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LIBRARY f ó - d . mic eview lift 4 v i " SEPTEMBER/OCTOBER 1980 FEDERAL RESERVE BANK OF ATLANTA NOWS • Southeast's Prospects RECOVERY How Strong? How Fast? INFLATION Still Number One 1 I REVIEWS o • Wage Rigidity in U.K. 1919-1939 • Tax Cuts: Supply-Side Effects «¡1 Last Chance to Renew Your Free Subscription If you returned the renewal card in our last issue, your subscription has already been continued. If you have not yet returned your card and you wish to stay on the Economic Review's mailing list, please fill in and mail the postcard in this issue. If we do not receive your card, we will remove your name from our mailing list. The purpose of the Economic Review is to inform the public about Federal Reserve policies and the economic e n v i r o n m e n t and, in particular, to narrow the gap between specialists and concerned laymen. For m o r e specialized readers, the Review also s u m m a r i z e s our basic research projects, which are available in complete f o r m in o u r Research Paper and Working Paper series. 2 SEPTEMBER/OCTOBER 1980, E C O N O M I C REVIEW page 4 NOW Accounts: Applying the Northeast's Experience to the Southeast p a g e 11 4 The Shape of the Recovery N O W ( N e g o t i a b l e O r d e r of W i t h d r a w a l ) A c c o u n t s will b e p e r m i t t e d at b a n k s a n d s a v i n g s a n d l o a n a s s o c i a t i o n s n a t i o n w i d e at t h e b e g i n n i n g of 1981. H o w will t h e s e interest-bearing c h e c k i n g a c c o u n t s c h a n g e the s h a p e of b a n k i n g c o m p e t i t i o n in t h e S o u t h e a s t ? Bill C o x s u r v e y s t h e e a r l i e r e x p e r i e n c e of t h e N o r t h e a s t a n d u s e s t h e r e s u l t s to e s t i m a t e w h a t w e c a n e x p e c t in t h e S o u t h e a s t in t h e n e x t f o u r y e a r s Inflation: Still O u r N u m b e r O n e Problem p a g e 16 11 With the l o n g - a n t i c i p a t e d recession m e e t i n g an early d e m i s e , o b s e r v e r s d i f f e r a b o u t t h e n a t u r e of t h e r e c o v ery Business economist Charles J Haulk responds to guestions about the recovery's p r o b a b l e strength, duration, a n d distinguishing characteristics, and offers a n a l t e r n a t i v e s c e n a r i o to t h e A d m i n i s t r a t i o n / C o n g r e s s consensus Working Paper Review 1919-1939 Reassessed: Unemployment and Nominal W a g e R i g i d i t y in t h e U n i t e d K i n g d o m 2 6 16 The recession w h i c h h a s just e n d e d e x a c t e d a h i g h c o s t in l a y - o f f s a n d lost j o b s , yet it is not o u r m o s t s e r i o u s e c o n o m i c p r o b l e m . I n f l a t i o n is. In t h i s i s s u e ' s Commentary. Harry Brandt explains why and traces the l o n g e r - t e r m f o r c e s b e h i n d inflation What h a p p e n s w h e n an industrialized society neglects t h e s e l f - r e g u l a t i n g c h a r a c t e r of its l a b o r m a r k e t ? H o w d o s t r o n g l a b o r u n i o n s , e x p a n d e d u n e m p l o y m e n t insurance, and w a g e control boards affect unemploym e n t ? In a f o r t h c o m i n g W o r k i n g P a p e r r e v i e w e d h e r e , B a r b a r a H e n n e b e r r y (Bloomington, Indiana), Robert E K e l e h e r ( F e d e r a l R e s e r v e B a n k of A t l a n t a ) , a n d t h e l a t e J a m e s G W i t t e ( I n d i a n a U n i v e r s i t y ) f o c u s o n t h e relationship between unemployment and nominal w a g e r i g i d i t y in t h e U n i t e d K i n g d o m f r o m 1 9 1 9 - 1 9 3 9 Research Paper Review S u p p l y - S i d e E f f e c t s of F i s c a l P o l i c y : S o m e Preliminary Hypotheses 2 8 Will a t a x c u t i n c r e a s e c o n s u m e r s p e n d i n g a n d t h e g o v e r n m e n t d e f i c i t a n d t h u s a d d to i n f l a t i o n ? In a R e s e a r c h P a p e r p u b l i s h e d in J u n e 1 9 7 9 . R o b e r t E K e l e h e r e x a m i n e d t h e e f f e c t s of tax c u t s o n t h e s o m e t i m e s n e g l e c t e d " s u p p l y - s i d e " of t h e e c o n o m y A rev i e w of t h e R e s e a r c h P a p e r . D i r e c t o r of R e s e a r c h : H a r r y B r a n d t A s s o c i a t e D i r e c t o r : W i l l i a m N . C o x III B u s i n e s s E d i t o r : G a r y W. T a p p Production and Graphics: S u s a n F. T a y l o r a n d E d d i e W. Lee, Jr. page 26 V O L U M E LXV, N O . 5 p a g e 28 3 N O W Accounts: Applying the Northeast's Experience to the Southeast by William N. Cox III A t the b e g i n n i n g of 1981, banks and savings a n d loan associations all over t h e c o u n t r y will be p e r m i t t e d t o offer N O W accounts o n w h i c h interest w i l l be paid a n d against w h i c h checks can be w r i t t e n . For t h e first t i m e in the Southeast, banks and savings a n d loan associations (S&Ls) will be c o m p e t i n g broadly a n d intensely for the retail financial customer's c h e c k i n g account business. 1 To assess w h a t t h e results of this n e w c o m p e t i t i o n are likely t o be in t h e Southeast, w e n e e d t o l o o k t o the Northeast, w h e r e N O W s are n o t so new. Since t h e i n t r o d u c t i o n of N O W s by a Massachusetts savings bank in 1972, banks a n d t h r i f t institutions in eight northeastern states have e n t e r e d t h e N O W arena. Here w e try t o extract relevant patterns f r o m t h e n o r t h eastern e x p e r i e n c e and t o see w h a t those patterns suggest f o r N O W activity in t h e Sixth District states of A l a b a m a , Florida, G e o r g i a , Louisiana, Mississippi, a n d Tennessee. Strategy. N O W accounts are essentially interest-bearing c h e c k i n g accounts. They can be o f f e r e d o n l y t o individuals a n d a few n o n p r o f i t organizations. Households use t h e m for transactions purposes: f o r paying bills and cashing checks. A l t h o u g h in many cases households have consolidated balances w h i c h w e r e previously split ' T h e Southeast (Alabama, Florida, Georgia, Louisiana, Mississippi, a n d T e n n e s s e e ) has n o m u t u a l s a v i n g s b a n k s , but m u t u a l s in o t h e r p a r t s o f t h e c o u n t r y a n d c r e d i t u n i o n s n a t i o n w i d e c a n also o f f e r N O W s in 1981. 4 b e t w e e n c h e c k i n g and savings accounts, most customers d o not apparently perceive N O W s as savings accounts: in p r a c t i c e , m o s t N O W s f u n c t i o n as transactions accounts. A c c o r d i n g l y , w e choose t o analyze N O W s by asking, first, " H o w many dollars of N O W balances and h o w many N O W accounts can a particular m a r k e t s u p p o r t ? " regardless of w h e t h e r those accounts w i l l be o p e n e d at a bank or an S&L. T h e n w e can g o o n t o ask, secondly, " H o w d o w e expect t h e banks a n d S&Ls t o split that m a r k e t ? " T h e total market is d e f i n e d by e c o n o m i c characteristics. In o t h e r w o r d s , t h e m a r k e t shares are d e t e r m i n e d by c o m p e t i t i o n a m o n g financial institutions for customer accounts. 2 A Closer Look at the Northeast. The experience of eight states seems like a lot of material t o tap. Actually, t h e r e is less applicable i n f o r m a t i o n than t h e r e m i g h t first appear t o be. Basically, in t h e Northeast, t w o states have had greater T y p i c a l l y , banks and S & L s p l a n n i n g for N O W s have taken a different a p p r o a c h , s t a r t i n g w i t h t h e i r o w n b a l a n c e sheets. B a n k s talk in t e r m s of t h e p r o p o r t i o n of t h e i r d e m a n d d e p o s i t b a l a n c e s that m i g h t b e " c o n v e r t e d " t o NOWs. Savings a n d loan planners like t o project an institution's N O W b a l a n c e s in r e l a t i o n t o t h a t i n s t i t u t i o n ' s o w n assets. T h e s e are t r a d i t i o n a l and understandable approaches, well suited to their particular purposes. W e take the "total m a r k e t / m a r k e t share" a p p r o a c h instead, however, for several reasons. O u r a p p r o a c h recognizes the well-established relations h i p b e t w e e n i n c o m e levels a n d t h e v o l u m e of t r a n s a c t i o n s a c c o u n t s . It r e c o g n i z e s , e x p l i c i t l y , t h a t t h e n u m b e r o f a c c o u n t s a n d b a l a n c e s at a p a r t i c u l a r i n s t i t u t i o n d e p e n d s o n t h e a g g r e s s i v e n e s s of t h e c o m p e t i t i o n , w h e r e a s p r o j e c t i n g a n i n s t i t u t i o n ' s N O W b a l a n c e s f r o m its b a l a n c e s h e e t i m p l i c i t l y i g n o r e s t h a t c o m p e t i t i o n It p r o v i d e s a c o m p r e h e n s i v e p i c t u r e a n d a v o i d s " a p p l e s a n d o r a n g e s " q u e s t i o n s s u c h as w h e t h e r it m a k e s s e n s e t o c o m b i n e e s t i m a t e s for b a n k s , b a s e d o n d e m a n d d e p o s i t s , w i t h e s t i m a t e s f o r S & L s , b a s e d o n assets If w e s t a r t a n y w h e r e b u t w i t h t h e f u l l m a r k e t , w e r u n t h e risk of a d d i n g u p i n c o n s i s t e n t p i e c e s . SEPTEMBER/OCTOBER 1980, E C O N O M I C REVIEW v The pattern of NOW development in northeastern states provides a basis for projecting what may happen in the Southeast. This preliminary study focuses on how many NOW accounts (and in what amounts) a particular market can support, how banks and thrifts will split NOW accounts and NOW balances, and how fast NOW accounts will probably grow in the Sixth District states. c o m p e t i t i o n b e t w e e n banks and thrifts than w e expect in t h e Southeast and f o u r states have had less c o m p e t i t i o n . In the r e m a i n ing t w o states, a c o m b i n a t i o n of small scale and o t h e r circumstances makes it d i f f i c u l t t o c o m p a r e experiences t h e r e w i t h t h e Southeast. Massachusetts and N e w Hampshire. These are t h e t w o states w h e r e it all began in 1972. Institutions a n d consumers alike w e r e u n c e r t a i n a n d skeptical. Banks d i d not receive N O W powers until the b e g i n n i n g of 1974, so t h r i f t institutions t h e r e had, in effect, a b o u t a one-year head start. Banks in these t w o states t e n d e d t o price N O W accounts cheaply in response t o thrift