Full text of Policy Statement and Position Papers : March 3, 1997

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University of Rochester
William E. Simon Graduate School of
Business Administration

BRADLEY POLICY
RESEARCH
CENTER
SHADOW OPEN MARKET COMMITTEE
(SOMC)
Policy Statement and Position Papers
March 2-3,1997
PPS 97-01
Public Policy Studies
Working Paper Series

TABLE OF CONTENTS

Page
Table of Contents

SOMC Members

SOMC Policy Statement Summary

Policy Statement

Notes on the Economy
H. Erich Heinemann

Medicare Reform
Lee Hoskins

Maintaining Healthy Economic Performance
Mickey D. Levy

Social Security Reform
Charles I. Plosser

The Boskin Commission Report
William Poole

Recent Behavior of Various Monetary Aggregates
Robert H. Rasche

SHADOW OPEN MARKET COMMITTEE

The Shadow Open Market Committee met on Sunday, March 2, 1997 from 2:00
p.m. to 6:30 p.m. in Washington, DC.

Members of the SOMC:

Professor Allan H. Meltzer; Graduate School of Industrial Administration; Carnegie
Mellon University; Pittsburgh, Pennsylvania 15213 (412-268-2282 phone, 412-268-7057
fax, am05@andrew.cmu.edu); American Enterprise Institute; Washington, DC (202-8627150 phone)
Mr. H. Erich Heinemann; Heinemann Economic Research; Division of Brimberg &
Co.; 7 Woodland Place; Great Neck, NY 11021-1034 (516-466-3893 phone, 516-4663872 fax)
Dr. W. Lee Hoskins, Chairman and CEO; Huntington National Bank; 41 S. High Street;
Columbus, Ohio 43287 (614-480-4239 phone, 614-480-5485 fax)
Dr. Mickey D. Levy, Chief Financial Economist; NationsBanc Capital Markets, Inc.; 7
Hanover Square, New York, New York 10004 (212-858-5545 phone, 212-858-5741 fax,
mlevy@ncmi-ny.com)
Dean Charles I. Plosser; William E. Simon Graduate School of Business Administration
and Department of Economics; University of Rochester; Rochester, New York 14627
(716-275-3316 phone, 716-275-0095 fax, plosser@mail.ssb.rochester.edu)
Professor William Poole; Department of Economics; Brown University; Providence,
Rhode Island 02912 (401-863-2697 phone, 401-863-1970 fax, williampoole@brown.edu)
Professor Robert H. Rasche; Department of Economics; Michigan State University;
East Lansing, Michigan 48823 (517-355-7755 phone, 517-432-1068 fax,
rasche@pilot.msu.edu)
Dr. Anna J. Schwartz; National Bureau of Economic Research; 50 E. 42nd Street; New
York, New York 10017-5405 (212-953-0200/ext. 106 phone, 212-953-0339 fax,
aschwar 1 @email.gc.cuny .edu)

SOMC POLICY STATEMENT SUMMARY

WASHINGTON, DC, March 3—The Shadow Open Market Committee today
called on the Federal Reserve "to reduce inflation to zero." The SOMC warned the Fed
not to meddle with the stock market. "The central bank should not adjust monetary
policy to affect stock market valuations."
The SOMC, a group of academic and business economists who comment
regularly on public policy, said the Clinton Administration was wrong in its views about
inflation.
"The 1997 Economic Report of the President is mistaken when it argues that the
costs of reducing inflation to zero exceed the benefits.

The experience since 1991

illustrates that the alleged trade-off is unreliable. Moreover, the ... report ignores the fact
that the benefits of zero inflation are permanent while any short-term loss of output is
temporary."
The SOMC, which meets in March and September, was founded in 1973 by
Professor Allan H. Meltzer of Carnegie-Mellon University and the late Professor Karl
Brunner of the University of Rochester.
The SOMC recommended that "growth of the monetary base should not exceed 2
percent this year." In the year ended February, the monetary base—bank reserves and
currency—grew approximately 5.4 percent. Achieving its policy recommendation, the
SOMC said, "will require a near-term increase in the Federal funds rate target."
The committee said the current upswing in business—now "71 months old, more
than 60 percent longer than the average postwar expansion"—"shows no sign of dying of
old age or exploding into an inflationary boom."
The SOMC also attacked President Clinton's budget for fiscal year 1998. "The
President's budget promises balance in 2002. Even if it could be achieved, balance in
2002 is a hollow accomplishment. The budget would be out of balance in 2003 and
subsequent years. Unless much more is done to reduce spending, the budget deficit
would rise year after year to record peacetime levels.

"Everyone who has looked seriously at the budget problem knows that the longterm problem cannot be solved without reducing spending for pensions and health care.
A responsible government would begin to address these long-term problems now, when
changes can be phased in gradually. The President's budget not only fails to address
these long-term problems, it adds to them by expanding old programs and introducing
new ones."
"The Republican leadership has apparently decided to act as if the President's
budget is a responsible start on a plan for fiscal balance. If the President agrees to more
capital gains tax reduction, the Republican leadership appears willing to accept spending
increases and potentially large new spending programs. Neither party mentions near-term
spending reduction."

SHADOW OPEN MARKET COMMITTEE
Policy Statement
March 3,1997

Inflation has fallen slowly. Predictions that low unemployment must be followed
by rising inflation have been proved wrong. Inflation and unemployment have fallen
together in this expansion. As we have written repeatedly, the unemployment rate is an
unreliable guide to inflation.
The current expansion is 71 months old, more than 60 percent longer than the
average postwar expansion. The expansion shows no sign of dying of old age or
exploding into an inflationary boom. This experience should be put to rest the idea that
expansions "run out of steam" or that inflation is inevitable. But it raises an important
question: Why is this cycle different?
A DIFFERENT POLICY
Higher inflation accompanies lower unemployment only if monetary policy
accommodates excess spending. Until recently, monetary policy has not encouraged
rapid growth in spending. Partly by chance and partly by explicit decision, the Federal
Reserve did not reproduce the pattern of rapidly rising money growth and spending
typical of the 1965-1980 period. Instead, monetary policy tightened in 1994 following
an acceleration in money growth.

The Federal Reserve should build upon its

achievement by continuing disinflationary policy.
The current expansion started slowly. Many observers criticized the Federal
Reserve because the slow pace of recovery contributed to rising unemployment. These
criticisms were wrong; they ignored the longer-term benefits of moderate, disinflationary
Federal Reserve policy that prolonged the expansion while reducing inflation. Contrary
to the Council of Economic Advisers, lower inflation did not exact a cost in higher
unemployment or lower output since 1991.

Chart 1 compares the acceleration of monetary policy in three long expansions—
1961-69, 1982-90, and the current expansion. The chart shows the difference between
the 12-month growth rate of the monetary base—bank reserves and currency—and
growth of the base in the last twelve months before the expansion began.
The three cycles are strikingly different. The monetary base accelerated in the
1960s as did spending and inflation.

When inflation began to rise, monetary policy

became more expansive. In 1969, the Federal Reserve reversed its course, bringing the
expansion to an end.
Growth of the monetary base rose and fell several times during the 1980s
expansion. The trend of base money growth declined as did the rate of inflation. At the
end of that decade, base growth rose, as did inflation. In the 1980s the base accelerated
modestly, and the rate of inflation fell.
The most recent cycle shows that policy on average has been disinflationary.
There is some sign of acceleration in the base at the end of the period.
Chart 2 repeats the comparison for accelerations of M 2 . The details differs, but
the thrust is similar. The 1960s show substantial acceleration from the pre-expansion
period. The 1980s show less acceleration on average. The recent acceleration is more
marked for M2 than for the base and suggests that inflation will begin to increase if
growth of these monetary aggregates remains high.
Chart 3 shows the monthly unemployment rate for the same periods. Differences
between the three periods are small. Unemployment reached a lower level in the 1960s,
but it is now generally understood that the lower rate was unsustainable, and
unemployment has not returned to that rate.
The charts suggest a simple answer to the question: Why is inflation lower? The
single, most important difference, we believe, is money growth has been slower.

MONETARY POLICY
Since the fall of 1996, all of the monetary aggregates have either accelerated or
achieved stable growth at a substantially higher level. If monetary growth continues at
current levels, spending and inflation will rise.

At our last meeting, we urged the Federal Reserve to reduce the growth rates of
the monetary base and other monetary aggregates to achieve zero inflation. We repeat
that recommendation and add another: Reduce money growth both to prevent inflation
from rising and to end inflation.

Growth of the monetary base should not exceed 2

percent this year. This policy will require a near-term increase in the Federal funds rate
target.
Our recommendation to the Federal Reserve is to reduce inflation to zero. The
central bank should not adjust monetary policy to affect stock market valuations.
The 1997 Economic Report of the President is mistaken when it argues that the
costs of reducing inflation to zero exceed the benefits.

The experience since 1991

illustrates that the alleged tradeoff is unreliable. Moreover, the Council's report ignores
the fact that the benefits of zero inflation can be made permanent while any short-term
loss of output is temporary.

THE BOSKIN COMMISSION'S REPORT
Economists have known for many years that the Consumer Price Index overstates
the rate of inflation. Actual inflation is lower than reported inflation as measured by the
CPI. The main issue is the size of the overestimate.
The members of the Boskin Commission are highly qualified economists. Their
report places the overestimate at 1.1 percent a year.
Over time, a 1.1 percent error has a large effect on spending, the budget deficit,
measurement of productivity and income. Mismeasurement of inflation distorts our
knowledge about the economy, benefits some and penalizes others. People with pensions
indexed to the CPI, including all social security recipients, receive excess compensation
for inflation. If the 1.1 percent estimate is correct, indexed wage and spending programs
are about 30 percent higher than they would have been with accurate adjustment.
We share the Boskin Commission's view that the CPI should accurately reflect
the cost of living. We do not believe that the President or Congress should decide on the
size of the adjustment. The judgment is technical, not political. It would be a mistake to
make a political decision about how much to adjust the CPI.

We believe that Congress should appropriate money and fix a deadline for a
decision on the proper size of the adjustment. The Bureau of Economic Analysis (BEA)
in the Commerce Department has recently revised its price and output series. It has the
technical competence and professional standing to evaluate the work of the Boskin
Commission and decide on the best way to adjust the CPI.

BEA or some other

technically proficient group should be adequately financed to render this judgment.
Adjustment of the CPI should not be used as the solution to the long-term Social Security
problem. Congress and the President must agree on a structural adjustment.

THE BUDGET
The President's budget promises balance in 2002. Even if it could be achieved,
balance in 2002 is a hollow accomplishment. The budget would be out of balance in
2003 and subsequent years. Unless much more is done to reduce spending, the budget
deficit would rise year after year to record peacetime levels.
Under the President's proposal, outlays increase $250 billion in the next four
years. The projected deficit is larger in 1999 than in 1996. Reductions in the deficit
begin in 2000; much of the reduction is achieved either by tightening price controls on
doctors and hospitals or by selling assets.
Everyone who has looked seriously at the budget problem knows that the longterm problem cannot be solved without reducing spending for pensions and health care.
A responsible government would begin to address these long-term problems now, when
charges can be phased in gradually.
The President's budget not only fails to address these long-term problems, it adds
to them by expanding old programs and introducing new ones.

The Republican

leadership has apparently decided to act as if the President's budget is a responsible start
on a plan for fiscal balance. If the President agrees to more capital gains tax reduction,
the Republican leadership appears willing to accept spending increases and potentially
large new spending programs. Neither party mentions near-term spending reduction.

We have long favored fundamental tax reform, emphasizing lower rates and a
broader tax base, for the purpose of raising economic growth and reducing administrative
complexity. Neither political party has proposals consistent with these objectives.

MEDICARE, MEDICAID, AND SOCIETY SECURITY
Governments cannot deliver health care; that requires doctors, nurses, hospitals,
and pharmaceuticals. All government can do is redistribute the cost of health care and
change the demand for and supply of services.
As in all redistribution, some pay more and others benefit.

But, government

intervention in health care also distorts the pricing and use of medical services. The
distortions impose large costs on all of us by separating payment from procurement.
Neither patients nor providers have reason to care much about costs.
Congress should completely reform Medicare and Medicaid by removing the
principal causes of the distortions. Most health care should be privately financed and
privately provided.

Some redistribution to the poor should continue to provide a

minimum health standard. Universal catastrophic health insurance should support people
facing very large expenditures. Price controls and tax exemption for health insurance
should end.
Social Security faces a longer-term problem than is faced by Medicare and
Medicaid. Yet the problem is real and cannot be ignored. The sooner we, as a nation,
address these problems, the less painful and more equitable will be the adjustment.
The Advisory Council on Social Security could not agree on appropriate reform.
None of their proposals is appealing; a successful solution does not require massive
government involvement. A desirable reform would give individuals the choice between
an actuarially should government program and private management of retirement funds.

* Difference between 12-month

Chart 1: Acceleration in Monetary Base from Previous Trough

moving average of monetary base growth and 12-month moving average of monetary base growth in month of preceding business cycle trough

Digitized *
forDifference
FRASER between 12-month

Chart 2: Acceleration of M2 from Previous Trough*

moving average of M2 growth and 12-month moving average of M2 growth in month of preceding business cycle trough

Chart 3: Monthly Unemployment
12%

10%

i 111111111111111111 i 11111; i i; i 1111111 M 111 M 111111 i 1 1 : ; : : i i: i i 11; 11111111111 i i 1111 M 1111 ii 11111111111111111111111

1961

1963

1965

1967

1969

1982

1984

1986

1988

1991

1993

1995

1997

NOTES ON THE ECONOMY
H. Erich HEINEMANN
Heinemann Economic Research
Division of Brimberg & Co.
Federal Reserve Chairman Alan Greenspan cautioned Congress last week about
"the sharp rise in equity prices during the past two years." He conceded that it was
possible that "something fundamentally new about this current period" could keep Wall
Street on an escalator indefinitely. However, he noted that "history is strewn with visions
of such 'new eras' that, in the end, have proven to be a mirage."
We warned bluntly that "another recession will doubtless occur some day owing
to circumstances that could not be, or at least were not, perceived by policymakers and
financial market participants alike." The business cycle, he said, had not been repealed.
As in 1990, prior to the last recession, Mr. Greenspan seems determined to fulfill
his own prophecy. "Given the lags with which monetary policy affects the economy,..."
he said, "we cannot rule out a situation in which a preemptive policy tightening may
become appropriate before any sign of actual higher inflation becomes evident."
Though Mr. Greenspan would deny it, I believe there is ample evidence that
monetary policy is now sufficiently tight to push the economy into a recession. Any
further tightening would likely result in a deeper, longer downturn than otherwise and
increase the risk of an inflationary monetary policy in 1998 or 1999.
Since January 31, 1996 the Federal Reserve System has fixed overnight interest
rates at about 5.25 percent. The Fed's intention when it set this target was to promote "a
slight easing of monetary policy." In practice, things did not turn out as Mr. Greenspan
intended.
Total bank reserves, the raw material for the money supply, have declined in the
past year, even after adjusting for distortions created by so-called retail sweep accounts.
Meanwhile, the real effective exchange rate of the U.S. dollar has increased and the dollar
price of gold has collapsed. These are all classic symptoms of tight money.
As important, sweep-adjusted reserves fell at an annual rate of 0.13 percent during
the 36-month period ended in January, a record low growth rate. This is tight money. By

contrast, the three-year rate of reserve growth peaked close to 14 percent in 1993. A
similar drop in reserve expansion from 1987 through 1990 set the stage for the last
recession.

