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STAGFLATION
HEARINGS
BEFORE THE
SPECIAL STUDY ON ECONOMIC CHANGE
OF THE
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
NINETY-SIXTH CONGRESS
FIRST SESSION
APRIL 30, AND MAY 7 AND 9, 1979
Printed for the use of the Joint Economic Committee
U.S. GOVERNMENT PRINTING OFFICE
51-421
WASHINGTON : 1979
F o r sale by the Superintendent of Documents, U.S. Government Printing Office
Washington, D.C. 20402
JOINT ECONOMIC COMMITTEE
(Created pursuant to sec. "5(a) of Public Law 304, 79th Cong.)
LLOYD BENTSEN, Texas, Chairman
RICHARD BOLLING, Missouri, Vice Chairman
HOUSE OF REPRESENTATIVES
SENATE
HENRY S. REUSS, Wisconsin
WILLIAM PROXMIRE, Wisconsin
WILLIAM S. MOORHEAD, Pennsylvania
ABRAHAM RIBICOFF, Connecticut
LEE H. HAMILTON, Indiana
EDWARD M. KENNEDY, Massachusetts
GILLIS W. LONG, Louisiana
GEORGE McGOVERN, South Dakota
PARREN J. MITCHELL, Maryland
PAUL S. SARBANES, Maryland
CLARENCE J. BROWN, Ohio
JACOB K. JAVITS, New York
MARGARET M. HECKLER, Massachusetts
WILLIAM V. ROTH, JR., Delaware
JOHN H. ROUSSELOT, California
JAMES A. McCLTJRE, Idaho
CHALMERS P. WYLIE, Ohio
ROGER W. JEPSEN, Iowa
JOHN.M. ALBERTINE, Executive Director
Louis C. KRAUTHOFF II, Assistant Director-Director, 8SE0
RICHARD F. KAUFMAN, Assistant Director-General Counsel
CHARLES H. BRADFORD, Minority Counsel
SPECIAL STUDY ON ECONOMIC CHANGE
LOUIS C. KRAUTHOFF II, Director
GEORGE D. KRUMBHAAR, Jr., Counsel
DOUGLAS N. ROSS, Senior Economist
RICHARD D. BARTEL, Economist
(ID
CONTENTS
WITNESSES AND STATEMENTS
MONDAY, APRIL 30,
1979
Boiling, Hon. Richard, vice chairman of the Joint Economic Committee:
Opening statement
Okun, Arthur M., senior fellow, the Brookings Institution, Washington,
D.CL__
Feldstein, Martin, president, National Bureau of Economic Research, and
professor of economics, Harvard University, Cambridge, Mass
Eckstein, Otto, president, Data Resources, Inc., Lexington, Mass
Hardy, Jerome, president, Dreyfus Corp., New York, N.Y
MONDAY, MAY 7,
1
3
13
17
32
1979
Boiling, Hon. Richard, vice chairman of the Joint Economic Committee:
Opening statement
Cagan, Phillip, professor of economics, Columbia University, New York,
N.Y., and research associate, National Bureau of Economic Research,
Cambridge, Mass
„_
.
.
Nulty, Leslie Ellen, professional economist, International Association of
Machinists & Aerospace Workers, Washington, D.C
Sprinkel, Beryl W., executive vice president and economist, Harris Trust
& Savings Bank, Chicago, 111
Sommers, Albert T., senior vice president and chief economist, the Conference Board, New York, N.Y
WEDNESDAY, MAY 9,
49
52
55
76
84
1979
Rousselot, Hon. John H., member of the Joint Economic Committee,
presiding: Opening statement
Leontief, Wassily, director, Institute for Economic Analysis, New York
University, New York, N.Y
.
Wachter, Michael L., professor of economics, University of Pennsylvania,
Philadelphia, Pa
....
Meltzer, Allan H., Maurice Falk Professor of Economics and Social
Science, Carnegie-Mellon University, Pittsburgh, Pa
Eichner, Alfred S., professor of economics, State University of New York,
Purchase, N.Y
111
113
117
130
142
SUBMISSIONS FOR THE RECORD
MONDAY, APRIL 30,
1979
Eckstein, Otto: Prepared statement
Okun, Arthur M.: Prepared statement
21
8
MONDAY, MAY 7,
1979
Nulty, Leslie Ellen: Prepared statement
Sommers, Albert T.: Prepared statement
Sprinkel, Beryl W.: Prepared statement
59
88
80
WEDNESDAY, MAY 9,
Meltzer, Allan H.: Prepared statement
Wachter, Michael L.: Prepared statement
(in)
.
1979
136
122
STAGFLATION
MONDAY, APKIL 30, 1979
CONGRESS OF THE UNITED STATES,
SPECIAL STUDY OK ECONOMIC CHANGE OF THE
JOINT ECONOMIC COMMITTEE,
Washington, D.O.
The committee met, pursuant to notice, at 10 a.m., in room 6226,
DIrksen Senate Office Building, Hon. Richard Boiling (vice chairman
of the committee) presiding.
Present: Representative Boiling and Senator Javits.
Committee staff present: John M. Albertine, executive director;
Louis C. Krauthoff II, assistant director-director, SSEC; Lloyd C.
Atkinson, Kent H. Hughes, and L. Douglas Lee, professional staff
members; Mark Borchelt, administrative assistant; Charles H. Bradford, minority counsel; and Stephen J. Entin and Mark R. Policinski,
minority professional staff members.
Special Study on Economic Change staff present: George D. Krumbhaar, Jr., counsel; Douglas N. Ross, senior economist; Richard I).
Bartel, economist; and Michael J. Lockerby and Carolyn EL Crowley,,
research assistants.
OPENING STATEMENT OF REPRESENTATIVE BOLLING, VICE CHAIRMAN
Representative BOLLING. The committee will be in order. The chairman, Senator Bentsen. is delayed a little bit. And I will start.
This morning we are opening the second set of public panel discussions of the Joint Economic Committee in connection with our Sperial
Study on Economic Change. I might explain for those not familiar
with the Special Study project that it grew out of discussions with the
majority and minority members of the Joint Economic Committee and
with the leadership in the House and Senate. We prepared
a prospectus
about 2 vears ago which calls for a 3i/£>-year stud}7 to identify the
nature of major economic changes occurring in the United States and
the. world that may have rendered ineffective the traditional methods
for achieving aims of the Employment Act of 1946. We believe thorough analysis of these profound changes would yield not only a better
understanding of long term problems confronting Congress, but would
also suggest fresh policy options for our consideration. On the basis of
this prospectus, House Concurrent Resolution 248 was introduced in
the House and passed overwhelmingly, then was approved by the Senate b}" unanimous consent on July 18.1977.
The underlying thesis of the Study is that economic, social, political, international, and technical conditions have changed, and are
(1)
still changing markedly. This suggests that conventional wisdom and
established economic tools may not be equal to the challenge of making
sound policies in the economic sphere. The so-called laws of economics
have not been repealed but all guiding principles presuppose certain
environmental conditions, customs, and practices. When these change
the implementation of new policies and modes of adjustment have to
change also.
This comprehensive project now has underway papers and reports
on the nature and consequences of economic change in nine major
areas: Human resources and demographics; materials and energy resources ; research and innovation; stagflation; government regulation;
Federal finance; State and local finance; pensions; and the international sector.
Today we turn our attention to the twin problems of inflation and
unemployment which our study addresses under the heading "Stagflation." Last Thursday Senator Bentsen said to Mr. Kahn when he testified before the JEC that he thought it premature to talk about a safe
landing when inflation is still taking off. It seems to me there is plenty
of time to worry about the landing when we started down from what
lias again become double-digit inflation. We are not here today to talk
about the short run aspects of stagflation. What we want to discuss today is where will the typical American family be in the next decade.
How long can they go on altering their spending and borrowing habits
to protect their purchasing power and standard of living ? How long
before continuing inflation corrodes the basic institutions of our free
society and market economy? Yet the American public and congressional legislators alike recognize that there are no quick or easy solutions to the twin problems "of extensive inflation and unemployment.
So serious are these problems in the minds of many congressmen
that the Joint Economic Committee for the first time in 20 years issued
a unified report endorsed by both the Democratic and Republican
members. The JEC report pointed out that in order to correct deeply
entrenched inflation and unsatisfactory levels of unemployment requires the Federal Government to put its financial house in order and
to meet the major challenges confronting us on the supply side of the
economy.
On the supply side we look for higher production, not lower. We
take no satisfaction when our index of industrial production rises
little or not at all. We look for more efficient production processes,
more effective management, higher investment, more skilled labor and
higher total productivity. It is our target to achieve price stability in
an expanding economy, not a declining one. We cannot make our peace
with either rising inflation or rising unemployment.
If we do not solve both of these problems of inflation and unemployment, not one but both, we may encounter in these United States, not
far down the road, challenges to both our economic and political institutions of a seriousness we have not recently hitherto contemplated.
To avert the tragedy of such destructive challenges is our primary
purpose.
Accordingly, the Special Study has invited a number of preeminent
economists, business leaders, and labor authorities to join us in a dialog
on the longer term outlook and solution to the problems of inflation
and unemployment. As in our hearing last year we have organized
today's discussions as a panel. Our experience with panel discussions
since the 1950's confirms our belief that the democratic process works
in an intellectual sense. The best ideas, the best insights emerge from
free exchange from a spirited dialog among a variety of people. Some
will draw from their academic experience and intellectual interests,
others from their political pursuits and others from their activities in
business and labor.
Our panelists today are too well known to need an introduction.
Arthur Okun, a senior fellow at Brookings; Otto Eckstein, president
of Data Resources, Inc.; Martin Feldstein, president of National
Bureau of Economic Eesearch; and Jerome Hardy, president of the
Dreyfus Corp. I think I ought to add one more fact you might not
know about Mr. Hardy. He is the former publisher of Life magazine.
Mr. Okun, you have as proposition 1 that in the mid-1970's chronic
inflation is new in our history. It is a new phenomenon that can't be
treated effectively with old prescriptions. I think it would be ideal for
you to start our discussions. We are delighted to have you.
STATEMENT OP AKTHTJE M. OKTJN, SENIOR PELIOW, THE
BKOOKINGS INSTITUTION, WASHINGTON, B.C.
Mr. OKUN. It is a privilege to address you. I did want to emphasize
the chronic problem and the need to think about its implications for
revising our theories.
Unlike all previous reported U.S. recessions, the 1970 recession did
not stop inflation in its tracks. Even more remarkably, the prolonged
1978-75 recession left us with a basic inflation rate of 6 percent.
The transformation of our inflationary behavior is rooted in a system
of pricemaking that, throughout modern times has departed farther
and farther from the textbook model. Most of our economy is dominated by cost-oriented prices and equity-oriented wages. Most prices
are set by sellers with principal focuses on maintaining customers and
market share over the long run. The pricing policies designed to treat
customers reasonably relies on some standard measure of costs and a
percentage markup that displays very little variation over the business
cycle.
Similarly, the key to wage decisions in both nonunion and union
areas is a common long-run interest of skilled workers and employers
in maintaining their job relationships. Employers make investments
in a trained, reliable, and loyal work force. They know that if they
curbed wages stringently in a slump, they would pay heavily for that
strategy with swollen quit rates by their workers during the next period
of prosperity, and so during recession and slack periods, nonunion
firms with workers on layoff and queues of eager job applicants find it
worthwhile to raise the wages of their workers, in order to protect
their longer-term personnel relationships.
In those nonunion areas where workers have rapid turnover and thus
employers and employees have little stake in lasting relationships,
wages respond more noticeably to the level of unemployment. But, in
most areas, personnel policies are sensibly geared to the long run with
an emphasis on equitable treatment. And the basic test of equity is that
the pay of workers is raised in line with the wage increases of other
workers in similar situations. Such a strategy introduces inertia in the
rate of wage increase; it creates a pattern of wages following wages.