aggressiveness. Vermont and Rhode Island. T h e experience of V e r m o n t a n d R h o d e Island is d i f f i cult t o apply t o t h e Southeast. Both states e n t e r e d t h e " N O W C l u b " at the b e g i n n i n g of M a r c h 1976. All types of institutions started t o g e t h e r this t i m e . But V e r m o n t ' s e c o n o m y is very small and rural — a b o u t 7 p e r c e n t t h e size of Massachusetts a n d o n e f o u r t h t h e size of Mississippi. There are f e w e r t h a n 50 N O W - e l i g i b l e financial instit u t i o n s in t h e state, and o n l y o n e - q u a r t e r of t h e m o f f e r e d N O W s d u r i n g t h e first year. N O W p e n e t r a t i o n in V e r m o n t has b e e n very slow. The R h o d e Island e c o n o m y is a bit larger e c o n o m i c a l l y , but t h e state's b a n k i n g structure contains an unusual a m o u n t of i n t e r l o c k i n g c o n t r o l . M a r k e t share data f r o m V e r m o n t and R h o d e Island are not available, as far as w e k n o w . For FEDERAL RESERVE BANK O F ATLANTA these reasons, w e set V e r m o n t a n d R h o d e Island aside in o u r analysis. Connecticut and Maine. C o n n e c t i c u t is u r b a n and high i n c o m e ; M a i n e is rural and less prosperous e c o n o m i c a l l y . But t h e i r e x p e r i e n c e w i t h N O W s has b e e n similar. Both states i n a u g u r a t e d N O W s in M a r c h 1976. Several m o n t h s p r i o r t o that, h o w e v e r , m u t u a l savings banks a n d S&Ls t h e r e w e r e also p e r m i t t e d t o offer personal (interestfree) c h e c k i n g accounts. This is an i m p o r tant distinction, f o r it o f f e r e d t h e thrifts a way t o c o m p e t e for bank customers w i t h o u t aggressively p r o m o t i n g a n d p r i c i n g N O W s . C o m p e t i t i o n for N O W balances was not exceptionally intense b e t w e e n banks a n d thrifts, p e n e t r a t i o n of N O W accounts was relatively slow, t h e banks w e r e able t o attach h i g h m i n i m u m balance r e q u i r e m e n t s (especially in C o n n e c t i c u t ) , and average balances at banks (and their market shares) have r u n very high as a result of checking-saving consolidation by bank customers. N e w York and N e w Jersey. Institutions here began w i t h N O W s at t h e b e g i n n i n g of 1979 and 1980, respectively. The N e w York pattern, and w h a t has h a p p e n e d so far in N e w Jersey, tends t o f o l l o w the Connecticut e x p e r i e n c e : C h e c k i n g accounts w e r e previously available at thrift institutions. N O W accounts, w h e n i n t r o d u c e d , s h o w e d l o w p e n e t r a t i o n in terms of n u m b e r of accounts, surprisingly h i g h average balances — $5,000 t o $8,000 — and high market shares at t h e banks. 5 The Outlook for the Southeast. For most S&Ls in the Southeast, the availability of N O W s in early 1981 represents — as it d i d in Massachusetts and N e w H a m p shire — t h e first o p p o r t u n i t y t o c o m p e t e broadly for transactions accounts. C o m p e t i t i o n b e t w e e n banks a n d thrifts in most of t h e Southeast, t h e r e f o r e , s h o u l d be m u c h stiffer than w e have seen in C o n n e c t i c u t , M a i n e , N e w York, or N e w Jersey, w h e r e thrifts w e r e a l l o w e d t o offer c h e c k i n g accounts b e f o r e t h e i n t r o d u c t i o n of N O W s . Aggressive m a r k e t i n g by southeastern S&Ls may make it d i f f i c u l t for banks t o i m p o s e high m i n i m u m balance r e q u i r e m e n t s w i t h o u t significant customer defections. Relative t o the patterns f r o m C o n n e c t i c u t , M a i n e , N e w York, and N e w Jersey, t h e n , w e w o u l d expect t o see greater p e n e t r a t i o n ( m o r e accounts per household) of accounts in t h e Southeast, l o w e r average balances, and l o w e r market shares for banks. The greatest danger of an uncritical e x t r a p o l a t i o n f r o m t h e Northeast is t o i g n o r e these p r o b a b l e effects of greater c o m p e t i t i o n . Florida, h o w e v e r , may be the e x c e p t i o n . Savings and loan associations t h e r e w e r e a u t h o r i z e d t o offer interest-free c h e c k i n g accounts as of midyear 1980. A clear possibility, j u d g i n g f r o m the northeastern e x p e rience, is that this n e w a u t h o r i t y w i l l shift Florida f r o m t h e "Massachusetts-New Hampshire pattern" to the "ConnecticutM a i n e - N e w Y o r k - N e w Jersey p a t t e r n . " If so, banks and S&Ls m i g h t c o m p e t e m o r e over c h e c k i n g accounts than over N O W s . This w o u l d probably hold d o w n the n u m b e r of N O W accounts o p e n e d in Florida, raise t h e banks' market share of N O W balances, and cause t h e average balances of N O W s at banks t o be higher than in o t h e r s o u t h eastern states. N O W Balances. H o w many dollars can w e expect t o see d e p o s i t e d in southeastern N O W accounts? Ultimately, t h e a m o u n t of N O W balances s h o u l d be closely related t o t h e v o l u m e of h o u s e h o l d transactions in a particular state or area. H o u s e h o l d transactions are hard t o measure. W e k n o w that transactions balances are closely related t o i n c o m e in e c o n o m i c t h e o r y . So since most 6 Chart 1 % 6 N O W B a l a n c e s ($) N.H. P e r s o n a l I n c o m e ($) Mass. Maine . . • • Conn. Years A f t e r Introduction N O W s are functionally transactions accounts and not savings accounts, t h e i n c o m e of a particular area w o u l d seem very closely related t o the v o l u m e of N O W balances that area will p r o d u c e or r e q u i r e at either banks or S&Ls. Chart 1 traces t h e ratio of state N O W balances per dollar of personal i n c o m e f o r N e w H a m p s h i r e , Massachusetts, C o n n e c t i cut, and M a i n e , a l o n g w i t h o n e reading for N e w York. The ratios are p l o t t e d t h e r e against t h e n u m b e r of calendar years elapsed since the i n t r o d u c t i o n of N O W s at banks. R e m e m b e r i n g , as w e l o o k t o t h e Southeast, that o u r state-by-state summary suggested that dollar balances are likely t o be a bit l o w e r initially than they w e r e in the t w o pioneers, Massachusetts and N e w H a m p s h i r e , and that N O W c o m p e t i t i o n w i l l be m o r e intense than it has b e e n in t h e o t h e r f o u r northeastern states, o u r inspect i o n of this chart leads us t o p r o p o s e the f o l l o w i n g general pattern in the Southeast: 1. O n e year after i n t r o d u c t i o n , at t h e e n d of 1981, N O W balances in t h e six southeastern states c o m b i n e d may well total a b o u t o n e p e r c e n t of personal income. 2. Two years after i n t r o d u c t i o n , at t h e e n d of 1982, N O W balances in s o u t h eastern states may w e l l total a b o u t 214 p e r c e n t of personal i n c o m e . 3. Three years after i n t r o d u c t i o n , at t h e e n d of 1983, N O W balances in southS E P T E M B E R / O C T O B E R 1980, E C O N O M I C REVIEW Chart 2 eastern states may well total a b o u t 3V2 p e r c e n t of personal i n c o m e . These are r o u g h rules of t h u m b , d e r i v e d , as w e have seen, f r o m a j u d g m e n t a l inspect i o n of the northeastern experience. W e expect s o m e t h i n g like this pattern t o e m e r g e over t h e next t h r e e years in the Sixth District. 3 N u m b e r of N O W Accounts. To estimate t h e number of N O W accounts in s o u t h eastern states, w e start w i t h t h e p r e s u m p t i o n , c o m m o n in bank m a r k e t i n g circles, that t h e n u m b e r of transactions accounts is related closely t o t h e n u m b e r of households in a given area. Chart 2 shows t h e p e n e t r a t i o n of N O W s , measured by t h e n u m b e r of accounts per h u n d r e d households, by years elapsed since i n t r o d u c t i o n in each northeastern state. The Massachusetts-New H a m p s h i r e p e n e tration pattern, w h e r e novelty and u n c e r tainty p r o d u c e d aggressive c o m p e t i t i o n , is p r o b a b l y a slight overestimate of w h a t w e can expect in each of t h e southeastern states, except Florida. A c c o r d i n g t o recent estimates of Massachusetts a n d N e w H a m p shire, p e n e t r a t i o n appears t o have reached 3 T h e s e r e s u l t s w o u l d be n o less r o u g h , i n c i d e n t a l l y , h a d w e " d i g n i f i e d " t h e m by r e g r e s s i o n analysis. T o o b t a i n e n o u g h d a t a p o i n t s t o run a regress i o n , w e w o u l d have t o e i t h e r " p o o l " data f r o m t h e several states, w h i c h s e e m s u n w a r r a n t e d in t h e l i g h t o f t h e states' v a r y i n g i n s t i t u t i o n a l c i r c u m s t a n c e s , o r w e w o u l d have t o c o n v e r t a n n u a l o b s e r v a t i o n s t o q u a r t e r l y o n e s by u s i n g q u a r t e r l y i n c o m e data, w h i c h are e s s e n t i a l l y i n t e r p o l a t e d . N e i t h e r a p p r o a c h p r o m i s e s t o a d d any q u a l i t y , e x c e p t p e r h a p s a n a r t i f i c i a l s o p h i s t i c a t i o n , t o t h e r u l e s of t h u m b w e have a l r e a d y g e n e r a t e d b y i n s p e c t i o n of C h a r t 1. FEDERAL RESERVE BANK OF ATLANTA 7 " m a t u r i t y " at a b o u t 80 accounts per h u n d r e d households. M a i n e , C o n n e c t i c u t , and N e w York e x p e r i e n c e d l o w e r p e n e t r a t i o n (Chart 2). A c c o r d i n g t o press reports, the same t h i n g is h a p p e n i n g in N e w Jersey. Because of t h e availability of interest-free c h e c k i n g at thrifts, saturation at m a t u r i t y in these states will p r o b a b l y fall far b e l o w t h e 80 accounts per h u n d r e d estimates for Massachusetts a n d N e w Hampshire. These f o u r states offer us an estimate of t h e p e n e t r a t i o n w e can expect in Florida, w h e r e thrifts also c o u l d offer interest-free c h e c k i n g accounts b e f o r e N O W s w e r e legalized. In general, t h e n , w e w o u l d expect a slower g r o w t h rate in n u m bers of N O W accounts in Florida than in t h e o t h e r southeastern states. M a r k e t Share. T h e market share q u e s t i o n h o w t h e banks