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FEDERAL RESERVE BANK OF RICHMOND MONTHLY V o lu m e 58 N u m be r 10 OCTOBER 1972 The M o n t h l y R e v i e w is produced by the Research Department of the Federal Reserve Bank of Richmond. Subscriptions are available to the public without charge. Address inquiries to Bank and Public Relations, Fed eral Reserve Bank of Richmond, P. O. B ox 27622, Richmond, Virginia 23261. Articles may be reproduced if source is given. Please provide the Bank’s Research Department with a copy of any publication in which an article is used. The Economics of Incomes Policies Following the lead of several Western European governments, U. S. authorities have added in the past 10 years a new set of anti-inflation weapons to the arsenal of economic stabilization policies. Known as wage-price, or incomes, policies, such instruments have been designed to supplement and complement the basic macroeconomic tools of monetary and fiscal policy. In the early 1960’s, incomes policies were introduced into the U. S. economy in the form of the wage-price guidepost formula, or average produc tivity rule, which suggested that hourly wage rates should rise no faster than the trend rate of advance of economy-wide labor productivity. M ore recently, of course, incomes policy instruments have constituted and price-stability goals by maintaining aggregate demand just at the point of full employment. The existence of market imperfections, however, drastic ally alters the picture. Such imperfections, by gener ating substantial upward pressure on wages and prices long before full capacity is reached, might make it impossible for monetary-fiscal policies alone to achieve simultaneously price-stability goals. society’s employment and By decreasing demand, these policies can control inflation that arises from market imperfections but only at the cost of high unemploy ment. The same problem exists when cost-push in flation stems from expectational forces. That is, the nucleus of the President’s New Economic Policy, only by depressing the level of economic activity initially in the form of the zero-growth wage-price could demand-adjustment policy dispel those deeply entrenched inflationary expectations manifested in ac freeze of Phase I and subsequently in the form of the 5.5 percent wage-adjustment criterion and profitmargin ceilings of Phase II. celerating wage demands and spiraling prices. Thus, Governments have resorted to incomes policies and bat cost-push inflation when conventional instru supplementary policies may be sought to help com other supplementary policy tools when monetary- ments threaten to impose too high a toll in the form fiscal policies seemed insufficient to achieve simultan of unemployment. eously society's basic economic goals of full employ Generally, three types of supplementary policies ment and price stability. Primarily oriented toward are available: labor market policies, institutional and the management of aggregate demand— and thus the legal reforms, and incomes policies. Labor market control of demand-pull inflation — monetary-fiscal policies consist of manpower training and retraining policies may be unsuitable for combating the type of programs, relocation subsidies, job information serv inflation that arises from the cost or supply side of ices, etc. the market. at breaking up monopoly elements and other struc Such cost-push inflation emanates from Institutional reforms include actions aimed certain prevalent market imperfections and expecta- tural-institutional impediments to the operation of the tional forces that affect costs and aggregate supply. free market. Market imperfections include: (1 ) monopoly power programs aimed at securing restraint in labor de possessed mands regarding pay and in business decisions re by firms, unions, and other pressure groups; ( 2 ) impediments to the geographical and Finally, incomes policies include those garding prices. occupational mobility of labor and capital; and (3 ) The purpose of this article is to examine the ration inadequacies in the provision of information on job ale for incomes policies and to explain how such poli vacancies. cies are designed to operate. Accordingly, the article: If all markets were perfectly competitive, resources freely mobile, and job information widely ( 1 ) explains how wages and prices are determined available, there would be little need for incomes and in the absence of incomes policies; ( 2 ) indicates how other supplementary policies. those policies are supposed to work in altering in In such an ideal econ omy, a general rise of wages and prices would not flationary wage-price behavior; and (3 ) assesses the occur before full capacity was reached, and monetary- probable future course of such policies in the light of fiscal policy could attain both society’s employment criticisms that have been leveled against them. FEDERAL RESERVE B A N K OF R IC H M O N D 3 Models of the Wage-Price Mechanism K n o w l edge of the mechanism of wage-price determination is essential if policymakers are to employ incomes policies to achieve anti-inflationary modifications in wage-price behavior. For purposes of policy analysis and prescription, the wage-price mechanism is often represented by a set of equations. In fact, several recent studies of the effectiveness of controls have employed variants of a two-equation model of the wage-price subsystem of the economy. These models specify the chief determinants of the rates of change of wages and prices. They also explain how cost inflation develops in the absence of wage-price poli cies and suggest how those policies might be most effective in arresting it. Comprising these models are a wage equation and a price equation. The wage equation identifies certain labor-market conditions and cost-of-living influences that determine wage in creases. The price equation then expresses how these wage increases are transmitted into rising prices. An extremely simple version of this model is presented in the following paragraphs. It should be strongly emphasized, however, that the model is a severe over simplification of a complex process and thus should be interpreted with some skepticism. Intended solely as an expositional device, the model purposely ab stracts from many of the forces that influence wage and price changes in the real world. In short, real ism has been sacrificed in the interest of expositional clarity. unemployment rate ( 1 / u ) and with the past rate of price inflation ( p — i ) . Specifically, the wage equa tion is w = a ( l / u ) -f- bp— i, where w and p — \ are the respective rates of change (both expressed in percentages) of current hourly wage rates and the previous period’s price level, u is the unemployment rate, and a and b are coefficients specifying how much unemployment and price inflation contribute to the rate of wage increase. In this equation the inverse of the unemployment rate ( 1 / u ) serves as a measure of the degree of excess demand or “ labor shortage” in the labor market. Thus, the equation states that the tighter the labor market— i.e., the smaller the unemployment rate (or rather, the larger its recipro ca l)— the larger the rate of wage increase. The