The customer and career relationships that desensitize wages and
prices from excess supplies and demands in the short run have a genuine social function. They are not creations of evil business monopolies
or unduly powerful labor unions, but rather efficient arrangements
for a complex interdependent economy in which customers and suppliers, workers and employers benefit greatly from ongoing relationships.
And the resulting influence on prices and wages cuts two ways. When
total spending in dollars starts to expand rapidly, most of the increase
takes the form of a bonus in output and employment, with little added
inflation. In that sense, these institutions make inflation slow starting.
But when the dollar value of GNP slows down, most of that takes the
form of a loss of production with little relief from inflation. So inflation becomes slow stopping.
As people recognize the persistence of inflation, they change behavior in ways that
make inflation more rapid and more tenacious.
Prior to the 1970?s, the U.S. economy had a basically noninflationary
environment—average inflation rates in peacetime rarely exceeded 2
percent for any sustained period.
In that environment, price and wage decisions relied heavily on the
dollar as a yardstick, a scorekeeping device, and a basis for planning
and budgeting.
During the 1970's, these institutions changed as Americans adjusted
to the persistence of inflation. The notion of par-for-the-course on
wage increases was revised upward. Escalator clauses spread through
the major collective bargaining contracts and thus made wages respond
promptly to inflation in the cost of living. Businessmen began to adjust
their pricing to reflect the growing gap between high replacement costs
and low actual historical costs. They shortened the intervals at which
th^y raised prices, and many stopped taking fixed-price orders. These
adaptations to chronic inflation speed up the spiral, transmitting
higher wages and other costs into higher prices and higher prices into
higher wages even more rapidly.
That takes me to the second point. If left untreated, the syndrome
of chronic inflation is likely to become more severe and to impose even
greater economic and social costs in the 1980's. This neglect of inflation is malign, not benign.
The adaptations to chronic inflation contributed to the bad news of
1978. Nonunion wages, which had been rising much less rapidly than
union wages during the preceding few years, began to catch up.
The American people identify inflation as domestic public enemy
number one in opinion surveys. And they did so by an overwhelming*
margin even during 1976 and 1977, when inflation proceeded at a
fairly steady 6 percent rate and was well predicted. They are concerned for good reasons. Only a small minority of Americans have obtained cost-of-living escalators that protect their real incomes effectively from inflation. They do not find opportunities in financial markets to protect their wealth against inflation and still preserve their
liquidity.
For the long run, no American can plan effectively in a world where
the dollar re-mains the yardstick, but shrinks in real value at an
uncertain rate.
Moreover, the ratcheting-up of inflation has produced a serious
credibility gap between the citizenry and its elected officials. Americans have been told again and again that inflation would be curbed.
But, in fact, it has kept racheting-up right to the present.
Finally, inflation has exacerbated social divisiveness. It is not easy
for families to know where they stand in the price-wage race. They
feel threatened by it and regard it as unfair. Many undoubtedly feel
that they are behind in the race, even when that may not be objectively
the case. And so, they feel that they have the short end of the stick
and are convinced that somebod}^ else must have the long end. The
principal new product of the American economy in the decade of the
1970's has been sticks with two short ends.
Finally, I want to stress that an efficient anti-inflationary program
must be diversified. It needs three major elements. First, enough fiscalmonetary discipline to provide a safety margin against excess demand.
Second, a coordinated Federal initiative to reduce private costs. And
third, constructive measures to obtain price and wage restraint.
We should set our fiscal and monetary policies to accept some downside risks on output and employment in the short run. We didn't
accept enough of those risks in 1977 and 1978. It turned out in retrospect that fiscal-monetary policy was too stimulative. We must do
better in the future to establish a safety margin against overly strong
markets.
On the other hand, we must recognize the ill effects of overdoses of
fiscal and monetary restraint. Those effects are clear in the sad experience of 1974-75, when we crusaded against inflation relying solely
on tight budgets and tight money.
With that approach, the Nation squanders about $200 billion of
real production and roughly 5 million worker-years of jobs for every
point that it reduces the inflation rate. The evidence of recent years
suggests that, through its fiscal and monetary policies, the Federal
Government can control—within a reasonable margin—the total
growth of the GNP measured in dollars. But it cannot control the
division of that growth between increases in output and increases
in the price level. That is determined by private price and wage
decisions.
During recession and slack periods, each dollar trimmed from GNP
means a loss of roughly 90 cents of output and the savings of about a
dime on the price level. Any anti-inflationary proposal that relies
solely on -balancing the budget and tightening money is, in reality, a
proposal for an encore of that experience. And it should carry a truthin-packaging label revealing that its probable contents are 90 percent
production losses and job losses and only about 10 percent inflation
saving.
There is no doubt that there is a pure fiscal monetary cure taken
by itself for inflation. Nobody questions that. Nobody should. The
questions all lie in the consequences of such a strategy. All the evidence
suggests that those consequences for production, employment, capital
formation, and for our social fabric would be horrendous. Average
citizens cannot reasonably be expected to recognize those consequences
fully, and it is understandable when some of them grasp at the straw
of budget balancing in the hope of a rescue from inflation. But our
political leaders ought to know better; and if they don't, they ought
to be willing to learn better.
Turning to Federal cost-reducing initiatives, I want to stress that
Federal policies have pervasive impacts on costs and prices in many
sectors of the economy. The Federal Government adds to the price
level when it imposes cost-raising taxes, like excises on products or
payroll taxes on employers. Its social regulation for safety, health,
and environment is a source of higher costs and prices—necessary in
part, but unnecessary to some degree.
Its economic regulation of industries with public utility characteristics influences their price and costs. In order to pursue certain equity
objectives, the Government sets floors on some prices—as in the dairy
and sugar program—and on pay; it works through supply controls on
planted acreage, timber cutting-, and oil leasing and through tariffs
and other restrictions on imports.
In my judgment, the most serious inflationary stimulus in recent
years came from a series of such self-inflicted wounds incurred during
1977: A major increase in payroll taxes on employers, a large rise in
the minimum wage, reinstituted acreage controls in farming, added
regulatory burdens on business, and new barriers to imports.
Proposals that would reduce costs have been frequently rejected.
Hospital cost containment was not passed by the last Congress; Presidential proposals to cut certain Federal excise taxes were ignored.
Indeed, to my amazement, some congressional leaders advocate a new
value-added tax, which would surely add to our inflationary woes.
There are enormous potential anti-inflationary benefits in this area.
We could cut Federal payroll taxes on employers; we could use grant
formulas to encourage States and cities to lower their price-raising
and cost-raising taxes. We could reform regulation to reduce its cost
burdens.
I have suggested again and again, and I will try once more, as a
first step into this area, a procedural reform—the development of a
system of inflation scorekeeping. The Congressional Budget Office,
or General Accounting Office, should be asked to issue a quarterly
report, identifying all actions and pending proposals by the President
and by the Congress that serve either to raise or to iower the price
level, and that report should show an impact. I think putting it on
the table would make an enormous difference in the way Congressmen
behave.
Finally, the need for price and wage restraint. During recent years,
the price-wage spiral has been the most fundamental source of rapid
inflation in the United States. Any efficient cure for inflation must
get directly at that source. At the present time, the administration's
program of price-wage standards deserves our full support.
Any plea for voluntary cooperation in our society implies a threat
of focusing the splotlight of public opinion on flagrant violators.
Beyond that, the present program carries that threat of sanctions
associated with privileged relationships that many business firms have
with the Federal Government. These provisions strengthen the credi-
bility of the program, although they invoke an unlegislated bureaucratic power that is not ideal. That informal structure is about right.
It is the best we can do.
I don't think we want to do more and I don't think we can afford
to do less. I do not expect the President to seek authority for price
and wage controls, ancl I personally would emphatically oppose any
mandatory structure of controls over prices and wages.
Despite a few collective bargaining settlements that exceeded the
wage standard, the overall behavior of pay since last October has
accorded remarkably well with the standard.
On the other hand, the overall behavior of industrial prices raises
strong suspicions of significant violations of the price standard. But
the identification of violators is apparently a, complex and difficult
task. All in all, I expect this program to contribute to the deceleration
of inflation, as some wage restraint passes into price restraint, and as
businesses are made more conscious of the urgent need for their
cooperation.
Informal semivoluntary policies of price and wage restraint have
helped significantly over some periods of time. But such programs have
been brittle in the face of changes in economic conditions and in business and labor reactions. And so they get phased out and then reshaped
and reinstituted. Keeping an incomes policy in the anti-inflationary
arena is not easy. P. T. Barnum once noted that keeping a lamb in a
cage with a lion requires a large reserve supply of lambs. Similarly,,
society may need a reserve supply of incomes policies, because we wilt
need some program of price-wage restraint for years to come.
Along with a number of economists, I have been advocating the development of a tax-based income policy, either in a reward or penalty
form. There is a tremendous social interest in wage and price restraint,
and it can be pursued better by providing market-type incentives for
such restraint through the tax system than by relying on voluntary appeals or rigid mandatory rules.
I presented a specific proposal last spring. I won't present it here,
but I will be glad to answer questions about it. This is getting to be an
old story for me, Congressmay Boiling.
I have been advocating a cost-reducing program and tax-based income policy as essential parts of an efficient anti-inflationary strategy—in combination with fiscal-monetary restraint—for the past 5
years. I realize that many of these proposals are untried and unproven,
and that many pose administrative problems and meet political opposition from major interest groups. So I remain patient and persistent.
I am more encouraged that the President saw to propose real wage
insurance than I am disappointed by its rejection by the Congress.
I do want to stress that my proposals are realistic. The only thing
that bothers me is when people call them imaginative. In fact, there are
two popular doctrines that require imagination. One predicts inflation
will simmer down naturally or become tolerable to the American people. And the other proclaims that fiscal and monetaiy restraint alone
can cure inflation without deep and prolonged recession. Those are the
imaginative strategies. They have been tried and proven false.
It is time to face the realities of the new disease of chronic inflation
and to focus on the prescriptions that are appropriate for curing it.
Thank you.
8
Representative BOLLING. Thank you.
[The prepared statement of Mr. Okun follows:]
PREPARED STATEMENT OF ARTHUR M.
OKUN1
It is a privilege to present to this distinguished committee my views on the
crucial issues posed by stagflation. Chronic inflation has been the outstanding
feature of the American economy in the seventies, and it is our foremost economic
problem as we approach the decade of the eighties. My statement will emphasize
x
three key propositions :
(1) That the chronic inflation of the seventies is unprecedented in our history.
I t is a new and different phenomenon that cannot be diagnosed correctly with
old theories or treated effectively with old prescriptions.
(2) If left untreated, the syndrome of chronic inflation is likely to become
more severe and to impose even greater economic and social costs in the eighties.
Thus, any neglect of inflation is malign, not benign.
(3) An efficient anti-inflationary program must be diversified. It needs three
major elements : (a) enough fiscal-monetary discipline to provide a safety margin
against excess demand; (b) a coordinated federal initiative to reduce private
*/costs; (c) constructive measures to obtain price-wage restraint.
THE DIAGNOSIS OF STAGFLATION
The recent era of inflation began in the mid-sixties with excess demand. That
initial episode of inflation fit the traditional definition of too much money chasing
too few goods. In 1966-68, the Federal budget was an engine of inflation, and it
was not effectively offset by monetary restraint. Employment, production, capital
spending, and real incomes soared—but so did prices. Serious mistakes of economic policy were made in the pursuit of guns and butter during the Vietnam
period. Yet, it must be remembered that every previous wartime period in U.S.
history was marked by more rapid inflation. The big difference this time was
that the end of the war did not bring the end of the inflation. On the contrary, it
ratcheted up further.