and thrifts w i l l split b o t h t h e N O W accounts a n d t h e N O W balances in each state — is t h e most interesting question. Since it is also the toughest quest i o n t o answer, o u r projections for market share have a l o w e r p r o b a b i l i t y of b e i n g correct. A g a i n , w e draw o n the northeastern e x p e r i e n c e as a possible clue t o t h e f u t u r e in t h e Southeast. We assume that t h e n u m b e r of b a n k i n g and S&L offices is a fair measure of c o m p e t i t i v e strength in retail b a n k i n g activities. We expect S&Ls in t h e five southeastern states outside Florida t o be aggressive pricers a n d advertisers, p e r haps o f f e r i n g accounts for m i n i m u m balances in t h e $100 t o $500 range, generally l o w e r t h a n thrifts in C o n n e c t i c u t , M a i n e , N e w York, and N e w Jersey. Based o n the Northeast's e x p e r i e n c e , b a n k - t h r i f t market shares s h o u l d be fairly stable o n c e established. T h e r e f o r e , o n the basis of i n f o r m a l discussions a r o u n d t h e District, w e expect that S&Ls will get m o r e accounts per office, b u t that these accounts will be m u c h smaller than N O W balances at banks, many of w h i c h are likely t o begin o f f e r i n g N O W s w i t h m i n i m u m balances in t h e $1,200 t o $1,500 area. W e w o u l d expect, t h e r e f o r e , in Alabama, Georgia, Louisiana, Mississippi, and Tennessee: (1) that thrifts w i l l o p e n a b o u t t w i c e as many N O W accounts per o f f i c e as w i l l banks b u t (2) that banks' N O W accounts will average b e t w e e n t w o and t w o and one-half times as large as N O W accounts at thrifts. O u r market-share estimates are n o better t h a n these r o u g h " p r i n c i p l e s . " The Florida Question. Florida c o u l d f o l l o w either pattern. A t this p o i n t , w e are i n c l i n e d t o base o u r market share m o r e heavily o n t h e N O W experience in C o n necticut, M a i n e , N e w York, and N e w Jersey. Because Florida S&Ls will be o f f e r i n g personal c h e c k i n g accounts as w e l l as N O W s , S&Ls will have a smaller n u m b e r of N O W accounts in relation t o the n u m b e r of households than in t h e o t h e r five s o u t h eastern states. Florida banks w i l l be able t o price N O W s m o r e conservatively (successfully i m p o s i n g higher m i n i m u m balance requirements) a n d , t h e r e f o r e , garner a greater share of N O W balances than elsew h e r e in t h e District. In o u r j u d g m e n t , t h e C o n n e c t i c u t - N e w York pattern is p r o b a b l y m o r e likely t o e m e r g e . Table G reflects these assumptions. 4 Final Considerations. As many observers are p o i n t i n g o u t , t h e r e are several reasons w h y southeastern institutions m i g h t not e n t e r the market q u i t e as aggressively as was generally t h e case in t h e Northeast. M o r e is k n o w n a b o u t t h e p r o f i t risks of " g i v i n g N O W s a w a y " because thrifts are 4 Under the alternative a s s u m p t i o n s , o u r m e t h o d yields very different estim a t e s f o r F l o r i d a , as t h e r e a d e r c a n see b y c o m p a r i n g T a b l e s F a n d G. To project the amount of NOW balances for the Southeast, we first had to make projections of personal income by state for the fourth quarters of 1981, 1982, and 1983. We began with Commerce Department personal income data for the fourth quarter of 1979 — the latest available — a n d applied to those figures our own estimates of each state's growth in real personal income between 1979 and 8 not as strong here, outside Florida, at least. Southeastern institutions are characteristically m o r e conservative. These considerations all suggest a slower southeastern response. But t h e r e are also reasons, m o r e p o w e r f u l in our o p i n i o n , t o expect a q u i c k e r response than in t h e Northeast. N O W s will be national in 1981, w i t h attendant p u b l i city a n d w i t h o p e r a t i o n a l s u p p o r t facilities for hesitant institutions. Thrifts are n o w in an increasingly better position t o c o m p e t e w i t h c o n v e n i e n t , o n e - s t o p retail packages than mutuals or S&Ls w e r e in N e w England, N e w York, and N e w Jersey. Households have lived w i t h h i g h inflation longer n o w and are presumably m o r e interested in new ways t o get interest o n their m o n e y . T h e Southeast has m o r e i n - m i g r a t i o n and m o b i l i t y than the Northeast, w i t h a higher p r o p o r t i o n of p e o p l e establishing n e w retail financial relationships. N O W s w i l l p r o b a b l y begin in a phase of cyclical recovery w i t h a stable saving rate, u n l i k e t h e 1975-77 pattern of d i m i n i s h i n g saving rates. Finally, g r o w i n g interstate c o m p e t i t i o n in retail finance is also a d d i n g steadily t o competitiveness in large southeastern markets, s p u r r i n g t h e larger financial institutions' willingness t o innovate. O u r o w n feeling, initially, is these factors may w e l l p r e d o m i n a t e over traditional s o u t h e r n conservatism a n d , t h e r e f o r e , that o u r estimates of N O W activity are, if anyt h i n g , m o r e likely t o be l o w than high. 1983. We have also incorporated different assumptions of future inflation: 10 percent in 1980, 9 percent in 1981, 8 percent in 1982, and 7 percent in 1983. With the resulting personal income estimates and the NOW-income relationships extracted from the northeastern experience, we have prepared the state-bystate estimates of NOW balances shown in Tables A through G. S E P T E M B E R / O C T O B E R 1980, E C O N O M I C REVIEW < » .< * Banks Thrifts A. ALABAMA B. GEORGIA 1981 D. MISSISSIPPI Total N O W Balances (Million $) 65% Banks/35% Thrifts 80% Banks/20% Thrifts 130,000 70,000 FEDERAL RESERVE BANK OF ATLANTA 2,100 1,000 Total 200,000 340 1,700 310,000 170,000 680 170 2,200 1,000 Total 480,000 850 1,800 Banks Thrifts 460,000 240,000 1,150 290 2,500 1,200 Total 700,000 1,440 2,100 60% Banks/40% Thrifts 80% Banks/20% Thrifts Banks Thrifts 160,000 110,000 400 100 2,500 900 Total 270,000 500 1,900 Banks Thrifts 390,000 260,000 990 250 2,500 1,000 Total 650,000 1,240 1,900 Banks Thrifts 580,000 380,000 1,680 420 2,900 1,100 Total 960,000 2,100 2,200 65% Banks/35% Thrifts 80% Banks/20% Thrifts 140,000 70,000 320 80 Total 210,000 400 1,900 Banks Thrifts 330,000 170,000 780 200 2,400 1,200 2,300 1,100 Total 500,000 980 2,000 Banks Thrifts 480,000 260,000 1,340 340 2,800 1,300 Total 740,000 1,680 2,300 70% Banks/30% Thrifts 85% Banks/15% Thrifts 1,900 1,000 1981: Banks Thrifts Total 120,000 200 1,700 1982: Banks Thrifts 200,000 90,000 430 80 2,200 900 Total 290,000 510 1,800 1983: Banks Thrifts 290,000 130,000 750 130 2,600 1,000 Total 420,000 880 2,100 90,000 30,000 70% Banks/30% Thrifts E. TENNESSEE 270 70 Average N O W Balances (Dollars) Banks Thrifts Banks Thrifts C. LOUISIANA N u m b e r of Accounts 170 30 85% Banks/15% Thrifts Banks Thrifts 170,000 70,000 360 60 2,100 900 Total 240,000 420 1,800 Banks Thrifts 410,000 170,000 890 160 2,200 900 Total 580,000 1,050 1,800 Banks Thrifts 600,000 250,000 1,530 270 2,600 1,100 Total 850,000 1,800 2,100 9 Total N O W Balances (Million $) N u m b e r of Accounts 40% Banks/60% Thrifts Banks Thrifts F. FLORIDA Based on Massachusetts New Hampshire — Patterns 60% Banks/40% Thrifts 220,000 320,000 600 400 G. FLORIDA Based on Connecticut Maine — New York — New Jersey Pattern 1982: 1983: 2,700 1,300 Total 540,000 1,000 1,900 Banks Thrifts 510,000 770,000 1,580 1,050 3,100 1,400 Total 1,280,000 2,630 2,100 Banks Thrifts 760,000 1,130,000 2,740 1,820 3,600 1,600 Total 1,890,000 4,560 2,400 35% Banks/65% Thrifts 1981: Average N O W Balances (Dollars) 75% Banks/25% Thrifts 6,200 750 Thrifts 120,000 240,000 250 1,100 Total 360,000 1,000 2,800 10,400 Banks Banks 190,000 1,970 Thrifts 360,000 650 1,800 Total 550,000 2,620 4,800 10,400 Banks 330,000 3,420 Thrifts 620,000 1,140 1,800 Total 950,000 4,560 4,800 The estimates of the number of NOW accounts presented in Tables A through G reflect the following rules of thumb: Accounts per 100 Households C o n n e c t i c u t - N e w York Pattern Massachusetts-New H a m p s h i r e Pattern F o u r t h Q u a r t e r 1981 10 15 F o u r t h Q u a r t e r 1982 15 35 F o u r t h Q u a r t e r 1983 25 50 p r o b a b l y a p p l y i n g to Florida applying to Alabama, Georgia, Louisiana, Mississippi, Tennessee, a n d possibly to Florida To convert these ratios into number-of-accounts estimates, we employed 1978 Census Bureau data — the latest available — on the number of households in each state, extrapolating them into 1981-83 estimates by applying the annual percentage growth rates measured during the 1975-78 period. BE] 10 SEPTEMBER/OCTOBER 1980, ECONOMIC REVIEW Q D o Congress and the Administration agree on what to expect from the economy in 1980-81? Basically, they b o t h see the recession e n d i n g b e f o r e the e n d of 1980 and a r e t u r n to fairly even g r o w t h t h r o u g h 1981. The A d m i n i s t r a t i o n ' s midyear o u t l o o k calls for real GNP, w h i c h was e x p e c t e d t o fall at a 3-percent rate in the last half of 1980, t o g r o w at 2.6 p e r c e n t f r o m f o u r t h quarter 1980 t o f o u r t h quarter 1981. U n e m p l o y m e n t is e x p e c t e d t o rise t o 8.5 p e r c e n t by t h e f o u r t h quarter of 1980 and stay t h e r e for the next year. Inflation, as measured by the GNP deflator, is expected t o r e m a i n in t h e 9-percent range. The Congressional Budget O f f i c e in its July forecast sees t h e e c o n o m y m u c h the same as does the A d m i n i s t r a t i o n , a l t h o u g h it puts w i d e r ranges o n values of t h e forecast variables. The C B O sees u n e m p l o y m e n t rising to as high as 9.4 p e r c e n t in 1981, f o r example. A The Shape of the Recovery ivith Charles J. Haulk With the worst of the recession apparently behind us, business analysts are turning their attention to the recovery. In this interview (conducted in August), Business Economist Charles J. Haulk comments on the prevailing government forecast for the upcoming year and explains why he thinks the recovery could be sluggish after a strong start. FEDERAL RESERVE