Retail sweeps are computer-driven manipulations of personal checking

accounts that banks use to lower the amount of non-interest-bearing reserves they keep on
deposit at Federal Reserve banks.
The sharp slowdown in monetary expansion over the last three years has already
resulted in a parallel deceleration in total spending and a severe profit squeeze in the retail
and service industries. Advance estimates by the Commerce Department show that
corporate profits declined in the fourth quarter.

Since profits were up a lot in big

companies, this suggests that profits of small firms were sharply lower.
This is crucial because small retail and service companies have created roughly
three-quarters of all net new jobs in the private sector over the past decade and 70.55
percent over the half century since World War II. As in 1990, when retail and service
hiring stops, the overall economy will go into reverse.
Fiscal policy is also tight. Washington—which keeps its books by an archaic set
of accounting rules that no sensible business would ever use—continues to be obsessed
with achieving a "balanced" federal budget. In reality, the Treasury's operating accounts
(revenues minus outlays except for net interest) already have a huge surplus.
This measure, the best yardstick of the government's impact on the economy, was
in the black by $107 billion in 1996—a record in dollar terms and the highest in a
generation as a percentage of gross domestic product (1.4 percent). That's a positive
swing of more than $200 billion since President Clinton took office. However, investors
should beware.

Operating surpluses in the Treasury budget have preceded every

recession since World War II.
Consumers normally buy big-ticket durable goods—for instance, automobiles and
appliances—with borrowed money.

Consumer spending for durables accounted for

almost 17 percent of the overall expansion of the economy in the past six years, well
above the 9.6 percent average during previous expansions.
Against this background, commercial banks have started to limit the availability
of consumer credit partly in reaction problems that borrowers have encountered in

servicing their debts. Delinquency on bank consumer loans, particularly credit card
loans, has increased substantially over the past two years. At finance companies that are
subsidiaries of automakers, loan delinquency rates rose to very high levels. Across the
country a record of more than 1 million individuals filed for bankruptcy last year.
The party line at the Federal Reserve is that the surge in Wall Street will offset
excessive consumer debt and leave the economy largely unaffected. I'm not so sure. The
four-way whammy of tight money, tight fiscal policy, dwindling profit margins that
undercut incentives to hire and debt-burdened consumers has tipped the economy into
recession in the past. It will do so again.

CYCLICAL CHANGES IN THE GROUTH OF BANK RESERUES

P
E 30.Ox
R
C
E 22.5X-I
N

30. Ox

Total Bank Reserves
K2.5X
15.OX

15.Ox
C
H
A
N
G
E

7.5*

I I I I I I I I I I I I 1 1 I I I I I I I I I I M I I'I I I I I I I I I'I I I I I I I I I I I I I I II'II TI II'II 11 I'I 111111111111111111111 I'm 11111111111111 n i r *~ f
-7.5x
Jan
Jan Jan Jan Jan
Jan
Jan Jan
Jan Jan
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996

Notes:

The chart shous yearly percent changes in total bank
reserves, adjusted for reserve requirement changes and
retail sweep activity. FRB data, seasonally adjusted in
current dollars. The vertical lines show recessions.

Sources:

Haver Analytics;

Heinemann Economic Research

.DX

CYCLICAL SUIMGS IN FEDERAL RESERUE POLICY

i i

11 — Domestic Monetary Base - FRB St. Louis

16x

12x

By.

\n
Jan
Jan
Jan
1951 1956 1961
Motes:

Jan
1966

Jan
Jan
1971 1976

Jan
1981

Jan
Jan
Jan
1986 1991 1996

The chart shous annual changes in the monetary base (FRB
St. Louis) minus U.S. currency held abroad plus an
adjustment for the effect of retail sueep activity.
Current dollars. The vertical lines shou recessions.

Sources: Haver Analytics;

Heinemann Economic Research

THE DOLLAR IS UP AND GOLD IS DOWN

I
N
D
E
X
1
9
9
0
Os

1
0
0

—
—

U.S. Dollar Index
London Gold Price

$420 $
P
$400 E
R

105 -I

10Z
$380 T
R
0
$360 V

0
$340 2

96
93 -I

$320
Jan

Notes:

Sources:

Jul
1993

Jan

Ju1
1994

Jan

Jul
1995

Jan

Jul
1996

Jan

The chart shous the J[.P. Morgan real effectiue exchange
rate index for the U.S. dollar (1990=100, left scale,
line) and the U.S. dollar price of gold in London
(right scale, dot).
Hauer Analytics;

Heinenann Economic Research

CYCLICAL CHANGES IN THE TREASURY'S OPERATING BUDGET
P
E 4*
R
C
E 2x

TT~\—r

I 4z

U.S. Treasury Operating Balance
2y.

-2y.

=4x
-6x

-6/.
Ql
1967

Notes:

Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
1970 1973 1976 1979 198Z 1985 1988 1991 1994 1997
The chart shous the U.S. Treasury's operating balance
(revenues minus outlays except net interest) as a percent
of gross domestic product. NIPA basis in current dollarsj
SAAR. The vertical lines show periods of recession.

Sources: Haver Analytics; Heinemann Economic Research

THE LONG-TERM TREND IN TOTAL TAXES

P 35/. E
R
G 30x
E
N
T 25*

[35/.
|

Government Receipts/GDP
30*
25/.

0
F 20x -

\2&/.

G
D 15/. P

1 1 15/.

10X J

IHUiI f 10x

1929
Notes:

1936

1943 1950

1957

1964

1971

1978

1985

1992

1999

The chart shous total receipts by federal, state and local
gowernnents as a percent of GDP. In current dollars, net
of federal grants-in-aid. The datum for 1996 is the
average for the first three quarters.

Sources: Haver Analljtics; Heinemann Economic Research

CHANGING PRIORITIES IN GOUERNNENT SPENDING

P
E 5GX -I
R
C
E 40X
N
T
30x
0
F
20X -I
G
D
P 10x -i

50x

Gov't Outlays ex Transfers
Transfer Payments

0
1928
Notes:

Sources:

1935

1942

1949

1956

1963

1970

1977

1984

1991

1998

The chart shows federal, state and local government spending as a percent of GDP — ex transfer payments (solid bar)
and transfer payments (shaded bar). Current dollars, net
of grants-in-aid. Break in series in 1959.
Haver Analytics;

Heinemann Economic Research

BANKS HAUE TIGHTENED UP OM CONSUMER LOANS

D
I
F
F
U
S
I
8
N
O

I
N
D -40
E
X
-80J

Ql
1966
Motes:

Ql
1969

Ql
1972

Ql
1975

Ql
1978

Ql
1981

Ql
1984

Ql
1987

Ql
1990

Ql
1993

Ql
1996

The chart shows the Federal Reserue Board index of bank
willingness to lend to consumers — the weighted responses
of banks more willing to lend minus those less willing.
IQ 1997 plotted. The vertical lines show recessions.

Sources: Haver Analytics; Heinemann Economic Research

Ql
1999

RETAIL « SERUICE J8BS D8MMATE PRIMATE EMPLBYMEMT

120x

1O0X

my.

1111 n o 1111 n W i 111111111111111111111111

Jan
1956
Motes:

Jan
I960

Jan
Jan
Jan
Jan
1964 1968 1972 1976

Jan
1980

Jan
Jan
Jan
Jan
1984 1988 1992 1996

The chart shous 10-year changes in retail and service
jobs as a percent of 10-year changes in total private
nonfarm payroll employment. Underlying data are thousands
of jobs, SA. The vertical lines show recessions.

Sources: Haver Analytics;

Heinemann Economic Research

THE SLQUDOUN IN CORPORATE PROFITS
P
E
R
C 30x
E
N
T 20x

C
H 10x
A
N
G
0
E

1—i

—

Federal Corporate Income Taxes

30x
ZOx

-J

r 10x

-lOx

-10*

Ql
1985

Motes:

Ql
1987

Ql
1989

Ql
1991

Ql
1993

Ql
1995

r—

Ql
1997

The chart shous annual changes in accruals of federal corpporate income taxes,' ex the Federal Reserve. 1997 data are
projections by the Bureau of Economic Analysis. Current $,
4Q moving averages. Uertical lines show the 1990-91 recession

Sources: Haver Analytics; Heinemann Economic Research

CYCLICAL CHANGES IN THE NABGINAL PROFITABILITY OF ENPLOYNENT

—

Profit per Job, Betailing fi Services
[ 75'/.

50x

25/.
to

-25/.
Ql
1977
Notes:

Ql
1979

Ql
1981

Ql
1983

Ql
1985

Ql
1987

Ql
1989

Ql
1991

Ql
1993

Ql
1995

Ql
1997

The chart shous annual changes in pretax profit per job in
the retail and service sectors, adjusted for shifts in
inventory valuation. In curent dollars. Third quarter
1996 plotted. The vertical lines show recessions.

Sources: Haver Analytics; Heinemann Economic Besearch

UNIT LABOR COSTS ARE DOWN IN MANUFACTURING, UP ELSEWHERE

-4x

l__

_
—
—

.-\

•

* f

V
^\

>A\/r
sk.

Ql
1980

Ql
1982

Ql
1984

Ql
1986

Ql
1988

\
\

-* i

V__ • « • •

z
.-- -•.""

•

^ V -* -. -

J 4x

-"" "•""""
.-•'

V - -

J—.—.—.—.—U H—i—1— i — r 1 H — i — i — r — T — i — i — i — i — i — i — i — i — i — i —

Ql
1978

16x

12*

\ /A

Motes:

Unit Labor Costs - Manufacturing
Unit Labor Costs - Nonnanufacturing

— —

p
E 16x
R
C
E 12*
N
T
8X
C
H
A 4x
N
G
0
E

Ql
1990

—i—i—i—i—i—i—i—i—i—i—i—i—i—r

Ql
1992

Ql
1994

Ql
1996

Ql
1998

The chart shous annual changes in unit labor costs in manufacturing (line) and in nonnanufacturing (nostly seruices
and construction, dot). Deriued fron BLS indexes, 1992 =
100. The vertical lines show recessions.

Sources: Haver Analytics; Heinenann Econonic Research

PR8DUCTIUITY IS UP IN MANUFACTURING, D8UN ELSEWHERE

P
E
R
C
E
N
T

Output per Hour - Manufacturing
Output per Hour - Nonnanufacturing

7.5x

5.0X

2.5*
C
H
A
M
G
E

-5.0X-U-T

Ql
1978
Motes:

Sources:

r—T—i—i—i—i—r—T"-\3 • U v X

Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
The chart shous annual changes in productivity in manufacturing (line) and in nonnanufacturing (nostly services
and construction, dot). Derived from BLS indexes, 1992 =
100. The vertical lines show recessions.
Haver Analytics;

Heinenann Economic Research

REAL WAGES ARE GOING UP

N3
ON

Notes:

The chart shows wage,and salary disbursements per hour to
all priuate workers, diuided by the chain weight deflator
for personal consumption expenditures (December 1996 equals
1G0). The vertical lines show the 1990-91 recession.

Sources: Haver Analytics; Heinemann Economic Research

THE CYCLICAL SHARE OF EXPANSION
Cumulative Changes in Output

|
9
| 11
8
10
12
Quarters of Expansion

1 9 9 1 - 1 9 9 7 Expansion

3 Prior Expansions

MEDICARE REFORM
LeeHOSKINS
The Huntington National Bank

THE PROBLEM
The Administration is pursuing legislation to control Medicare costs, partly in an
attempt to achieve a balanced budget and partly because the hospital trust fund portion of
Medicare will be broke as early as the year 2001. Yet there is nothing in the President's
proposal that effectively addresses the long-term problem of inefficiency and subsidized
consumption of medical services which is exacerbated by the same demographic trends
that plague Social Security. Tinkering with the current system may keep a lid on the
problem for a few more years but won't make it go away. Fundamental reform means
families and individuals must take responsibility for purchasing medical services or
insurance as they do for all other goods and services. If rational reform is started now, it
will cost less than reform by "crisis" later.
The problem as reviewed by Congress and much of the public is that the cost of
providing health care to future Medicare recipients will outgrow the ability of the
younger working population to finance it through payroll taxes:
For the last 15 years, the cost of Medicare has grown at an average annual rate of
11 percent, faster than any other federal program. To pay for those benefits, the
Medicare tax has exploded from 0.7 percent of the first $6,000 of wages 30 years
ago to 2.9 percent of every dollar of wages earned today. Medicare this year will
spend every penny of taxes it collects from workers, every penny of premiums
from beneficiaries, plus $60 billion of general revenues, and still will be forced to
draw down its reserves by $9.7 billion just to pay for current benefits. It gets
worse: Medicare will exhaust its cash reserve within four years and be $500
billion in debt in 10 years.
Add in the aging population, which will increase the number of new retirees by
800 percent in 15 years, and we have a real disaster on our hands. When
Medicare started in 1965 there were 5.5 workers for each of the 19 million
beneficiaries; today there are 3.9 workers for each of the 37 million beneficiaries.
Medicare trustees estimate that by 2030, when the last baby boomer turns 65,

there will be only 2.2 workers per beneficiary. That makes Medicare—which
depends on direct transfer payments from workers to retirees—unsustainable.1
While the financing of Medicare is in the spotlight, the real long-run disaster is
the misallocation of resources caused by government interference with the market
mechanism. Government laws, regulations, tax policy, and health care transfer programs
(such as Medicare and Medicaid) separate the payment for medical goods and services
from the procurement of those goods and services. By inflating demand and restricting
supply, the decoupling of payment and procurement drives up prices, which strains the
federal budget and distorts the allocation of society's economic resources.
Patients directly paid less than one-quarter of all health care expenses in 1990, up
from more than one-half before Medicare was enacted in 1965. (See Figure 1) Patients
paid an astonishingly small 5 cents out of every dollar of hospital charges in 1990. And
more than 80 cents on the dollar of physician fees were picked up by third parties,
including Medicare and Medicaid.2 The availability of steeply discounted medical goods
and services created a rush to stake health claims that raised Medicare spending, alone, to
2.6 percent of GDP last year.3

Medicare spending, as a share of GDP, is expected to

double by 2015, triple by 2030, and top 9 percent in 2070.4 (See Figure 2)
The anticipated increase in Medicare spending will be caused mainly by
escalating prices for medical goods and services.