For the years 1968 through 1978, the inflation rate of our GNP averaged
6.1 percent, and at its lowest was 4.1 percent in 1972. In contrast, for the years
1952 through 1967, inflation averaged 2.0 percent and at its worst was 3.4 percent in 1957. Thus, every year since 1968 has had a higher inflation rate than any
year between 1952 and 1967. Rapid inflation became a chronic disease for the
first time in our history. In 1970, we experienced a recession that, unlike all
previous recorded U.S. recessions, did not stop inflation in its tracks. Even more
remarkably, the prolonged and severe 1973-75 recession left us with a basic
inflation rate of 6 percent, which remained essentially unchanged from late 1975
to the end of 1977.
The transformation of our inflationary behavior is rooted, in my judgment, in
a. system of price and wage decisionmaking that, throughout modern times, has
^departed farther and farther from the textbook model in which supply and
demand call the tune promptly and reliably. As I will explain, our system of
^cost-oriented prices and equity-oriented wages actually slows down an inflationary trend initially, but it also makes inflation much more stubborn once it
has become entrenched. The resulting inertia of inflation feeds on itself, changing
patterns of behavior that were once geared to an essentially noninflationary
environment in ways that speed the wage-price spiral.
The realUies of the price-wage system.—In a small and shrinking sector of
the U.S. economy, products are traded in organized auction markets, and prices
vary from day to day to keep supply and demand in balance. Those prices respond promptly and sharply to recession. For example, prices of sensitive industrial raw materials fell by 15 percent between May 1974 and March 1975.
That area, which matches the textbook model, offers a striking contrast to the
rest of the economy.
Most of our economy is dominated by cost-oriented prices and equity-oriented
wages. Most prices are set by sellers whose principal focus is on maintaining
•customers and market share over the long run. The pricing policies designed
1
The views expressed are my own and are not necessarily those of the officers, trustees,
©r other staff members of The Brookings Institution.
9
to treat customers reasonably and maintain their loyalty in good times and bad
times rely on some standard measure of costs. Prices are set to exceed costs by a
percentage markup that displays only minor variation over the business cycle.
Similarly, the key to wage decisions in both union and nonunion areas is the
common long-run interest of skilled workers and employers in maintaining their
job relationships. Employers make investments in a trained, reliable, and loyal
work force as well as in plant and equipment. They know that if they curbed
wages stringently in a slump, they would pay heavily for that strategy with
swollen quit rates by their workers during the next period of prosperity.
Thus, during recession and slack periods, nonunion firms with workers on
layoff and queues of eager job applicants find it worthwhile to raise the wages
of their workers, in order to protect their longer term personnel relationships.
In those nonunion areas where workers have rapid turnover and thus employers
and employees have little stake in lasting relationships, wages respond more
noticeably to the level of unemployment. But, in most areas, personnel policies
are sensibly geared to the long run with an emphasis on equitable treatment.
And the basic test of equity is that the pay of workers is raised in line with the
wage increases of other workers in similar situations. Such a strategy introduces
inertia in the rate of wage increase; it creates a pattern of wages following wages.
The customer and career relationships that desensitize wages and prices from
excess supplies and demands in the short run have a genuine social function. They
are not creations of evil business monopolies or unduly powerful labor unions,
but rather efficient arrangements for a complex interdependent economy in which
customers and suppliers, workers and employers benefit greatly from ongoing relationships. And the resulting influence on prices and wages cuts two ways.
When total spending in dollars starts to expand rapidly, most of the increase
takes the form of a bonus in output and employment, with little added inflation.
In that sense, these institutons make inflation slow starting. But when the
dollar value of GNP slows down, most of that takes the form of a loss of production with little relief from inflation. So inflation becomes slow stopping.
Adapting to inflation.—As people recognize the persistence of inflation, they
change behavior in ways that make inflation more rapid and more tenacious.
Prior to the seventies, the U.S. economy had a basically noninflationary environ*
ment—average inflation rates in peacetime rarely exceeded 2 percent for any
sustained period. In that environment, price and wage decisions relied heavily
on the dollar as a yardstick, a score-keeping device, and a basis for planning1,
and budgeting. Americans adjusted to a reasonable notion of the wage increase
that met par-for-the-course. And so labor and management were willing to sign
contracts that fixed wage rates over a three-year interval. Finns set their prices
on the basis of known actual costs that they had paid for their labor and supplies,
rather than on hypothetical calculations of replacement costs. Salesmen accepted
orders for the future delivery of products at guaranteed prices. Advertising
catalogues carried price lists that were subject to change only infrequently,
often at stated intervals. Public utility and other regulatory commissions reviewed rates only occasionally.
During the seventies, these institutions changed as people recognized the
persistence of inflation. The notion of par-for-the-course on wage increases was
revised upward. Escalator clauses spread through the major collective bargaining contracts and thus made wages respond promptly to inflation in the cost of
living. Businessmen began to adjust their pricing to reflect the growing gap
between replacement costs and actual historical costs. They shortened the intervals at which they raised prices, and many stopped taking fixed-price orders.
These adaptations to chronic inflation speed up the spiral, transmitting higher
wages and other costs into higher prices and higher prices into higher wages
even more rapidly.
THE PRINCIPLE OF MALIGN NEGLECT
Because reliance on the dollar is so heavily embedded into our economic practices and thinking, these adaptations to inflation have really just begun. If theinflation rate is not reduced, they are bound to spread much further as people
keep adjusting to inflation in self-defense. In a sense, some of these adjustments
represent ways of learning to live with inflation, and hence they are welcomed
by some economists. But while they can reduce the amount of' pain per point
of inflation, they are bound to increase the number of points of inflation. Tn my
judgment, they are more of a disease than a cure. If these institutional adapta-
10
tions keep spreading, the inflation rate will keep ratcheting up. Inflation tends to
feed on itself rather than to correct itself. And thus neglect of inflation is, in
principle, malign rather than benign.
The adaptations to chronic inflation contributed to the bad news of 1978.
Nonunion wages, which had been rising much less rapidly than union wages
during the preceding few years, began to catch up. Because of the wide gap
between historical and replacement costs, businessmen felt a need to raise their
markups when the markets for their products strengthened—long before excess
demand, in any objective sense, appeared. These developments should not have
surprised anyone; they were predictable—indeed, I predicted them in October
1977.
To be sure, food and energy have played a significant role in the acceleration
of inflation during the past year. But prices of those products tend to spurt and
slow down; indeed, the major inflationary danger they pose over the longer run
stems from the way they can get into the wage-price spiral. Over the entire
period of 4 years of economic recovery since March 1975, food and fuel have not
raised the inflation rate significantly. Since March 1975, the consumer price index
has risen at an average annual rate of 7.2 percent; the average for all items
except food and energy has been nearly as large—7.0 percent. Thus, we have been
experiencing primarily wage-price spiral inflation—not food, fuel, or other
special-factor inflation.
The American people identify inflation as domestic public enemy no. 1 in opinion surveys. And they did so by an overwhelming margin even during 1970 and
1977, when inflation proceeded at a fairly steady 6 percent rate and was wellpredicted. They are concerned for good reasons. Only a small minority of
Americans have obtained cost-of-living escalators that protect their real incomes
effectively from inflation. They do not find opportunities in financial markets
to protect their wealth against inflation and still preserve their liquidity. The
stable interest rates on passbook deposits that once provided them with a predictable, reasonable return on liquid assets now do not even allow their principal to keep up with the price level—not even on a before-tax basis. Common
stocks have been miserable failures as inflation hedges, because the era of stagflation brought higher volatility and lower growth of real corporate earnings.
The single-family home has been the one good investment for most Americans,
but many who have taken advantage of that opportunity have had to sacrifice
liquidity and some have plunged over their heads with commitments for cash
payments on mortgages. For the long run, no American can plan effectively in
a world where the dollar remains the yardstick, but shrinks in real value at an
uncertain rate.
Moreover, the ratcheting-up of inflation has produced a serious credibility
gap between the citizenry and its elected officials. Americans have been told again
that inflation would be curbed. The acceptable rate of inflation in policyinaking
rose from 1% percent in the early sixties to 3 percent in the early seventies, and
apparently, to 6 percent in the mid-seventies. Anyone familiar with that history
must wonder whether the present inflation rate of about 8 percent will be reduced or whether it will be just one more turn of the ratchet.
Finally, inflation has exacerbated social divisiveness. It is not easy for families
to know where they stand in the price-wage race/They feel threatened by it and
regard it as unfair. Many undoubtedly feel that they are behind in the race,
even when that may not be objectively the case. And so, they feel that they have
the short end of the stick and are convinced that somebody else must have the
long end. The principal new product of the American economy in the decade of
the seventies has been sticks with two short ends.
A DIVERSIFIED ATTACK ON INFLATION
Inflation must be reduced substantially over the years ahead. That can only
^be accomplished gradually; and it can only be accomplished efficiently through
a concerted use of a variety of anti-inflationary policies—including fiscal-monetary restraint, federal cost-reducing initiatives, and price and wage restraint.
Fiscal-monetary restraint.—In battling against inflation, we must accept some
downside risks on output and employment in the short run, in order to clear the
way for sustained growth in the long run. In retrospect, we did not balance these
risks prudently enough in setting fiscal-monetary policy during 1977-78. We
must do better in the future to establish a safety margin against overly strong
markets.
11
On the other hand, we must recognize the ill effects of overdoses of fiscal and
monetary restraint. Those effects are clear in the sad experience of 1974-75, when
we crusaded against inflation relying solely on tight budgets and tight money.
During fiscal year 1974, the federal budget was nearly balanced in the face of a
recession; during calendar year 1974, the growth of money (currency and demand
deposits) was held to 4% percent. The beneficial impact on inflation was disappointingly small, while the unfavorable impact on employment, production,
and capital formation was enormous.
With that approach, the nation squanders about $200 billion of real production
and roughly 5 million worker-years of jobs for every point that it reduces the
inflation rate. The evidence of recent years suggests that, through its fiscal and
monetary policies, the Federal Government can control—within a reasonable
margin—the total growth of the GNP measured in dollars. But it cannot control
the division of that growth between increases in output and increases in the
price level. When the government pushed the economy into deep recession and
prolonged slack, each dollar trimmed from GNP meant a loss of roughly 90 cents
of output and a saving of about 10 cents on the price level. Any anti-inflationary
proposal that relies solely on balancing the budget and tightening money is, in
reality, a proposal for an encore of that experience. And it should carry a truthin-packaging label revealing that its probable contents are 90 percent production
losses and job losses and only about 10 percent inflation saving.
Undoubtedly, inflation could be eliminated by fiscal-monetary restraint alone,
but the consequences of such a strategy for production, employment, capital formation, and our social fabric would be horrendous. Average citizens cannot reasonably be expected to recognize those consequences fully, and it is understandable when some of them grasp at the straw of budget balancing in the hope of a
rescue from inflation. But our political leaders ought to know better, or to learn
better.
Federal cost-reducing initiatives.—Federal policies have pervasive impacts on
costs and prices in many sectors of the economy. The federal government adds
to the price level when it imposes cost-raising taxes, like excises on products or
payroll taxes on employers. Its social regulation for safely, health, and environment is a source of higher costs and prices—necessary in part, but unnecessary to some degree. Its economic regulation of industries with public utility
characteristics influences their price and costs. In order to pursue certain equity
objectives, the government sets floors on some prices (as in the dairy and sugar
program) and on pay (as in the minimum wage). It affects the supply of various
private industries through such provisions as acreage controls, timber cutting,
and oil leasing. It also influences price and costs through tariffs and other restrictions on imports.