co efficient a attached to the unemployment variable ex presses the degree of response of the rate of wage inflation to increasing pressure in the labor market. A low coefficient indicates that the rate of wage in crease reacts only slightly to a tightening of the labor market. A high coefficient, on the other hand, indi cates that the rate of wage increase is quite sensitive to declines in the unemployment rate. The larger the coefficient, the larger the increment in the propor tionate rate of money wage change accompanying a given reduction in the unemployment rate. Deter mining the size of the reaction coefficient a are several factors, including: ( 1 ) the dispersion of unemployment among separate labor markets; ( 2 ) the degree of trade union aggressiveness and bar gaining strength; (3 ) the extent of dissemination of The W age Equation M any m odels o f the w age- job market information; (4 ) the substitutability of price mechanization show the rate of change of wages capital for labor in productive processes; and (5 ) the (w ) varying directly both with the inverse of the mobility and flexibility of the labor force. Generally, IN CO M ES POLICIES TO REDUCE THE RATE OF WAGE-PRICE INFLATION Eq u atio ns of the W a g e - P ric e M ech an ism WAGE Percentage rate of change of hourly wages EQUATION w PRICE i 1 1 1 I Coefficient | Inverse of 1 linking rate 1 unemployJ of wage , ment rate , inflation to I (unemployment1 J variable j a(l/u) = i i | | I l 1 1 Percentage rate of change of price level EQUATION p 4 = Incom es Policies i PricePast rate expectations . of price coefficient | inflation 1 1 I 1 bp-i r WAGE POLICIES 1. Replace wage equation with an official wage-adjustment standard. 2. Reduce size of price-expectations coefficient b. 3. Modify structure of labor market to improve its efficiency. Reduce size of coefficient a. 4. Tie wage increases to productivity via productivity bar gaining. ' Percentage rate of change of wages w 1 J i 1 l 1 — Percentage rate of change of productivity q PRICE POLICIES 1. Freeze prices. Constrain p to zero. 2. Raise rate of advance of productivity q. Includes produc tivity bargaining. 3. Profit-margin ceilings to insure that rate of price change p varies in step with rate of change of unit labor costs. M O N TH LY REVIEW, OCTOBER 1972 the size of the coefficient will vary directly with the extent of unemployment dispersion, union aggressive ness, and information flow s; and inversely with the degree of input substitutability and mobility. Past rate of inflation ( p — i ) , the other independ ent variable in the wage equation, represents the lagged cost-of-living factor in wage adjustments, as workers seek to restore real earnings eroded by rising prices. It also serves as a proxy for antici pated inflation, as workers endeavor, via wage gains, to protect their earnings from expected future rises in the cost-of-living. This direct link between costof-living increases and wage increases is expressed in the last term of the wage equation. The price coeffi cient b measures the extent of labor’s wage reaction or response to increases in the cost-of-living. A co efficient of unity (on e) signifies that wages respond fully to changes in the cost-of-living. Wages, in this case, are said to be determined in real (purchasing power) rather than monetary terms. On the other hand, a price coefficient with a value of less than unity signifies that the wage response to cost-ofliving changes is only partial and incomplete. In this latter case, real wage rates will suffer partial erosion from inflation. Generally speaking, the magnitude of the price coefficient b depends on the extent of the inflationary psychology of workers. The more con scious workers are of inflation and the more deeply rooted are their convictions that it will continue, the greater will be the weight they give it in formulating their wage demands. Thus, the stronger the infla tionary psychology, the more sensitive and responsive are wage demands to rises in the cost-of-living, and consequently the closer will the price coefficient ap proach the value of unity. The size of the price coefficient b plays a crucial role in determining the nature of the path followed by wage-price inflation. Below some critical level of unemployment, a coefficient of unity (or greater) is associated with an explosive, accelerating inflationary process. A s previously mentioned, a coefficient of one indicates a complete feedback of past price in unity in value. According to these economists, except for temporary periods of discrepancy between actual and anticipated price changes, workers always bar gain for real wages. Hence, expected price changes will be completely incorporated in current wage claims, i.e., money wage increases will respond fully to price inflation to maintain real wage rates. Other economists, however, argue— largely on the basis of empirical findings of econometric studies— that in both the long run and the short the coefficient is normally much less than unity. But some members of this latter group of economists now agree that there may be a critical threshold rate of inflation beyond which the price coefficient becomes unstable. A t rates of inflation below this threshold there may be little worker recognition of or concern over price changes, in which case the price coefficient would remain stable. But when inflation exceeds the thresh old rate for a certain period of time, the price co efficient starts to rise as workers assign increasingly greater weight to price movements in formulating wage demands. Moreover, the more pronounced and protracted the inflation, the faster the coefficient approaches its critical value of unity. In short, the magnitude of the price coefficient may depend on the severity and duration of inflation. Normally dormant at rates of inflation below the threshold of perception and concern, worker response to discrep ancies between real and money wages becomes in creasingly active when rates of inflation are high. Thus, the higher the rate of inflation, the stronger the money wage reactions to price increases as work ers endeavor to protect the real value of their wage increases. In short, the more severe the inflation, the stronger the link, as measured by the magnitude of the price coefficient, between price and wage in creases. Moreover, the longer the inflation has per sisted, the more downwardly inflexible becomes the price coefficient, i.e., the more resistant and independ ent this coefficient is to subsequent declines in the rate of inflation. creases into current wage increases, thereby gener T he Price E quation ating another round in the inflationary spiral. A co cost, or cost mark-up, model of business pricing efficient of less than unity, on the other hand, implies policy, the price equation represents the second link a dampened, decelerating inflationary process. In D erived from a so-called full of the wage-price mechanism. Full cost pricing is the extreme case of a zero coefficient, the circular thought to be characteristic of many of the large, price-wage-price linkage would be severed, thereby oligopolistic firms that operate in American indus quickly terminating the inflation. try. Much controversy