Thayer Watkins

The 1974-1975 Recession in the U.S.

Policy makers in 1974 perceived inflation as a major problem. The Federal Reserve pursued a tighter monetary policy which produced higher interest rates which reduced the level of investment purchases. Investment projects extend over a period of time so the higher interest rates produced a decline over an extended period of time as past investment committments were completed and new investment projects were not undertaken.

The decline in investment purchases produced a decline in production (GNP) and a highter unemployment rate. This was the intention of the tighter monetary policy because the decline in production and the higher unemployment were supposed to discourage price increases.

The recession did not have the intended effect on inflation and there was worry that the unemployment rate would go above ten percent and that people would start talking about depression rather than recession.

both the Ford Administration and Congress wanted to pursue anti-recession policy; i.e., to do something to stimulate the economy. Alan Greenspan who was head of the Council of Economic Advisors for President Gerald Ford prepared an economic stimulus plan. The plan involved some tax cuts for households and businesses but it also involved some tax increases to discourage the importation of foreign petroleum. When the Greenspan plan was examined in detail it was found to involve not net tax cut for households.

Congress rebeled against the Greenspan plan and made their own tax cut proposal. Congress' tax rebate was to have its impact on tax day, April 15, 1975. Some critics argued that temporary tax cuts would have no stimulus effect on the economy. William Simon, who was Secretary of the Treasury at the time, had a more specific argument against the tax cut. Secretary Simon, who before coming to Washington had been a bond trader on Wall Street, said that the tax cut would increase government borrowing and thus would reduce the funds available for business to borrow. He coined the term crowding out at that time. The increase Federal borrowing would, according to Simon, crowd out private investment borrowing. Therefore, according to Simon, whatever stimulus that might come from increased consumer incomes would be offset by reduced investment purchases. It was an interesting and plausible conjecture but it is not borne out by the statistics for the economy.

Below are the National Income Account statistics for the period.

National Income Accounts
$1972 Billions
Consumption InvestmentGovernment
Net Exports

The GNP figures tell the story of the decline in production. GNP reached a low in the first quarter of 1975. When the tax cut came there was an increase and the economy started to grow again. The graph of the quarterly GNP figures gives the best picture of the period.

The sagging decline in GNP was less ominous than the accelerating decline in investment. But the decline ended in the second quarter of 1975. Thereafter investment increased as the tax cut gave promise to increasing demand and the need for more capacity. Investment was not crowded out by the tax cut, instead it was enticed in.

This increased investment occured despite the increased deficit of the Federal Government and borrowing it entailed. Below shows the Federal deficit quarter by quarter and the sharp occasioned by the tax cut.

While the increased deficit did not prevent a recovery of investment purchases the increased deficit did, in fact, increase interest rates, as shown below. The discouragement of higher interest rates was more than offset by the effect of the prospect of recovery and economic growth. It is notable that the prime interest rate was falling during the recession and investment was also falling. But in the immediate aftermath of the tax cut the prime interest rate did rise.

Although a recession is defined in terms of real output the real story of a recession is told in terms of the unemployment rate.

The unemployment rate rose during the recession and it began to come down in the recovery but much more slowly than it rose. This is because during the lost years of economic growth during the recession the labor force grew. Also productivity increased. In order for growth in real output to bring down the unemployment rate the rate of economic growth must be greater than the sum of the growth rate os the labor force and the rate of growth of productivity.

Another way to look at the impact of the recession, tax cut and recovery is in terms of what happened to consumers disposable income. This shown below. Disposable income was declining along with GNP as part of the effect of the recession but the tax brought a significant jump. In fact, the tax cut brought the level of disposable income up to what it was before the recession began. In those terms it was an instant recovery.

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