Because most individual government actions and policy changes in these areas
have relatively small effects, they often go unnoticed. And jet they add up to a
great deal. In my judgment, the most serious inflationary stimulus in recent years
came from a series of such self-inflicted wounds incurred during 1977: a major
increase in payroll taxes on employers, a large rise in the minimum wage, reinstituted acreage controls in farming, added regulatory burdens on business, and
new barriers to imports.
Proposals that would reduce costs have been frequently rejected. Hospital
cost containment was not passed by the last Congress; presidential proposals to
cut certain Federal excise taxes were ignored. Indeed, to my amazement, some
congressional leaders advocate a new value-added tax, which would surely add
to our inflationary woes.
There are enormous potential anti-inflationary benefits in this area. We could
cut federal payroll taxes on employers; we could use grant formulas to encourage states and cities to lower their price-raising and cost-raising taxes. We
could reform regulation to reduce its cost burdens. This is the most efficient strategy for curbing the price level. It does not put people out of work, and it does
not have to constrain private price and wage decisions.
I have suggested again and again, as a first step into this area, a procedural reform—the development of a system of inflation scorekeeping. The Congressional
Budget Office (or General Accounting Office) should be asked to issue a quarterly
report, identifying all actions and pending proposals by the President and by
the Congress that serve either to raise or to lower the price level and estimating
their dollar impact. Nobody has yet told me why this idea is defective, but nobody
has acted to implement it.
12
Price-wage restraint.—During recent years, the price-wage spiral has been the
most fundamental source of rapid inflation in the United States. Any eflicient cure
for inflation must get directly at that source. At the present time, the administration's program of price-wage standards deserves our full support.
Any plea for voluntary cooperation in our society implies a threat of focusing the spotlight of public opinion on flagrant violators. Beyond that, the present
program carries that threat of sanctions associated with privileged relationships that many business firms have with the Federal Government. These provisions strengthen the credibility of the program, although they invoke an unlegislated bureaucratic power that is not ideal. All in all, I can accept them.
I would also consider it useful for the President to have clearly legislated authority to delay major price or wage decisions that could pose a threat to the
viability of the entire program. But the very discussion of such legislation would
intensify the widespread fears of business that we are on the road to controls.
In fact, I do not expect the President to seek control authority, and I personally
would emphatically oppose any mandatory structure to controls over prices and
wages.
As proposed by the President, the overall program was reasonably equitable
as between business firms and workers. But that fairness depended heavily on
the real wage insurance provision. Without that provision, the standards impose
on workers a heavier burden of restraint and much more potential risk than they
do on businessmen. America's workers are being asked to ante up for the deal.
And thus far most are doing so. Despite a few collective bargaining settlements
that exceeded the wage standard, the overall behavior of pay since last October
has accorded remarkably well with the standard. On the other hand, the overall behavior of industrial prices raises strong suspicions of significant violations
of the price standard. But the identification of violators is apparently a complex and difficult task. All in all, I expect this program to contribute to the
deceleration of inflation, as some wage restraint passes into price restraint, and as
businesses are made more conscious of the urgent need for their cooperation.
Our historical experience, as well as that of many other countries, suggests
that informal, "semivoluntary" policies of wage and price restraint can help significantly over some periods of time. But such programs have been brittle in the
face of changes in economic conditions and in business and labor reactions.
And so they get phased out and then reshaped and reinstituted. Keeping an
incomes policy in the anti-inflationary arena is not easy. P. T. Barnum once noted
that keeping a lamb in a cage with a lion requires a large reserve supply of lambs.
Similarly, society may need a reserve supply of incomes policies. We will need
some program of price-wage restraint for years to come.
Along with a number of other economists, I have been advocating the development of a tax-based incomes policy, either in a reward or penalty form. There is a
social interest in wage and price restraint, and it can be pursued better by providing market-type incentives for such restraint through the tax system than by
relying on voluntary appeals or rigid mandatory rules. The tax approach allows
people to make choices in light of the rewards or penalties provided. The tax
seeks to make it worthwhile for most firms and workers to practice the restraint
that benefits the entire society. Undoubtedly, such a program adds to the burdens
on the tax system, but so do the rules on capital gains, the residential energy
credit, and the targeted jobs credit. I presented specific proposals for a wage
reward form of tax-based incomes policy to the Senate Banking Committee last
spring. I would be delighted to discuss these issues further in response to your
questions.
CONCLUSION
I have been advocating a cost-reducing program and tax-based incomes policy
as essential parts of an eflicient anti-inflationary strategy (in combination with
fiscal-monetary restraint) for the past 5 years. I realize that many of these proposals are untried and unproven, and that many pose administrative problems and
meet political opposition from major interests groups. So I remain patient and
persistent. I am more encouraged that the President saw fit to propose a real
wage insurance than I am disappointed by its rejection by the Congress. I am
convinced that my proposals are realistic—not "imaginative," as some have
labeled them. In fact, there are two popular doctrines that require a lot of imagination. One keeps predicting that inflation will either simmer down naturally or
become tolerable to the American people. And the other proclaims that fiscal and
13
monetary restraint can cure inflation without a deep and prolonged recession.
Those "imaginative" strategies have been tried, and they have been proven false.
It is time to face the realities of the new disease of chronic inflation and to
focus on the prescriptions that are appropriate for curing it.
Bepresentative BOLLING. Next, Mr. Feldste-in is president of the
National Bureau of Economic Research, and a professor of economics
at Harvard University.
Mr. Feldstein.
STATEMENT OE MAETIN TSLD3TEIU, PRESIDENT, NATIONAL
BU&EATJ OE ECONOMIC &ESEAP.CH, AND PROFESSOR OE ECONOMICS, HARVARD UNIVERSITY, CAMBRIDGE, MASS.
Mr. FELDSTEIN. Thank you.
I am pleased to have this opportunity to participate in these hearings on stagflation. Although we have a single word for it, stagflation
is not one problem but three separate problems: High unemployment,
high inflation, and low growth of productivity.
But trying to understand stagflation is like trying to understand a
club sandwich. It is important to understand not only the individual
parts but also the interactions among them. As I will explain this
morning, I believe that our high unemployment rate has contributed
to our high rate of inflation and that our high rate of inflation has
reduced the rate of productivity growth.
TJNEMPLOTMENT
Let me begin with unemployment. For more than a decade now,
the unemployment rate has been widely regarded as unsatisfactorily
high. I agree with this view. I think that our high unemployment rate
represents a substantial waste of productive capacity and, especially1
for young people, is symptomatic of much more serious problems.
There is no economic reason why we in the United States cannot
achieve the much lower unemployment rates that have traditionally
been enjoyed by other industrial countries.
It is crucial, however, to recognize that our high unemployment rate
represents structural and incentive problems and is not an indication
of inadequate aggregate demand.
Despite the seemingly high overall unemployment rate, labor markets are actually very tight. The unemployment rate among married
men is now at 2.6 percent and has only been lower for 1 year—1973—
since 1969.
The latest figures on manufacturing layoffs show as low a layoff
rate—0.8 percent—as we have had in the past two decades. The number
of employees on payrolls grew more than 4 percent last year. And
average hourly earnings rose 8.8 percent, up from 7.7 percent the year
earlier despite the substantial growth of new entrants.
A permanent reduction in the unemployment rate cannot be achieved
by expansionary macroeconomic policies. Dealing with the unemployment aspect of stagflation will require microeconomic policies that
1
See M. Feldstein, "The Private and Social Costs of Unemployment," American Economic
Review, Proceedings, 197S.
51-421—79
2
14
focus on." specific labor market problems, including the high unemployment rates of young people and the unemployment created by our
current unemployment insurance rules.1
INFLATION
Unfortunately, the high measured rate of unemployment has misled
us and has encouraged monetary and fiscal policies that are overly
expansionary. The increasing inflation rate over the past decade has
been largely the result of the excess demand generated by misguided
monetary and fiscal policies.
It is in this sense that our high measured rates of unemployment have
contributed directly to our high rates of inflation.
Most economists are now predicting that there will be some slowdown of the economy in 1979 or 1980. There is also a widespread agreement among economists that this slowdown is likely to be both small
and short lived, and that it is then likely to be followed by a vigorous
expansion of demand.
A very short slowdown of this type will temporarily reduce employment and output while having relatively little effect on inflation. To
bring the inflation rate down permanently, we need a more sustained
period of economic slack.
The 1973-75 gains in fighting inflation were quickly lost by reflating
too soon and too much.
The expectations developed because of the experience of 1973 to
1975 will mean that the inflation response to the current slowdown will
be even smaller.
I think it's important not to understate the magnitude of the
response then. After all, the inflation rate, the CPI rate in general, was
going up at slightly more than 12 percent in 1974, and dropped to less
than 5 percent 2 years later.
And for finished goods, the drop was even more dramatic, from more
than 18 percent to just slightly more than 3 percent.
So slack in the economy clearly can bring down our rate of inflation.
But if we sustain market slack for a few years—enough slack to keep
the unemployment rate about 1 percent above the level at which wage
and price inflation starts accelerating—we will succeed, I think, in
gradually bringing down the rate of inflation.
As the policy is seen to be working, expectations will shift and the
inflation rate will come down more rapidly.
This, in turn, will be reinforced by a strengthening dollar which
will reduce the cost of imports and the dollar value of potential
exports.
I t is important to bear in mind that a sustained but temporary
period
of slack demand will achieve a permanent reduction in inflation.2 Failure to accept greater slack in the next few years merely
postpones the problem or leaves us committed to a permanently higher
rate of inflation.
1
For specific ways to reduce unemployment, see my earlier study for this committee
("Lowering the Permanent Rate of Unemployment," Joint Economic Committee, 1973) or
the summary that appeared as M. Feldstein, "Economics of the New Unemployment," Public
Interest,
1973.
2
Martin Feldstein. "The Welfare Cost of Permanent Inflation and Optimal Short-Run
Economic Policy," NBER Working Paper No. 201, forthcoming in the Journal of Political
Economy.
15
Moreover, if we do not eliminate the current inflation, every new
shock will be regarded as the beginning of further inflation and will
merely add to the existing rate of inflation.
The knowledge that we can achieve a permanent reduction in inflation by accepting a temporary period of slack should reinforce the
widespread public sentiment that reducing inflation is the No. 1 priority for macroeconomic policy.
Despite this, maintaining slack for a long enough period will require
significant political courage.
Fortunately, our unemployment compensation system will eliminate much of the personal hardship that would otherwise accompany
cyclical increases in layoffs.
lasized a few moments ago, it is possible to proMoreover, as I empha
ceed with labor market policies that reduce the unemployment rates
of young people and other high-unemployment groups at the same
time that macroeconomic policies maintain slack in the demand for
experienced skilled workers.
LOW PRODUCTIVITY GROWTH
This brings me to the third and final aspect of stagflation: The low
rate of productivity growth. This year's Economic Eeport of the
President identified several reasons for the recent slowdown in the
growth of productivity. I will limit my remarks on this problem to the
way in which our high inflation rate and existing tax rules have combined to reduce productivity.
With our existing tax rules, inflation automatically raises the effective tax rate on corporate income. These high effective tax rates discourage investment and risktaking.
Let me be more specific. In a recent study at the National Bureau of
Economic Eesearch,1 we found that the mismeasurement of depreciation and inventories raised the 1977 tax burden on the income of nonfinancial corporations by more than $32 billion. This represents a
50-percent increase in the total tax paid on corporate source income by
corporations, their shareholders, and their creditors.
Inflation raised the 1977 effective tax rate on the total real capital
income of the nonfinancial corporate sector to 66 percent. Thus, taxes
now take two-thirds of the total real income on corporate capital.
This represents a return to the tax level of the mid-1950's before
accelerated depreciation and the investment tax credit began reducing
the total tax burden.
