At the time the recession of 1973-75 was considered a severe recession. It was the most severe since World War II. The Economic Report of the President for 1975 starts with the lines:

The economy is in a severe recession. Unemployment is too high and will rise higher.

Below is the graph of the levels of quarterly real Gross Domestic Product (GDP) levels, seasonally adjusted and in billions of 1972 dollars.

As can be seen in the above graph, the real GDP from the fourth quarter of 1973 (1973IV) to 1975I was decreasing. It was not a catastrophic decline being only 6.8 percent, but the unemployment rate was increasing significantly. What was decreasing catastrophically was investment purchases.

Investment purchases is the key variable of concern. History has demonstrated how important this variable is. The immediate cause of the Great Depression of the 1930's was the catastrophic collapse of investment purchases. There were prior causes, such as the real interest rate stemming from restrictive monetary policy, but it is in investment purchases that these factors have their effect.

This was the picture of the investment conditions seen by economists and politicians in 1975. It was not a comforting picture. It was, in fact, a classic picture of a catastrophic collapse in progress.

The Statistical Details

Having shown the situation concerning investment it is now appropriate to review the other statistics in detail.

Below are the figures from the Bureau of Economic Analysis of the U.S. Department of Commerce for quarterly real Gross Domestic Product (GDP) levels, seasonally adjusted and in billions of 1972 dollars.

Although a recession is defined in terms of real GDP it is felt and perceived in terms of the unemployment rate. The quarterly unemployment rates were as follows:

The unemployment rate jumped from the five percent level to nearly the nine percent in about a year and a half. The unemployment rate goes up if the creation of jobs fall short of the increase in the labor force. For there to be a net creatio of jobs the growth of real output has to exceed the rate of productivity increase. If output is falling then the decline in jobs is excessive.

Why was output (GDP) falling? Well one major factor was the decline in investment purchases. From 1973IV to 1975II the level of investment purchases declined by 89 billion 1972 value dollars. With a multiplier of about 2 for the U.S. economy that decline would account for a decline in GDP of about $178 billion. The actual decline in GDP was only about $84 billion. The explanation for the discrepancy is that consumption was holding up better than would expected. Consumers' disposable income declined by $32 billion but consumer purchases did not decline. It actually increased by a small amount. This could be described as an upward shift in the consumption function. Government purchases stayed about the same level over the period. Net exports increased by about $10 billion over the period.

The decreases in investment purchases was in all components of investment spending; producer equipment, producers structures, residential structures and the changes in business inventories.

The source of the decline in investment is not so easy to find. Nominal interest rates were up but the level of inflation was such that there was no rise in the real rates of interest. The data on the prime interest rate and the rates of inflation are shown below. The prime interest rate is the rate which banks charge their best industrial and commercial customers.

Leaving aside the question of what was collapsing investment purchases the perception in the second quarter of 1975 was that something should be done and that the best anti-recession action was a tax cut. Not everyone was in agreement on this matter. William Simon, the Secretary of Commerce and former Wall Street bond trader, argued that a tax cut that led to a government deficit would result in increased borrowing by the government in financial markets and this would crowd out the private borrowers thus reducing their investment purchases. This led to media attention to the notion of crowding out. Nevertheless President Gerald Ford wanted a tax cut. He wanted to seek election in November of 1976 and he did not the country to be in a recession at election time. The head of the Council of Economic Advisors for Gerald Ford at that time was Alan Greenspan.

The Proposed Gerald Ford - Alan Greenspan Tax Cut

The Economic Report of the President for 1975 states:

We therefore confront three problems: the immediate problem of recession and unemployment, the continuing problem of inflation, and the newer problem of reducing America's vulnerability to oil embargoes.
…
As I propose to you in my State of the Union message, the economy needs an immediate one-year tax cut of $16 billion. … We chose the method that would provide immediate stimulus to the economy without permanently exacerbating our budget problem. Accordingly, I recommend a 12 percent rebate of 1974 taxes, up to a maximum of $1000. The rebate will be paid in two large lump sum payments totaling $12 billion, the first beginning in May and the second by September.
I have also proposed a $4 billion investment tax credit which would encourage businessmen to make new committments and expenditures now on projects that can be put in place this year or by the end of next year.…
But in recognizing the need for a temporary tax cut, I am not unmindful of the fact that it will increase the size of the budget deficit. This is all the more reason to intensify our efforts to restrain the growth of Federal spending. I have asked Congress to institute actions which will pare $17 billion from the fiscal 1976 budget. Even so, we foresee a deficit of more than $50 billion for the fiscal year beginning July 1.
…
The energy program will entail costs. The import fee and tax combination will raise approximately $30 billion from energy consumers. However, I have also proposed a fair and equitable program of permanent tax reductions to compensate consumers for these higher costs. These will include income tax reductions of $16 billion for individuals, along with direct rebates of $2 billion to low-income citizens who pay little or no taxes, corporate tax reductions of $6 billion, a $2-billion increase in revenue sharing payments to State and local governments, and a $3-billion increase in Federal expenditures.

The tax cuts and energy tax increase tabulates as follows:

A careful consideration of the tax cut combined with the energy tax increase reveals that no net tax cut is involved and therefore there would not be any stimulus to the economy. Furthermore the impact of the rest of the package would have been a decrease in aggregate demand of $2 billion. Thus this package would have had no stimulus for the economy; if anything it would have slightly depressed the economy slightly.

Congress rejected the proposed package and enacted its own tax cut.

The following table shows the cash flows for the Federal government for the period along with the investment purchases:

The tax cut became effective through changed withholding in the first quarter of 1975 but primarily its impact came in the second quarter of 1975. The Federal budget deficit leaped from $25 billion to $54 billion to $102 billion. This was was an enormous increase in Federal borrowing in the financial markets. Nevertheless investment purchases financed in part by private borrowing increased in the third quarter by over 19 percent. Investment continued to increase to $154 billion in the fourth quarter of 1975.

Thus private borrowing for private investment was not crowded out by the increased government borrowing; instead it was enticed in by the credible prospect of an economy that would be once again growing. Investment is a function of the real interest rate but is not a function of only the real interest rate. The real interest rate is probably not the most important determinant of investment; instead expectations of future growth of output is probably the most important determinant.

The level of real GDP increased for the $1168 billion in 1975II to $1201 billion in 1975III. Real GDP then increased to $1217 billion in 1975IV. The recession was over.

The evidence is that:

• 1. The tax cut was effective at stimulating the economy
• 2. The level of investment purchases was increased despite the increased government borrowing to finance the tax cut.

These were important lessons in fiscal policy. Just as important a lesson is that the decline in investment came from the public expectation that the economy was going to be put through a wringer to cure inflation. As noted above, although interest rates increased they did not increase enough to bring about high real interest rates. And another lesson is to beware of the assumption that because investment depends upon interest rates that it depends only upon interest rates.

(To be continued.)