exists concerning the magnitude of the price coefficient. Many economists argue that According to the mark-up model of the pricing process, businessmen set prices on the basis of a percentage mark-up applied to unit labor and unit in the long run, where expected and actual rates of material costs at some standard level of plant oper inflation are identical, the coefficient is necessarily ation or capacity utilization. FEDERAL RESERVE B A N K OF R IC H M O N D Included in the mark 5 up are the costs per unit of output of non-labor and non-material inputs as well as the businessman’s profit margin per unit of output. In the cost mark-up formulation, several factors may contribute to price increases, including increases in standard unit labor and unit material costs and expansion of percentage mark-ups or profit margins. However, although rises in material costs and profit margins may exert significant upward pressure on prices in the short run, empirical studies have indi cated that increases in unit labor costs are the pre dominant price-raising factor in the long run and often the paramount factor in the short run. For purposes of exposition, it is useful to assume that changes in unit labor costs alone influence prices and that both profit margins and unit material costs are constant. If business profit margins, or mark-ups, and mate rial costs both remain constant, then price changes will be strictly labor cost determined. In this simplest of pricing models, a rise in unit labor costs will be matched by an equiproportionate rise in prices as businessmen protect their profit margins by trans mitting the cost increase into higher prices. In other words, the percentage change in prices (p ) will equal the percentage change in unit labor cost (u lc), i.e., p = ulc. But since the percentage change in unit labor cost is equal to the difference between the percentage change of hourly wage rates (w ) and man-hour productivity ( q ) , the rate of price change (p ) can be expressed by the price equation, p = w — q. The price equation, p = w — q, merely states that businessmen ordinarily raise prices in order to protect profit margins when wages rise faster than labor productivity. A s noted earlier, the difference be tween the percentage increases of wage rates and pro ductivity is simply the percentage increase in unit labor cost, that is, ulc =r w — q. Thus, according to this oversimplified version of the price equation, the rate of price inflation (p ) is determined solely by the “ pass-through” of labor cost increases into prices. More realistic versions of the price equation would the backlog of unfilled orders relative to productive capacity. Yet, even in this augmented, more-realistic version of the price equation, changes in unit labor costs would play an important role. Th e Com plete P rice -W a g e -P rice N exus T o gether, the price and wage equations summarize the operation of the wage-price system, including the mutual determination of wages and prices, and the circular interaction process whereby wage increases are transmitted into price increases, which, in turn, feed back into wage increases, etc. The wage-price model also provides a framework that may be used for interpreting the rationale of incomes policies. In this light, incomes policies are directed at alter ing the wage and price equations, thereby lowering the rate of inflation. Incomes policies may be sub divided into wage policy and price policy, corre sponding to the particular equation the policy seeks to modify. The reader should be warned, however, that, because of the two-way interaction between the wage and price equations, this classification of poli cies is somewhat artificial. For example, price poli cies may be employed not only to affect the price equation but also to reduce the inflationary expecta tions term in the wage equation. W a g e P o licy W a g e p olicy refers to actions di rected at modifying the wage equation in such a way that wage increases will be smaller than if no policy had been applied. W age policy can take at least three forms. First, wage policy can replace the wage equation with an official wage-adjustment standard. For example, during the early 1960’s, an attempt was made to obtain voluntary agreement by labor to sub stitute the constant guidepost criterion or average productivity wage-adjustment rule for the terms in the wage equation. This criterion stated that hourly wage rates should grow no faster than the economywide percentage trend rate of growth of average pro ductivity ( q ) . In the current incomes policy, too, a constant wage criterion occupies a prominent posi tion. Phase II guidelines call for wage rates to grow no faster than 5.5 percent, the sum of trend produc contain terms representing the percentage changes in tivity growth, estimated to be about 3 percent per unit material costs and profit margins. year, and an intermediate target rate of price inflation Rising mate rial costs attributable, say, to shortages of domestic (p* = 2.5 percent). Thus, although somewhat of an ally produced materials and/or to currency devalu oversimplification, it may be said that policy at ations or increases in foreign prices that raise the dollar price of imported raw materials are likely to tempted to replace the wage equation, w = a ( l / u ) -fbp— i, with the voluntary guidepost criterion, w = q, have a noticeable impact on final product prices. in the early 1960’s and with the Phase II criterion, Moreover, profit mark-ups may expand temporarily w — q — p*, in 1972. | — as firms exploit excess demand positions manifested A s a second means of lowering wage inflation, by increases in the unfilled orders/capacity ratio, i.e.. wage policy may be aimed at reducing the magnitude 6 M O N TH LY REVIEW, OCTOBER 1972 of the price-reaction coefficient b in the wage equa tion, thereby diminishing the price-feedback effect on wages. Although an objective of both the earlier guidepost program and the current New Economic Policy, reduction of the size of the price coefficient was not as urgent in the former episode as in the latter. Problems of inflationary expectations and priceinduced wage increases were not as severe in the early 1960’s as in more recent years. The actual rate of inflation in the early 1960’s was lo w ; and consequently anticipations of inflation were virtually absent when the guideposts were introduced. Thus, the value of the coefficient b was probably small and stable. By m id-1971, however, the price situation was far different from what it had been in the early 1960’s. Instead of a prior period of price stability, policy makers in 1971 were faced with a severe inflation that had been in process some seven years, with the rate of price increase accelerating over much of this peri od. Expectations of permanent inflation were wide spread throughout the economy and clearly had a major effect on wage behavior patterns. The price coefficient in the wage equation, normally small in magnitude, was apparently approaching a critical value. The immediate objective of the President’s New Economic Policy was to break the inflationary spiral and simultaneously reverse the upward move ment of the price-feedback coefficient that was