct. 5.5 pct.

S 6.2 pct. 5.5 pct.

O 6.3 pct. 5.3 pct.

N 6.3 pct. 5.3 pct.

Originally published, 1.14.91