Expected growth in enrollment

accounts for only a small share of the expected increase in spending, rising at an annual
rate of 1.2 percent between 1996 and 2002.5 Most of the increase in spending is the result
of growth in spending per enrollee. Increased spending per enrollee reflects increases in
the number and complexity of services demanded per enrollee and increases in prices,
both of which are inflated by the decoupling of the payment for and the procurement of
medical goods and services. The unfortunate consequence will be a misallocation of
resources that will undermine economic growth.

ECONOMICS 101 FOR HEALTH POLICYMAKERS
Health policymakers are faced with an indomitable fact of life that has marked
man's trek through time—scarcity.

There are, and always have been, an unlimited

number of competing uses to which man can devote his limited resources. Hence, even
the wealthiest of nations cannot have all it wants of everything. Choices must be made.
The problem of obtaining more or better medical care is painful testimony to this
pervasive and inescapable fact. Society simply does not have the resources to take all
known steps to prevent or cure illness and postpone death while continuing to meet the
claims of housing, food, and pursuits of

"the good life."

Moreover, classifying

particular economic goods such as housing, food, or medical care as "needs" does not
alter the fact that the world in which we live is one of too few resources relative to our
desires.
"Needs" are not readily observable absolutes, nor are they costless to satisfy.
Consequently, the problem society faces is to determine the level of medical "needs" or
wants it is willing to pay for. In other words, what are we willing to give up for more or
better medical care? To say we are willing to supply all that is "needed," while laudable,
is misleading.

At some point, society will find that additional resources are more

valuable in other areas.
Yet, the problem posed by scarcity is effectively dealt with daily in most areas of
our economy. Why does it seem to reach crisis proportion in the medical sector? An
important part of the answer can be found in the crippling of the market system usually
employed to resolve scarcity difficulties.
The U.S. economy relies primarily on private incentives and consumer wants
expressed through competitive market forces to settle problems posed by a world of too
few resources. The underlying notion behind this form of economic organization is
simply that individuals in their role as consumers and producers, by attempting to make
themselves better off, end up putting their privately owned resources to uses most highly
valued by society as a whole. That is, resources automatically would be put to socially
desirable uses and in the appropriate amounts. This notion works surprisingly well in a
market-oriented economy when markets are open to all comers and are allowed to
respond to competitive forces. All the information and incentives needed to make the
system work are guided by the "invisible hand" of the market.

The medical care system, for the most part, is shielded from this process, and
market forces are severely crippled. Because so few of the funds paid out for health and
medical care are private expenditures made in a market situation, the market signals
yielded are confused and often go unheeded. Little information is generated on the most
economically productive combination of medical resources (doctors, nurses, and
hospitals). For example, since neither doctors nor hospitals openly compete on price,
charges vary for similar services. Among other things, this lack of competition hides
information about the most efficient methods, hospitals, and doctors.
Even more of a problem is the decision about how much) care people want or
demand is separated from the decision on the amount to be supplied or financed through
programs such as Medicare. Supply and demand decisions pose a problem if they are
split up because individuals behave differently when making choice decisions through
groups (governments) than when making private decisions. For example, if a national
health program or insurance scheme is financed through government, as the MedicareMedicaid programs are, an individual citizen is involved in a "group" choice on the
amount of medical services to finance through government. Higher levels of medical
care then imply higher taxes for individuals. The gains (more or better medical care) are
weighed against the costs (higher taxes) by the individual through his Congressional
Representative and a specific level of care is set for a specific dollar amount in taxes.
Medical care on the supply side is in no sense "free."
But if the decision on the demand side to use medical care is an individual one
where a good deal of care is offered "free" (or at nominal charges) after joining the
program, then individuals would attempt to obtain more or better quality medical care
than they indicated they were willing to pay for through the group or government
decision. This behavior is perfectly consistent. Even under a government program, the
amount or quality of medical care people actually seek is a private decision or choice.
They weigh the added benefits from more service against the added cost. But since the
added cost is essentially zero or minimal to them once they have joined the program,
people seek more or better quality medical care than they would if each had to pay for it
out of his own pocket.

A simple analogy would be a luncheon in which a group of people agree to split
the bill. Each person has an incentive to order a more expensive lunch than the next
fellow, since everyone in the group will bear part of the added cost. As a result, the total
bill is likely to be larger than if each had agreed to pay for his own lunch separately.
It could be argued that a lower price or cost of "needed" care will not induce an
individual to purchase more of it. It is certainly true that for some types of medial care,
price will have little effect on the amount people seek. It is doubtful that a lower price
would have much influence on the number of broken limbs repaired or slashed arteries
stitched. But it may have a considerable impact on whether the more expensive hospitals
or doctors are selected. Thus, for medical care as a whole, price or cost does have an
impact on the amount and quality sought. People want ("need") more or better medical
care when the price to them is lower.
The outcome of splitting the supply and demand decision is that the actual
government expenditures run far in excess of the planning amounts. Congress tries to
limit the overruns since they imply even higher taxes. The outcome of such controls is a
breakdown in the quality of service. Doctors refuse to treat patients covered under
Medicare and Medicaid programs or give less time to them. A similar result occurs if
hospital charges are also directly controlled.

FUNDAMENTAL REFORM: INDIVIDUAL RESPONSIBILITY
The private enterprise system is able to allocate medical goods and services as
well as it allocates all other goods and services the economy supplies to meet consumer
demands. Without government interference, individuals would be responsible for paying
for their medical care or medical insurance as they were prior to the advent of Medicare
in 1965.

Tax preference also leads to "over consumption" of medical services.

Employees receive medical benefits without paying taxes on them and this tax preference
causes more medical benefits to be consumed than otherwise. Thus, fundamental reform
starts with making individuals more financially responsible for their consumption of
medical services.

Personal responsibility and reliance on market forces form the basis of Milton
Friedman's recommendation to reprivatize medical care:
The reform has two major steps: (1) End both Medicare and Medicaid and
replace them with a requirement that every U.S. family unit have a major medical
insurance policy with a high deductible, say $20,000 a year of 30 percent of the
unit's income during the prior two years, whichever is lower. (2) End the tax
exemption of employer-medical care; it should be regarded as a fully taxable
fringe benefit to the employee—deductible for the employer but taxable to the
employee. Each of these reforms needs further discussion.
Preferably, the major medical insurance policy should be paid for by the
individual family unit, which should receive a reduction in taxes reflecting the
reduction in cost to the government. There would be an exception for lowerincome families and for families who were unable to quality for coverage at an
affordable fee. The government would help them finance the policy though not
administer it. That would be done by private competitive insurers, chosen by each
individual or family separately. Each individual or family would, of course, be
free to buy supplementary insurance if it so desired.6
If reform of this magnitude is deemed political suicide by the Administration and
Congress, then at least the principle of increasing an individual's financial responsibility
for his medical care decision should be a guide post in their reforms.

Consideration

should be given to using vouchers for Medicare and Medicaid that would be used to
purchase HMO services. By setting the voucher at the rate charged by the most efficient
HMO's in a geographic area, Congress would encourage competition which would weedout inefficient suppliers of medical services. Congress would be relying on the market to
contain the rapid growth in per capita consumption of services by Medicare recipients.
If this proposal is deemed too bold by our current political leadership, then at a
minimum, Medicare recipients should have higher deductible or co-payments than they
do currently. This would push the problem back a few years, but that is probably all it
would do. Permitting anyone to pair a high deductible insurance policy with a Medical
Savings Account would go much further. The alternative is to do nothing and wait for
the inevitable budget crises to occur down the road. While this outcome may be the most
probable, it certainly will be the most costly.
To be successful, health care reformers must recognize the problem in the U.S.
health care industry and address its causes. The problem is that prices of medical goods

and services are so high and have been rising so fast relative to incomes that many people
are concerned they will be unable to purchase those that they might want. The high level
and steep trajectory of prices reflect increases in demand fueled by the separation of the
decision to obtain medical goods and services from payment for those goods and services.
Payment is divorced from procurement in two ways.

First, the tax code

encourages insurance policies that provide what amounts to first-dollar coverage.
Individuals pay pre-tax dollars at the beginning of each year for an uncertain amount of
unspecified medical goods and services, the unit cost of which can be lowered by
consuming as many medical goods and services as possible during the year, regardless of
prices. Second, government programs, such as Medicare, dilute the restraining effect of
price on demand by providing enrollees with as many goods and services as they can
consume according to a set of rules, again, without regard to prices. The lack of control,
under existing law, over a significant and growing share of the federal budget and the
misallocation of the nation's resources are unfortunate byproducts.
Fundamentally flawed attempts to subsidize health care have short-circuited the
market mechanism, bloated our appetites for medical goods and services, and distorted
resource allocation.

Any reforms that fail to address the causes and consequences

directly by increasing the exposure of the health care industry to market forces will not
succeed and will likely make the situation worse.

NOTES
'Phil Gramm, "How to Avoid Medicare's Implosion," The Wall Street Journal
Februarys 1997,p. Al8.
2

John C. Goodman and Gerald L. Musgrave, Patient Power (Washington, D.C.:
Cato Institute, 1992), p. 77.
3

The Economic and Budget Outlook: Fiscal Years 1998-2007, Congressional
Budget Office, January 1997, p. 117.
^Economic Report of the President (Washington, D.C.:
Government Printing Office, 1997), p. 98.

United States

CBO,op. cit.,p. 119.

Milton Friedman, "Gammon's Law Points to Health-Care Solution," The Wall
Street Journal November 12,1991.

Figure 1

Personal Health Expenses Paid By Third Parties
Percent of Total
100 n

Hospital

AH Services

1965

1990

1965

1990

1965

1990

Source: Goodman and Musgrave, Patient Power, p. 77, from the Health Care Financing
Administration, Office of the Actuary.

Figure 2
Medicare Spending
Percent of GDP
10

•10

I960

1980

2000

1—

2020

2040

1970
1990
2010
2030
2050
Source: CBO Economic and Budget Outlook: Fiscal Years 1998-2007 and
Economic Report of the President 1997.

1 —

2060
2070

MAINTAINING HEALTHY ECONOMIC PERFORMANCE
Mickey D. LEVY
NationsBanc Capital Markets, Inc.
Inflation remains low, the economy continues to expand, and its structure is
sound, largely absent potentially disruptive imbalances that would sidetrack the
expansion. These favorable outcomes, including healthy employment growth and higher
real wages, rising investment and profits, and robust financial market performance and a
strong U.S. dollar, are no accident.

They stem from the favorable environment

established by the Federal Reserve's credible low-inflation monetary policy that has
squeezed nominal spending and smoothed fluctuations in aggregate demand.

These

trends have constrained inflation while facilitating efficient adjustments in the good,
labor and capital markets.
Can this healthy economic performance be sustained?

Yes, but the Fed's

continued credible pursuit of its long-run objective of price stability is a necessary
ingredient. This requires a monetary policy that slows growth of dollar spending toward
the nation's long-run capacity to grow. This objective should take precedence; the Fed
must not concern itself with the rising U.S. dollar or high stock valuations, as they result
from sound economic performance and policies, and it must distinguish between using
real wages, reflecting productivity gains, and rising inflation that is generated by excess
demand.

SQUEEZING INFLATION
The substantial decline in inflation since the early 1980s and its stabilization at or
below 3 percent 1992 (core CPI currently is at its lowest year-over-year level since June
1966) is a direct function of a Federal Reserve policy that has ratcheted down growth of
money supply and nominal spending. The low inflation has nothing to do with the
alleged decline in the NAIRU (nonaccelerating inflation rate of unemployment), as
argued in detail in the Economic Report of the President, 1997 and elsewhere. Inflation
is generated by excess demand, not by low unemployment and healthy real economic

growth. Inflation approaches the extent to which nominal spending growth exceeds the
nation's long-run capacity to grow. In the past, low unemployment rates and rising
inflation were associated because excess demand created the umbrella under which prices
in the labor and goods markets accelerated. It is incorrect to say that the higher wages
caused higher inflation; excess demand was the source of both. The prime example was
1978-1980, when nominal GDP growth averaged 11.5 percent annualized, while
misguided fiscal and regulatory policies suppressed aggregate supply; the excess demand
generated a double-digit wage-inflation spiral.
The disinflationary process has been spearheaded by the squeeze on excess
demand, as the Fed's monetary policy has slowed nominal spending growth toward
capacity growth; each succeeding peak in nominal GDP growth has been lower. The
slowdown in current dollar spending has inhibited the ability of businesses to raise prices
without losing market share and has encouraged businesses to constrain unit labor costs
in order to maintain profit margins. Compensation increases have slowed, reflecting
flattening trends in both wage and nonwage compensation.
From 1995 Q4 to 1996 Q4, nominal GDP grew 5.0 percent, modestly faster than
its 3.9 percent growth in 1995, but a significantly larger portion of the spending growth
was real, while inflation declined. Real GDP grew 3.2 percent while the implicit GDP
deflator rose 1.8; in 1995, real GDP rose 1.3 percent and the deflator 2.5 percent. Over
the last 12 quarters, nominal GDP growth has averaged just below 5 percent annualized.
The Fed's central tendency forecast for nominal GDP growth from 1996 Q4 to Q4 1997
is 4.5-4.75 percent, implying a modest slowdown. With healthy real growth, this would
preclude any acceleration of inflation.
Increases in productivity seemingly have contributed to the low inflation by
lowered unit labor costs and increasing potential output, but the magnitude of the
contribution is muddied by measurement problems.

Strong productivity gains have

outpaced wage increases in the manufacturing sector, generating declines in unit labor
costs, but a seeming understatement of productivity gains in the service producing sectors
have led to an associated overstatement of unit labor costs in total nonfarm businesses.

The inflation pipeline in production remains more empty than full: excluding the
volatile food and energy components, the core PPI for finished goods has risen 0.6
percent year-over-year, while the core PPI indices for intermediate and crude goods have
declined 0.5 percent and 3.7 percent, respectively. That production costs remain relatively
unchanged despite the increases in wages reflects largely productivity gains.