BANK OF ATLANTA Q D o you see any factors which could make the recovery differ from the consensus view? Yes. To begin w i t h , it appears that t h e recession has b e e n c o n f i n e d p r i m a r i l y t o autos and h o u s i n g and related industries. Seventy-five p e r c e n t of t h e G N P d r o p in the second quarter was attributable t o residential c o n s t r u c t i o n and c o n s u m e r d u r a b l e outlays, a very large p o r t i o n of w h i c h was in a u t o sales. Car sales, domestic and i m p o r t e d , p l u n g e d after t h e credit t i g h t e n i n g and credit restraint p r o gram in M a r c h . Changes in inventories A 11 w e r e small in real terms in the second q u a r t e r , contrary t o most expectations. The e x p o r t sector a n d g o v e r n m e n t s p e n d i n g s h o w e d small g r o w t h . Chart 1 REAL G N P GROWTH . . . Consensus as of Aug. 1980 .... The g o v e r n m e n t ' s m i d - y e a r forecast (Chart 1) shows a substantial real GNP d r o p in t h e t h i r d quarter and a small d e c l i n e in real G N P in the f o u r t h quarter, w i t h the recession e n d i n g b e f o r e the quarter is over a n d t h e n a r e t u r n t o fairly even g r o w t h t h r o u g h o u t 1981. M y alternative scenario, d e p i c t e d by t h e g r e e n bars, calls for a r e b o u n d of fairly strong dimensions in t h e f o u r t h quarter, maybe 4 p e r c e n t or higher. A f t e r t h e f o u r t h quarter, t h e strength of t h e recovery w e a k ens as m o n e t a r y restraint drives interest rates higher very q u i c k l y d u e t o fears o f r e k i n d l e d inflation a n d t i g h t e n i n g credit markets. U n e m p l o y m e n t rates in t h e 8-percent range w i l l likely not s u b d u e g r o w t h in c o m p e n s a t i o n or unit labor costs q u i c k l y e n o u g h t o change expectations of inflation substantially. N i n e t e e n eighty-one's second half c o u l d be a p e r i o d of very slow b u t positive g r o w t h , w i t h u n e m p l o y m e n t not i m p r o v i n g appreciably (Chart 2) a n d inflation s h o w i n g very slight i m p r o v e m e n t by year-end (Chart 3). This scenario, o r any o t h e r for that matter, d e p e n d s o n h o w soon the Federal Reserve is f o r c e d t o rein in m o n e y g r o w t h , w h i c h d e p e n d s , in t u r n , o n w h e t h e r t h e r e has b e e n a shift in t h e d e m a n d f o r m o n e y a n d a recovery f r o m that shift. If m o n e y g r o w t h is w e l l above Federal Reserve targets in the t h i r d q u a r t e r , that p r o b a b l y means t h e e c o n o m y is r e b o u n d i n g strongly a n d m o v i n g t o w a r d f u r t h e r g r o w t h in t h e f o u r t h quarter. If m o n e y g r o w t h is t a m e r , I t h i n k interest rates c o u l d r e m a i n steady at o r slightly b e l o w c u r r e n t levels, w h i c h appear t o be l o w e n o u g h t o c o n t i n u e e n c o u r a g i n g recovery, so either w a y the next f e w m o n t h s l o o k g o o d for real activity. The o n l y e x c e p t i o n w o u l d be if m o n e y g r o w t h is so fast that a r u n - u p in short rates of 300-400 basis points o c c u r r e d , p u t t i n g t h e housing and d u r a b l e g o o d s sectors o n t h e skids again, in w h i c h case t h e recovery 12 A n n . Rt. Alternative 1 • - • — Q3 Q4 I Q1 Q2 1980 Q3 Q4 1981 Chart 2 UNEMPLOYMENT RATE y h vl v h >/M 1980 vt 1981 Chart 3 IMPLICIT GNP 1980 4 % Chg., A n n . Rt. DEFLATOR 1981 w o u l d be forestalled b e f o r e it proceeds very far. The same m i g h t h o l d if t h e Fed l o w e r e d its m o n e y g r o w t h targets in fear of t o o fast a recovery a n d a r e k i n d l i n g of inflation fears. SEPTEMBER/OCTOBER 1980, E C O N O M I C REVIEW Q A What is the rationale for your alternative scenario? M y belief that t h e r e will be a sharp t u r n a r o u n d by the f o u r t h quarter is predicated o n t w o things. First, t h e history of recessions since the second W o r l d War is that, by and large, t h e d o w n t u r n and the recovery t e n d a p p r o x i m a t e l y to be m i r r o r images. The Q What effects do these structural changes have on the economy? Structural changes have created an e c o n o m y w h i c h resists d o w n turns and has great r e b o u n d capacity, b u t w i t h a strong inflationary bias. First, t h e r e has b e e n a d e c l i n e in the share of m a n u f a c t u r i n g , particularly durables, in t h e nation's o u t p u t and e m p l o y m e n t t o g e t h e r w i t h g r o w t h in the share of i n t e r est rate-/'nsensitive sectors, such as services and g o v e r n m e n t . Second, because g o v e r n m e n t participation in t h e e c o n o m y leans t o w a r d p r o t e c t i n g or creating jobs and maintaining spending power (unemploym e n t c o m p e n s a t i o n , trade adjustment c o m pensation, n e w jobs programs, etc.), behavior of the private sector has been altered in a way w h i c h leads t o expectations of m o n e tary a n d fiscal stimulus at the first i n d i c a t i o n of u n e m p l o y m e n t rate increases. A FEDERAL RESERVE BANK O F ATLANTA d r o p in real G N P in t h e second quarter was the largest absolute o n e - q u a r t e r d e c l i n e and the second largest percentage d r o p in the history of m o d e r n GNP a c c o u n t i n g , 34 b i l l i o n 1972 dollars and 9.1 p e r c e n t , respectively. A fast u p t u r n is almost surely c o m ing. Secondly, t h e r e are crucial changes in t h e structure and institutions of the e c o n o my w h i c h some e c o n o m e t r i c models have either d i s c o u n t e d o r i g n o r e d altogether and w h i c h have led t o forecasting errors in recent years. These expectations of p r o m p t stimulus have steadily pushed u p w a r d the u n e m p l o y m e n t rate at w h i c h inflation begins t o slow and also have pushed higher t h e u n e m p l o y m e n t rate r e q u i r e d t o p r o m p t r e d u c e d wage demands. This has led t o an increase in the fraction of t h e labor force persistently o u t of w o r k or u n d e r e m p l o y e d . T h i r d , the g r o w t h of the u n d e r g r o u n d e c o n o m y , w h i c h is p r e d o m i n a n t l y serviceo r i e n t e d a n d , t h e r e f o r e , not interest ratesensitive, creates additional recession resistance and recovery potential. These plus t h e cost of g o v e r n m e n t a l regulations and o t h e r rigidities create a situation w h e r e inflation is harder and harder t o c o n t a i n . The situation w e face n o w and f o r t h e foreseeable f u t u r e is an e c o n o m y w i t h sectoral hardship in a f e w areas but o n e w i t h a lot of i n h e r e n t overall strength. The p r o b lem is that, w i t h each recovery, inflation gets worse. 13 D o you see any particular developments which will definitely play a role in the recovery? The hefty 14.7-percent increase in Social Security benefits boosted personal i n c o m e in July. The savings rate, w h i c h had risen for o n e q u a r t e r , will likely not rise f u r t h e r . That means relatively strong c o n s u m p t i o n s p e n d i n g w i l l r e t u r n , especially in view of t h e e l i m i n a t i o n of credit controls. A This is an election year. How will fiscal policy affect the recovery? N e w factory orders for d u r a b l e goods, o t h e r than transportation, actually rose in June, and n o n d u r a b l e orders w e r e a b o u t u n c h a n g e d f r o m M a y , indicating some t u r n - a r o u n d in m a n u f a c t u r i n g may be c o m ing by early fall. July d u r a b l e goods orders rose by over $6 b i l l i o n . Total labor force g r e w by 780,000 f r o m A p r i l t o July, a sign that p e o p l e are still relatively optimistic about finding work. The p e n t - u p d e m a n d for cars, c o m b i n e d w i t h the n e w , small lines of domestic autos, s h o u l d p r o v i d e a m u c h n e e d e d lift t o the auto makers and their workers. Chart 4 FEDERAL DEFICIT/SURPLUS Bil. $, Ann. Rt. . . . Consensus as of Aug. 1980 . . . . The federal b u d g e t has m o v e d steeply i n t o deficit and s h o u l d be acting to c o n t a i n the recession. W i t h a tax cut likely early next year, the Federal G o v e r n m e n t w o u l d r e m a i n stimulative unless substantial s p e n d i n g cuts w e r e also f o r t h c o m i n g (Chart 4). W i t h an e l e c t i o n c o m i n g u p in N o v e m b e r , it is p r o b a b l y safe t o say that t h e r e c o u l d be some surprises o n the fiscal f r o n t , either b e f o r e or after the election o r b o t h . It also seems safe to say that fiscal policy will remain stimulative for a w h i l e l o n g e r , alt h o u g h not as m u c h as some w o u l d wish. Alternative A In any event, unless there are expectational effects f o l l o w i n g the N o v e m b e r elect i o n that are strong e n o u g h t o have an 14 1980 - 40 - 80 1981 i m m e d i a t e impact o n inflationary t e n d e n cies, 1981 does not appear t o be a very robust year. We c o u l d g o t h r o u g h a n o t h e r roller coaster year, w i t h swings less t u r b u lent than in 1980. SEPTEMBER/OCTOBER 1980, E C O N O M I C REVIEW Some people speak of a "full employment budget" being in surplus, thus making fiscal policy not stimulative at all. Apparently, you are unconvinced by this view. ln previous Review articles, you predicted the Southeast would fare better than the nation. What is the current outlook? There is a c o n c e p t in the e c o nomics literature called the ""full e m p l o y m e n t surplus or d e f i c i t " w h i c h calculates t h e federal deficit by estim a t i n g revenues that w o u l d be f o r t h c o m i n g if t h e e c o n o m y w e r e at full e m p l o y m e n t , c u r r e n t l y d e f i n e d at 5.1-percent u n e m p l o y m e n t . Those w h o accept the c o n c e p t argue that w e are c u r r e n t l y restrictive w i t h fiscal policy. M y o w n o p i n i o n is that t h e c o n c e p t of full e m p l o y m e n t is t o o arbitrarily d e f i n e d a n d does not adequately take i n t o a c c o u n t t h e reality that inflation n o w worsens l o n g b e f o r e a 5-percent u n e m p l o y m e n t rate is reached. M o s t of the District has o u t p e r f o r m e d t h e nation d u r i n g t h e recession, a