I really doubt that you or other Members of Congress intended to
wipe out those two decades of tax reductions, but that is exactly what
inflation has done, because our tax rules are not geared to dealing with
an inflationary situation.
Now some lawyers and economists have previously argued that inflation does not increase the effective tax rate on real corporate income
because firms deduct nominal interest payments—rather than real interest payments—in calculating taxable profits, or to put that a different way, corporations are not taxed on the fall in the real value of their
debts that results from inflation.
1
Martin Feldsteln and Lawrence Summers, "Inflation and the Taxation of Capital lac.
In. the Corporate Sector," NBER Working Paper No. 312, 1979.
16
That argument, I think, is misleading because it focuses specifically
on the corporations rather than the total return on capital income in
the corporate sector.
I think it's important to go beyond the corporations to their owners,,
the shareholders, and creditors, those who own their bonds and other
debts.
Our calculations show that the extra tax paid by the creditors on the
inflated interest payments is as large as the tax savings by corporations and their owners.
In other words, debt is awash, and can be ignored in evaluating the
net impact of inflation on the total tax burden on corporate capital.
The 66-percent tax burden that I mentioned before is the total
burden on both debt and equity capital, on total capital, in the corporate sector.
The implication of a 66-percent effective rate of tax on corporate
income, I think, is clear. Since the real rate of return on corporate capital before Federal taxes is approximately 12 percent, the net rate of
return after tax is only one-third of this or 4 percent.
A net return of 4 percent is just not enough of an incentive to sustain the desirable level of saving and risktaking.
If there were more time, I could continue to discuss the ways in which
inflation distorts the taxation of the income of both financial and
nonfinancial businesses. The same general conclusion would emerge
from all of these analyses: Inflation causes a substantial increase in the
rate on the real income from savings. These higher tax burdens discourage both saving and real investment.
The most important direction for tax reform is to eliminate the
distorting effects of inflation on the taxation of capital gains and
corporate profits. Although we all want to see the inflation rate
reduced permanently to the near zero level that our country enjoyed
in the early 1960's, I believe that it would be risky and unwise to leave
the tax laws unchanged in the hope that such a reduction in the inflation will occur in the near future.
Even if inflation is eventually eliminated or substantially reduced,
a tax system based on indexed depreciation would be useful in limiting
investors' fears of the adverse effect of potential future inflation.
In short, I believe that eliminating the inflation bias in our tax
rules deserves the highest priority in tax reform if we are to reestablish proper incentives for saving and investment.
CONCLUSION
This brings me back to my original statement that stagflation is
really three separate problems that require three types of policies.
First, specific labor market policies are required to lower the employment rate.
Second, tighter monetary and fiscal policies are required to lower
the inflation rate.
And, third, changes in our tax laws to prevent the distorting effects
of inflation and to enourage savings and investment are required to
reverse the slowdown in the growth of productivity.
Thank you.
Representative BOLLING. Thank you very much, Mr. Feldstein.
Next, we welcome Mr. Otto Eckstein, president, Data Resources, Inc.
17
STATEMENT OF OTTO ECKSTEIN, PRESIDENT, DATA
RESOURCES, INC., LEXINGTON, MASS.
Mr. ECKSTEIN. Thank you, Congressman Boiling.
I was delighted to see the Joint Economic Committee has returned
to the study of the longrun economic problems of this country. When
you and I were engaged in these works 20 years ago we thought we had
made some progress, but here we are again. I also note on the list of
the committee there are only three members who go back to that earlier
study. I think most usefully I could summarize my lengthy prepared
statement for you by focusing on the tables and charts that are in it.
My basic proposition here is that today's stagflation is not some deep
mystery but can readily be explained by theories that have long been
at our hand, and that what is new is not so much the fact that there
is a fundamental change in structure but rather that we are sitting
here at the end of a 15-year process in which we have gradually, inexorably, day by day made the core inflation rate risk worse.
Today the core inflation rate is about 7y2 percent, defining the core
inflation rate to be that element of the inflation which is the fundamental cost thrust on labor and capital. If you turn to table 1 of my
prepared statement, you will see that indeed the United States has
lost its membership in the low inflation club. We used to be along
with Switzerland and West Germany, a country with 2-percent inflation or less. In the last 3 years our inflation rate has placed us in the
middle inflation position, indeed in the last 8 to 10 years.
We have now joined countries such as the Netherlands, Belgium,
and Canada as those unable to sustain that low inflation performance.
Let me turn to the short run. In my judgment we are not suffering
from stagflation today. We are currently in a state of excess demand.
The U.S. economy has expanded very rapidly in the last 3 years at an
annual average rate of 4.8 percent. Employment is up by 10 million in
those 3 years, far above sustainable increases. Unemployment for the
prime working groups is at rock bottom levels. The utilization rate of
industries is at 89 percent. Vendor performance has deteriorated
sharply. Our monitor, which takes a dozen of these measures of excess
demand, stands at 62 in March. In industry today there is every evidence of a certain amount of hoarding and of inventory building
because of the fear of shortages and also because of the fear of
inflation.
As a result of that current condition, it is my belief that nothing
stands a chance in reducing our inflation, including the micromeasures
which we all know we should undertake, until the excess demand is
wiped out of the economy. Indeed, to launch incomes policies, to
launch the President's anti-inflation pay and price standards or even
to adopt real wage policies in terms of any of these measures, while
the total demand is too high, dooms these policies to failure and discredits them. The place to begin is to bring aggregate demand down
to a level that the economy can sustain. Now, of course, forecasts say
that demand will weaken; that high interest rates and excessive consumer debt burden will bring the economy down in our forecast with a
mild recession. The administration forecasts a little softer landing.
But that is absolutely critical. There is a possibility here that
demand will just keep on advancing as businesses and households try
18
to beat the inflation by strong purchases. If that occurs then thesemicromatters will become even less important because the economy
will simply head for a boom-bust path.
Turning now to stagflation, I think we have suffered it three times
in the postwar years. We invented it in 1956 to 1958, particularly in
1958 when we had a severe recession and prices kept on rising. At
that time there were random events that created that situation. There
was a frost in Florida and food prices rose as a result. Also we had
some bad luck in timing with the wage settlements of 1956. As a result
of that when unemployment went to 7 percent there was no immediate
reward in terms of reduced inflation for the recession. Actually that
recession did its job. After that recession, we entered 6 years of stable
prices. Stagflation disappeared. The word remained. But once aggregate demand retreated to a level the economy could manage, whatever
microsins we committed, and I imagine the Congress at that time also
raised minimum wages, raised payroll taxes and did all the things it
usually does, I'm sure the administration proposed things that made
matters worse, despite that there was no inflation. So the matter must
lie in something other than new microsins that we have developed
later.
The second bout was in 1969-70. At that time we again had a certain
amount of bad luck. Recession came. Not much happened. You had
already a building up of price expectations. You had a catchup of
public employees which drove public sector prices up sharply. You
had a catchup of union and nonunion workers. Of course, productivity
also happened to go sour at that time, though at that time we didn't
recognize how important a phenomenon that was. We got impatient
and as a result we put on wage and price controls of August 1971, even
though at that time also a little less demand might well have done more
for us.
If we now try to convert all the random events that somehow all
seem to work out badly for us into some kind of theory and take the
mystery out of this process, and I think it is important to take the
mystery out because what we are really doing here by doing nothing
but wringing our hands about the situation and crying for new paradigms and new solutions, we are really saying to the American people
that we don't understand it. That something fundamental has gone
wrong with the capitalist system. I don't believe there is a shred of
evidence that that is the case. I think as you will now see and I hope I
carry along on this analysis, that there is no mystery to it.
I think to make sense of it you first have to divide the stagflation
or overall economic inflation into three elements. If you turn to chart 2
and subsequent charts in my prepared statement you will see that. The
first is the core rate of inflation. In the core rate of inflation, it principally grows out of the longrun trend in unit labor costs. Those represent two-thirds of all costs in the economy. Of course, unit labor costs
are themselves principally the result of fundamental wage movements
and the extent to which productivity offsets them. We learn from our
econometrics, here I think the proof is pretty strong, that wage claims
are based on a long previous experience with inflation. Wages do not
respond to current inflation. We see that even now.
19
After all, even the Teamsters with all the economic clout they possess, with all the flexibility the Government musters on its pay standards, the Teamsters did not sign for a real wage increase. If you believe
a current rate of inflation was permanent, the Teamsters were taken
and signed for a small real wage cut because they got less than the
current inflation rate. Of course, others would be taking even larger
cuts. So wage claims do not reflect current inflation but rather look
backwards. Productivity if you turn to chart 1, you see it has slowed
down. Of course we all know the reasons for that, including diminished
capital formation and diversion of some capital to pollution controls
and also a change in the mix of economic and various other factors.
In any event, the hard core inflation rate based on wages and productivity shows a steady acceleration since 1966. We did gain some
relief in the period of slack demand. The core inflation rate which was
built up in the mid-1950?s, the inflation rate we studied back then
which got up to 2y2 percent went away to zero before this whole new
set of events unloosed demand inflation, shock inflation, all interacting
to gradually build up the core.
;he shock rate, and here for our formal analysis all
When we turn to th<
we have done is analyzed food and energy and those more immediately
measurable Government components including social security taxes,
minimum wages, when we look at the composite shock rate, we see it
added a half percentage point until 1972. Then it got much worse
over the food runup, and energy runup of OPEC. It then again faded
away. We are now in a second round which is not fully reflected on the
chart because it stops at the end of 1978.
Of course on chart 4 you see just the energy and food price shock
rate, and you see that, first food made things much worse in 1972-73
over the Russian wheat deal, and world crops, then, of course, you
had OPEC a year later.
When we turn to the demand component of inflation, what we see
is, let me first explain how we did that. We asked ourselves, what
happens after you take out the core rate and shock rate and erratic
factor ? What's left to explain ? Then we ran a statistical correlation
between remaining inflation and measures of aggregate demand, in
this case the vendor performance, and the GISTP gap of the old-fashioned type.
We then derive an equation. You will be able to convert and evaluate that equation with the inputs, as shown in chart 5 of my prepared
statement. What you see there is that we have got a lot of demand
inflation in 1966 to 1970 during the Vietnam war when unemployment
was down to less than 3% percent. It didn't become visible because
there are lags on demand inflation and because it gradually only works
its way into the core rate. Ultimately it winds up in the core rate. That
is one major reason why we have the trouble of the 1970's.T
Now, we had another bout of demand inflation in 1973 w hen it was
completely miserable because of price controls. But demand again got
too strong and added to the core rate. We then had the drastic recession which did reduce the core rate somewhat. If you go back to the
plot of the core rate, you see a period of drop of the core rate. It did
improve for a year or two. Of course, the weak demand and of course
the fact that food prices did fall in 1976 helped to bring the core down
a bit.
20
Now we are in another round of demand inflation. Demand is too
high. It is not yet visible on chart 5 because the effect is mainly ahead
of us. This chart stops at the end of 1978. We are going to add about
half a point a year to the inflation rate of 1979-80 because of the excess
demand inflation into which we have stumbled through overreaction to
the last recession, and that is just adding to the situation.
Well, what is the prospect on the inflation if you take this composition of inflation into its three main pieces? Core, demand, and
shock. On the core rate, because it moves so slowly, it cannot get much
better and it cannot get much worse. The maximum change you can
see in it is about 1 percent a year. I don't think we are going to see
the maximum in either direction. The chances are the core rate will
get a little worse before it gets better so you may get maybe half a
point out of that.
The demand inflation is going to add at least half a point to the
inflation for the next couple of years.
