26 Jun 2009

Sample Essay: 1973 Recession

1973, is considered by many analysts as the turning point in the history of the twentieth century. Pre-1973, the world had become accustomed to an abundant supply of inexpensive fossil fuels: coal, petroleum, and natural gas. The developed nations had built their economic edifice on the premise of assured availability of cheap fossil fuel. The availability of these fossil fuels was taken for granted, so much so; that the economic health of most of the developed nations depended entirely upon their steady and continued availability.  For example, the average price of a barrel of oil in 1973, was $2.70 and the average cost of gasoline at the pump about 35¢ a gallon.

An assortment of unrelated but equally important factors combined in 1973, to change this picture dramatically. The most prominent of those factors was a decision made by the Arab members of the Organization of Petroleum Exporting Countries (OPEC) to impose drastic cuts on its export of petroleum to the developed nations of the world due to the American support to Israel during the 1973 Arab-_Israeli War. The decision taken on October 18, 1973, curtailed the direct flow of fossil fuel to the US to almost Zero. The sudden implementation of the oil embargo by the OPEC countries put the US economy under severe strain, and the consequence was a soaring inflation beyond 10% a year, mounting interest rates and unmanageable trade deficit.

It must be borne in mind that the rate of inflation was considerably high, even before the oil embargo was imposed by the OPEC countries. The pattern right through the later half of the 60 and spilling over to the early 70s indicated a reasonable Fed tolerance for rising inflation. Notwithstanding  Fed  propensity to fight inflation, their decision to contract substantially in 1973-74, at a time when the economy was already passing through a critically downward  phase was neither inevitable nor likely. It is pertinent to highlight the fact that the expansionary monetary policy accounts for a major portion of the blame for the inflation during the early 1970s. Tight monetary policy is conventionally thought to be the proximate cause of the fiscal downturn. Thus, monetary policy and the oil crisis precipitated the economic distress in the US thereby leading to the recession of 1973.


Decreasing GDP. Scrutiny of the financial data from the fourth quarter of 1973 (1973 IV) to 1975 I  indicates that the  real GDP was decreasing steadily. Since the decrease in GDP was only  6.8 percent, it was not an alarming decline; the point of concern was that the rate of unemployment  was increasing substantially. The aspect of concern however was the catastrophic decline of Investment Purchases. Figures from the Bureau of Economic Analysis of the U.S. Department of Commerce for quarterly real Gross Domestic Product (GDP) levels ( in billions of  dollars) are indicated in the table below:

Srl No                         Quarter           GDP

(a)                   1973 III          1236

(b)                   1973 IV          1241

(c)                   1974 I                         1229

(d)                   1974 II            1217

(e)                   1974 III          1210

(f)                    1974 IV          1187

(g)                   1975 I                         1157

(h)                   1975 II            1168

Unemployment.Although the real GDP is a primary factor for determining and defining a recession ,it gets  manifested and  perceived in terms of the unemployment rate for the corresponding period. For the period under consideration, i.e.  1973 IV to 1975 IV ,  the quarterly unemployment figures for the US were as follows:

Srl No                         Quarter           GDP

(a)                   1973 IV          4.9%

(b)                   1974 I                         5.0%

©                     1974 II            5.3%

(d)                   1974 III          5.9%

(e)                   1974 IV          7.2%

(f)                    1975 I             8.5%

(g)                   1975 II                       8.7%

(h)                   1975 III          8.6%

(j)                    1975 IV          8.3%

From the above mentioned details it can be concluded that the rate of unemployment went up drastically  from the five percent level to nearly the nine percent in a span of 18 months. For a given period ,if the number of jobs created is lower than the net increase in the labour force available, it results in a corresponding increase in the unemployment rate. This implies that to have a viable increase in the number of jobs available, the growth of real output has to exceed the increase in the rate of productivity. Reduced output leads to excessive decline in the number of jobs.