l t h o u g h high u n e m p l o y m e n t in Alabama and Tennessee b r o u g h t overall u n e m p l o y m e n t in the District t o 7.8 p e r c e n t in July, e q u a l l i n g t h e national rate. The m o r e favorable industry mix in t h e Southeast, the lack of o v e r b u i l d i n g p r i o r t o t h e onset of recession, a n d special factors in Florida a n d Louisiana have kept t h e District as a w h o l e in g o o d shape. Barring a c o m p l e t e collapse of the national recovery, the Southeast s h o u l d c o n t i n u e t o o u t p e r f o r m the nation t h r o u g h o u t t h e r e m a i n d e r of 1980 a n d 1981. Q A Q Could you c o m m e n t further on the prospects for the longer term, especially with regard to inflation? As I m e n t i o n e d earlier, o u r econo m y has u n d e r g o n e several i m p o r t a n t changes w h i c h create a bias t o w a r d inflation and resistance t o d o w n t u r n . These d e v e l o p m e n t s create a particularly d i f f i c u l t situation for m o n e t a r y policy. In o r d e r t o decelerate inflation, t h e e c o n o m y has t o be slowed sufficiently t o alter expectations and c u r b wage d e m a n d s in the heavily u n i o n i z e d sectors, particularly d u r a b l e goods m a n u f a c t u r i n g and c o n s t r u c t i o n . Unless progress can be m a d e in A FEDERAL RESERVE BANK O F ATLANTA Q A r e d u c i n g wage d e m a n d s , t h e n , overall d e m a n d s must be restrained f u r t h e r t o slow inflation. W i t h an e c o n o m y i n h e r e n t l y strong d u e t o structural changes that have o c c u r r e d , it becomes necessary t o inflict ever m o r e crushing b u r d e n s o n d u r a b l e goods, particularly autos a n d h o u s i n g , t o accomplish d e m a n d restraint sufficient t o r e d u c e inflation. The longer t e r m o u t l o o k f o r inflation will likely n o t i m p r o v e substantially until t h e g o v e r n m e n t ' s p r o - e m p l o y m e n t , j o b and i n c o m e p r o t e c t i n g policies, and the g o v e r n m e n t ' s i n f l u e n c e o n wage setting, are c h a n g e d . 0R] 15 Commentary Inflation: Still Our Number One Problem by Harry Brandt ER's Commentary section presents personal opinion on topics of current interest: in this issue, why is inflation so dangerous and so difficult to control? Because inflation has become embedded in our economy, the author argues, only a major, wide-ranging attack can break inflation's stranglehold. T h e U.S. e c o n o m y is e m e r g i n g f r o m a recession w h i c h many observers are calling " s h o r t " in d u r a t i o n a n d "slightly worse than m o d e r a t e " in severity. To many of t h e w o r k e r s w h o w e r e laid off o r lost t h e i r jobs, of course, t h e r e was n o t h i n g " m o d e r a t e " a b o u t it. The cost of recessions, in terms of h u m a n suffering, s h o u l d not be m i n i m i z e d . Recessions, h o w e v e r , are cyclical p h e n o m e n a ; they d o not intrinsically w e a k e n t h e e c o n o m y over t h e l o n g run. Inflation, o n t h e o t h e r h a n d , is a m o r e sinister l o n g - t e r m p r o b l e m w h i c h u n d e r mines the f o u n d a t i o n s of o u r e c o n o m y . Despite t h e recession, o u r n u m b e r o n e p r o b l e m is still inflation, and w e can o n l y c o n t r o l it by attacking its u n d e r l y i n g causes. Inflation is not a n e w p h e n o m e n o n . W h a t is n e w and d i s t u r b i n g is its accelerat i o n in recent years. From 1.8 percent b e t w e e n 1950 and 1965 a n d 4.4 p e r c e n t f r o m 1965 t o 1973, t h e average annual inflation rate (measured by t h e C o n s u m e r Price Index) j u m p e d t o 9.4 p e r c e n t in the last six years and t o p p e d 14 in t h e first half of 1980 (Chart 1). M e a s u r i n g inflation in terms of t h e G N P i m p l i c i t price d e f l a t o r , w h i c h is technically a better measure of t h e actual inflation p e o 16 ple e x p e r i e n c e , does not change t h e basic pattern of accelerating inflation. W h e n w e l o o k at t h e rate of inflation for t h e year f o l l o w i n g each recession (Chart 2), w e see t h e rise of inflation (measured by t h e C o n s u m e r Price Index) f r o m a s o m e w h a t d i f f e r e n t perspective: Since 1955, inflation started f r o m a higher base after each successive recession. W h e t h e r this happens o n c e again, in t h e aftermath of t h e c u r r e n t recession, w i l l d e p e n d in part o n t h e policies f o l l o w e d in t h e i n t e r i m . The d i s t u r b i n g t r e n d , h o w e v e r , suggests t h e r e is an " u n d e r l y i n g " rate of inflation w h i c h c o n t i n u e s rising t h r o u g h e c o n o m i c e x p a n sions and contractions. W h y is l o n g - r u n inflation such a serious p r o b l e m ? Assuming a l o n g - r u n inflation rate of 10 p e r c e n t (a f i g u r e p i c k e d for illustrative purposes only), this is w h a t a dollar w e put in a n o n - i n t e r e s t - e a r n i n g account today w o u l d be w o r t h : 39 cents after 10 years, 15 cents after 20 years, 6 cents after 30 years, and 1 cent after 50 years. Inflation is clearly intolerable. A l t h o u g h it benefits some groups, it tends t o h u r t savers, lenders, a n d those o n f i x e d incomes. It causes distortions in t h e e c o n o m y a n d can u n d e r m i n e political institutions. A l l o w e d t o c o n t i n u e , it can precipitate a b r e a k d o w n in SEPTEMBER/OCTOBER 1980, E C O N O M I C REVIEW % Chg. from Yr. Ago 1 — 18 Consumer Price Index Inflation is accelerating. GNP Implicit Price Deflator o '80 1st half % Chg. from Yr. Ago — 18 Consumer Price Index and starts higher after each recession. 76 '80 1st half t h e f u n d a m e n t a l structures of society. For this o v e r r i d i n g reason, u n c h e c k e d , e n d e m i c inflation is m o r e d a n g e r o u s than s h o r t - t e r m recession. Inflation must be r e d u c e d and controlled. In o r d e r t o attack this p r o b l e m successfully, FEDERAL RESERVE BANK OF ATLANTA w e must first u n d e r s t a n d the forces responsible for t h e accelerated inflation. Some of those forces bear m o r e blame than others. M a n y are interrelated, and most acted w i t h d i f f e r e n t intensity at d i f f e r e n t times. Yet, they have all played a part. 17 High Federal spending boosted deficit, while. Money growth was too rapid, Chg. f r o m Yr. A g o % of G N P Total Federal Spending Fiscal Policy Monetary Policy To many minds, t h e first is t h e federal g o v e r n m e n t ' s p o o r l y designed e x p e n d i t u r e and r e v e n u e policies. Too m u c h fiscal stimulus tends t o push total resource d e m a n d in t h e e c o n o m y b e y o n d w h a t can be supplied at existing prices. M e a n w h i l e , m o n e t a r y policy, instead of r e d u c i n g inflation, has c o n t r i b u t e d historically t o t h e inflation process by p e r m i t t i n g t o o fast a rate of m o n e y g r o w t h (Chart 4). The expansion in t h e m o n e y supply over t h e last t w o decades has b e e n generous, e x c e e d i n g t h e e c o n o m y ' s average real ^ g r o w t h rate by a substantial margin. In fact, by t h e traditional M - 1 d e f i n i t i o n , m o n e y has g r o w n faster than real o u t p u t in each of the last 16 years, t h e r e b y p r o v i d i n g fuel t o the inflation. W i t h t h e V i e t n a m war, federal s p e n d i n g relative t o G N P began t o rise sharply, a n d by 1975, t h e f e d e r a l g o v e r n m e n t was s p e n d i n g an a m o u n t equivalent t o 231/2 percent of GNP (Chart 3). M o r e recently, this ratio has leveled off at a b o u t 22 percent. The most d r a m a t i c s p e n d i n g increases have b e e n in t h e f o r m of transfer payments (such as Social Security, u n e m p l o y m e n t insurance, a n d M e d i c a r e ) . Federal grantsin-aid, t h r o u g h w h i c h h i g h w a y , mass transit, e d u c a t i o n , and p o l l u t i o n c o n t r o l m o n e y is f u n n e l e d , also increased rapidly as a p e r cent of GNP and had m u c h of t h e same effect. This acceleration in p r i m a r i l y n e w social programs clearly c o m p o u n d e d o u r inflation p r o b l e m . The result has b e e n an almost u n b r o k e n string of annual b u d g e t deficits. Deficit f i n a n c i n g has c o v e r e d t h e red ink b u t has c r o w d e d o u t private b o r r o w e r s f r o m t h e credit markets at times w h e n overall credit d e m a n d s have been h i g h . 18 Fast m o n e y g r o w t h and h i g h rates of inflation g o t o g e t h e r . T h e r e is a close historical relationship b e t w e e n m o n e y g r o w t h To attack inflation successfully, SEPTEMBER/OCTOBER 1980, E C O N O M I C REVIEW and was tracked by prices after two years. Saving rate dropped sharply, contributing to... % Chg. f r o m Yr. A g o % of Personal I n c o m e Saved Saving Rate "Lagged 24 m o n t h s I '61 1 '65 I I '70 '75 I '80 '50 '60 '70 '75 '80 1st half 1st half Lagging Investment and prices (the G N P price deflator), lagged 24 m o n t h s (Chart 5). In o t h e r w o r d s , overly rapid m o n e y g r o w t h intensifies inflation a b o u t t w o years later. The Federal Reserve has a c k n o w l e d g e d , in retrospect, that t h e overexpansion of m o n e y a n d credit over >much of this p e r i o d has c o n t r i b u t e d i m p o r tantly t o t h e acceleration of inflation, but in t h e last year, t h e Fed increased its resolve not t o repeat this pattern in t h e f u t u r e . O n e i m p l i c a t i o n of this resolve t o h o l d d o w n m o n e t a r y g r o w t h is that t h e a d d i tional f e d e r a l b o r r o w i n g is even m o r e likely t o c r o w d private b o r r o w e r s o u t of the credit markets. we must understand the forces responsible for it. FEDERAL RESERVE BANK OF ATLANTA Fiscal and m o n e t a r y policies are t w o of t h e most i m p o r t a n t forces b e h i n d o u r inflat i o n p r o b l e m , but t h e r e is a n o t h e r that, at t h e same t i m e , has h e l d d o w n t h e g r o w t h in o u r e c o n o m y ; n a m e l y , lagging saving a n d investment. U.S. households are c o n s u m i n g m o r e and saving less. U.S. businesses have cut back, if not reversed, t h e t r e n d of substituting capital for labor. Capital investment has been w e a k , b o t h t h e a m o u n t of p r o d u c t i v e capacity and its efficiency have suffered, and t h e result has b e e n a n o t h e r c o n t r i b u t i o n t o the u p w a r d pressure o n prices. The d r o p in t h e saving rate (the p r o p o r t i o n of i n c o m e saved rather than spent) since 1975 has been r e m a r k a b l e and dist u r b i n g (Chart 6). Faced w i t h accelerating inflation not m a t c h e d by after-tax i n c o m e , t h e c o n s u m e r has b e e n increasingly inclined t o " b u y n o w rather than later" a n d t o spend a larger p r o p o r t i o n of his paycheck d o i n g it. As that same c o n s u m e r has seen t h e real value of his saving d i m i n i s h e d by inflation, he has b e e n understandably reluctant t o d e v o t e a higher p r o p o r t i o n of his i n c o m e t o savings. This r e d u c e d rate of savings and t h e larger rate of c o n s u m p t i o n have c o m b i n e d t o d i m i n i s h b o t h t h e f i n a n cial capital a n d t h e p r o d u c t i v e resources available f o r n e w plant a n d e q u i p m e n t . 