The shock element, here I'm speaking mainly of energy, is going
to add at least a percentage point to the inflation rate. The deregulation
of oil and gas, which I believe was desperately necessary as a matter
of restoring our national independence vis-a-vis OPEC, as well as
the OPEC increases themselves, are simply going to add a point to
the inflation rate. In addition, we are going to pay a little price for
the runup of food prices which is now, I believe, mainly behind us.
So, when you get all through with it you look at an inflation prospect of around 9 percent. Let me turn to the real focus of the hearing
which is, can the core inflation rate be improved ?
Again let me reemphasize, no way on Earth can it be improved
until the economy is moved out of the excess demand territory. If the
administration is very lucky and very skillful, it will be a soft landing. But one way or another the real growth rate of this economy
must be kept below 3 percent for the next 3 years. If it were held
below 2y2 percent we would be a little safer. Now, that is on the demand side.
On the shocks, obviously if the Congress and administration stop
making things worse that would be a blessing. If OPEC behaved itself, that would be a blessing. But those matters, I believe, we economists have very little ability to influence. So we then of course
quickly turn to the easy part of improving the core rate. That is to
boost productivity. It's easier because that usually winds up with a
conclusion. What we have to do is cut business taxes and I think that
is a good idea. Although, I would hope we would find a program a
little more balanced than that. The main issue on the productivity
side—there really are several. First, can we boost the rate of capital
formation ? The rate of capital formation used to be around 4 percent.
Last year it was 2i/> percent. We ought to get it back to a higher rate.
The rate of E. & T>. advance measured by a stock of research and
development used to be 4 to 5 percent a year. Now it's down to 1V2
percent.
One way or another we will have to accelerate the rate of development of E. & D. Let me emphasize, none of these measures stand a
£rhost of a chance until we bring aggregate demand back to a level
that will work to reduce the core rateof inflation rather than to make
it worse.
Thank you.
21
Representative BOLLING. Thank you, Mr. Eckstein.
[The prepared statement of Mr. Eckstein follows:]
PREPARED STATEMENT OF OTTO ECKSTEIN
What Is Stagflation
Really?1
SUMMARY
(1) The core inflation rate has worsened to V/2 percent. To understand the
inflation in the modern economy, it is necessary to disentangle the core rate, the
shock rate and the demand rate;
(2) The core rate is the product of past demand levels and shocks, which have
created the price expectations that underlie the trends of unit costs of labor and
capital;
(3) The shock rate is the contribution of inflation created by exogenous events
like world oil and food prices, changes in tax rates and government regulatory
and other policies;
(4) The demand rate is the contribution to inflation from the level of aggregate
demand;
(5) Stagflation, the combination of high inflation and weak demand, occurs
whenever the core rate plus the shock rate exceed the demand rate;
(6) Stagflation lias occurred at least three times in the postwar period:
(7) The U.S. economy is not suffering just from stagflation at this time : Growth
has been very rapid for three years and there is demand inflation along with the
shocks and the high core rate;
(8) The immediate goal of policy should be to slow down the economy with only
a limited business cycle disturbance;
(9) The solution to the stagflation problem is (1) more cautious demand management policies to get rid of the demand inflation ; (2) increased capital formation and R&D to restore productivity performance and slow the core rate; (3)
an energy policy to limit OPEO's power to create oil shocks; (4) greater care in
the design of government policies to limit inflationary repercussions; (5) measures to make the economy more competitive.
Stagflation has become a rallying cry for dissatisfaction with the performance
of the American economy >and of its economists. People wish to believe that there
is some deep mystery about double-digit inflation. I do not believe that stagflation
escapes our understanding. Tlie ability to combine high employment and stable
prices is rare for any society. The few who have attained it have done so by
combining the national determination to avoid inflation with strong government
policies to promote industrial development and success in export markets. For
tlie rest of us, the middling and high-inflation countries, strong economic policies
have been impossible for reasons of political structure, the pursuit of other national purposes or weakness of leadership. We will suffer from stagflation until
we put stronger economic policies at the top of our priority lists, and even then
it will take years to overcome the underlying problems.
TABLE 1.—INFLATION IN MAJOR INDUSTRIALIZED COUNTRIES
{Consumer Price Index, compound annual percent change]
High inflation:i
United Kingdom
Italy
Japan
France
Intermediate:
Belgium
Netherlands
Canada
United S t a t e s . . . .
Low inflation:
Switzerland
West Germany...
.
_
1950-60
1960-70
1970-75
1975-78
4.0
3.0
4.1
5.8
2.2
2.1
4.1
3.9
5.8
4.0
3.0
4.0
2.7
2.8
13.0
11.3
11.5
8.8
8.4
8.6
7.3
6.8
13.5
15.7
7.0
9.5
6.9
6.4
8.1
6.6
1.4
1.9
3.3
2.6
7.7
6.1
1.3
3.7
_
_
_
_
_
t Countries ranked by 1970-78 inflation.
iThis paper was coauthored by Paul M. Warburg, professor of economics, Harvard
University.
22
I congratulate this committee for undertaking this study and continuing th*a
JEC tradition for balancing its short-run focus on current conditions and policies
with a surging examination of the underlying causes of our economic problems.
SHORT-RUN MATTERS
Today, we are suffering not just from stagflation. That would imply that our
resources are not fully utilized and that our growth is slow. But in the last 3
years, the U.S. economy has expanded at an annual rate of 4.8 percent. Employment is up by 10 million, or 3.7 percent a year, far above sustainable long-term
increases. Of course, these were years of recovery from the worst of the post-war
recessions. But during the last nine months, the economy has clearly entered
the area of overfull resource utilization. Unemployment for the prime working
groups is at figures usually found in times of high prosperity. The utilization rate
of the primary processing industries has been 89 percent, a figure always associated with demand inflation. Vendor performance, an important sensitive measure
of delivery conditions in industrial markets, has deteriorated sharply. The DRI
Boom Monitor stands at 62 in March, close to a boom reading. Ttoe opening months
of this year have seen a scramble for inventories and increasing shortages and
bottlenecks. The price performance that has been created by these boom conditions shows an acceleration of industrial prices, excluding energy, from 6 percent
S years ago to 9.3 percent over the last 9 months. And this despite the introduction of the President's anti-inflation program.
One new element of stagflation is the slowdown of productivity. As Chart 1
shows, the 5-year productivity trend is now at its low point, up at a mere 0.8
percent rate, 1973-78. Whatever the underlying reasons for this productivity
slowdown, it serves to explain the extraordinary employment gains and raises
some of the deepest questions about current economic performance.
32
M
ill
54 5S 38 60 62 £4 6S 68
70
72
74
76
78
CHART 1.—The 5-Year Productivity Trend (5-Year Average Percent Change)
No anti-inflation policy stands a chance of success until the level of aggregate
demand is brought down to sustainable levels. The Federal government
affects
aggregate demand through monetary and fiscal policies. Elsewhere,1* I have
argued that a balanced budget for 1981 would be a sound strategy under the
present circumstance. This budget balance should be attained if the economy is
operating in the neighborhood of 6 percent unemployment, and assuming a rate
of inflation in the consumer price index of 8 percent a year between the first
quarter of 1979 and the third quarter of 1981. If unemployment should prove
higher because of recession, revenues will clearly fall short and the budget will
go into automatic deficit. If the inflation should prove worse, the budget will go
into automatic surplus because of the workings of the personal income tax. To
achieve budget balance, the Congress will have to forego significant tax reducla
"Can We Break the Inflation Spiral ?" Otto Eckstein, testimony presented to the Subcommittee on Economic Stabilization of the Senate Banking Committee, Mar. 23,1979.
lions for 1980 and 1981, unless it can find new ways to dramatically lower spending. The increase of interest rates made by the Federal Reserve this month will
also be helpful in puncturing the current bubble.
Once the economy has retreated from its current excess demand, sensitive
material and finished goods prices will fall and will give some temporary relief
from double-digit inflation. The telescoping of OPEC increases into the period
of Iranian shortfalls also distorts the price outlook by creating the prospect of
lesser increases later on. Consequently, an improvement in the inflation rate
in the summer is a realistic prospect. But no one expects a brief and mild recession
to solve the inflation problem. The "core" inflation rate, which deteriorated from
about 6 percent 4 years ago to 7V2 percent today, goes up a lot more easily than
it comes down. It therefore is appropriate to examine the stagflation phenomenon
in a broader context in order to assess how we might make more progress in the
longer run.
STAGFLATION: A HISTORIC OVERVIEW
Since World War II, the U.S. economy has experienced three bouts of stagflation. Perhaps something can be learned from a sketchy historical review.
Stagflation first became an intellectual concern in 195G-58. Inflation, which
had briefly disappeared during the period of falling world raw material prices
after Korea reached 3.4 percent in 1957, and stubbornly refused to disappear
during the severe 1958 recession. I believe the term "stagflation" was coined at
that time, and the fear of inflation led to the overly restrictive fiscal policies of
1960 which brought about the briefest and also the only incomplete business
cycle recovery of the postwar era.
The stagflation of that period can easily be explained by the peculiar circumstance of that cycle. The automobile boom of 1955 was quickly followed by a
capital goods boom, to create a sectoral demand inflation. After early 1956, the
economy showed very little growth of markets. As a result, productivity stagnated. Unfortunately, the automobile and steel industries signed very costly
3-year wage agreements based on the temporary cyclical profits of 1955-56, which
then had some secondary effects on the wage structure generally and produced
an unfortunate unit labor cost trend which continued to convert itself into higher
industrial prices even while the economy was weakening.
The discovery of "stagflation" however, owes itself to an even flukier development. While the economy was collapsing in 1958, frosts hurt the fruit and
vegetable supply, producing a surge in the consumer price index. Thus, in the
first half of 1958, price performance, particularly as measured by the CPI, continued at what was then considered inflationary levels raising the question
whether we had lost the ability to manage our affairs in a noninflationary way.
Once the weather improved and food prices fell, the inflation disappeared. In
the years 1958 to 1964, the consumer price index rose by 1.2 percent per year, an
Increase which can easily be accounted for by changes in product quality. The
wholesale price index did not rise at all for 6 years after the "stagflation" of
1956 to 1958.
The next bout of "stagflation" occurred in 1969-71. This time, the inflation developed because of the Vietnam War and the inadequate fiscal and monetary
•policies. Unemployment below 4 percent from 1966 to 1969 created a classic
demand inflation, which was held down only by good price expectations created
by the previous history of stable prices, and by President Johnson's active guidepost policies. The stagflation began with the 1969-70 recession which failed to
bring the expected relief from the inflation. Having tried a gradualism-cumreeession policy without success, the government turned to mandatory price
and wage controls in August 1971.
The stagflation of that period also had institutional and historical shocks in it
which disengaged the timing of price behavior from the business cycle to produce
the perturbing combination of rising unemployment and rising prices. At that
time, the trouble lay in a bulge in the implicit price index for the public sector
which was driven up by catch-up pay increases for government workers, a bulge
in food prices mainly related to the weather, a surge in homeownership prices
caused by high interest rates and low housing production, and weak productivity
performance. With the economy flattening out, output per manhour showed virtually no change in 1969 and 1970, converting 6.6 percent increases in total compensation per man-hour into unit labor cost increases of the same magnitude.
Wages did not slow down because inflation expectations were deteriorating.
24
While the higher unemployment of 1970 surely had some moderating effect on
wages in the unorganized sector, the worsening inflation experience outweighed
this effect and kept wage increases unchanged.
The third bout of stagflation is the period during and immediately after the
1975 recession. Inflation never disappeared despite unemployment approaching
9 percent and industrial utilization rates in the low 1970's. As the economy grew
rapidly for four years to close the gap of unutilized resources, inflation went
from 5 percent to the current double digits. The oil shock was still working its
way through the system and old contracts and poor price expectations kept
wages advancing at inflationary rates.