The

personal consumption deflator has risen 2.5 percent in the last year, modestly faster than
the GDP deflator because it does not reflect the declining costs of business investment in
information processing equipment. The CPI exhibits the most inflation:

3.0 percent

year-over-year and 2.5 percent excluding food and energy. The 10 percent decline in oil
prices from their recent peak has not yet been reflected in the CPI and is expected to
suppress its rise in coming months. The strengthening U.S. dollar continues to restrain
the cost of imports relative to domestic goods and services; in the last year, prices of
nonpetroleum imports have declined 1.9 percent, and this trend is projected to continue.
As long as monetary policy constrains growth in nominal spending and limits
excess demand, there is no inconsistency between low unemployment and low inflation.
Rising wages associated with productivity gains—measured or unmeasured—simply
reflect increased returns o labor and do not lift unit labor costs. Increasing unit labor
costs that result from wage increases above productivity gains squeeze margins and raise
the labor share of national income, but do not push up inflation unless excess demand
provides the flexibility to raise prices.
Mounting evidence of low inflation amid sustained healthy real economic growth
and low unemployment reveal the weaknesses of NAIRU-based predictions of inflation:
by failing to consider aggregate demand, they do not accurately capture the inflation
process. After-the-fact, ad hoc analyses that re-estimate the NAIRU to "fit" recent
inflation experience, witness the Economic Report of the President, are unreliable for
forecasting and provide a misguided framework for conducting monetary policy. While
the Fed continues to publicly express its concerns that tight labor markets will renew
wage and inflation pressures, its official forecasts implicitly recognize the weaknesses of
NAIRU: it forecasts no change in the unemployment rate thorough 1997 Q4 (its central

tendency forecast is 5.25-5.5 percent) and a modest decline in inflation (its central
tendency forecast for the CPI is 2.75-3.0 percent).

IMPROVED ECONOMIC EFFICIENCY
Economic performance has been enhanced by the reduced volatility of aggregate
demand as well as the low inflation. This is in sharp contrast to the poor and erratic
economic and financial market behavior of the 1970s-early 1980s that resulted from the
Fed's procyclical, stop-go-stop monetary policies that generated wide swings in nominal
spending.

That uncertain environment hampered economic decision making by

households and businesses, as the economy careened from temporary spurts of robust
growth to recession. Periods of rapid growth of nominal spending generated accelerating
inflation; subsequent efforts to suppress inflation expectations were costly, largely due to
the Fed's unsure and erratic behavior, and its consequent lack of inflation-fighting
credibility.
The recent muted fluctuations in nominal spending and lower inflationary
exceptions have established a favorable environment for sustained economic growth and
productivity advancements. Heightened flexibility of productive processes and labor
markets have enhanced adjustments to minor fluctuations in demand and helped avoid
potentially disruptive imbalances.
With the squeezing of excess demand, a rising portion of nominal GDP growth
has been real output, while inflation has receded. Real GDP has grown 2.6 percent
annualized since the expansion began in 1991 Q2 and 3.2 percent in the last year.
Growth of businesses fixed investment has significantly outpaced GDP and has risen as a
share of national output, contributing to expanded capacity. Growth of corporate profits
and cash flows have also outpaced GDP, underlying the rising expected rates of return on
investment and providing internal financing for business investment and expansion.
Employment has increased 1.9 percent annually (2.3 percent in the last year), lowering
the unemployment rate to its pre-recession level, and real wages have rebounded.
A continuation of these favorable trends is expected in 1997, with sustained low
inflation and healthy economic growth. The rate of growth is decelerating toward a

sustainable pace following the robust 3.9 percent annualized pace in 1996 Q4.
Annualized growth in 1997 Ql is pointing toward approximately 2.25-2.5 percent. Retail
sales and housing activity began 1997 Ql moderately, while businesses investment
should remain healthy but below the near double-digit growth pace of 1994-1995. This
would generate approximately 2.75 percent growth in domestic final sales. The net
export deficit, which declined sharply in 1996 Q4, adding 2 percent of GDP growth, is
expected to widen modestly in 1997Q1 and subtract from GDP.

Under current

conditions, real GDP growth is projected to fluctuate narrowly around a healthy trendline.

MONETARY THRUST AND ECONOMIC GROWTH
A potential concern for 1997-1998 is the acceleration of both money supply and
nominal GDP growth which, if sustained, would generate rising inflation and adversely
affect economic performance, financial markets, and the Fed's monetary policy. Since
last October, growth in both the narrow and broad monetary aggregates have accelerated:
in the last six months, sweep-adjusted bank reserves and the monetary base have grown
7.9 percent and 8.9 percent annualized, bringing in their year-over-year growth rates to
8.8 percent and 6.8 percent. Sweep-adjusted Ml growth has been 5 percent in the last
six months and 5.8 percent in the last year. M2 has grown 5.4 percent in the last 6
months and 4.9 percent in the last year. Meanwhile, the spurt in economic growth in
1996 Q4 pushed year-over-year growth of nominal GDP to 5.2 percent.
At issue is whether the rise in money growth is temporary, reflecting a rise in
money demand, or a more sustained pickup in money supply that would generate an
inflationary pickup in nominal spending growth.

There is insufficient evidence to

confirm a trend, although our assessment is that the acceleration has been a temporary
rise in money demand in response to stronger economic growth, large increases in wealth,
and in lagged response to the lower interest rates in Fall 1996, which lowered the
opportunity costs of holding money. A sustained acceleration of money supply seems
unlikely given the stable federal funds rate, narrowly fluctuating GDP growth and
moderating credit demands. If temporary, the pickup in money growth would mirror the
pattern in 1996: following the acceleration of money growth and economic activity in the

first half of 1996, interest rates rose, economic growth moderated, and money growth
flattened. In recent weeks, growth in the narrow aggregates and M2 has already begun to
taper off. The pickup in currency growth has contributed to the recent acceleration in
money; however, in recent years, fluctuations in foreign demand have made it a
problematic indicator of monetary thrust.
This assessment suggests that monetary policy is consistent with nominal GDP
growth of approximately 4.25-4.75 percent; this would be associated with 2.25-2.75
percent real growth and a 2 percent rise in the GDP deflator. With sustained moderated
nominal spending growth, there would be little support for rising inflation.

IS ZERO INFLATION A WORTHWHILE TARGET?
The economic benefits of reducing inflation to low levels is unambiguously
positive; that is widely agreed. Presumably economic performance would improve by
achieving rice stability. The Economic Report of the President 1997 disagrees. It argues
that the costs would exceed the benefits, for two reasons: first, the reduced economic
output in the transition to zero inflation would outweigh the future benefits, and second,
the economy functions less efficiently, and with undesired distributional consequences,
operating with zero inflation than with low inflation. Its arguments are wrong on all
counts.
The assumed transition costs presume a necessary tradeoff between output and
inflation; this Phillips curve tradeoff was used in the past to argue against reducing
inflation from higher levels. Whether reducing inflation involves a short-term reduction
in output depends on the ability of economic agents in the goods, labor, and capital
markets to anticipate shifts in monetary policy and adjust to changes in aggregate
demand. The Fed's heightened inflation-fighting credibility and the associated increased
speed of adjustment have reduced the short-run transition costs of achieving lower
inflation. In fact, since 1991, the reduction in inflation has occurred without short-term
transition costs: real GDP has grown 2.6 percent annualized, employment has risen and
the unemployment rate has declined, and real wages and incomes have increased. With a
credible monetary authority, there is no necessary short-run tradeoff between output and

inflation. The Fed has clearly announced its long-run objective of price stability, and
market responses are efficient.

Phillips curve-based assessments overestimate the

transition costs of achieving price stability.
The argument that zero inflation would reduce economic performance—based on
the assertion that unemployment would increase due to wage stickiness, that the central
bank's efforts to stabilize aggregate demand would be inhibited by its inability to impose
negative real interest rates, and that zero inflation increases the potential for deflation—
are unfounded.

In this period of moderate demand growth and healthy economic

expansion, there is mounting evidence of declining compensation (wages plus benefits)
within same job categories, suggesting more flexibility of labor markets than is assumed
in standard Keynesian models.
Nor would inflation constrain the ability of monetary policy to manage aggregate
demand. At zero inflation and expectations of price stability, the argument is that the
Fed's demand management would be inhibited by its inability to impose negative real
interest rates. This is a false concern: even in the severe hypothetical situation of
insufficient aggregate demand and zero short-term interest rates, the central bank could
still engage in open-market operations, increasing bank reserves and money supply, and
generating an acceleration in demand. (The recent experience in Japan is not an example
of the constraints of zero inflation on monetary policy, as some allege; instead it
illustrates how misguided monetary policy results from targeting short-term interest rates
rather than money supply and misreading economic and price conditions: in response to
declining nominal and real GDP, the Bank of Japan allowed money supply to decline
while interest rates minus actual and expected deflation were very high.) Insofar as the
Fed's ability to manage aggregate demand at price stability would not be impaired, the
potential for deflation is not a threat.
The argument that zero inflation would generate undesired distributional
consequences is highly suspect; here, the analysis in the Economic Report of the
President is simply wrong.

Insofar as zero inflation is consistent with sustained

economic expansion and job creation, marginally skilled and low income individuals
would benefit from the reduction in unemployment, a major source of low income and

income disparities. The assertion that wealthy individuals benefit disproportionately
from zero inflation, as it raises the real return to cash, is at best erroneous. Few lowincome individuals are in the position to benefit from inflation, for example, through
home-ownership. Also, low-income individuals hold the greatest share of their wealth in
the form of currency; hence, they typically suffer disproportionately more from inflation.

FINANCIAL MARKETS
Current conditions of low and stable inflation and healthy, seemingly sustainable
economic growth have generated healthy financial market outcomes: 1) low bond yields
and a relatively flat yield curve, reflecting low inflationary expectations; 2) narrow
corporate bond spreads over Treasury bond yields, reflecting high perceived
creditworthiness; 3) a strong stock market, reflecting sustained growth of corporate
profits and cash flows, the high quality of profits due to the low inflation, and low interest
rates that raise the present value of the expected stream of earnings; and 4) a strong U.S.
dollar, reflecting the high expected rates of return on dollar-denominated assets relative to
assets denominated in other currencies whose nations suffer from poor economic
performance and/or misguided economic policies.
While the economic fundamentals underlying the robust stock market gains are
obvious, it remains uncertain whether future profits will rise sufficiently to meet
expectations and support valuations. However, what is clear is that the rising market in
no way reflects an asset price bubble generated by expansionary monetary policy; in fact,
the strong stock market seems more a reflection of the Fed's successful disinflationary
policies and the healthy economic environment that has resulted. In this regard, while the
Fed's concern that a stock market selloff would damage economic performance is
understandable, its policy objective must remain low inflation, not stock price
management.
In the near term, bond yields are expected to remain in their recent range of 6.25-7
percent, and are expected to gradually recede toward a 6.25 percent as the market adjusts
its expectations of inflation downward. Meaningful fiscal reform and long-term deficit
reduction would push bond yields closer to 6 percent.

The current posture of monetary policy does not require a change in the federal
funds rate in order to maintain inflation at its recent level. However, achieving zero
inflation would require a modest rise in the funds rate in order to slow growth of money
and nominal spending toward long-run potential growth, and eliminate excess demand.
Such a process would involve a temporary rise in short-term interest rates, and a flatter
yield curve, as the market adjusted down its inflationary expectations as the Fed
tightened.

N a t i o n s B a n c Capital Markets, Inc.
7 Hanover Square. 15th Floor
New York, New York 10004-2616
Tel 212 858-5500
Fax 212 858-5741

NationsBank

Economic & Financial Perspectives

MICKEY D. LEVY
CHIEF ECONOMIST
NATIONSBANC CAPITAL MARKETS, INC.

SHADOW OPEN MARKET COMMITTEE
MARCH 2-3,1997

USA

QS?P

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1994/1996
Federal Reserve Bank of St. Louis

49
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Levels
QUARTERLY DATA
Nominal GDP
GDP
Domestic Demand
Final Sales
Domestic Final Sales
Disposable Personal Income
Consumption
Residential Investment
Business Investment
Inventory Investment
Government Purchases
Exports
Imports
Current Account
GDP Deflator
Employment Costs (Private)
Unit Labor Costs (Non-Farm)
1 Productivity (Non-Farm)
Compensation (Non-Farm)
i Corporate Profits A/T
Operating Profits A/T
Net Cash Flow

1995
1996
Q1-96
Q2-96
Q3-96
Q4-96
7715.4
7616.3
7426.8 " 7545.1
6994.4
6928.4
6892.6
6814.3
7090.3
7060.7
7003.0
6914.6
6977.4
6892.7
6884.7
6815.2
7073.3
7024.9
6995.2
6915.5
5145.9
5114.6
5054.5
5037.6
4733.3
4693.5
4687.6
4649.1
277.6
277.8
281.5
271.1
791.8
781.4
750.5
743.5
16.4
34.5
7.1
-3.0
1274.8
1276.1
1278.2
1254.7
862.5
816.1
817.9
806.7
962.5
953.5
932.6
910.7
NA
-48.0
-40.2
-34.9
(c
110.7
110.2
109.6
109.0
130.6
129.6
128.8
127.8
110.7
110.3
109.4
108.5
102.2
101.7
101.7
101.5
113.2
112.2
111.3
110.2
NA
402.2
408.1
408.8
(a)
NA
661.2
655.8
645.1
(a)
NA
657.7
658.4
654.8
Jaj
___
Levels

Quarterly % Change (annualized) [
Yr-to-Yr% Change
||
1995
1996
j
1995
1996
I
Q2-96
Q3-96
Q4-96
I Q1-96
Q2-96
Q3-96 ~Q4-96
||
I Q1-96
|
4.7
3.9
3.8
4.2
6.5
4.2
5X7
5^1!
1.7
3.9 |
2.7
2.0
2.2
2.1
4.7
3.2
1.4
1.7 j
3.3
2.7
2.5
5.2
3.0
3.3
4.1
3.1
3.0
5.0
0.5
3.2
2.2
2.5
4.1
2.9
2.8
1.7
4.7
3.3
2.7
2.2
2.5
4.8
2.7
3.1
3.0
2.7
1.3
2.0
2.6
3.4
0.5
2.7
2.5
3.4
3.5
2.1
-0.3
9.7
7.4
4.2
5.9
2.0
-5.2
16.3
5.4
9.5
17.5
8.7
5.6
5.6
3.8
11.6
NA
NA
NA
NA
NA
NA
NA
NA I
1.0
-0.4
-0.7
2.0
1.0
-0.6
7.7
1.6
7.4
24.8
4.2
-0.9
7.2
7.2
5.7
1.8
4.1
3.8
8.4
7.8
5.4
9.3
10.0
10.6
-10.3
0.8
NA
4.2
-7.8
-5.3
NA
-4.4
1.8
2.1
2.1
2.2
2.2
2.1
2.2
2.2
2.8
2.8
2.5
2.7
'*~3~1 |
3.2
2.9
!
2.9 1
2.4
3.3
2.9
2.7
1.5
3.3
3.4
1.5
1.1
0.4
0.8
1.0
2.0 j
0.0
0.8
1.6
3.6
3.7
3.8
3.8
3.6 j
3.3
4.1
3.3
NA
5.1
8.7
NA
-1.4
8.4
-0.2
6.0
NA
8.0
16.6
NA
0.8
15.2
5.4
1.7
NA
5.1
6.7
6.1
NA
-0.1
0.5
3.8
12 Month % Change " _. -.•*•*
_ _ :|l
Monthly % Change
j