magni fying it. Since anticipations of price increases tend to be influenced by current and recent experience, the dampening of inflationary expectations required a slowing of the actual rate of inflation. Inflationary expectations were thought to be so firmly established as to be impervious to all but the most drastic action, which took the form of the 90-day wage-price freeze of Phase I. This is a good example of price policy interlocking with, and complementing, wage policy. In this case, the goal of reducing inflationary expec tations and reversing the price coefficient in the wage equation required a strong price policy. If the purpose of Phase I was to reverse the direc tion of movement of the price coefficient, the aim of Phase II has been to induce further declines in its magnitude. The plan for Phase II calls for deceler ating inflation accompanied by steadily-subsiding in flationary expectations. Although no specific con ditions have been set for the lifting of controls, Finally, structural policies aimed at improving the efficiency of the labor market provide a third means of altering the wage equation. Such measures, which might include job-retraining programs, job-information services, and the provision of relocation subsidies, as well as actions aimed at curtailing the market power of labor unions, would be designed to reduce the magnitude of the coefficient a attached to the unemployment term in the wage equation. A smaller unemployment coefficient signifies that any given reduction in the level of unemployment will be asso ciated with a smaller rate of wage increase than before. If successful, structural policies would render wages less sensitive to changes in excess demand for labor and thus improve the trade-off between wage increases and unemployment. Some economists, however, hold that structural policies should be distinguished from incomes poli cies, the difference being that the latter attempt to influence wage-price behavior without necessarily altering the institutional structure of the labor mar ket. Although both structural and incomes policies are directed toward the alteration of the wage equa tion, a distinction is generally made between the two on the basis of whether or not they modify behavior without altering the institutional framework of the economy. M ore succinctly, structural policies at tempt to eliminate or reduce monopoly power and other market imperfections, whereas incomes policies are aimed merely at inducing restraint in the exer cise of market power. Price P o licy W age policy seeks to reduce price inflation indirectly. In other words, wage policy operates directly on the rate of money wage increase (w ) and then relies on the reduced rate of wage increase to affect the rate of price inflation (p ) through the price equation, p = w — q. By contrast, price policy seeks to reduce price inflation directly by altering the price equation. O f course, the direct impact of price policy on die rate of inflation, if successful, will be augmented by strong indirect effects emanating from the wage equation. That is, not only would price policy lower inflation directly but also indirectly by reducing the price-feedback into wages and thus the wage pass-through into prices. There are several ways that price policy might try to reduce the rate of price inflation ( p ) . First, policy might try to boost productivity growth ( q ) , policymakers are hopeful that Phase II can hasten which would reduce the effect on prices of given the day when inflationary expectations will have rates of increase in wages and other cost elements. vanished and the price coefficient will have receded For example, the purpose of the National Commis to more nearly normal levels. sion on Productivity, appointed by the President in FEDERAL RESERVE B A N K OF R IC H M O N D 7 1970, was to develop new ways to raise the rate of productivity growth. Incidentally, it should be noted that policies promoting productivity bargaining, i.e., union agreements to make productivity-enhancing alterations in work-rules in exchange for wage in creases, could be classified as either wage or price policies. Price policy could also take the form of ceilings on profit margins. By preventing unwarranted expan sions of margins, such ceilings would insure that reductions in the rate of rise of unit labor costs would be transmitted, for the most part, into lower rates of price increases rather than into higher profits. Herein lies the rationale for the Phase II standard for maxi mum profit ceilings. This standard prohibits price increases that would raise profit margins above their base-period average, i.e., the average margin prevail ing in the best two of the three years immediately pre ceding the wage-price program. It is true that the profit standards of Phase II permit moderate expan sion of profit margins from their abnormally de pressed levels of 1970. Under Phase II rulings, prices are allowed to rise roughly as fast as the rates of growth of standard unit labor costs and other unit costs. In addition, profit gains arising from the current above-average rate of productivity growth are permitted .1 Such disparities between actual and longer-term average productivity usually develop in the early stages of business expansion and, together with the declining unit overhead (fixed) costs that ac company increasing volume, account for the normal, cyclical recovery of profit margins from their trough or recession levels. But this allowable moderate ex pansion of margins is not in conflict with the policy ceiling as long as profit margins are below their base period average. Generally, an important principle of U. S. price policy has been the passive, limited one of preventing profit margins and profit’s income share from exceed ing their longer-term or base-period average levels. It has been recognized that if policy is to receive the support necessary to its success, it cannot be used to achieve a redistribution of income. Some observers, should have two goa ls: ( 1 ) reduction of inflation and (2 ) redistribution of income. But both the earlier guidepost program and the current incomes program were presumably intended to be neutral with regard to longer-term or base-period average income shares.2 The Future of In com es Policies W h a t are the longer-run prospects for incomes policies in the U. S. ? A re such policies destined to become a permanent, or at least a recurrent, feature of the economic system? W ill it be necessary to maintain some form of wageprice controls beyond the current Phase II period? Can one expect the social benefits (reduced inflation) resulting from the extension of such controls to ex ceed their social costs (reduced freedom and effi ciency) ? Is it likely that incomes policies will have any success in checking future inflation ? These ques tions are currently the center of vigorous controversy and doubtless will continue to be hotly debated in the months ahead. Unfortunately, debate over the effectiveness of in comes policies cannot be resolved by empirical evi dence. For example, recent figures indicate that there has been some moderation of the inflation rate over the past year. W ere controls responsible? Or is the