“Plucking”

Lars Christensen has brought up Friedman´s “Plucking Model” of economic fluctuations. In essence the model says:

1. The economy might be thought of as a plucked string: The farther you pull it, the more forcefully it snaps back (rebounds), and
2. That there appears to be no systematic connection between the size of an expansion and the succeeding contraction.

Importantly, description #2 casts grave doubts on those theories that see the source of a deep recession/depression in the excesses of the prior expansion.

How does the theory hold up? In the figure I show RGDP and its growth rate, where the shaded areas denote recessions. We observe that between 1955 and 1984, the larger the RGDP drop in a recession, the stronger the “bounce back”. There are two notable exceptions (dark circles):

1. The strong rebound from the “weak pluck” that characterizes the 1960/61 recession.
2. The strong rebound following the almost “total absence of pluck” in the 1969/70 recession.

Both cases have, so to speak, “political roots”. In 1961, President Kennedy´s inauguration – the “Nobel Prize” CEA (with people like Tobin and Samuelson as advisor), the belief in a stable Phillips Curve, Okun´s “potential output” and how the economy was far below it – witnesses a strong rise in nominal spending. With inflation tamed, real output growth “jumps”.

President Nixon “teamed up” with the recently appointed Arthur Burns as Fed Chairman. Nixon was paranoid (remembering his 1960 defeat to Kennedy) about getting the economy “going” to reduce unemployment. Again, nominal spending soars. Inflation was coming down and just to be on the safe side, a price freeze was enacted in August 1971. With unemployment and inflation coming down, Nixon clinched the election (the Watergate shenanigan was “overkill”).

Note also that following the long and robust expansion of the 1960´s the 1969-70 recession was very weak. The same feature is observed in the recessions following the long expansions of the 1980´s and 1990´s

After the strong bounce back from the deep 1981/82 recession the economy enters a period that came to be known as “Great Moderation”, that lasts through 2007. This period was characterized by an almost complete absence of “plucks” and, therefore, of “big bounce backs”. The defining characteristic of the period is the maintenance, for most of the time, of a stable spending growth along a level path.

This comes to an end in 2008, when the Fed allows nominal spending to tank, to a degree not seen since the 1930´s! The reasons have been exhaustively discussed by the group of Market Monetarists. The question is: why was there no vigorous “bounce back” from such a strong “pluck”?

The figure below illustrates. While from the recession through in late 1982 nominal spending (well controlled by the Fed) rebounded strongly – and this is a characteristic of all the observed “bounce backs” – following the through of the 2007/09 recession nominal spending growth, despite the previous “off the charts” drop, has been constrained by “inflation hawkishness” and other fears. The result, no “bounce back”, so the economy stays inside the hole and unemployment “up in the clouds”.

And the longer it does, the worse the prospects for the future trend level of income.