MONTHLY DATA

' •' * : : : ••*- -

Oc£96

1sJov-96

Oct-96 Nov-96 Dec-96 Jan-97
Dec-96
Jan-97
-3.3
2.7
4.0
-1.6
52.0
53.8
271
261
181
261
120.753 121.024
18
14
8
13
18.294
18.276
0.1
0.0
0.1
0.0
5.4
5.3
-2.0
0.6
0.9
34.1
-1.2
34.8
0.1
0.5
0.8
-0.1
12.06
12.05
4.0
1.5
-1.9
-2.0
15.5
14.9
4.4
8.2
-1.7
-10.0
7.5
6.9
0.0
0.5
0.8
0.2
117.7
117.7
-0.2
0.1
0.5
-0.1
83.3
83.5
-0.3
0.6
0.2
0.2
133.0
133.4
0.0
0.1
0.1
-0.2
142.4
142.4
0.1
0.3
0.3
0.3
159.4
159.2
0.1
0.2
167.9
0.2
0.2
167.7
0.6
0.3
-0.1
0.7
209.1
207.9
-11.0
2.0
5.6
-4.3
1350
1323
-1.5
0.3
4.1
-2.6
1400
1422
-6.1
13.5
0.6
-17.7
13.4
18.8
3.6
-1.8
-1.7
0.6
174.8
168.8
NA
-1.3
-0.5
1.1
NA
316.1
NA
0.8
0.6
0.1
NA
6638.9
NA
0.5
0.4
0.9
NA
5433.6
NA
0.3
0.2
-0.7
NA ;
5.4
NA
0.1
0.2
0.0
NA |
102.8
NA
-0.1
-0.0
0.5
NA
1009.5
NA
0.00
0.00
0.00
NA
1.39
34
NA
-2.3
0.1
NA
-10.3
0.04
0.12
-0.12
5.03 " f -0.10
4.9J"
0.08
0.23
-0.21
-0.32
6.01
5.78
0.10
-0.33
-0.30
0.28
6.58
6.30
-0.33
0.07
0.28
6.83 I -0.22
6.55
1.9
5.4
3.3
6707.0 I
4.2
6435.9
4.9
3.1
1.0
3.9
766.22
743.25
2.0
-1.1
0.6
2.6
91.0
88.7
3.4
1.5
-0.1
2.3
118
114
-1.0
2.7
1.3
1.60
3.4
1.55
0.1
-0.0
-0.1
1079.6 I
1080.9
-1.2
0.6
0.6
0.4
0.3
3849.7 !
3833.0
0.6
-0.5
-2.4
50167
-1.5
49403 I
0.7
-0.2
NA
NA
1.1
970.9
0.4
0.4
NA I
1195.4
NA
0.6

52.4
Purchasing Managers Index
50.4
120.492
1 Non-Farm Payrolls
(b) 120.311
18.262
18.254
Manufacturing Payrolls
(b)
5.3
Unemployment Rate
5.2
(c)
34.6
34.3
Average Workweek (sa)
11.99
I Avg. Hourly Earnings (sa)
11.90
14.7
14.9
Total Vehicle Sales, incl. Lt. Trucks
6.6
6.7
| Domestic Unit Auto Sales
117.1
Industrial Production
116.2
83.4
Capacity Utilization
83.0
PPI
132.6
132.3
142.2
PPI Ex. Food & Energy
142.1
158.8
[ CPI
158.3
167.4
167.0
| CPI Ex. Food & Energy
207.3
Retail Sales
207.5
1486
Housing Starts
1407
1418
I Permits
1362
!
-37.9
-40.3
Federal Budget Surplus/Deficit (d)
171.9
174.9
Durable Goods Orders
320.2
321.9
Manufacturing Orders
1
6583.6
6543.7
Personal Income ($)
5408.7
5386.1
Personal Outlays ($)
*
5.1
4.9
Personal Saving Rate
(c)
102.7
102.5
| Leading Economic Indicators
1011.3
Total Business Inventories
1010.9
1.39
1.39
Inventory/Total Sales
(c)
-7.9
-8.0
International Trade
(c)
5.03
4.99
3 Month Bill
(c)
5.70
5.91
2 Year Note
(c)
6.20
6.53
10 Year Note
(c)
6.48
6.81
30 Year Bond
(c)
6318.4
5996.2
DJIA
735.67
701.46
! S8P500
87.0
88.0
3 U.S. Dollar (FRB)
112
112
!| Yen/$
1.51
1.53
! DM/$
1079.9
1080.1
; MI
3809.3
3787.8
M2
49875
50135
j Bank reserves
960.1
953.4
!: C&l Loans & Non-Financial CP
1190.5
I 1185.4
! Consumer Credit
(a) Quarterly % changes are not annualized
(b) Monthly changes are in levels
(c) All changes are in levels or basis points
(d) Monthly: change from same month last year;
Annual: sum of past 12 months
Note: All GDP data reflect chain-weighted measures.

Digitized Mickey
for FRASER
D. Levy, Chief Economist, NCMI

" li

Oct-96 Nov-96 Deo96 Jaffr97
l|
16J1
17.5
14.4
7.7
2.50
2.22
2.20
2.18
-0.08
-0.50
-0.50
-0.67
-0.3
-0.3
-0.3
-0.3
0.9
1.5
0.6
-0.6
3.8
3.8
3.5
3.0
6.3
-4.2
-1.1
2.5
7.4
-8.1
-7.8
-6.3
4.7
4.3
3.9
3.3
1.1
0.6
0.2
-0.4
2.5
2.8
3.0
3.0
0.6
0.6
0.6
0.8
3.0
3.3
3.3
3.0
2.6
2.5
2.6
2.5
4.9
4.2
4.6
5.7
-5.8
-6.5
2.4
1.8
1.6
-4.4
-2.2
-2.2
-116.7
-110.6
-124.1
-124.7
4.5
0.7
5.8
7.4
3.3 '' NA
6.0
6.8
NA
5.9
5.7
I
5.4
NA
4.7
5.2
5.5
NA j
0.5
-0.1
-0.6
NA
1.6
1.8
1.6
NA
1.9
1.8
2.0
NA
-0.03
-0.05
-0.06
11
NA
-3.9
-1.8
-0.23
O03|
-0.33
I -0.29
0.46
0.90
0.22
0.21
0.59
0.93
0.27
0.49
0.49
0.78
0.22
0.44
25.3
29.5
28.0
26.0
20.9
24.8
23.5
20.3
5.5
4.3
3.4
4.6
11.5
11.9
10.2
11.5
7.8
9.6
6.7
8.0
-3.8
-4.3
-4.7
-4.9
4.9
4.9
4.7
I
4.4
-11.0
-11.2
-11.5
-11.8
NA
6.6
6.0
6.7
8.3
8.8
NA I
I
9.5

L --

02/28/97

Peter E. Kretzmer, Economist

02/28/97

Chart 1
Trends and Cyclical Fluctuations in Economic Performance
Real GDP
10.0

8.0 M
1
6.0

»: A 1

Real Consumption
10.0

8.0

T~TK \AM i
\ i
1/1 \J
\\l ™ U ;
0.0 . ; !
-2.0

6.0

g 4.0
u
_I| ;
& 2.0
i

£ 4.0

•,

-2.0

\
^*S^-

•A

1 V /

j IV

8 5.0

<u
ex.

-15.0

70 72 74 76 78 80 82 84 86 88 90 92 94 96
— Year-over-year

— 6-year moving average

Employment

r \ \ f

l^yT^W^

IJ-S^^^

S
i
i
m i i i i i i in in i. 1II11I1..IH •. i...., .i

LUlUllilUllll m i n i

_
.
. m i ii n is m i

70 72 74 76 78 80 82 84 86 88 90 92 94 96
— Year-over-year

70 72 74 76 78 80 82 84.86 88 90 92 94 96

_ 6-year moving average

— Year-over-year

— 6-year moving average

Inventory Building
|

7
rsj
M
<y>

;

{

%" J

1 30 _ h
_'
uin

•*\

• 11
II

Inflation
i

2.0

15.0

* i

i i!
I \\A •
• ~A1H" T

II
I
I Dinn
Uoi
o
V^
=
-10 .
CO

I j"

^~ "~^—Jl

1.5

10.0

j J

~" n H L 1

lP-

Hi
In 1
^^m
i

•
•

1.0E
o
2

5.0

0.5

k \lJ J

^_x

-sn

i i u m UUUU liLllll

lumuuiumUiUWJ iium Uiamiiniiii

iiiimiiiiimiimii:iiiii;i>iiitiLi_

0.0

l , immm

A
it ^

IV0 DP

r^V,

/^*

70 72 74 76 78 80 82 84 86 88 90 92 94 96

70 72 74 76 78 80 82 84 86 88 90 92 94 96
• Change in Business Inventories
— Inventory/Sales Ratio: Total Business (SA)

j I

**r
~ ^ ^ I H L . I \ S ^ ^ "" ^M— t ^^?

i
!

lllllll

| AI I

j
4
v
-\
/ T\ / / ;

-5.0

i
I

niiiii m i n i

__ 6-year moving average

/ \j

i iJ

15.0

Real Business Fixed Investment
25.0

fckJfckJ,.
\jWj |

l y

-4.0

-4.0 70 72 74 76 78 80 82 84 86 88 90 92 94 96
— Year-over-year

; A

0.0

! /l 1

fc 2.0

t y

- Year-over-year

_ 6-year moving average

NatlonsBanc capital Markets, inc.

02/28/97

Chart 2
Measures of Monetary Thrust
10-Year Treasury Bond/Federal Funds Spread

Nominal and Real Federal Funds Rate

;
:

•

;

f^\J^

97
89

— Federal Funds Rate
— Inflation Adjusted Funds Rate

c 20

-20

SS/T^;

I
91

w*^*^^*»*"^

•^0

I i , , i , , — . . M . U D . I U I I UJ

llllllMIHIlllllllnliiliii;

—11 M 111111 n u j j x m i m l i . i 111111111

I—11 in 1111111 i n i n i i 1111111111 >.i i n i h i n u 11111 iri n i m i nti i n i i i m i l tin i i i i i i i l i i i u i i i m l

— Year-over-year Growth
_ 3-Month Growth (Annualized)

- Year-over-year Growth
_ 3-Month Growth (Annualized)

* Based on FRB estimates.

Based on FRB estimates.

MZM

M2
10

a\ 6
c
.c 4
U
£ 2
u

^iuv-i v
KT\ V !V

a--10

Adjusted for Sweep Accounts'

U 10

Bank Reserves

I*
JZ

Adjusted for Sweep Accounts *

30
i

/ \

\ //

: A
**

|rVC // ivVs.

I J

!
'

v ^ ^

-10

liniiiiiiiii.iminniii

iniiiiiiiiiJiiiii

^10
c
u
a, 0

^- ^

lllilililill liillllllll

— Year-over-year Growth
_ 3-Month Growth (Annualized)

rJ
X]\ [/4
90

iiuiiiiiii

i i u i i i i i i i •UJ I I I U l l I

91
92
93
94
95
— Year-over-year Growth
_ 3-Month Growth (Annualized)

fw
JUUUUli.

NatlonsBanc capital Markets, inc.

Table 1
Federal Reserve Estimates of the Impact of Sweep Accounts
Cumulative Sweeps of Transaction Deposits into Money Market Funds

CumulativeTofal
(Billions $)
5.3
7.5
7.5
7.5
7.5
7.5
7.5
7.5
9.0
9.6
9.9
9.9
9.9
9.9
9.9
9.9
14.9
22.2
22.8
27.4
33.3
41.0
45.3
54.5
68.2
75.2
81.6
89.4
97.7
106.2
114.1
127.5
138.3
153.1
162.1
170.7

Jan 94
Feb 94
Mar 94
Apr 94
May 94
Jun94
Jul 94
Aug 94
Sep 94
Oct 94
Nov 94
Dec 94
Jan 95
Feb 95
Mar 95
Apr 95
May 95
Jun95
Jul 95
Aug 95
Sep 95
Oct 95
Nov 95
Dec 95
Jan 96
Feb 96
Mar 96
Apr 96
May 96
Jun96
Jul 96
Aug 96
Sep 96
Oct 96
Nov 96
Dec 96

* Figures are the estimated national total of transaction account balances initially swept into MMDAs owing to
the introduction of new sweep programs, on the basis of monthly averages of daily data.
Produced by: Division of Monetary Affairs of the Board of Governors of the Federal Reserve System

02/28/97

Chart 3
Selected Indicators of Income and Consumption
Real Disposable Personal Income

Conference Board Consumer Confidence

160
140

120

r - ^ \ A r, w
^y v/1
F vp-h ^A/^\

100

y V
w>

Lz-v/^

80
2%

.. i 1 1 1 1 1 1 1 1 1 1 1

-LJ

- Current Conditions - Expectations

_ Year-over-year Percent Change

Unit Auto Sales

Retail Sales
10

§ 8

93
•Total Retail Sales, Mth/Mth % Change
«3-Month Growth Rate (Annualized)

- Unit Auto Sales (SAAR, Mil)
- Unit Truck Sales: Light, 0-10,000 Lbs (SAAR, Mil.)
Real Consumption

Real Personal Consumption: Services
6% ,
!

4%
2%
0%
-2%

•ft A ifrfU
Ww
J.J

i i i i i i » i i i i i i i i i i i i i i i

•

^
\
!
|

1ri

>n
hi
1V

— i — i — i — — i

i i i i i » i i i ia.U-L_

i _ _ _i

-Year-over-year Percent Change
_ Quarter-over-quarter Percent Change

_ 3-Month Percent Change
- Year-over-year Percent Change

A -v

wLA

Ni
l

/"^

A f

NationsBanc Capital Markets, Inc.