slowing pace of inflation just the delayed result of a slack economy? It is impossible to say. The trouble is that no one can know precisely what would have happened to inflation in the absence of controls. Moreover, even if it were possible to separate the impact of controls from other forces affecting infla tion, it would still be too early to declare incomes policies a success. A policy might appear to have a substantial short run impact, yet prove to have no lasting influence. And so, unresolved by the record, the debate continues. The Case Against Incomes Policies A large group of observers are opposed to incomes policies on the grounds that such policies : ( 1 ) interfere with the market mechanism, thereby creating a distorted, in efficient pattern of resource allocation as well as a structure of inflexible, disequilibrium prices; ( 2 ) divert talent, time, and effort away from productive pursuits into the socially unproductive task of com however, advocate more ambitious objectives for price policy. According to this view, incomes policies 1 bince April, the Price Commission has published industry trend rates of productivity growth (q) to be used by firms in computing rates of increase in unit labor costs reported in requests for price hikes. As computed, these increases in unit labor costs (w ■ q) — will exceed those actually incurred (w — q) if the actual rate of productivity advance (q) exceeds the trend rate (q ). Thus, when productivity grows faster than its trend, prices will tend to rise in greater proportion than actual unit labor costs, and profit margins will expand accordingly. 8 2 The policy rules have been consistent with constancy of longer-run or base-period distributive shares. Constancy of labor’s long run relative income share requires that real wage rates grow as fast as trend productivity. Alternatively, expressed in money rather than real terms, constancy of labor’s share requires that the propor tionate rate of increase of money wages (w) equals the sum of the growth rates of trend productivity (q) and the price level ( p ), i.e., w = q + p. In terms of the simple price equation, U. S. incomes policy criteria call for prices to increase no faster than the differ ence between the growth rates of hourly wages and trend produc tivity, or p = w — q. But the policy rule, p — w — q, automatic ally implies the condition of labor share (and thus non-labor share) constancy, w = q + p. M O N TH LY REVIEW, OCTOBER 1972 plying with the policies; (3 ) create uncertainty; (4 ) restrict basic personal and economic freedoms, e.g., freedom of choice and freedom of contract; and (5 ) entail an administrative or bureaucratic burden in the form of the additional staff necessary to ad minister the controls. O f these criticisms, the first seems to be the most significant. The critics point out that a wage-price guideline in the form of an economywide standard, if effective, is tantamount to freezing the structure of relative wages and prices. Such arbitrarily imposed structural rigidity is con trary to principles of economic efficiency, which call for the pattern of relative wages and prices to vary in response to dynamic changes in tastes, technology, and resource supply. Moreover, opponents of incomes policies contend that such policies, in addition to being harmful, are totally unnecessary as anti-inflationary instruments. Thus, the monetarists argue that inflation is primarily a monetary phenomenon, fully controllable by proper regulation of the growth rate of the money stock. Monetarists reject the explanation of cost-push in flation, which is a chief rationale for incomes policies, and deny the existence of cost-push linkages running from monopoly power to price inflation. Monetarists maintain that a viable cost-push or market-power explanation of inflation must imply an ever-increasing degree of monopoly p ow er; otherwise, monopolists could not continually inflate prices but would instead merely effect a one-time upward adjustment of prices to the level consistent with full exploitation of m o nopoly potential. This implication is rejected by monetarists as contrary to the facts, which show little evidence of increasing monopoly power. A second group opposed to incomes policies, the ncoinjlationists, also deny the necessity for such poli cies. Neoinflationists argue that chronic inflation, if accurately anticipated and fully adjusted for via purchasing power guarantees in all contracts, is not a major social menace. In the opinion of neoinflation ists, the social cost involved in fighting inflation far exceeds the cost of inflation itself. Accordingly, the government should abandon the policy objective of price stability and jettison the incomes policy instru ment associated with it. A third group, the antimonopolists, argue that in comes policies are unnecessary because procompetitive policies can stem inflation with greater efficiency and smaller social cost. Unlike monetarists, anti monopolists believe that market restrictions and m o to promote inflation via legislation that establishes minimum wages, agricultural price supports, subsi dies, quotas, tariffs, and other protectionist measures — all of which interfere with the effective functioning of the market. Contrary to the neoinflationists, antimonopolists believe that the social costs of infla tion are high enough to warrant strong anti-inflation ary policy .3 But price-wage controls are not the proper components of such a policy, claim the anti monopolists. Instead, policy should aim at the com plete eradication of monopoly elements, government subsidies, trade restrictions, and other structuralinstitutional impediments to price stability. The Case for Incomes Policies Advocates of in comes policies include two grou p s: those who think such policies should be temporary and episodic and those who maintain that such policies should be permanent. Generally in sympathy with the freemarket philosophy, the first group maintains that price-wage policies are justifiable only as a short run measure to be applied in specific crisis situations. This group believes that the Phase II machinery should be maintained just long enough to eliminate inflationary expectations and to improve the wageprice performance of the economy. After these goals are accomplished, the controls should be dismantled. W hile agreeing that prolonged application of wageprice controls may cause serious maladjustments, distortions, and inequities, this group does not think that these problems will be serious if the policy appli cation is limited to the short run. Others, however, think that price-wage controls are indispensable. They argue that inflation has become so firmly embedded in the economy that it cannot be contained effectively without permanent controls. This group cites an impressive array of psychological, institutional, and structural factors supposedly rendering the economy more inflationprone than formerly. The list includes: the exag gerated wage and job expectations of young workers (w ho constitute a growing proportion of the labor force) ; the truculence with which workers now press their wage demands; and the fragmentation of society into numerous competing factions, each