A GENERAL MECHANISM FOR STAGFLATION?
Is it possible to identify a general theory of stagflation? The historical account
makes clear that each episode contained various "chancy" elements. Sometimes
an inflationary shock struck just after the cyclical productivity upswing was
complete, so that food or energy prices combined with rising unit labor costs to
produce inflation in.a weakening economy. In another case, the stagflation of 197577, the previous history of inflation which had created poor expectations was the
explanation; the energy price increases in those years were offset by exceptionally
favorable behavior of food and other material prices. Thus, in a sense, the theory
of stagflation cannot stand alone, but is simply the application of a general view
of the economy as it operates in some particular circumstances which happen
to produce the stagflation result. The question is not so much why there is stagflation, but why the economy has a permanent inflationary bias.
A broad range of economists would agree on the list of factors which imparts
the inflation pressure into our economic performance, though they would surely
disagree on the relative emphasis. First, in the short-run, the inflation rate does
respond to the level of aggregate demand, and does so in a quite nonlinear fashion.
In particular, when excess demand develops, even if it is only for some sectors of
the economy, inflation gets much worse. But even the pure demand effects take
as much as a year before the demand pressure is fully converted into price
pressure.
Second, it is impossible to run the economy in the excess demand territory in
the long-run. The public's inflation expectations gradually adjust to the correct
levels. It therefore takes accelerating inflation to maintain a constant level of
real activity. Since neither the financial system nor the public can live with
accelerating prices, a recession is the inevitable outcome. I think this is the true
and correct meaning of the common assertion that there is no Phillips curve
in the long-run, that the unemployment-inflation tradeoffs are temporary.
Third, inflation expectations are formed rather gradually. The public partially
discounts a temporary extreme condition in its consumer buying actions or in
its willingness to buy fixed-income securities. But over a period of several
years, inflation expectations are adjusted fully to reflect the true reality.
As a result, expectations are a major component of the core inflation rate.
If expectations can be changed only very slowly, then wage and unit labor cost
trends can change only very slowly, largely limiting the effects of recession to
sensitive prices and wages, the improvement of efficiency, with only a small
benefit to the core rate.
Fourth, shocks vary the inflation rate in the short-run, and are, in part,
converted into long-term inflation as well. Whether a disturbance originates in
a run-up of food prices which may be reversed later on, in higher minimum
wages and payroll taxes, or in OPEC prices, long-term inflation expectations
are affected, and a portion of the temporary inflation enter into wages, unit
labor costs, capital costs and therefore the ''core" inflation rate.
Fifth, the government is a major source of inflation shocks. There is a bias
in a pluralistic democracy toward inflation-creating actions. The political process
finds it very difficult to limit cost increases, as can be seen in the current troubles over the hospital containment program and truck deregulation, but finds
it very easy to extend additional protection to various producer groups both
on the business and labor sides. Special pleas are always very reasonable, and the
lobbyists know their profession.
25
Sixth, there are major elements of monopoly in both product and labor
markets which slow down the conversion of demand weakness into lower prices.
Business prefers price discipline and the resultant shared quantity variations to
competitive price cutting which would let recession produce a higher antiinflation benefit.
Seventh, in a world which contains OPEC and the strong industrial economies
of West Germany and Japan, any domestic inflationary bias is ultimately converted into a weakening exchange rate which fans the domestic inflation further. If the authorities delay the drop in the exchange rate through market
intervention, they hold back excess demand a bit by inviting a flood of imports,
but they do so at the expense of the productivity performance of domestic manufacturing industries and of a more dramatic exchange rate movement later on.
These general ideas can be converted into a theory of stagflation. The actual
inflation rate in any period has three components: (1) the core inflation rate
based on unit labor and capital cost trends, (2) the shock inflation rate based
on nonsystematic actions of the government and the outside world, (3) and
the demand inflation rate, based on the aggregate level and composition of
demand. It is possible to identify these three components of inflation from
standard economc variables included in the Data Resources Model of the U.S.
Economy. Chart 3 plots the results of a preliminary analysis of the three
components. DRI will extend this work in the coming months.
It can be seen that the core inflation rate gradually became worse from the
mid-1960s until the period of price controls in 1971, and then showed some small
improvement. As the price controls dissolved and the enormous OPEC increase
struck, the core inflation rate embodied a considerable fraction of these ''temporary" increases, worsening the core rate to 6 percent by 1975. The recession
and the sharp decline of food prices in 1976 brought a pause in the rise of the
core rate. However, the strong real growth of the recovery, and ultimately the
excess demand of 1978-1979, gradually were converted into an acceleration of
the core rate which today is estimated near 7.5 percent.
9
z\
-2
55
53
1 1 1 1 ) 1 1
60
CHAET
62 64 66 68 70 72 74 76
2.—The Core Eate of Inflation (Percent)
78
26
38
60
62
I64 66
1
68
170 1?2 174 i76
7B
CHART 3.—The Shock Component of Inflation (Percent)
The shock rate of inflation has been particularly troublesome in recent years,.
Agricultural prices have shown erratic movement throughout the postwar period,
but outside of the 1972-73 crop and policy disasters, the declines were as great
as the increases. We appear to be in the midst of another, though smaller,
such policy episode. On the energy side, the stability of energy prices of the
1960's actually served as a retarder of inflation, and helped the U.S. economy
to get through the Vietnam War with its excess demands without a really sharp
breakout of the price level. But the constancy of energy prices ultimately had
to come to an end, and when it did, shock inflation at least temporarily became
the main problem. Chart 4 shows how the huge bulge of 1974 added to the overall inflation rate. We are now in the midst of a second round of massive OPEC
boosts which is creating a new shock inflation, whose waves will gradually reach,
the core inflation rate, several elements in shock inflation have not yet been fully
modeled.
27
SS
5S
SO S2
64
SS
S3
70
72
?4
7$ ?B
4.—The Contribution of Energy and Food Price Shocks
(Energy—Line, Food—Pot, Percent)
The government policy element in shock inflation was confined to the effects
of changes in the Social Security tax rate and the minimum wage, as calculated
through simulation of the DRI model. The movements of world material prices,
which are, of course, dominated by the worldwide business cycle, are not treated
separately here, although they were of importance in the years 1972-74. Nor
is separate allowance made for the movements of the dollar in foreign exchange
markets, which added to inflation in 1978 particularly, but which was, itself,
a result of the previous U.S. inflation performance.
The demand component of inflation is calculated out of the inflation rate
that remains after the shock and core components are accounted for. Specifically,
demand inflation was defined as that part of the residual which could be explained, through regression analysis, by two measures of demand: vendor performance, and the GNP gap. Chart 5 shows the estimates derived from the
regression, 1957-1978, smoothed over three quarters. It can be seen that demand
had a drastic impact after the mid-1960's, and once more in 1973-74.
CHART
28
138 SO
1 62
1 64
1 66
1 68
1 70
1 72
1 74
I 76
1 178
CHART 5.—The Demand Component of Inflation (Percent)
Last Point Plotted, 1978:4
The sum of three components of the inflation rate is shown in Chart 6. The
core rate has gotten worse since its near-zero values of the early 1960's. Price
controls and the 1975 recession brought short-lived small improvements. The
core rate was flat near 7Y2 percent until the current round of troubles. Shocks
and demand were also inflationary, though the effects were concentrated in a
few periods. Unfortunately, the temporary effects gradually drove up the core
rate.
29
/
N
-2
-3
- i — I — 1 — I — 1 - 1 1 1 1 1 1 30
SO S2 64 SS S3 70 72 74 ?S T8
6.—The Three Components of Inflation: Core (Dash), Shock (Line),
and Demand (Dot)
Chart 7 compares the sum of the three estimated components of inflation with
the actual inflation record. Much is explained but there remain some residuals.
The inclusion of capital costs, world material costs, the exchange rate and more
items of government policy should complete the analysis.
The core inflation rate can be decomposed further into its principal sources.
Chart 8 shows the movements of long-term unit labor costs as they are created
by changes in the productivity trend and long-term rate of wage increase.
€HABT
51-421—79
3
30
14
12
10
8
6
/AT
i—I—I—I—hr-1—h
36 58 60 62 S4 65 S3 ?0 72 74 7$ 7B
CHART 7.—Year-Over-Year Changes in Consumer Price Index Compared to Sum
of Core, Demand and Shock Inflation Components
io r
5€
CHAET
58
SO
S2
h-f—i
I
1 1
8.—^The Composition of the Core Rate Wage Trend (Line), Productivity
Trend (Dot)
31
INFLATION PROSPECTS
Seen in the light of this analysis, the uncertainty of inflation prospects can
readily be understood. The core inflation rate can be identified within a reasonably narrow range because it moves so slowly. Since it ultimately is the
product of short-run influences, it cannot be known precisely, but it is evident
that it cannot improve more than a point over the next two years even with a
recession or price controls. Nor is it likely to get worse by more than a point.
The "shock" inflation rate also has a number of known elements in it. OPEC
prices are up, and domestic energy prices are being deregulated, adding close
to a full percent to the inflation rate over the next three years. Food prices are
much less predictable, but should ease after beef prices reach their new equilibrium after a 15 percent drop of supply. The government seems
to have become
a little more careful, though payroll taxes and minimum wTages keep going up.
It is demand inflation which is most immediately under the effective control
of the government. The demand component is just beginning to contribute positively to the overall inflation rate. This is due to the typical lagged response
of prices to aggregate demand built into the estimates. Since the economy has
just recently moved near boom levels, the full effects of this burst in demand
will be felt for the rest of this year. The DRI forecast calls for a mild recession
beginning in the second half of this year, and a return to reasonably normal
growth for 1980-1981. Under this scenario, although demand pressures are likely
to add 0.5 percentage points to the inflation rate over the next few quarters, the
recession will work in the opposite direction in the 1981 price performance. If
the recession does not occur, i.e., if the current inflation-beating purchases of
households and businesses keep the economy moving above its potential trend
for another year and a half, the demand factor will continue to acid 0.5 percentage points to the inflation rate. Conversely, if the recession should prove to
be a lot more severe than DRI forecasts, demand inflation improvement would
be bigger.
CAN THE "CORE" INFLATION RATE BE IMPROVED?
The government can do little to change the mechanism by which actual price
experience is converted into inflation expectations. The public reacts to actual
events and learns from experience, and discounts the statements of public officials. The core inflation rate can only be improved by reducing shocks, keeping demand moderate and by working on the productivity factor.
A recent DRI analysis by Ms. Robin Siege! 2 decomposes the sources of the
slowdown in labor productivity (Table 2). It can be seen that the drop in productivity performance was 1.8 percentage points, comparing 1955-65 with 197378. Cyclical factors account for 0.6 percentage points, energy prices 0.7 points,
and diminished capital formation 0.6 points. This analysis points the way
toward the solution of the productivity element in the worsening core inflation
rate.
Reduced U.S. dependence on imported oil will slow the rise of world energy
prices and will let a more normal productivity advance be restored. Higher
capital formation will directly add to output and productivity and slow the core
rate. Measures that promote these goals are the principal means for creating
a reversal of the core rate from the supply side.
TABLE 2.—COMPOSITION OF PRODUCTIVITY GROWTH i
{Average annual percent change]
Timetrend
Economic utilisation
Labor market tightness
Output surprise...
Energy pricesPollution abatement expenditures.
Output mix
Demographic composition of work force
Capital-labor ratio
_
_
Tax effect
Nonfarm productivity growth
.._
_
_
1973-78
1965-73
1955-65
2.4
—.4
.2
—.2
—.7
0
0
—.4
0
—.1
.8
2.4
.1
—.1
.2
0
—.5
2.4
0
0
.2
0
0
0
—.6
.6
—.1
2.6
.