02/28/97

Chart 4
Selected Indicators of Employment & Production
Nonfarm Payroll Employment
600 r-n

Manufacturing Employment
3%

, 4

-1—|-i-|

L\i TIMI

PEL

3 °
j-20
Z

-200

I 1 I 1 I I I 1 I I I i I I

-40

-60

l l . i l l l I II I I I I I I I I

•

1 1 1 1 1 1 1 1 1 1 1

-80 93

• Month-to-month difference
mm Year-over-year Percent Change

-2%

35.0

-1 4%
34.5

-2%
!
!
-4%

_.,

-1%

• Month-to-month difference
• Year-over-year Percent Change

r .i,„.

Average Hourly Workweek

j
I

0%'o

U 1 .LJLU IJLU. 1.
.XJ-Li 1 1 1 M It
1 1 1 1 1 M 1 1 1 1 1 1 1

Aggregate Hours Worked
4%

fW
<r\
\
V

1% £

i l l XJ-LI J -U-i 1.1 i, „••,. ^J. .1,,-L^-l,,.. .
J 1 1 1 1 I I 1 I 1 I l-LJUU.1111 M
,1-LJ-L

34.0

-2%
33.5
93

• Month-over-month Percent Change
• Year-over-year Percent Change

- Private Non-Farm Establishment

Productivity

Industrial Production
6.0%

i= 4.0%

| 2.0%
i

>
<? 0.0%

-2.0%
89
a Month-over-month % Change
-Year-over-year % Change

- Non-Farm Business — Manufacturing

NationsBanc Capital Markets, Inc.

02/28/97

Chart 5
Trends in Corporate Profits and Cash Flows
Corporate Profits

Corporate Net Cash Flow

30%

-10%
89

-Year-over-year Percent Change

- Profits After Tax (SAAR, Bil.$)
Domestic Profits

Rest-of-World Profits

600

500

c
o
=400
5

=70

300

200

50
89

Growth of Profits Relative to GDP
60%

NationsBanc Capital Markets, Inc.

02/28/97

Chart 6
Selected Stock Market Indicators

S&P500: P/E Ratio,
4 Qtr. Trailing Earnings
30

•
>

25
i

'•

•

: ;
i

;

f\ j

^
\ j

\ /\ \ 1

- - ..liiiiniii

until

^
1 1 1 1 1 1 1

70 72

_LUJJ_LL

62 64 66

JJ-LILU- J_ULULU. D I M M JLU11)11, I I I M I L
•t ULllfcUXl 1 1 1 I1J

74 76 78 80 82 84 86

Mill

90 92 94 96

S&P 500: After-tax Earnings Per Share
12
10

£ 8

!
i

;

!
i

!
j

I
I

/
i

1 . ! i
i i L^k~

Af
S / TV

^\J

Al
V

\lV
V
1

•>•>—«~>
iui.UuilMIMI

i m i n

62 64 66

11 i n i > ii i i i ; i i l l i i i l i i i n i i i n i l i i i i i i i L i i l L L i i m J i L -LLLUIJ. 11,1 11 M JJ-UJJJJ I I I M i l l J l i X U l liXLULU.

70 72 74 76

78 80 82 84 86 88

n i n 11 Li.ni

90 92 94 96

— Level

Consumer Price Index
20
c
u

S 10

r^4
60

62 64 66 68

70 72 74 76 78 80 82 84 86 88 90 92 94 96

NationsBanc Capital Markets, Inc.

02/28/97

Chart 7
Trends in Wages and Unit Labor Costs
Average Hourly Earnings
a,5%
AA A.

J? 4%

;

!
/x/VA* V * 1

*3%
<v

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i L i • • Linii i I I I I I I I I I

7%
<v

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•

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i

Compensation

S4%
i

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o
fa 2%
>•
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89

_ Non-Farm Business - Manufacturing

Employment Cost Index

Productivity

(Civilian Workers)
6%

8,6%

C
m
JZ

54%

~5%
c
Of
u
k.

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a;
^4%

? 0%

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o

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89

_ Non-Farm Business — Manufacturing

- Compensation

Unit Labor Costs

Employment Cos): Index
(Civilian Workers)

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c
ns
JC

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A,V

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>
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oi
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~ Unit Labor Costs: Nonfarm Business
- Unit Labor Costs: Manufacturing

-Benefits -Wages

NationsBanc Capital Markets, Inc.

02/28/97

Chart 8
Selected Inflation Indicators
Consumer Price index

Producer Price Index

-CPI-U, All items (SA)
-CPI-U Excluding Food & Energy (SA)

89 90 u 9 1 92, 93 94 95 4 96 97
- Finished Goods*
- Intermediate Goods*
± Crude Goods*
'Excluding Food & Energy

GDP Deflators

Import Price Index

10%

c
nj
s:
U

flj

u
*

Year-•over--Year

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-5%
10%

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-Chain-weighted GDP Deflator
- Implicit GP Deflator

IIIIUIULU i i i u i m n j j i i i m i i i

uinnuii

IIIIIIIIIU

— Import Price Index: All Imports (Yr/Yr)
- Import Price Index: Non Petroleum (Yr/Yr)
NAPM: Survey of Prices

Commodity Prices
OJ

[

100

1
t

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3

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89

- CRB Futures Price Index: All Commodities
-CRB Futures Price Index: Industrial Materials

JF"

IIIIIIIIIU

-NAPM Survey-Diffusion Index, Prices, SA, (%)

NationsBanc Capital Markets, Inc.

02/28/97

Chart 9

Trend in Nominal GDP

70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97

NationsBanc Capital Markets, Inc.

02/28/97

Chart 10
Selected Interest Rates
14
12
10

30 Year Treasury Bond — 2 Year Treasury Note

Inflation Adjusted Yields
10

— 30 Year Treasury Bond minus Inflation

— 2 Year Treasury Note minus Inflation

Yield Spreads Over the Federal Funds Rate
!

u
•

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/v
r^
V6

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i i i m u u i m m i i m .UJJJ_LJU.Ui I I I I I U J L L U I I I Ml 1 II II I l l l II l l l l t l l l l l l l l l l II 11111 i n 111 ii m t u r n i n n i i i i i i i i i i u i i i i i i LL1L111 1 1 1 1.lJ.l.lllllJLLLii.lJUl.lllJ
11

30 Year Treasury Bond minus Federal Funds Rate
— 2 Year Treasury Note minus Federal Funds Rate

NationsBanc Capital Markets, inc.
61

Table 2

Federal Reserve Objectives and Actual Performance
Central Tendency Forecasts for 1996 Q4 to 1997 Q4*

July 1996 Est. Feb. 1 9 9 7 Est.
Real GDP
1.75% to 2.25%
2% to 2.25%
CPI Inflation
2.75% to 3%
2.75% to 3%
Nominal GDP
4.25% to 5%
4.5% to 4.75%
Unemployment Rate (4th Qtr.) 5.5% to 5.75% 5.25% to 5.5%

Actual Performance
1995 Q 4 1996 Q 2 1996 Q 4
1 9 9 6 Q4
3.4
3.4
3.2 (2.5, core) 3.0 (2.6,core)
5.2
5.0
5.4 currently

as
to

II.

The Fed's Money Targets and Actual Trends

Money Supply Targets*
Q4:95 - Q4:96
Not Targeted
Bank Reserves t
Mlt
Not Targeted
1%to5%
M2
2% to 6%
M3
3% to 7%
Debt

Annupalized % Change
Last 3 Months Last 6 Months Yr/Yr
13.2
7.9
8.8
6.7
5.0
5.8
6.7
5.4
4.9
9.1
8.4
7.4
5.2
5.2
5.4

* Source: Board of Governors of Federal Reserve System, Monetary Policy Report to the Congress. July 1996 and February 1997.
* Adjusted for FRB estimates of sweep accounts

02/28/97

Table 3

Economic Conditions in the G-7 Nations
Real GDP

Yr/Yr
Current
Unemployment
c
£ Change
Condition
Rate %
Britain
3.4
moderate pickup
6.5
Canada
moderate pickup
9.7
1.6
France
1.4
rebounding from recession
12.7
Germany
2.4
rebounding from recession
12.2
Italy
0.7
decelerating
11.9
Japan
rebounding from recession
3.3
3.2
United States
3.2
healthy growth
5.4

II.

Inflation
PPI (Yr/Yr)
CPI (Yr/Yrl
2.8
1.5
2.2
-0.5
1.7
-3.5
1.8
1.5
2.6
0.5
0.6
1.0
3.0
2.5

Comment
moderate pickup
stable
stable
stable
decelerating
stable
stable

Interest Rates and Yield Spreads

10-Year Bond Short-term Yield Inflation-Adjusted Yields
Bonds Short-Term
Spread
Yields
Yields
Britain
7.1
6.0
3.2
4.3
1.1
Canada
6.2
3.0
0.8
4.0
3.2
1.9
France
5.2
3.3
1.6
3.5
Germany
5.4
3.1
3.6
2.3
1.3
Italy
7.3
7.3
4.7
4.7
0.0
Japan
2.5
0.5
-0.1
1.9
2.0
2.4
United States
6.5
5.4
3.5
1.1

U.S. Dollar Against
Selected Foreign Currencies
120
110
c100
(V

-hx
!—L.L-1 i i i i - i - i .

1.8

,/vSK

1.7
1.6^

90 |_ !
80

Bond Yield Differentials

;

1.5Q
1.4

i i i

1.3

— Foreign Exchange Rate: Japan (Yen/US$)
_ Foreign Exchange Rate: Germany (D. Mark/US$)

Inflation Adjusted
Yield Spreads to U.!
Bonds Short-Term
0.8
0.8
-1.6
0.5
-0.8
-1.1
0.1
2.3
1.2
-2.3
-1.6
—
—

-.Germany Minus U.S. -France Minus U.S.
* U.K. Minus U.S.

NationsBanc capital Markets, inc.

SOCIAL SECURITY REFORM
Charles I. PLOSSER*
University of Rochester

The Social Security Act requires that every four years an Advisory Council on
Social Security be appointed to review the Social Security System. In March 1994 an
Advisory Council was appointed and it finally reported its findings in January 1997. It
was an unusually lengthy process and the report makes it clear why it took so long. The
Council could not come to any consensus as to the nature of the "problem" nor to its
sensible solution. As a consequence, the report presented three views of what to do about
Social Security and a series of Appendices where the members of the Council accuse
each other of not understanding the merits of their preferred approach.

THE PROBLEM WITH SOCIAL SECURITY
When it comes to entitlements, there are only two programs in the U.S. that really
matter—Social Security and Medicare. Both programs involve significant transfers from
the working population to the elderly and are funded primarily on a pay-as-you-go basis.
In both cases the expenditures are rising rapidly, consuming larger and larger fractions of
the Federal budget and national output.

In fact this is true for many countries-

retirement and healthcare entitlements are often among the largest and most
uncontrollable budget items.
Like a typical chain-letter, Social Security is a pay-as-you-go redistribution from
the young to the old and depends to a significant degree on an ever expanding pool of
new payers to reward the individuals who got into the system earlier. The problem is that
like a chain-letter, someone usually gets left holding the bag.
This all seemed well and good in 1935 and even into the 1950's. Unfortunately,
the pyramid scheme is becoming increasingly burdensome.

Since its inception, the

system's viability has rested on the premise that there would always be many more
workers supplying funds than retirees having a claim to those funds. It was never meant

to be a true pension or retirement plan.

Unfortunately, two changes occurred that

dramatically undermined the system's long-term health.
First, Americans became healthier and began living longer. Figure 1 shows that
life expectancy for someone born in 1935 was less than 62 years. Thus, in the beginning,
a retirement age of 65 seemed actuarially sound. By 1965, however, life expectancy had
risen to over 70 years and it climbed to over 75 years by 1995. With people living
longer, the cost of the program has risen significantly. By 2030, our life expectancy is
anticipated to approach 80. Thus, the number of people eligible for Social Security has
grown significantly simply because we are living longer.
The second factor is a change in birth rates, which has interacted with life
expectancy to exacerbate the problem. There was a tremendous increase in the birth rate
after World War II—the so-called baby boom. While this actually helped spread the
burden of supporting retirees for a while, it also meant that the baby-boomers would
eventually retire and wish to claim their Social Security checks This would not have
been so bad except that the baby-boomers decided to have fewer children on average than
their parents. Consequently, as the baby-boomers retire, there are fewer workers per
retiree.
As shown in Figure 2, there were more than 4.5 employed workers for every
Social Security recipient in 1965. Today, that ratio has fallen to 3.3 to 1. By the year
2030, there will only be 2 employed workers for every beneficiary and by 2070 the ratio
will have declined to just 1.8 to 1. Thus, every family with two wage earners not only
will be supporting themselves and their own children, but also shouldering the burden of
Social Security and Medicare benefits of one retiree. These demographic trends alone tell
a frightening tale about the cost of maintaining the current benefit structure of the Social
Security system.
In 1965 (the year Medicare was established), Social Security accounted for less
than 16 percent of non-interest outlays of the Federal government (see Figure 3). By
1970, Social Security accounted for almost 17 percent and Medicare for 4 percent—a
combination accounting for about 21 percent of non-interest outlays of the government.
In 1995, Social Security alone amounted to 26 percent of non-interest outlays and

Medicare to 14 percent for a combined total of 40 percent of Federal non-interest outlays
going to the elderly. The Congressional Budget Office projects that by the year 2030,
unless fundamental changes are made, 56 cents of every Federal dollar not used to pay
interest on the debt will go to the elderly.

Overall, the CBO projects that Federal

expenditures net of interest will grow from just 20 percent of GDP to about 28 percent by
the year 2050—largely due to payments to the elderly. The Federal government is
becoming more and more simply a vehicle to redistribute income form the working to the
retired.
Figure 4 shows the implications in terms of payroll taxes on the workforce if
current law doesn't change. Currently, payroll taxes amount to 15.3 percent of covered
wages—12.4 percent for Social Security (OASDI) and 2.9 percent for Medicare-Part A
(Hospital Insurance—HI). In order to meet our obligations under current law, OASDI
would have to increase to 17.1 percent by 2030 and Medicare to 8.5 percent for a
combined payroll tax of almost 26 percent by 2030. By 2070, the rate would have to rise
to 18.8 percent to cover OASDI and 11.8 percent to cover HI for a combined total in
excess of 30 percent, which is double the current payroll tax rate. And these figures do
not include expenditures in what's known as Medicare-Part B coverage, which provides
supplemental coverage for physician and outpatient services and is paid for out of general
revenues. The more limited growth in the Social Security tax from 2030 to 2072 relative
to the period 1995 to 2030, stems from the assumption that most of the baby boomers
will have retired by 2030.
In some respects, Social Security has been extraordinarily successful.