19 which also fell as percent of GNP. lower plant and equipment spending 7 Bil. of 1972 $ N e w Plant a n d Equipment Spending — 150 8 % of G N P Plant and Equipment 5 yr. mvg. avg. Spending (Ratio Scale) Plant and Equipment Employment - 10 - 9 —100 _ 5q I '55 '60 '70 '80 1st half N e w plant and e q u i p m e n t s p e n d i n g increased sharply f r o m 1960 t o 1969, e x c e e d ing e m p l o y m e n t g r o w t h . But after 1969, plant a n d e q u i p m e n t s p e n d i n g slowed w h i l e e m p l o y m e n t accelerated (Chart 7). A l t h o u g h t h e r e is m o r e than o n e explanat i o n for this, w e k n o w that some businesses raised o u t p u t by a d d i n g employees instead of e q u i p m e n t . A n d even some of t h e e q u i p m e n t that businesses b o u g h t a d d e d n o t h i n g t o capacity but was installed t o r e d u c e p o l l u t i o n or fuel costs. C o n s e q u e n t l y , d u r i n g t h e seventies, annual plant and e q u i p m e n t s p e n d i n g , as a p e r c e n t of GNP, actually fell slightly (Chart 8). This s l o w d o w n of t h e seventies contrasts sharply w i t h t h e capital b o o m of t h e sixties, w h i c h was p r o p e l l e d by c o r p o r a t e i n c o m e tax r e d u c t i o n s , d e p r e c i a t i o n liberalization, and t h e t h e n n e w investment tax credit. Such business tax reforms n o m i n a l l y l o w e r e d c o r p o r a t e i n c o m e tax liabilities d u r i n g m u c h of t h e sixties. But w h e n y o u take Inflation causes distortions in the economy and can undermine political institutions. Allowed to continue, it can precipitate a breakdown in some of the fundamental structures of society. 20 SEPTEMBER/OCTOBER 1980, E C O N O M I C REVIEW „ Business tax reforms were offset by inflation. % of R e a l Corporate Income (adjusted for of Tax Income U.S. capital investment rate trailed Japan and Germany. 10 % of impact Additions to Fixed GNP Capital inflation) Liabilities — - 70 - 60 Japan — 40 — 30 - 20 — 10 Germany U.S. - 50 I '55 > 70 '60 I '77 i n t o account t h e c o m p l e t e impact of inflat i o n , as Chart 9 does, y o u can see that the tax c u t t i n g was t e m p o r a r y and partly illusory. By 1977, c o r p o r a t e i n c o m e tax liabilities adjusted for inflation had r e t u r n e d t o t h e high level of t h e mid-fifties. Thus, t h e distorting effects of inflation o n depreciat i o n and inventories have substantially o f f set t h e entire business tax relief of t h e past t w o decades. H i g h taxes, of course, r e d u c e t h e dollars available for investment in plant and e q u i p m e n t and r e d u c e profitability. •73 I '76 '79 This means t h e U n i t e d States is d e v o t i n g a smaller share of o u r G N P t o capital investm e n t than are many o t h e r countries, a m o n g t h e m , Japan and G e r m a n y (Chart 10). T h e savings rates of these t h r e e countries present a similar pattern. Varying institutional arrangements m a k e such international comparisons tricky, b u t t h e fact remains that w e are d e v o t i n g a smaller share of o u r p r o d u c t i o n t o t h e e n h a n c e m e n t of p r o d u c t i v e facilities. N O T E : C h a r t 9 is b a s e d o n d a t a in M a r t i n F e l d s t e i n a n d L a w r e n c e S u m m e r s , Inflation and the Taxation of Capital I n c o m e in the C o r p o r a t e Sector, W o r k i n g Paper No. 312, N a t i o n a l B u r e a u o f E c o n o m i c R e s e a r c h , Ine For this overriding reason, unchecked, endemic inflation is more dangerous than short-term recession. F E D E R A L RESERVE B A N K O F ATLANTA 21 U.S. productivity dropped and fell increasingly behind other countries. 11 % Chg. O u t p u t per _ Man-hour Manufacturing ( N o n f a r m Business) _ 8 Productivity 1967=100 Japan 220 France Italy W. G e r m a n y 160 Canada — '78 Productivity and Wage Trends Low rates o f capital investment are related t o a n o t h e r p r o b l e m : the lag in p r o d u c t i v i t y , d e f i n e d as o u t p u t per m a n - h o u r . The g r o w t h of U.S. p r o d u c t i v i t y (Chart 11) fell f r o m 2.4 p e r c e n t annually b e t w e e n 1950 and 1965 t o 2 p e r c e n t b e t w e e n 1965 and 1973 a n d t o n i n e - t e n t h s of 1 p e r c e n t b e t w e e n 1973 and 1978. D u r i n g 1979 and t h e first half of 1980, p r o d u c t i v i t y actually declined. As y o u w o u l d expect, t h e U.S., in terms of m a n u f a c t u r i n g p r o d u c t i v i t y , has fallen increasingly b e h i n d o t h e r m a j o r industrial countries (Chart 12). This has severely r e d u c e d o u r competitiveness at h o m e and abroad. From a cost s t a n d p o i n t , o u r p o o r p r o d u c tivity p e r f o r m a n c e must be f u r t h e r w e i g h e d 22 against t h e pressure for h i g h e r wages as w o r k e r s try t o offset t h e squeeze o n t h e i r incomes by inflation. The f o l l o w i n g figures s h o w t h e extent of this " c o s t - p u s h " inflation. D u r i n g t h e sixties, average annual p r o d u c t i v i t y rose 2.5 percent, c o m p e n s a t i o n rose 4.9 percent, and unit labor costs (roughly the d i f f e r e n c e b e t w e e n t h e t w o ) rose 2.3 percent. This was o n e of t h e p r i m e reasons for t h e l o w rate of inflation d u r i n g this p e r i o d . But in t h e seventies, the situation c h a n g e d : Productivity gains fell, c o m p e n s a t i o n g r o w t h rose sharply, and, as a result, unit labor costs t r i p l e d , t o 6.9 percent. So it is not surprising that u n d e r these pressures t h e inflation rate was m u c h higher (7.1 percent) d u r i n g this decade t h a n t h e o n e before. SEPTEMBER/OCTOBER 1980, E C O N O M I C REVIEW Federal regulations mushroomed, energy costs skyrocketed, 13 14 w Thous. of pages, A n n . $ per Retail - Federal Register Gal. Rt. _ so - 60 Gasoline Price 1.20 1.00 1st half ' 8 0 Bil. Budgets: Regulatory 56 Federal 6 Agencies 0.50 0.20 '80 1st half Government Regulation Energy Prices W h e n it comes t o inflation, g o v e r n m e n t regulations must also s h o u l d e r some b l a m e because h o w e v e r socially desirable they may be, they increase costs and prices. T h e g r o w t h in t h e n u m b e r of pages in t h e Federal Register, s h o w n in Chart 13, illustrates t h e m u s h r o o m i n g of regulations over this p e r i o d . The explosive increase in the b u d gets of 56 federal agencies w h i c h regulate business is a n o t h e r indicator of this t r e n d . Yet, of the many forces c o n t r i b u t i n g t o inflation, the q u a n t u m j u m p in energy prices has perhaps b e e n t h e most n o t i c e able. Thanks largely t o OPEC, the retail gasoline price (Chart 14) has j u m p e d f r o m 20 cents per gallon in 1950 t o a b o u t $1.20 recently. Higher energy costs m e a n higher energy prices, u n q u e s t i o n a b l y . But some o t h e r industrial nations i m p o r t a greater p r o p o r t i o n of their energy supplies than w e do, a n d yet they have had better results w i t h inflation. Energy costs have c o n t r i b u t e d w i t h t h e i r increase, but o n l y because w e have failed to achieve a lessening of inflat i o n elsewhere in the e c o n o m y . O n e reliable study estimated that t h e annual cost of m e e t i n g federal regulations f o r c o n s u m e r p r o d u c t safety, j o b safety, e n v i r o n m e n t a l p r o t e c t i o n , paper w o r k , a n d o t h e r areas t o t a l e d $102.7 b i l l i o n in 1979. This a m o u n t , w h i c h includes administrative a n d c o m p l i a n c e costs, was e q u i v a l e n t t o a b o u t 4 p e r c e n t of GNP. N O T E : C h a r t 13, " B u d g e t s " p o r t i o n , is b a s e d o n data i n t h e s t u d y by M u r r a y L. W e i d e n b a u m , " T h e H i g h C o s t o f G o v e r n m e n t R e g u l a t i o n , " in Challenge, N o v e m b e r / D e c e m b e r 1979. F E D E R A L RESERVE B A N K O F ATLANTA 23 Consumers spent more, saved less. and the dollar weakened. 15 Feb. 1973=100 Dollar Exchange Rate of Personal I n c o m e Saved Saving Rate - 100 - 90 - - I '74 I I '76 I I '78 4 80 I '80 '50 '60 '70 '75 '80 1st half Weakness of the Dollar Inflationary Expectations N o list of inflationary influences w o u l d be c o m p l e t e w i t h o u t c i t i n g t h e weakness of t h e dollar in t h e f o r e i g n exchange markets compared to other major foreign currencies. T h e 1973 dollar d e v a l u a t i o n a n d t h e f u r t h e r fall in t h e dollar exchange rate (Chart 15) have raised t h e cost of w h a t w e i m p o r t and have lessened t h e price c o m p e t i t i o n f r o m imports o n domestically p r o d u c e d products. The b r o a d peak in t h e dollar back in 1976 marks t h e last t i m e that U.S. inflation was l o w a n d e x p e c t e d t o be l o w in c o m p a r i s o n w i t h o t h e r industrial nations. Inflationary expectations, m e a n i n g t h e anticipation of c o n t i n u e d i n f l a t i o n , is t h e last but not least of t h e forces b e h i n d inflat i o n . M u c h of t h e inflationary m o m e n t u m built into t h e e c o n o m y has c o m e f r o m t h e e x p e c t a t i o n of e m p l o y e r s that inflation w o u l d c o n t i n u e , thus p e r m i t t i n g t h e m t o pass g e n e r o u s wage increases along t h r o u g h h i g h e r prices. I n d e x i n g of wages and prices has b o t h reflected and c o n t r i b u t e d t o these expectations. I n d e e d , if it persists l o n g e n o u g h , inflation begins t o affect t h e psychology of most groups, especially consumers. Seeing t h e purchasing p o w e r of their i n c o m e e r o d e d by inflation, consumers, since a b o u t 1970, have r e d u c e d t h e p e r c e n t of i n c o m e saved ( w h i c h , as w e saw earlier, has r e d u c e d capital available for investment) a n d , instead, have spent a n d b o r r o w e d m o r e freely (refer t o Chart 6, repeated above). This urge t o b u y has a d d e d directly t o t h e d e m a n d for goods a n d services, resulting in higher prices. 