motivated by feelings of discontent and inequity to seek enlarge ment of its relative income share. Additional forces which, it is claimed, may be amplifying the endemic inflationary bias of the economy include: the increase nopoly power, especially that wielded by trade unions, are important contributors to inflation. Antimonop olists also point out that the government itself tends 3 Neoinflationists and monetarists could, of course, believe that re duction in monopoly power would be socially beneficial for reasons other than its potential for reducing inflation. FEDERAL RESERVE B A N K OF R IC H M O N D 9 in union monopoly power ;4 the greater willingness of unions to exercise the market power in their posses sion ; certain changes in the age-sex composition of employment; and shifts toward services in the outputmix. Both of these latter two forces are expected to have an adverse effect on future productivity trends. Proponents of permanent price-wage controls also point to other, short run influences expected to inten sify inflationary pressures in the months ahead, in cluding the anticipated large deficits in the Federal budget and the large number of key labor contracts to be negotiated next year. All these reasons, it is claimed, necessitate the continuation of anti-inflation ary controls to reinforce other policy weapons. Advocates of incomes policies do not deny that such policies are a “ second-best” approach to the problem of inflation control. They recognize that the restor ation of competition in markets would help to reduce inflationary pressures. But they think that such an ideal procompetitive policy would be politically or technologically impossible to achieve in the foresee able future. Thus, in view of the unavailability of a “ first-best” procompetitive policy, a “ second-best” incomes policy must be relied upon. 4 The alleged increase in union monopoly power is attributed to certain factors that augment union strike capability, such as avail ability of unemployment compensation and food stamps to striking workers and the increasing relative importance of fixed or overhead costs in manufacturers’ total cost structures, which raises the po tential loss to employers of any strike-induced shutdown. Prognosis It appears probable that, over the next decade, incomes policies will be employed from time to time as inflation flares up. Permanent application of such policies seems unlikely, however. A large segment of the public probably shares the same pro market sentiments and antipathy to controls harbored by the opponents of incomes policies. Consequently, this segment of the public would be unwilling to assent to or tolerate permanent controls. But the public also opposes inflation and expects policymakers to combat it. Given the two constraints: (1 ) society’s full employment target and ( 2 ) the structural-institutional imperfections of the economy, policymakers will continue to experience difficulty in fighting in flation with monetary-fiscal policy. A further com plication is that policy may be operating in an en vironment characterized by increasingly sensitive in flationary perceptions and expectations. In principle, one solution to the policy dilemma would be to eradi cate market imperfections, thereby eliminating a con straint to the effective use of monetary-fiscal policy. Such a strategy, however, is likely to be rejected as involving too severe a political cost. Therefore, a feasible alternative will be to resort to incomes poli cies. Thus, a future marked by the periodic recur rence of wage-price controls would seem to be a dis tinct possibility. Thomas M . Humphrey Appendix THE INFLATION-UNEMPLOYMENT TRADE-OFF Not only is the two-equation wage-price model useful both in describing the linkages of an inflationary wageprice interaction process and in interpreting the ration ale of incomes policies, but it also serves to specify the set o f inflation-unemployment “ trade-offs” available to the monetary-fiscal authorities. To sim plify the discus sion, the time lag on the price variable in the wage equation is ignored. The trade-off relation m ay be derived by substituting the unlagged wage equation into the price equation and then solving for the inflation rate (p ). The resulting equation, p = — q / ( l — 6) + [a/ (1 — 6 ) ] ( 1 /u ) , which contains all the inflation-deter mining relations inherent in the underlying wage and price equations, indicates the trade-offs or “ menu of policy choices” between inflation (p) and unemploy ment (u) attainable via monetary-fiscal policies alone. In other words, the equation specifies the set o f alter native inflation-unemployment combinations available to policymakers armed only with monetary-fiscal weap ons. I f the set o f trade-offs is favorable, incomes policies would be unnecessary. In this case the mone tary-fiscal authorities could purchase successive reduc tions in unemployment at the cost of only slight addi 10 tional inflation. A n unfavorable menu o f trade-offs, however, m ay w arrant the use o f incomes and other policies designed to improve the set o f inflation-unem ployment combinations attainable via monetary-fiscal policy. The trade-off between inflation (p) and unemploy ment (u) depends on the size o f the bracketed term [ a / (1 — 6] attached to the unemployment variable in the trade-off equation. The larger this term, the worse the trade-off, i.e., the larger the increment in the rate o f inflation necessary to achieve a given decrement in the unemployment rate. The reader will note that the magnitude of the bracketed term [a/ (1 — 6 ) ] depends crucially on the price-expectation coefficient 6 from the wage equation. The nearer the price-expectation co efficient is to zero, the lower will be the value o f the bracketed term ; and the lower the value o f the brack eted term, the less sensitive will be the inflation rate to reductions in the unemployment rate. I f both coeffi cients a and 6 were low, the policymakers would be confronted with a favorable trade-off, because it would be possible to engineer a reduction in the unemployment rate via monetary-fiscal policy without generating much M O N TH LY REVIEW, OCTOBER 1972 additional inflation in the process. However, the in fla tionary potential o f any policy-induced reduction in the unemployment rate rises rapidly when the price coeffi cient deviates significantly from zero. For example, a rising price-expectations coefficient m ay have been largely responsible for the rapidly deteriorating trade o ffs confronting the authorities during the roughly three-year period immediately prior to the imposition of Phase I controls in 1971. The closer the price coeffi cient b is to unity, the more unfavorable the trade-off. In the limit, as b approaches its critical value o f one, the bracketed term [ a / (1 — 6 ) ] becomes infinitely large and the inflation rate (p) becomes indeterminate. A t this point, the trade-off vanishes. In short, if b equals one, it is impossible to decrease the unemployment rate by increasing inflation. In fact, since the inflation rate in this extreme case is infinitely sensitive to changes in unemployment, attempts to reduce the latter via monetary-fiscal policy will only serve to