It has

reduced the poverty rate of the elderly, which is now lower than that of the rest of the
population. Larry Kotlikoff has estimated that due, in large part, to Social Security and
Medicare, the consumption of the average 70 year old has increased from 70 percent of
what an average 30 year old consumed in 1960 to almost 120 percent of the consumption
of a 30 year old in the late 1980's.
The Medicare portion of our commitment to the elderly is facing the same
demographic problem as Social Security. Unfortunately, its problems are made worse by
the nature of the benefit. Unlike Social Security, which entitles the beneficiary to an

inflation-adjusted dollar benefit based on the individual's wage history, Medicare grants
the elderly an open-ended entitlement that places no dollar limit on the benefits each
participant may receive. If the cost of health care services rises, then the cost of Medicare
rises. Improved technology and higher quality care have contributed to the cost of
covered medical services, causing them to rise much faster than wages or other prices.
Moreover, since the beneficiary pays little or nothing for the services there is a tendency
to demand unlimited care no matter the cost to the system.
Improved quality and an insatiable demand have combined to exacerbate the
demographic problem and to make the cost of the Medicare system increase at very high
rates. Figure 5 shows that the actual spending per beneficiary grew at almost 14 percent
per year during the 1970's, while the rate of inflation was less than 8 percent. During the
1980's Medicare spending/?er beneficiary grew at almost 10 percent per annum, or twice
the average rate of inflation. Even in the 1990's the trend has continued, with spending
per beneficiary growing at 8 percent per year while inflation has averaged about 3
percent. The bottom line is that Medicare spending is growing faster than anything else
in the economy—faster than the wages of working Americans who must pay for it; faster
than the number of elderly who qualify for it; and faster than spending elsewhere in the
U.S. healthcare system.

The typical Medicare recipient is simply living longer and

consuming more and more medical care.
Good or bad, Social Security and Medicare have resulted in a large, systematic
transfer of wealth from the young to the old, and it is growing larger with each passing
year. Justified or not, the working population will have an increasingly difficult time
sustaining these transfers of current rates.
One axiom of economics that is worthwhile to keep in mind was made popular by
Herbert Stein, former Chairman of the Council of Economic Advisors under President
Nixon. He was always quick to point out that one of the few things we know about
unsustainable trends is that they won't be sustained.
One of the major difficulties Congress and the Administration have in addressing
these "unsustainable" trends is that imminent disaster is not yet at hand. Social Security
will not become a serious financial threat until sometime between 2025 and 2030, when

the bulk of the baby-boom generation will have retired. The Medicare crisis will occur
between 2000 and 2005 because the cost of Federally provided health care is rising
rapidly and Medicare recipients are consuming more and more of an increasingly
expensive commodity.
There are those who will try to argue that we can delay—that the problem remains
far into the future. This is a bad idea. Even if we were certain that Social Security would
remain solvent for another 30 years, the longer we delay making necessary changes, the
more difficult and disruptive they will become. Unfortunately, we really cannot be
certain that the system will last 30 years. In 1977, President Carter found himself facing
an insolvent Social Security system and signed a law reducing benefits and increasing
taxes with the assurance that the system would remain solvent for the next 50 years.
Well, he was wrong. There was another crisis five years later and in 1983 the Greenspan
Commission approved an increase in the retirement age and further increases in the
payroll tax.
The U.S. is not alone.
populations.

Many OECD countries are facing rapidly aging

Depending on the size of the entitlements granted and the method of

funding, may of these countries will be coming under increasing financial strain. The
dependency ratio—which represents the number of persons over 65 as a percentage of
those between the ages of 20 and 64—rises significantly for all major industrialized
countries. (See Figure 6.) Indeed, Japan, Italy and Germany could be facing major
challenges as they approach 60 retirees for every 100 people of working age. It would
seem certain that entitlement programs funded out of general tax revenues or payroll
taxes will have to be modified.
What are the options and what should be done? In the case of Social Security, the
options range from a) trying to maintain the basic structure and adjust various parameters
in order to make financially viable the current system, to b) a complete restructuring of
the entire apparatus. In the first scenario, there are only a limited number of alternatives
to consider.
• You can increase the tax rate on the working population.
• You can change the way Social Security benefits are taxed.

• You can raise the retirement age.
• Or you can change the way benefits are calculated. The primary option under
consideration here is to reduce the so-called inflation adjustment calculation
because the Consumer Price Index is thought to overstate the true rate of inflation.

There are other ways to help alleviate the pressure but they do not appear
politically acceptable. For example, if part of the problem is that the workforce is too
small to support the elderly, it might make sense to seek out ways of expanding the
workforce. Two obvious methods are to encourage more births and to permit more legal
immigration. In the current political environment it appears that the government is more
likely to curtail legal immigration rather than expand it. In so doing, we will only
aggravate these problems.
At the other end of the spectrum is the view that the whole system is
fundamentally flawed and should be completely overhauled. One idea that is gaining
increased respectability is that the Social Security system should be substantially
privatized and transformed into something that looks more like a funded, definedcontribution retirement plan, much like we see in the private sector.
Privatization may sound like a radical idea to some, but it may not be as difficult
to accomplish as it first appears. In fact, it has been done elsewhere. Chile established a
social security system in 1924, over a decade before we did. In fact, we borrowed much
of our structure from the Chilean system. By the late 1970's, Chile faced a rapidly aging
population and a growing tax burden to support it. Their response to a crisis that was
very similar to the one we currently face was to replace their old pay-as-you-go system
with a substantially privatized, defined-contribution pension plan. By all accounts, the
new system, implemented in 1981, has been both successful and popular.

PROPOSED SOLUTIONS
The U.S. Advisory Council on Social Security recently issued a report with three
alternative plans to salvage the system's finances. The reason there were three plans was
that the panel could not reach a consensus. There are and will be many who express the

view that any change is bad and must be resisted to preserve the existing system. This
perspective is based on the view that the Social Security system is not and should not be a
true pension system. That it was created as a redistribution plan that was, more or less,
universal and that that is its strength. At the other end of the spectrum are those that
would like to see a more fundamental reform of the entire system. They view the basic
concept of a pay-as-you-go scheme as flawed and in need of repair. The Council could
not agree on an approach to reform and as a result have offered three proposals.

Option 1
The proposal backed by six of the members is the most moderate of the three. It
seeks to reform the system while making as little change as possible. It is called the
"Maintenance of Benefits" plan. This proposal has five key elements.
1. All Social Security benefits in excess of already taxed employee contributions
would be included in Federal taxable income and the proceeds deposited in
OASDI trust funds. (This includes revenue now going to the HI Trust fund,
which would be redirected to OASDI.)
2. All state and local government employees hired after 1997 would be covered
under Social Security.
3. The benefit computation would be extended from 35 to 38 years—phased in
over the 1997-1999 period.
4. In 2045 there would be a 1.6 percentage point increase in the payroll tax—0.8
percent levied on the employer and 0.8 percent levied on the employee.
5. Study the possibility of investing up to 40 percent of Social Security assets in
private equities. "An investment policy board nominated by the President and
confirmed by the Senate" would oversee these assets.
It must be pointed out, that while the plan only proposes that the investment in
stocks be studied, the plan does not cover the financial deficit in the system unless such
investments are carried out. In other words, the other proposed changes are not adequate
alone. Either further increases in taxes or a reduction in benefits must be adopted if the
higher returns are not achieved in the investment portfolio.

Option II
The "intermediate" proposal, recommended by two members of the Council is
referred to as the "Individual Account" plan. The key element of this plan is as follows.
1. Regular Social Security benefits in excess of already taxed employee
contributions would be included in Federal taxable income. (Unlike the MB plan,
there would be no redirection of taxes from the HI Trust Fund to the OASDI Trust
Fund.)
2. All state and local government employees hired after 1997 would be covered
under Social Security.
3. The benefit computation would be extended from 35 to 38 years—phased in
over the 1997-1999 period.
4. The gradual increase in the age of eligibility for full retirement benefits would
be accelerated and extended. In particular, eligibility would rise to 67 by the year
2011 and would rise slowly thereafter with overall longevity.
5. Some modest reductions in the growth of benefits from middle- and high-wage
workers.
The most significant element of the plan is:
6. The establishment of an additional mandatory defined contribution individual
account in the amount of 1.6 percent of covered payroll. This is equivalent to a
forced savings plan.

These accounts would be held by the Government as

defmed-contribution individual accounts. Individuals would have a constrained
set of investment choices ranging from a bond index fund to an equity index fund.
These funds would not be part of the Federal budget. The accumulated funds
would be converted into an annuity when the individual retired. The funds would
be taxed only once. That is they may be tax-deductible when saved and taxable
when withdrawn or taxable when saved and tax-free when received.

Option III
The third plan proposed by the Council, and supported by five members is called
the "Privately-Held Individual Accounts." This plan moves the Social Security system

to something much more like a funded defined-contribution plan that is frequently found
in the private sector. When fully phased in, the system would take the place of the
present Social Security system. The new system would be a two-tired system with the
first tier providing a flat retirement benefit for full-career workers and the second would
be the funded individually retirement accounts.
1. Tier 1 benefits would provide a floor of support to all workers. This benefit
would be $410 per month and indexed.
2. The gradual increase in the age of eligibility for full retirement benefits would
be accelerated and extended. In particular, eligibility would rise to 67 by the year
2011 and would rise slowly thereafter with overall longevity.
3. All state and local government employees hired after 1997 would be covered
under Social Security.
4. Tier II benefits would come from Personal Security Accounts (PSAs). Each
individual would reallocate 5 percentage points of the employee's share of the
current OASDI tax rate into a PSA dedicated to retirement. These accounts would
be individually owned and privately managed (unlike the accounts in the previous
plan). Minimal regulatory restriction would apply to ensure that funds were
invested in instruments widely available in the financial markets and that they
were held for retirement purposes. Every worker under the age of 55 would
participate.
5. Transition issues must be addressed. Workers over the age of 55 would be
covered under existing rules. Workers under the age of 25 would be covered
immediately under the new system. Workers between the ages of 25 and 55
would receive their accrued benefit under the existing system plus a share of the
flat (Tier 1) benefit under the new system. The financing of the transition would
be accomplished by a 1.52 percentage point increase in the payroll tax for 72
years. While this is sufficient in present value terms, the expense of funding in
more heavily front end loaded. Thus Federal borrowing would have to occur in
the amount of $1.9 trillion over the next 40 years. The bonds issued would be
fully repaid by the excess tax revenues in subsequent years. In one sense, this

debt financing is more like that which occurs at the local level where specific
taxes are dedicated to specific bond issues.

A major problem with Option I and Option II is that in their effort to solve the
financial crisis looming in the Social Security chain-letter, they arrange for the Federal
government to heavily invest in the U.S. financial markets. This is troubling on a number
of accounts. The risk of government deciding to use the investment strategy of these trust
funds for political purposes is cause enough to be wary of these proposals. One also
should be concerned with the risk that government appointed managers could directly
influence the governance of privately held companies.
None of these plans go far enough towards privatization. There is no underlying
reason for the government to be involved in providing retirement income for individuals.
No eternality is involved and there is no reason why individuals can not make their own
decisions regarding retirement savings.

If government wants to provide welfare or

income supplements to the needy, then it should separate that goal from the provision of
retirement income. The current Social Security system hopelessly muddles these two
issues.
It should be recognized as well that Social Security could become less of a
financial burden if real per capita productivity could be raised by say 0.5 percent per year
over the next 75 years. The higher growth rate of real wages that resulted would allow
the current payroll tax to find all of the projected liabilities currently promised.
Unfortunately, we know of no sure-fire method of obtaining such a result and so it would
be folly to ignore Social Security reform in the hopes that it will occur. Nevertheless,
government should continue to pursue policies that would promote increase in
productivity, including tax reform and regulatory reform.

NOTES
T h e author is Dean and John M. Olin Distinguished Professor of Economics and
Public Policy at the William E. Simon Graduate School of Business Administration,
University of Rochester, Rochester, New York 14627.

Figure 2

Figure 1

WORKERS PER BENEFICIARY

LIFE EXPECTANCY AT BIRTH

Source: Social Security Administration

J£I

2070
diulei L Hone*. Simon School I2/996

Figure 3

Figure 4

PROJECTED EXPENDITURES

PROJECTED PAYROLL COSTS

Source: Congressional Budget Office

Source: Social Security Administration
• OASDI
• Medicare (Part A)
• Combined

O Social Security
I I Federal Outlays(Net of Interest)
• Social Security + Medicare
Percent of GDP
A

•• JmJm
'r~i mfc
HawJUl IrlB,A

v\ t\ mm/v

OmUt1 R o w . SMMM School 12/»%

Figure 5

Figure 6

GROWTH IN MEDICARE
SPENDING PER BENEFICIARY

PROJECTED ELDERLY
DEPENDENCY RATIOS
• 1990
• 2030

D Medicare
• CPI Inflation
Annual Growth Rate (%)
15

Italy
Germany

THE BOSKIN COMMISSION REPORT
William POOLE*
Brown University

The Advisory Committee to Study the Consumer Price Index, named informally
the "Boskin Commission" after its chairman, presented its final report last December.1
The Commission, established by the Senate Finance Committee, consisted of Michael J.
Boskin, Stanford University (Chairman); Ellen R. Dulberger, IBM Personal Computer
Company; Robert J. Gordon, Northwestern University; Zvi Grilliches, Harvard
University; and Dale Jorgenson, Harvard University. The Commission members are all
recognized experts in the area of price index theory and practice. The Commission's
Report of almost 100 pages is an excellent summary of the major issues surrounding the
CPI; the Report deserves to be taken seriously.
The Commission's findings may be summarized under four major headings: the
purpose of the CPI; problems with the existing CPI; consequences of the
mismeasurement of inflation in the existing CPI; recommendations. I will organize my
memorandum under these four headings.

THE PURPOSE OF THE CPI
Price indexes serve a number of different purposes, but the principal purpose of
the CPI should be, according to the Boskin Commission, to measure as accurately as
possible the cost of living. "A cost of living index is a comparison of the minimum
expenditure required to achieve the same level of well-being (also known as welfare,
utility, standard-of-living) across two different sets of prices. Most often this is thought
of as a comparison between two points of time." (page 20 of Commission Report,
hereafter, all page numbers indicated will refer to the Commission Report).
The CPI is widely used in indexing government spending programs, tax law
provisions, and private wage contracts. The purpose of indexing is to prevent inflation
from changing real outcomes—that is, affecting the welfare or standard of living of

individuals. This purpose is clearly demonstrated in the history of indexing of Social
Security benefits. As inflation rose in the 1960s and early 1970s, and before indexing,
Congress periodically raised Social Security benefits in an effort to keep up with
inflation—to offset the effects of inflation in the purchasing power of Social Security
benefits.