24 SEPTEMBER/OCTOBER 1980, E C O N O M I C REVIEW Inflationary Forces Fiscal Policy Monetary Policy Saving and Investment Productivity and Wage Trends Government Regulation Energy Prices Remedies Restrain Federal Reduce Money Teamwork: Lower Reduce Alternative Energy Inflation Inflationary Expectations Reduce Inflation FEDERAL RESERVE BANK OF ATLANTA Wage Increases Regulation Reduce But fiscal a n d m o n e t a r y restraint a l o n e are not e n o u g h . To stimulate investment and p r o d u c t i v i t y , w e s h o u l d r e d u c e c o r p o rate i n c o m e taxes and accelerate depreciat i o n schedules. To raise p r o d u c t i v i t y , w e also n e e d m o r e t e a m w o r k and less c o n f r o n t a t i o n b e t w e e n g o v e r n m e n t a n d business a n d b e t w e e n business and labor. A n d Growth Reduce Corporate Income Taxes Weakness of the Dollar The forces c o n t r i b u t i n g t o inflation are c o m p l e x a n d deep-seated. Yet, o n c e w e have i d e n t i f i e d these forces, some remedies present themselves. O u r list is not meant t o be c o m p l e t e . To shed t h e inflationary effects of fiscal policy, w e n e e d most of all t o restrain Federal s p e n d i n g . In t h e area of m o n e t a r y p o l i cy, it is i n c u m b e n t for t h e Federal Reserve t o r e d u c e m o n e y g r o w t h over a l o n g time. This goes t o t h e r o o t of t h e inflation p r o b l e m and is, t h e r e f o r e , essential t o any p r o g r a m for c u r b i n g inflation. Spending Sources t h e l o w e r the w a g e increases, t h e l o w e r t h e inflation w i l l be. W e must r e d u c e g o v e r n m e n t regulation. W e must push harder for alternative energy sources t o r e d u c e o u r d e p e n d e n c e o n oil. A n d w h e n w e achieve a steady r e d u c t i o n of inflation, b o t h the weakness of t h e dollar internationally and t h e pervasive m o m e n t u m of inflationary expectations will take care of themselves and begin c o n t r i b u t i n g t o disinflation. T h e r e is obviously n o t h i n g novel a b o u t these suggestions. They have b e e n p r o posed by a lot of o t h e r p e o p l e . But t o a large extent, they have not b e e n put into effect. Yet, inflation has b e c o m e so e m b e d d e d in o u r e c o n o m y that o n l y a major battle w a g e d o n many fronts, a i m e d at breaking t h e inflationary pattern, has any h o p e of m o v i n g this p r o b l e m f r o m its n u m b e r o n e position. BE] 25 W o r k i n g Paper Review T h e f o l l o w i n g a r t i c l e is a staff r e v i e w of a m o r e c o m p l e t e s t u d y in t h e F e d e r a l R e s e r v e B a n k of A t l a n t a W o r k i n g P a p e r s e r i e s . Barbara Henneberry Robert E. Keleher James G. Witte 1919-39 Reassessed: Unemployment and Nominal Wage Rigidity in the United Kingdom T h e h i g h u n e m p l o y m e n t of t h e 1919-39 period in t h e United K i n g d o m was related t o t h e d e t e r i o r a t i o n in flexibility of a g g r e g a t e n o m i n a l wages. T h e a u t h o r s a r g u e t h a t t h e m o r e rigid wage levels w e r e primarily d u e t o t h e g r o w i n g power of t r a d e u n i o n s a n d t o expanded social legislation ( e . g . , u n e m p l o y m e n t i n s u r a n c e a n d m i n i m u m w a g e laws). N O T E : Barbara H e n n e b e r r y , economist, lives in Bloomington, Indiana. Robert E. Keleher is a Financial Economist at the Federal Reserve Bank of Atlanta. James G. Witte, deceased, was o n the e c o n o m i c s faculty at Indiana University. 26 It is b e c o m i n g increasingly clear that many of t h e e c o n o m i c p r o b l e m s of t h e postW o r l d W a r II era are r o o t e d in t h e policies, social attitudes, a n d institutional changes of t h e 1920s a n d 1930s. It was d u r i n g this p e r i o d b e t w e e n W o r l d War I a n d W o r l d War II that, because of t h e alleged b a n k ruptcy o f traditional t h e o r y , influential e c o n o m i c t h i n k e r s persuaded policymakers t o a d o p t a " n e w " (Keynesian) e c o n o m i c t h e o r y . C o n t e n d i n g that m u c h o f this " n e w " t h e o r y and policy o f t h e i n t e r - w a r p e r i o d was n o t o n l y unnecessary b u t actually destructive t o e c o n o m i c stability, t h e authors of this W o r k i n g Paper have focused o n some o f t h e changes w h i c h t o o k place in t h e labor markets a n d labor market institutions in t h e U n i t e d K i n g d o m f r o m 1919 t o 1939. A n i m p o r t a n t e l e m e n t o f pre-Keynesian e m p l o y m e n t t h e o r y was that a flexible n o m i n a l wage structure facilitates t h e e q u i l i b r a t i o n of t h e labor market. In times of high u n e m p l o y m e n t , f o r e x a m p l e , e m p l o y e r s c o u l d hire m o r e w o r k e r s if wages w e r e l o w e r e d . C o n t e m p o r a r y e c o n o m i c t h e o r y and policy, o n t h e o t h e r h a n d , c o m m o n l y assume a d e g r e e of n o m i nal wage rigidity (wages w i l l n o t fluctuate u p and d o w n ) a n d shelve t h e larger t o p i c of wage flexibility a n d its determinants. This attitude derives largely f r o m Keynes, w h o b l a m e d t h e sluggish British e c o n o m y o f t h e 1920s o n t h e policies pursued by t h e m o n e tary authorities a n d n o t o n labor market SEPTEMBER/OCTOBER 1980, E C O N O M I C REVIEW c o n d i t i o n s ( w h e r e t h e m o n e y w a g e rate was actually t o o high for full e m p l o y m e n t , given t h e rate of interest). In this W o r k i n g Paper, H e n n e b e r r y , Keleher, a n d W i t t e r e e x a m i n e the m o n e y wage issue. Britain is e x a m i n e d because it constitutes o n e of the first experiences of a relatively rapid d e t e r i o r a t i o n of n o m i n a l wage flexibility in a m o d e r n industrial e c o n o m y . M o r e o v e r , the " n e w " economic theory developed within this c h a n g e d institutional e n v i r o n m e n t . The authors c o n c l u d e that t h e h i g h u n e m p l o y m e n t of t h e i n t e r w a r p e r i o d in Britain was i n d e e d related t o the d e t e r i o r a t i o n in flexibility of aggregate n o m i n a l wages. The e m p i r i c a l data indicate that a certain d e g r e e of n o m i n a l wage flexibility existed in Britain u n t i l a b o u t 1922. N o m i n a l wages, in o t h e r w o r d s , fell significantly in t h e face of high levels of u n e m p l o y m e n t , a n d this wage r e d u c t i o n served t o e l i m i n a t e a substantial a m o u n t of that u n e m p l o y m e n t . The data also clearly indicate that this relative d e g r e e of n o m i n a l wage flexibility was never e x h i b i t e d after 1922. The principal reasons f o r this shift t o m o r e rigid wage levels i n t h e 1920s, the authors a r g u e , w e r e (1) the g r o w t h in t h e p o w e r a n d i n f l u e n c e of trade u n i o n s a n d (2) t h e effects of social legislation, i n c l u d i n g u n e m p l o y m e n t insurance and m i n i m u m wages (together w i t h t h e absence of significant i m m i g r a t i o n f r o m 1904 t o 1930). Trade u n i o n m e m b e r s h i p , for e x a m p l e , d o u b l e d f r o m 1914 t o 1920, u n i o n s became m o r e centralized, and strike activity increased substantially. Thus, e m p l o y e r s became m o r e reluctant t o risk costly clashes w i t h labor, a n d wage rigidity was s t r e n g t h e n e d . Social legislation, particularly t h e Trade Boards A c t of 1918, r e d u c e d wage flexibility by t r a n s f o r m i n g t h e wage b o a r d i n t o a wage control mechanism for unorganized industries instead of simply enforcers of the m i n i m u m w a g e law. A t t h e same t i m e , FEDERAL RESERVE BANK OF ATLANTA British e x p e n d i t u r e s o n u n e m p l o y m e n t insurance benefits increased 52 f o l d b e t w e e n 1920 and 1922. As a result, u n e m p l o y e d w o r k e r s c o u l d n o w refuse t o w o r k at less than t h e standard rate and still c o n t i n u e t o d r a w benefits. The u n e m p l o y m e n t insurance p r o g r a m also relieved t h e u n i o n s of t h e responsibility f o r t h e u n e m p l o y e d ; this b u r d e n was shifted to t h e taxpayers. The authors, t h e n , show that the loss of n o m i n a l wage flexibility in Britain d u r i n g this i n t e r w a r p e r i o d was related t o the g r o w i n g strength of labor unions, the rapid expansion of u n e m p l o y m e n t insurance, a n d t h e regulation of certain wages by trade boards. Because t h e British e x p e r i e n c e was a m o n g t h e first w i t h such rapid institutional change, the authors i d e n t i f y it as a harb i n g e r for " o t h e r Western industrialized societies that are, even today, c o n t i n u i n g t o e l i m i n a t e t h e self-regulating character of t h e i r respective labor markets." If Britain is, in fact, such a h a r b i n g e r , this rigidification of t h e n o m i n a l w a g e structure has i m p o r tant implications f o r e c o n o m i c policy relating t o stabilization a n d inflation as w e l l as t o longer t e r m policies relating t o labor market conditions. 0R] 1919-1939 Reassessed: Unemployment and Nominal Wage Rigidity in the U.K., by Barbara Henneberry, Robert E. Keleher, and James G. Witte, August 1980, 40 pp. Bibliography. A copy of this study is available upon request to the Research Department, Federal Reserve Bank of Atlanta, P.O. Box 1731, Atlanta, Georgia 30301. 