Investment purchases. It is identified as the most important variable of concern, as  has been amply demonstrated on various occasions in History . It can be safely stated that the principle cause leading to the  Great Depression of the 1930’s was the catastrophic collapse of investment purchases. Other prior causes existed , like steep rise in real interest rates due to the restrictive monetary policies( a point of concern), but these factors have their effect in investment purchases. Economic analysts and decision makers had observed a similar pattern for the investment conditions in 1975, and in fact, it was the indicator of  a catastrophic collapse in progress.


Having identified collapsing investment purchases as the principle factor leading to the recession, it was widely perceived in the second quarter of 1975  that a remedial measure was urgently needed, and that introduction of a tax cut was the most effective anti-recession measure. However, this proposal was not acceptable and convincing to everone as a substantial number of economists felt that a tax cut that lead to a government deficit meant increased borrowing by the government financial markets which would effectively push out the private borrowers thereby curtailing their investment purchases. President Gerald Ford planned to seek re-election in November 1976 , and it would not be acceptable for the country to be in a recession  at election time. Hence, he wanted to have the cut in place. At this time ,  The head of the Council of Economic Advisors for Gerald Ford  was Alan Greenspan.

Three major issues identified to be resolved by the Proposed Gerald Ford – Alan Greenspan Tax reduction Plan were  the immediate problem of recession and unemployment, rising  inflation, and the need to identify alternative energy sources in the light of American vulnerability to oil embargoes. However, analysis of the tax -cut   scheme along with the proposed energy tax increase, revealed that the net stimulus to the economy would be negligible since  no net tax cut was involved. Infact, the impact of the balance of the plan would result a decrease in aggregate demand of $2 billion. As it was felt that the package would have no positive impact on the economy, 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: – (Billions $)

Quarter           Receipts          Expenditures             Deficit Investment Purchases

1973 III          260                        265              5              206

1973 IV          266                        271               5             213

1974 I                         276                        281               5             196

1974 II            286                        294              8             184

1974 III          299                        307               8             173

1974 IV          293                        319                25          167

1975 I                         284                       337                54              130

1975 II            250                        352               102             124

1975 III          293                       364                  71           148

Source: Economic Reports of the President, 1975, 1980

Although the tax cut came in to effect through changed withholding in the first quarter of 1975,  its impact was observed in the second quarter of 1975. It led to a huge increase in the Federal budget deficit  $25 billion to $54 billion to $102 billion, which in turn dictated a significant  increase in Federal borrowing from the financial markets. Despite this, in the third quarter, there was an increase of 19 % in investment purchases which was financed in part by private borrowing. The increase in Investment continued steadily and went up to $154 billion in the fourth quarter of 1975.

Thus, it was experienced that although the tax cut led to increased government borrowing from theb financial markets, it did not lead to crowding out of the private investment .In fact, private borrowing for private investment was instead  enticed  by the credible prospect of a  recovering economy that would again  become robust. Investment is not solely a function of the real interest rate, and it became clear that investor confidence and expectations of future growth prospects of the economy are more important factors determining levels of investment. The real interest rate may not be the  most important determinant of investment.

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 figures are as follows:-

Srl No                         Quarter           GDP

(a)                   1975 I                         1157

(b)                   1975 II            1168

(c)                   1975 III          1201

(d)                   1975 IV          1217


The tax cut led to increased government borrowings from the financial markets, but it did not result in crowding out the private investments. Instead, it only encouraged increased participation by private purchases/investments. Thus it can be inferred that the signs of a financial recovery and portends for a healthy growth output are more important factors encouraging the level of investment purchases. Since the tax cut was planned and structured appropriately, it was effective at stimulating the economy. Decline in public investment probably occurred due to the expectations of tightfisted economic policy in order to fight inflation  and sluggish growth output. Although, interest rates increased, the net increase was not adequate to bring about hike in real interest rates. These were important lessons in fiscal policy. And another lesson is to beware of the assumption that because investment and interest rates are closely interlinked, any increase in investment   depends only upon interest rates.

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