provoke explos ive, ever-accelerating inflation. Some economists now believe that, in the long run the price-expectation co efficient becomes unity, and thus there is no permanent trade-off between inflation and unemployment. Justification for incomes and structural policies be comes quite compelling when the economy is rapidly converging on a position of zero trade-offs at high (socially intolerable) levels of unemployment. In this case, conventional macroeconomic weapons, by them selves, are helpless. Attem pts to use monetary-fiscal policy to lower unemployment will only serve to provoke explosive inflation. Thus, incomes policies and struc tural policies must be utilized to twist the inflationunemployment relation in a more favorable direction, thereby permitting m onetary-fiscal policy to operate more effectively in achieving acceptable rates of in fla tion and unemployment, at least in the short run. Bibliography Ackley, Gardner. “ Observations on Phase II Price and W a ge Controls.” Brookings Papers on Economic A c tivity ( 1 :1 9 7 2 ) , pp. 173-90. --------------- . “ A n Incomes Policy for the 1970’s.” Review o f Economics and Statistics, 54 (A ugust 1 9 72 ), 21823. Bronfenbrenner, Martin. “ Guidelines, Guideposts, and Incomes Policies.” Chapter 17 of Income Distribution Theory. Chicago: Aldine • Atherton, Inc., 1971, pp. 445-76. Eckstein, Otto and Roger Brinner. The Inflation Proc ess in the United States. A study prepared for the Joint Economic Committee, Congress of the United States. W ashington: Government Printing Office. 1972. Feige, Edgar L. “ The 1972 Report of the President’s Council o f Economic Advisers: Inflation and Unem ployment.” American Economic Review, 62 (Septem ber 19 72 ), 509-16. Fiedler, Edgar R. “ The Price-W age Stabilization Pro gram .” Brookings Papers on Economic A ctivity (1 : 1 9 72 ), pp. 199-206. Haberler, Gottfried. “ Incomes Policy and In fla tio n : Some Further Reflections.” American Economic R e view, 62 (M ay 19 72 ), 234-41. Houthakker, Hendrik. “ Thoughts on Phase I I .” Brook ings Papers on Economic A ctivity ( 1 :1 9 7 2 ), pp. 19598. and R. L. Teigen. 2nd ed. Homewood, Illinois: R. D. Irwin, Inc., 1970, pp. 152-63. Kessel, Reuben A . “ The 1972 Report o f the President’s Council o f Economic A d visers: Inflation and Con trols.” American Economic Review, 62 (September 1 9 7 2 ), 527-32. Lipsey, R. G. and J. M. Parkin, “ Incomes Policy: A Re-appraisal.” Economica, 37 (M ay 1 9 70 ), 115-38. McCracken, Paul W . “ Fighting Inflation A fte r Phase Tw o.” Fortune, 85 (June 1 9 72 ), 84-85 and 157-58. Perry, George L. “ Controls and Income Brookings Papers on Economic A ctivity Shares.” ( 1 :1 9 7 2 ) , pp. 191-94. Pitchford, J. D. “ The Usefulness o f the Average-Productivity W age Adjustm ent Rule.” Economic Record, 47 (June 1 9 71 ), 255-61. Smith, David C. “ Incomes Policy.” Britain’s Economic Prospects. Ed. R. E . Caves and Associates. W ash ing ton, D. C .: The Brookings Institution, 1968, pp. 10444. Ulman, Lloyd. “ Cost-Push and Some Policy A lterna tives.” American Economic Review, 62 (M ay 19 72 ), 242-50. Wage Restraint: A Study o f Incomes Policies in W estern Europe. Berke --------------- and Robert J. Flanagan. ley: University of California Press, 1971. --------------- . “ Are Controls the A n sw er?” Review o f E co nomics and Statistics, 54 (A u gu st 19 72 ), 231-34. W eber, Arnold R. “ A W age-P rice Freeze as an Instru ment of Incomes Policy: or the Blizzard o f ’ 71.” American Economic Review, 62 (M ay 19 72 ), 251-57. H ym ans, Saul H. “ The T rad e-O ff Between Unemploy ment and Inflation.” Readings in Money, National Income, and Stabilization Policy. Ed. W . L. Smith Weidenbaum, M urray L. “ New Initiatives in National W age and Price Policy.” Review o f Economics and Statistics, 54 (A u gu st 19 72 ), 213-17. FEDERAL RESERVE B A N K OF R IC H M O N D 11 COAL M A K ES A CO M EBACK IN W EST VIRGINIA During the 1950’s and early 1960’s, U. S. con sumption of bituminous coal waned, and the number of workers employed by the industry dropped drasti annual production fell from $854 million in 1951 to $559 million in 1961. Since 1969, however, this downturn has been re In W est Virginia, where coal mining ac versed ; and consumption has been increasing, pri counted for nearly one-fourth of all workers on non- marily because of the rising demand of electric agricultural payrolls in 1950, the state’s economy was utilities for coal. particularly sensitive to changes in the coal industry. coal industry, moreover, has been relatively stable cally. Employment in the W est Virginia x\verage daily employment in the state’s bituminous during the 1960’s. coal industry declined from 12 1 thousand in 1950 to should continue in the near future, as the demand approximately 43 thousand in 1961. for electric power rises and coal remains a readily The value of Indications are that these trends available energy source. Although coal mining today accounts for a much smaller share of W est Virginia employment and output than it did in 1950, West Virginia remains the nation’s leading producer of bituminous coal, which is in increasing demand. The coal industry, therefore, continues to be an important factor in W est Virginia’s economy. Production A fter reaching a peak o f 176 million tons in 1947, annual bituminous coal production in West Virginia fell irregularly to 113 million tons in 1961. Rising steadily from the 1961 low to 153 mil lion tons in 1967, coal production again fell in 1969 to 141 million tons. During the 1950’s, the value of production was subject to even greater fluctuations than total production because of varying shifts in coal prices. Except for a slight decline in 1968, the value of production increased at a regular rate after 1961. Throughout the period from 1947 to 1969, W est Virginia was continually the leading U. S. bi tuminous coal producer; and in 1969 the state pro duced over one-fourth of the nation’s total output. The largest coal producing counties are Kanawha, Boone, Logan, W yoming, McDowell, and M onon galia— each producing more than 10 million tons in 1970. W ith the exception of Monongalia, all are lo cated in the southern and central portions of the state, where the largest proportion of W est V ir ginia’s coal is mined. Monongalia is located in an important, but smaller, coal mining region on the 12 M O N TH LY REVIEW, OCTOBER 1972 Pennsylvania border. McDowell had the largest out put in 1970 with 16.5 million tons, and Logan was mines in the state. second with 13.3 million. underground operations, and of this number 527 em In recent years, approximately 90 percent of W est Virginia’s bituminous coal production has been de rived from underground mines, with the remainder attributed to surface mining techniques. The latter type includes strip mining, which faces a rather ployed less than 15 men. The number of under ground operations has decreased in recent years, uncertain future in the U. S. because of recent at tacks by environmentalists and proposed legislation to limit this form of mining. However, W est V ir ginia would not be affected as greatly by such legis lation as a number of other states where strip mining is relatively more important to total