27 Robert E. Keleher Supply-Side Effects of Fiscal Policy: Some Preliminary Hypotheses R e d u c t i o n s in tax r a t e s t e n d t o increase t h e supply of labor b e c a u s e of s h i f t s f r o m leisure t o w o r k a n d f r o m n o n - m a r k e t t o m a r k e t activity. They also i n c r e a s e t h e supply of capital because of s h i f t s f r o m c o n s u m p t i o n t o savings a n d i n v e s t m e n t activity a n d f r o m tax s h e l t e r s t o m o r e p r o d u c t i v e u s e s of capital. In a paper p u b l i s h e d in June 1979 as part of t h e Federal Reserve Bank o f Atlanta's Research Paper Series, Robert E. Keleher discussed some key issues s u r r o u n d i n g tax cuts a n d , i n particular, e x a m i n e d t h e effects o f tax cuts o n t h e " s u p p l y - s i d e . " A longer article based o n t h e Research Paper appeared i n t h e S e p t e m b e r / October 1979 Economic Review, but because of t h e recent, increased att e n t i o n t o t h e t o p i c , a brief o u t l i n e of some of t h e paper's major points may be of interest t o some readers. In particular, t h e political c a m p a i g n and t h e " t a x r e v o l t " have focused a t t e n t i o n o n t h e e c o n o m i c effects o f a major tax cut. O p p o n e n t s of a tax c u t fear that increased c o n s u m e r s p e n d i n g a n d an increased g o v e r n m e n t deficit will result in higher inflation. In t h e debate over t h e effects o f c u t t i n g taxes, many economists of b o t h Keynesian a n d monetarist persuasions have focused almost entirely o n h o w tax cut policies affect aggregate d e m a n d . Because o f this p r e o c c u p a t i o n w i t h aggregate d e m a n d , these economists d o n o t distinguish b e t w e e n t h e e c o n o m i c effects o f tax cuts a n d g o v e r n m e n t s p e n d i n g increases o r b e t w e e n tax rate changes and tax r e v e n u e changes. A c c o r d i n g t o economists ( i n c l u d i n g Keleher) w h o s u p p o r t t h e so-called " s u p p l y - s i d e " view, tax rate cuts n o t o n l y affect disposable i n c o m e b u t also may i n d u c e changes i n t h e supplies of factors of p r o d u c t i o n such as labor and capital and h e n c e changes in aggregate p r o d u c t i o n , supply a n d e c o n o m i c g r o w t h . Tax rate changes, they argue, are relative price changes and thus will affect choices b e t w e e n w o r k a n d leisure, c o n s u m p t i o n a n d saving-investment, a n d market and n o n market activity. These changes i n t h e supply of factors of p r o d u c t i o n t o t h e market e c o n o m y c o n s e q u e n t l y affect aggregate supply a n d e c o n o m i c g r o w t h . Supply-side effects, in their view, are a 28 SEPTEMBER/OCTOBER 1980, E C O N O M I C REVIEW key t o the l o n g - t e r m g r o w t h of the e c o n o m y . For those economists, t h e n , these effects are m o r e relevant t o g r o w t h t h e o r y and policy than t o stabilization t h e o r y ( w h i c h seeks t o c o n t r o l s h o r t - t e r m , cyclical f l u c t u a t i o n s in t h e e c o n o m y ) . A l t h o u g h most economists agree that the supply-side effects of fiscal policy exist and that these effects have l o n g b e e n neglected in m a c r o e c o n o m i c s , Keleher says t h e r e is still m u c h disagreement a b o u t t h e policy i m p l e m e n t a t i o n of these ideas. If the e c o n o m y is o n t h e u p p e r p o r t i o n of the so-called "Laffer C u r v e , " for example ( w h e n , theoretically, rising tax rates d i m i n ish incentives t o w o r k and t o supply capital and eventually reduce tax revenues), t h e n the substantial increase in tax rates in recent years has i n d u c e d a slowd o w n in aggregate market p r o d u c t i o n that, t o g e t h e r w i t h u n d i m i n i s h e d monetary expansion, has p r o d u c e d " s t a g f l a t i o n " (i.e., t h e coexistence of high rates of i n f l a t i o n a n d sluggish real e c o n o m i c growth). A c c o r d i n g l y , supporters of this v i e w r e c o m m e n d a r e d u c t i o n in tax rates w h i c h they c o n t e n d w i l l increase p r o d u c t i o n (aggregate supply), the tax base, a n d , c o n s e q u e n t l y , tax revenues. They argue f u r t h e r that if such policies are c o u p l e d w i t h a gradual d e c e l e r a t i o n in t h e g r o w t h of t h e m o n e y supply, such tax cuts can c o n t r i b u t e t o slowing the rate of inflation. O t h e r economists have questions a b o u t the location of the e c o n o m y o n the "Laffer C u r v e , " the m a g n i t u d e of t h e supply-side effects, and the t i m i n g of the effects. Empirical tests of refutable tax cut hypotheses, they argue, have not b e e n c o n d u c t e d . Tax cuts, in their view, c o u l d create pressures t o m o n e t i z e t h e increased deficit and thus create inflationary pressures in t h e short run. Supply-side theorists r e s p o n d that these are s h o r t - t e r m uncertainties w h i c h d o not invalidate the l o n g - t e r m supply-side effects of a c o n sistent fiscal a n d m o n e t a r y policy. FEDERAL RESERVE BANK OF ATLANTA Proponents of the supply-side t h e o r y i n c l u d e those economists w h o s u p p o r t tax c u t t i n g policies in o r d e r t o slow t h e increase in total g o v e r n m e n t s p e n d i n g (as a p r o p o r t i o n of GNP). Instead of m a k i n g decisions a b o u t g o v e r n m e n t s p e n d i n g in isolation f r o m decisions a b o u t r e v e n u e c o l l e c t i o n and taxation (as is c u r r e n t l y the case), they argue, the electorate s h o u l d first d e c i d e a b o u t levels of taxation and t h e n allow its representatives to allocate these revenues. Keleher's study analyzes specifically h o w these " s u p p l y - s i d e " tax cuts i n f l u e n c e (a) incentives, (b) t h e market supplies of factors of p r o d u c t i o n , and (c) aggregate supply. A l t h o u g h the study is in the nature of " s o m e p r e l i m i n a r y hypotheses," Keleher concludes that reductions in tax rates t e n d t o increase the supply of labor services because of shifts f r o m leisure t o w o r k and f r o m n o n m a r k e t t o market activity. They also increase the supply of capital because of (a) shifts f r o m c o n s u m p t i o n t o savings and investm e n t activity a n d (b) f r o m tax shelters t o m o r e p r o d u c t i v e domestic uses of capital. C o n s e q u e n t l y , such restrictions in tax rates are likely t o increase t h e e c o n o m y ' s aggregate supply of real goods and services. In a c o n c l u d i n g section, Keleher also summarizes some of the criticisms and various implications of the " s u p p l y s i d e " position. 01] Supply-Side Effects of Fiscal Policy: Some Preliminary Hypotheses, by Robert E. Keleher, June 1979, 24 pp. Bibliography. A copy of this study is available upon request to the Research Department, Federal Reserve Bank of Atlanta, P.O. Box 1731, Atlanta, Georgia 30301. 29 ALSO AVAILABLE WORKING PAPER SERIES: Estimating Sixth District Consumer Spending by Brian D. Dittenhafer Changes in Seller Concentration in Banking Markets by B. Frank King Regional Impacts of Monetary and Fiscal Policies in the Postwar Period: Some Initial Tests by William D. Toal A Framework for Examining the Small, Open Regional Economy: An Application of the Macroeconomics of Open Systems by Robert E. Keleher Southern Banks and the Confederate Monetary Expansion by John M. Godfrey An Empirical Test of the Linked Oligopoly Theory: An Analysis of Florida Holding Companies by David D. Whitehead Regional Credit Market Integration: A Survey and Empirical Examination by Robert E. Keleher Entry, Exit, and Market Structure Change in Banking by B. Frank King Future Holding Company Lead Banks: Federal Reserve Standards and Record by B. Frank King Money-Income Causality at the State-Regional Level by Robert E. Keleher and Charles J. Haulk The Influence of Selected Factors on the Slowdown in Southeastern Manufacturing Productivity by Charlie Carter 1919-1939 Reassessed: Unemployment and Nominal Wage Rigidity in the U.K. by Barbara Henneberry, Robert E. Keleher, and James G. Witte Home Office Pricing: The Evidence from Florida by David D. Whitehead 30 SEPTEMBER/OCTOBER 1980, E C O N O M I C REVIEW Copies of these publications are available upon request from: Research Department, Federal Reserve Bank of Atlanta, P.O. Box 1731, Atlanta, Georgia 30301. Please include a complete mailing address with ZIP Code to ensure delivery. Interested parties may also have their names placed on a subscription list for future studies. RESEARCH PAPER SERIES: No. 1 Impact of Holding Company Affiliation on Bank Performance: A Case Study of Two Florida Multibank Holding Companies by Stuart G. Hoffman No. 2 No. 3 Convenience and Needs: Holding Company Claims and Actions by Joseph E. Rossman and B. Frank King Small Banks and Monetary Control: Is Fed Membership Important? by William N. Cox, III No. 4 Component Ratio Estimation of the Money Multiplier by Stuart G. Hoffman No. 5 Holding Company Power and Market Performance: A New Index of Market Concentration by David D. Whitehead No. 6 Fundamental Determinants of Credit Volume: A Survey and Regional Application by Robert E. Keleher No. 7 State Usury Laws: A Survey and Application to the Tennessee Experience by Robert E. Keleher No. 9 Supply-Side Effects of Fiscal Policy: Some Preliminary Hypotheses by Robert E. Keleher No. 10 An Empirical Analysis of Sectoral Money Demand in the Southeast by Stuart G. Hoffman FEDERAL RESERVE BANK OF ATLANTA 31 Federal Reserve Bank of Atlanta P.O. Box 1731 Atlanta, Georgia 30301 Bulk Rate U.S. Postage PAID Atlanta, Ga. Address Correction Requested Free subscription and additional copies available u p o n request to the Information Center, Federal Reserve Bank of Atlanta, P.O. Box 1731, Atlanta, Georgia 30301. M a terial herein may be reprinted or abstracted, provided this Review, the Bank, and the author are credited. Please provide this Bank's Research Department with a copy of any publication in which such material is reprinted. Permit 292
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