Without these adjustments, inflation would have substantially reduced the

purchasing power of Social Security benefits in just a few years.
Social Security indexing took affect in 1975. Congress believed that formal
indexing provided a more reliable method of offsetting the effects of inflation on benefits
than periodic legislation to change benefits. Experience suggested that legislation tended
to increase benefits by more than was justified by inflation per se, and to raise political
problems that seemed unavoidable every time the political process touched Social
Security. These problems were avoided by the automatic indexation of Social Security.
In fact, the initial indexation formula was incorrectly constructed, leading to an excess
allowance for CPI changes. This error was corrected in due time, but overindexing due to
the upward bias in the CPI itself has not been corrected.

PROBLEMS WITH THE EXISTING CPI; REPAIR APPROACHES
When Social Security indexation was enacted, the problem was to deal with the
main issue of putting the inflation adjustments on a sound and routine basis. In the early
1970s, economists knew, or at least widely believed, that the CPI overstated inflation, but
that belief did not affect the decision of Congress because the overstatement seemed
small compared to the political problems to be solved by indexing. Now, with over 20
years of experience with indexing Social Security, and experience of shorter duration
with indexing other features of federal law, the issue of the accuracy of the CPI needs to
be addressed.
The bottom line of the Commission's findings is that the Consumer Price Index is
subject to an upward bias which, by the Commission's estimate, is about 1.1 percentage
points per year. The upward bias in the CPI arises for a number of reasons. For anyone
who is not an aficionado of the theory and practice of constructing prices indexes—99.9

percent of non economists and probably 98.9 percent of economists—understanding the
sources of the bias requires studying issues of mind-numbing complexity and tedium.
The principal problems of CPI construction arise because we live in a world of
rapid economic change. It is hard conceptually to define what is meant by "the cost of
living" when new goods enter the consumption stream. It is easy enough to understand
what is meant by the change in the cost of bread, but what is the change in the cost of
treating a disease that used to be unbeatable and is now curable? This problem for CPI
statisticians is significant because consumers today spend a significant part of their
income on goods that did not exist even a few years ago.
A less extreme, but still very important problem, is that the quality of goods
changes, typically bit by bit year by year. Most, but certainly not all, quality changes in
the U.S. economy are improvements. Many of the goods we consume today are similar,
although not identical, to goods consumed twenty years ago. An example of this type of
good is the automobile. Manufacturers have improved cars year by year: fuel economy
has improved, components are, for the most part, more durable; safety advances have
increased the probability of surviving a crash; many cars handle more securely;,
maintenance intervals are longer; and so forth and so on.
The Commission also emphasized that the basic design of the CPI as a Laspeyres
index overstates inflation because this type of index does not allow for consumer
substitution of lower for higher priced goods when prices change. A Laspeyres index
measures the price of a fixed market basket of goods, and therefore answers the question
of how much additional expenditure is necessary to buy the fixed market basic of goods.
When relative price change, however, consumers routinely substitute one good for
another, to a degree that depends on the type of good involved. For example, the CPI as
currently constructed misses the substitution of new low-cost air travel for rail and auto
travel.

(This example is on my mind now that Southwest Airlines has entered the

Providence - Baltimore market at prices dramatically lower than prices charged by air
carriers previously in this market.)
Other methods of calculating a price index using the same underlying price data
on individual goods are available—there is no need for the Bureau of Labor Statistics to

retain the Laspeyres formula. Although there are many technical issues to be decided,
replacing the Laspeyres index is perfectly feasible, as shown by the fact that the Bureau
of Economic Analysis uses an alternative index (the chain-weighted index) in calculating
deflators in the National Income and Produce Accounts. Although the conceptual and
data problems of dealing with quality change and new goods are substantial, substituting
another index formula for the Lespreyres formula will not be costly or difficult
technically, and the Commission makes a strong case for doing so.
Another set of problems concerns data collection and the need to construct the
CPI within a budget. The Bureau of Labor Statistics does not, and should not, have an
unlimited budget for the CPI. Consumers taken together buy scores of thousands of
distinct goods from thousands of1 different companies at hundreds of thousands of
different locations. When collecting prices, the BLS must decide how many stores and
how many brands of specific goods to sample. The BLS must decide how often to update
its sample design. These decisions necessarily reflect a tradeoff of accuracy against
government expenditure on constructing the price index. The magnitude of this task is
suggested by the fact that, "[e]ach month, prices for approximately 71,000 goods and
services are collected from 22,000 outlets, in 44 geographic areas" (page 12).
The BLS must also decide how to allocate its budget between ongoing activities
and research on new approaches. For example, an area under active study now is the use
of store scanner data. Many stores today scan bar codes at the checkout counter, and
firms use the data to improve the management of inventories, track trends in consumer
buying, and conduct other types of research. The BLS might reduce the cost of its
operations and increase the range of goods included in the CPI by using scanner data.
Clearly, though, there are important issues of incompatible and/or changing software
standards, coverage of outlets not using scanners, and so forth. Research into such issues
is expensive, and diverts resources from the estimation of the CPI using current methods.
Still, such research obviously promises great gains in the future in improving the
accuracy of the CPI and reducing the cost of constructing it.
These comments are meant to just skim the surface of some of the important
issues surrounding the CPI. What should be absolutely clear is that constructing the CPI

is an enterprise requiring great technical expertise. Although it has been a staple of
economists' thinking for as long as I have been in the profession, and no doubt longer,
that the CPI has an upward bias, fixing the bias and measuring its true extent is far from a
trivial task. There is also a danger that in correcting areas that create an upward bias,
other areas with a downward bias will be neglected. The goal of the BLS should be to
create the best CPI possible and not just to create a CPI with a lower measured inflation
rate. The Boskin Commission offers many specific suggestions on improving the CPI.
Experts are sure to evaluate these suggestions and the BLS should implement as many of
the sound suggestions as possible, as soon as possible.

CONSEQUENCES OF CPI MISMEASUREMENT
Certain parts of the federal budget, such as Social Security, are formally indexed
to the CPI. Tax brackets, the personal exemption, the standard deduction, and certain
other features of the tax law are also indexed to the CPI. The federal government now
issues bonds indexed to the CPI. Taking the tax law and benefit schedules as given,
overstatement of the CPI increases the federal budget deficit compared to what the deficit
would be if the CPI were accurate.
The Commission, relying on estimates prepared by the Congressional Budget
Office, emphasizes that CPI mismeasurement is a major issue for the federal budget. If
the measured CPI were to rise by one percentage point less than currently projected, by
2006 the federal budget deficit would be lower by $134 billion and by 2008 the national
debt would be $1 trillion lower than currently projected (page 10). These amounts in part
reflect overpayments to beneficiaries of federal programs—"overpayments" in the sense
of payments in excess of those needed to compensate for inflation correctly measured.
The budgetary impact of CPI mismeasurement also reflects underpayments by
taxpayers—"underpayments" in the sense that dollar tax payments at current tax rates are
lower than required to just offset the effects of a rising price level correctly measured.
The Commission does not discuss the effects of CPI mismeasurement on private
indexed contracts. That effect is probably minimal. In he private sector, wage indexation
is typically partial and the basic wage rate easily adjusted to offset the effects of CPI

mismeasurement. However, the Treasury's new indexed bonds raise interesting issues.
Because the Boskin Commission reported before the Treasury sold its first issue of
indexed bonds, the yields presumably reflect investor expectations of the probability of
changes in the construction of the CPI. Once those changes, if any, are announced, new
issues of indexed bonds will reflect investors' expectations of the effects on the measured
CPI of new BLS procedures. As a practical matter, it seems likely that the BLS will
introduce changes in the CPI gradually, which will keep the effects on holders of indexed
bonds relatively small.

RECOMMENDATIONS
The Boskin Commission makes clear that the large budgetary impacts of
mismeasurement of the CPI provides a compelling case for the government to devote
more resources to the construction of the CPI. Although a better CPI will be available for
many other reasons as well, expenditures on an improved CPI will be returned many
times over in a smaller budget deficit, at least to a point.

Obviously, as with all

expenditures, there will be diminishing returns to additional dollars spent on the CPI.
Moreover, it should also be understood that the BLS cannot improve the CPI
instantaneously.

Still, the return in the form of a lower budget deficit of increasing

expenditures now to improve the CPI will without question be large and relatively quick
in appearing.
Although its recommendation is stated carefully, the Commission also makes a
case for the Congress to reduce indexation in government programs and tax provisions
by, say, 1.1 percentage points per year until the BLS is able to put in place the
improvements to the CPI.

This recommendation has much to recommend it.

The

Commission emphasizes that it is not suggesting an adjustment for past overindexing, but
only for prospective future overindexing.
It is important to emphasize that political adjustment of the CPI itself is a terrible
idea. For one thing, there is no way to know whether the government will impose an
adjustment that is in fact justified, or whether the government might impose additional
adjustments in he future. For another thing, private contracts based on the CPI already

reflect the understanding of the contracting parties as to the possible bias in he CPI.
Adjusting the indexation formula in indexed programs to provide for "CPI less 1.1"
should not be confused with adjusting the CPI itself. At the end of five years, the
government could review progress in correcting the CPI and then decide whether to
continue with CPI less 1.1.
"CPI less 1.1" however, cannot be applied to indexed bonds currently
outstanding, because the government has a contractual obligation to existing bondholders.
Nor would it make sense to sell new issues of indexed bonds under the "CPI less 1.1"
formula, because the bond market would simply price the bonds to offset this provision.

CONCLUDING COMMENT
The CPI has widespread use.

Economists use many price indexes in their

research, but the CPI is the only index in general use in formal indexed contracts. Many
labor contracts have cost-of-living-adjustments (COLAs) based on the CPI; the federal
government has just issued bonds with payments tied to the CPI; Social Security
payments and tax brackets are tied to the CPI by law. It would be a disaster of the first
order if the political arms of the federal government were viewed by users of the CPI as
affecting the professionalism with which the BLS constructs the index. For example,
political manipulation of the index with the effect of reducing the interest burden of the
newly issued indexed bonds would be the equivalent of a government fraud perpetuated
on bondholders. The issue of the government's credibility is extemely important, and
nothing should be done that compromises confidence in the professionalism of the
government's statistical operations.

NOTES
^inal Report to the Senate Finance Committeefromthe Advisory Commission to
Study the Consumer Price Index, December 4, 1996, Updated Version. The foil text of
the Report is available on the World Wide Web at
<http://www.politicsnow.com/news/special/cpiI/>.

RECENT BEHAVIOR OF VARIOUS MONETARY AGGREGATES
Robert H. RASCHE
Michigan State University

The attached charts illustrate the behavior of various monetary aggregates
(including some that I had not heard of six months ago) over the past three years. The
latest data plotted are December, 1996. The measures, roughly in order of narrowest to
most inclusive definitions are as follows:
1)

Base = St. Louis Adjusted Monetary Base

Ml = Reported Ml plus the estimated "Sweeps" series

Ml plus = Reported Ml + Savings Deposits (this is the most narrowly
defined measure that internalizes the "Sweeps" process.

MzM = Zero Maturity Money as defined by Bill Poole: M2 - Small Time
Deposits + Institution type Money Market Funds

M2minus = M2 - Small Time Deposits

The solid line in each picture measures the annualized month-to-month rate of
growth. The broken line is the year-over-year growth rate ending at the month plotted.
Finally, in each of the graphs a horizontal reference line has been plotted at five percent.
The starting period of these graphs roughly coincides with the decision by the
FOMC to start increasing its Funds rate target from the three percent level that had been
maintained for several years. These last three years are a period in which there is a
remarkable similarity in the growth rates of all of these aggregates. With the exception of
the growth rate of the Adjusted Monetary Base, the growth rates of all the aggregates
declined into the early part of 1995 (month-to-month basis) and then jumped to roughly a
five percent rate of growth that was roughly maintained until the last several months. On
a year-over-year moving average basis, the growth rates obviously bottomed out
somewhat later, typically around the middle of 1995, and then rose steadily until early
1996. By late 1996 the year-over-year growth rates of all these aggregates has risen to or
exceeds the five percent level. Mlplus and MzM are the two aggregates whose growth

rates are the highest over the past year with current year-over-year growth rates that are
substantially in excess of five percent.
The growth rate of the Adjusted Monetary Base continued and stayed around five
percent from the middle of 1994 through the middle of 1995, then dropped sharply and
trended upward until the middle of 1996 and has remained roughly around a five percent
rate over the past six months. Consequently the year-over-year moving average of this
rate did not reach a minimum until early 1996. This characteristic behavior of Base
growth probably reflects a significant reduction in exports of U.S. currency during 1995
from the levels of 1994. By the end of 1996 the year-over-year growth rate of the base is
also approaching five percent.
The issue that needs to be considered here is how will growth rates of these
aggregates evolve if the current Funds rate target is maintained. Last September we
concluded that the policy current at that time (a 5.25 percent Funds rate target), if
maintained, would not substantially reduce inflation below the then current levels. We
urged the Fed to reduce the growth rates of the monetary base and other monetary
aggregates to achieve zero inflation. We argued that monetary acceleration of the past
year should not be permitted to continue.
The data that have become available since our last meeting are not consistent with
our recommendation. The most charitable interpretation that can be read in these graphs
is that monetary growth was stabilized over the past six months; a more cynical view is
that it has continued to increase during this period. Recent forecasts of the outlook for
the U.S. economy for the next two years provide no evidence of expectations that
inflation will slow from current levels. The CBO's forecast in The Economic and Budget
Outlook: Fiscal Years 1998-2007 is for CPI inflation for 1997 and 1998 to continue at
the 2.9 percent annual rate experienced in 1996. In the same document the CBO quotes
the Blue Chip forecasters as projecting 2.9 percent CPI inflation for 1997 and a 3.0
percent rate for 1998 (p. 13). The CBO economic projections (not their forecasts) for
1999-2007 are for CPI inflation of either 3.0 or 3.1 percent (p. 15). The administration's
forecasts of CPI inflation (fourth quarter over fourth quarter) for 1997 and 1998 are 2.6
and 2.7 percent respectively (Economic Report of the President February, 1997. p. 90)

and its projections for 1998 through 2003 are 2.7 percent.

These forecasts and

projections suggest that presently there is no credibility associated with the announced
Federal Reserve policy of reducing inflation until it achieves a level that is no longer a
significant factor in the economic decisions of private agents.

Growth rates of Monetary Aggregates 1995-1996
Solid = Monthly Growth; Broken = Year over Year Growth
Base

Mlplus

MzM

Growth rates of Monetary Aggregates 1995-1996
Solid = Monthly Growth; Broken = Year over Year Growth
M2iriinus