production. mines have been increasing; but, as pointed out A t the end of 1970, 948 companies operated 1,350 O f these 1,350 mines, 900 were although these mines continue to produce by far the largest share of W est Virginia’s coal output. Strip above, they are still relatively less important in W est Virginia than in a number of other mining states. D em and and U ses T h e pattern o f U. S. coal consumption has undergone major changes over the C h a rt 2 COAL CONSUMPTION AND EXPORTS United States: 1950-1969 M illio n s o f N et Tons Cem ent Steel & R olling M ills O th e r M a n u fa c tu rin g & M in in g Ind u stries C okin g C oal Electric P ow er C om panies 01 _______ I_______ I_______ I_______ I_______ I_______ I_______ I_______ I_______ I_______ I_______ I_______ I_______ I_______ I_______ I_______ I_______ I_______ I_ _ 1950 Sources: 1952 1954 1956 1958 1960 1962 1964 1966 1968 N a tio n a l C oal A sso cia tio n , B itum inous C oal Facts; U. S. D e p a rtm e n t o f In te rio r, B ureau o f M ines, M in e ra ls Y e a rb o o k . FEDERAL RESERVE B A N K OF R IC H M O N D 13 Ta b le and the relatively low cost and high availability of I coal. BITUMINOUS COAL PRODUCTION* West V irg in ia : 1950-1969 A rise in the demand for electrical power was foreseen during the fifties, but coal was not then con Year P ro du ctio n (Thousands o f N e t Tons) V a lu e o f P roduction (Thousands o f D ollars) A v e ra g e V a lu e Per T o n f (D ollars) 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 144,116 163,310 141,713 134,105 115,996 139,168 155,890 156,842 119,468 119,692 118,944 113,070 118,499 132,568 141,409 149,191 149,681 153,749 145,921 141,011 754,370 853,894 741,421 6 93,594 541,370 653,388 824,043 875,587 635,201 621,003 5 97,222 5 58,525 578,293 634,794 693,572 726,096 753,851 800,683 7 75,720 807,811 5.23 5.23 5.23 5.17 4.67 4.69 5.29 5.58 5.32 5.19 5.02 4.94 4.88 4.79 4.90 4 .87 5 .04 5.21 5.32 5.73 sidered a likely future energy source. The coal mining industry had relatively low productivity, and atomic power plants were being planned to replace coal-burning power plants. Because of automation and a number of other factors, however, the coal in dustry is now competitive with other fuels. superior source of fuel, has recently encountered problems, such as fears by the public of thermal pollution and radioactivity. Also, current cost esti mates for the projected atomic power plants are far higher than original cost predictions. Coal, there fore, appears likely to continue as a leading source of electrical power in the near future. A number of manufacturers still operate coal-fired power plants, and coal remains the fuel used by many homeowners in their heating systems. ‘ Includes L ig n ite . fA v e r a g e v a lu e p er to n is ta ke n as va lu e o f th e co a l a t th e m ine. S ource: U. S. D e p a rtm e n t o f th e In te rio r, B ureau o f M ines, M in e ra ls Y e a rb o o k . last 20 years, as can be seen from Chart 2. In 1950, the categories of electric utilities, coking coal, other manufacturing and mining industries, and retail dealers each accounted for approximately one-fifth of the U . S. total. By 1969, the electric utilities’ share had risen to over half; and the shares, as well as total consumption, of the other three had fallen. Coal-burning locomotives, which were once respon sible for the railroads’ leading demand for coal, have virtually disappeared. Despite the declines in these four areas, however, the electric utilities’ rising demand managed to bring U. S. coal consumption in 1969 to its highest level since 1948. Although not comparable to the electric utilities’ increase, exports of coal also rose during the 1960’s. The W est Virginia coal industry, which produces a relatively high-quality coal, has benefited in particu lar. Much of the exported coal is used by foreign steel industries for coking, which requires a highgrade coal. W est Virginia’s ability to produce a high-quality coal also accounts for the state’s large share of the U. S. steel producers’ market for coal. The upward trend in the utilities’ demand for coal can be explained by the increasing demand for power 14 For in stance, atomic energy, which once seemed a far M O N TH LY REVIEW, OCTOBER 1972 In addi- tion, numerous future possibilities for the use of coal Ta b le II EMPLOYMENT, PRODUCTIVITY, AND EARNINGS IN BITUMINOUS COAL INDUSTRY* West V irg in ia : 1950-1969 Y ear A ve ra g e W o rke rs Per Day 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 A v e ra g e Tons Per M an Per Day 120,888 111,886 102,996 88,985 60,011 66,231 7 1,996 71,201 62,437 53,847 51,062 43,611 43,763 44,534 39,308 41,008 43,769 44,064 42,471 ** 6.41 6.66 6.97 7.78 8.86 9.38 9.65 10.05 10.66 11.68 12.07 12.99 13.57 14.44 15.31 15.90 15.96 16.01 15.77 ** A ve ra g e H o u rly E arnings J . 1 $2.25 2.32 2.51 2.51 2.57 2.81 3.01 3.02 3.28 3.27 3.26 3.21 3.29 3.41 3.60 3.67 3.85 3.90 4.17 are being explored by the industry. Am ong these are the production of a synthetic gasoline; sewage treatment; and, surprisingly, a potential role in the campaign against air pollution. E m ploym ent and P rodu ctivity E m ploym ent in the W est Virginia coal industry reached its peak in 1940 when over 130 thousand men were employed. By 1961, this figure had dropped to approximately 43 thousand, where it has remained for the past 10 years. In addition to slack demand, the primary cause of the drop in employment was the expanding mechanization within the industry, which resulted from low productivity and wage pressures. Average hourly earnings rose from $2.25 in 1950 to $4.17 in 1969. Despite this rising hourly wage rate, coal has remained competitive because rising productivity, which increased nearly two and a half times between 1950 and 1968, has partially offset rising wage rates, thereby keeping labor costs (a major component of *ln c lu d e s Lign ite . price ) from rising. Because of the adaptability of the fS e rie s n o t a v a ila b le p rio r to 1951. industry, coal mining in West Virginia can now **S e rie s fo r 1969 n o t a v a ila b le . Sources: U. S. D e p a rtm e n t o f Lab o r, Bureau o f Labor S tatistics, E m p lo ym e n t a nd E arnings; U. S. D e p a rtm e n t o f In te rio r, Bureau o f M ines, M in e ra ls Y e a rb o o k ; U. S. D e p a rtm e n t o f the In te rio r, Bureau o f M ines, M in e ra l In d u s try Surveys. anticipate a far brighter future than was envisioned just 10 years ago. FEDERAL RESERVE B AN K OF R IC HM O ND Thomas Y. Coleman 15 BANKING IN THE CONSUMER PROTECTION A G E William F. Upshaw Banking in the Consumer Protection A ge, which first appeared as a series of Monthly Review articles, reviews the development of consumer protection legisla tion in the United States, with particular emphasis on the Truth in Lending Act and the Fair Credit Reporting Act. In addition, important legislation involving bank credit cards is examined, and the work of the National Commission on Con sumer Finance is discussed. Reprints of Banking in the Consumer Protection A g e are available upon request from Bank and Public Relations, Federal Reserve Bank of Richmond, P. O. B ox 27622, Richmond, Virginia 23261. M O N TH LY REVIEW, OCTOBER 1972