—.6
.7
—.3
2.0
1
i "Why Has Productivity Slowed Down?" March DRI Review*
Note: Columns may not sum because of residual in equation.
2
"Why Has Productivity Slowed Down ?" by Robin Siegel, March DRI Review, pp.
L59-I.65.
32
Representative BOLLING. Our next witness is Mr. Jerome Hardy,
the president of the Dreyfus Corp.
STATEMENT OF JEROME HARDY, PRESIDENT, DREYFUS
CORP., NEW YORK, N.Y.
Mr. HARDY. Thank you, Congressman Boiling. I am delighted that
you identified me as a publisher rather than an economist. I t may
explain the mystery of some of the things I am going to say or why
I am here.
Your invitation to appear here this morning is, like all compliments, hugely gratifying and mildly mystifying. I am neither a
planner nor an economist.
My remarks will be neither learned nor technical.
I have, however, spent a number of years reading and talking and
thinking about the nature, the pace, and the effects of change, and
simultaneously figuring out what motivates people to behave in certain ways in spending or hanging on to their money.
Since your schedule for the next 10 days will involve your hearing
from, I think, seven more of the country's most distinguished economists, I will limit myself to a few observations about the nature of
change and how I believe it should affect your study. I will also urge
you to consider some radical alterations in the composition of our
society that are now rapidly developing and may well become dominant in fixing economic policy. I hope I will be helpful; I promise
not to take more than 10 minutes.
Resolution 248, which established this study, raises a number of
questions—among them, whether or not "numerous profound changes
in the United States and world economies have rendered ineffective
traditional remedies—for solving unemployment problems."
The answer to that question is probably going to be "yes," but in
the course of getting to the answer, I suspect that several other conclusions will be reached.
One will, I think, be that changes in the U.S. and world economies
have been companion to changes now occurring in attitudes, goals,
and even in deep beliefs within our society and others.
You will be handed a great many papers and studies, more than
you can read. One I hope you will read carefully is called "Prospects
for the Future: Metamorphosis Through Metanoia," by Willis W.
Harman. Mr. Harman is a professor of engineering-economic systems
at Stanford University. The metamorphosis which he believes is now
upon us is nothing less than a basic change from the rational, secular,
scientific, and technological period which began 8 to 10 centuries ago.
The metanoia, or total change in the underlying beliefs which permit
the common consent every social paradigm needs has now begun, he
believes, and may proceed with startling speed. Mr. Harman's paper
will not be the most important document you read—unless he's right.
If he is, and he may be, your entire assignment will be vastly changed.
Meanwhile, at the heart of our problems of unemployment, inflation
and rigid institutions with their cynical stake in perpetual continuity,
there is a long history of accepting as "good" that information which
is useful and productive in a scientific or technological sense, and thus
33
in an economic sense. And so we have focused on curing disease, not on
holistic health, on economic productivity as if it were somehow indifferently related to the passions of the worker.
When a future reporter writes the story of our days, he may note
that by 1979 we had reached the place where we referred to the goal
and value of a project as "the bottom line," a phrase that comes to us
not from a philosopher, but from the practice of accounting. Amongst
those familiar with money, it is called, affectionately, the old bottom
line.
We know that questions of personal growth and fulfillment, the
desire of people to have meaning in their lives, is important. But do we
yet know that these yearnings are important to economics and economic planning ?
I believe that we are near a change that will no longer permit us t©
base our economic planning on the assumption that people work almost entirely to acquire things and that their appetite for material
goods and services is insatiable.
Science, people now perceive, will not bring heaven to earth. Applied
science, in fact, has been getting some very bad press on the subjects of
clean air, clear water, the greed that mars land use, and the contrary
nature of nuclear reactors.
I urge you, too, to pay close attention to the rising volume of talk
about "quality of life." Such talk is not just California psychobabble,
and it does not refer just to goods and services. I believe it also refers
to work that is useful, meaningful and even enjoyable.
People do spend a large part of their lives working and at last they
know work should be a decent part of living. That's what happens in
an educated democracy.
I hope you can weave into this study a serious and continuing attempt to find out why people work—beyond the cruel assumption that
they have to. We should try to find out what is happening to the social
organization that will change our perception of good work, useful
work, interesting and rewarding work. No economic plan will succeed
that fails to understand why people work, why they will want to work,
what they will want to do and—most of all—how and why all that is
changing so fast.
Now to my second point of two.
There is another change, much talked about, subject to pretty accurate projection in its numerical aspects, but little understood yet
in its revolutionary social, political and therefore economic aspects.
The accelerating growth in that part of our population that is at or
near what John McCloy calls sixty-five: the age of presumptive incompetence is unique in all history.
In a few years people 65 and over will be dominant in the voting
population. They are the generation that survive,d the Great Depression, won World War I I , and built the technological society that produced the age of affluence. They have endured revolutionary behavior
in their own children, and contempt from former allies and enemies
alike. Up to now they have been bemused but not troublesome.
Now I suggest a giant meltdown is forming in the threescore-yearold group which is going to change the economy, if not the count ry7
in ways no social containment structure can hold.
34
For example:
Thirteen percent inflation for people living on social security is
a betrayal of 40 years of promises.
For example, our retirement policies are transported intact from
a past that no longer exists. Most of the working population now is
dependent on some institution to work effectively—a company, a
school, a government body, a hospital, a big store. Arbitrary, forced
retirement at any age leaves competent, energetic people without the
institutional connection which enabled them to be effective.
Abrupt retirement from an institution-related job stigmatizes a
person as worthless. That is bad enough. But I doubt that any economy
can stand the weight of 30 to 35 percent of its population living longer
and longer without contributing to the GNP. Advancing compulsory
retirement to 70 for those people whose retirement pay is under $27,000
is not a good solution. I t continues compulsory retirement in the old
tradition, although at age 70, but says achievers and successful contributors ought to be kicked out at 65. Exempt, of course, are lawyers,
doctors, writers, artists and successful politicians. But that leaves a
lot of us victim to a foolish custom.
For example, there are strange and inexplicable aspects in our
public policy toward the old. If one is retired and has only social
security, he or she must either work or live in poverty. But, as you
know, if he or she earns enough to relieve the poverty, the law reinstates
it by cutting off social security. That's weird.
Last, the concept of vesting retirement benefits after 10 or 15 years
celebrates the institution over the individual. It is interesting that our
educational system, where a high proportion of bright people work,
has had portability of pension benefits for decades.
And so I submit, in all seriousness, that the growing older population will soon feel so alienated and betrayed that it will be likely to
respond to the kind of demagog who can focus fear and anger behind
a few oversimple promises. Proposition 13 was a warning. It would
be a good idea now to reread the story of the Townsend Plan in the
1930's. The plan was advanced as a way to cure the Depression. I t
promised every person over 65 a check for $200 a month, then a
comfortable living wage.
The recipient had only to prove that he or she had spent the $200
to get the next check.
At that time when there were only 100 million people in the United
States, there were 2.5 million dues-paving members of Townsend
Clubs.
By the way, when the Townsend Plan was turned down in the Congress, four-fifths of the House was absent, perhaps through some discomfort at turning it down.
So my second of two suggestions is to include in your study, as
one of its most important components, a total reexamination of this
country's unconscious and historically unique rejection of its most
experienced and wise people, and its most organizable voting minority.
Finally, I would like to offer three brief comments on inflation. For
the person with a comfortable margin of his or her income at the discretionary level, inflation is different—totally and fearfully differ-
35
ent—than it is for the vast middle-income group who are above the
poverty level and below the level of modest affluence. Recent months
have revealed that an overall inflation figure of, say, 10 percent can
include inflation of 14 percent for food.
For the worker at the lower end of the middle-income scale, the
inflation rate for daily necessities—food, shelter, and necessary transportation—is the real and only rate of inflation.
They are not fooled by published figures that differ from numbers
stamped on supermarket shelves. In my working life in New York
City, the price of a subway ride has gone up 1,000 percent. I can remember when each increase made a difference.
In the same way there is a bitter joke in the way inflation hits both
the very poor and the upper-middle-income salaried worker. The very
poor live, for the most j)art, in the city.
Food prices in the city are consistently above those in the outlying
suburbs, as reported once again in yesterday's New York News inflation
watch.
For the person rising toward a comfortable salary level, the graduated income tax has a special Alice in Wonderland quality in inflationary times. Because each new increase in salary puts him or her in a
higher tax bracket, a raise that appears to offset inflation passes
through a tax table which actually reduces take-home purchasing
power.
I will leave to your economists the answers to questions of the effect
of Federal deficits on inflation. I know these are difficult and complex
questions, although something convinces me that Dr. Keynes never
urged us to have large deficits in good times and huge deficits in bad
times.
My plea is that you approach the worthy goals of this study knowing
that powerful social and political changes are already preparing to
write some of your answers, and that, as always, economic planning
will succeed only if it harmonizes with people's dearest concepts of
what is good, fair, and just.
As for time, you already know that events are moving swiftly and
that inflation always produces a bitter harvest.
Thank you.
Representative BOLLING. Thank you very much, Mr. Hardy.
I think Mr. Hardy's statement is a good point from which to take
off, both in comment on the study, and the panel approach, we have
found it necessary not to have certain witnesses who were unwilling
to appear in panel. We had a few witnesses who told us that unless
they could be here by themselves, they were not going to appear.
Some of them were very distinguished, but we did not include them
in our plans.
But we are delighted that we have with us four very distinguished
gentlemen who aren't afraid to appear with each other. Nor do they
feel that it's beneath them to appear with each other.
But having said that, the purpose of the panel approach is to get
exchange among different kinds of people. I, of course, am like Mr.
Okun in one respect. I have for 25 years advocated something that is
revolutionary in Congress. And that is that the President have certain
discretion with regard to raising and lowering taxes, so that we get
some additional flexibility into the system.
36
But what I would like is to have everybody comment on Mr. Hardy's
point that, essentially, we are dealing with a fundamental change in
the attitude of the society toward itself. I think that is a fair way to
say it. If you agree or disagree, I would just be curious to hear.
Starting with Mr. Okun.
Mr. OKUX. I think there have been fundamental changes in social
attitudes. Maybe in any 15-year period, we observe some of them. I
really think that what has been unique about this period has been the
chronic stagflation that we have developed. As I have indicated, some
of the feelings of greater divisiveness, less gloom in the society, less
sense of fairness and justice, really turns on the inflation, and that
while solving that problem won't solve all our ills, I think it would
turn around a number of developments that have given people a feeling
that they have no basis for planning, no sense of fairness.
Money is a language in our society. It's a way people have learned
to think. It's a way they have learned to plan. We talk about how
people make out in real income. There isn't a soul in the world who
knows how he's made out in real income, except by taking his money
income and then asking what's happened to the prices.
I couldn't tell you what's happened to my real income over the last
25 years, except by going through that two-step process. And I think
that all of the aspirations of people have been built into a set of
thinking in nominal terms. People who had some kind of an income
objective in mind early in their career, then reached that objective and
found that it doesn't mean what they thought it was going to mean,
are bound to feel frustrated.
The whole search for the villain of the piece, the guy with the long
end of the stick, is a function of a society whose calculus has been
distorted by a shrinking yardstick. It doesn't know how to do its
reckoning anymore.
The typical kind of thing I am confronted with at cocktail parties
is getting cornered by a young lawyer who wants to know how much he
needs to save in order to put his kids through college and makes the
point that his father knew—it might not have been easy for his father
to find the amount to save, but his father knew what it took, and he
doesn't know what it takes, and I don't know what it takes.
The whole ability to do any long-run planing in this society, and to
achieve anything that you can call security for retirement, the amount
of life insurance and so forth is vastly distorted by the inflation.
Representative BOLLING. HOW does that relate to the fact, and I think
it clearly is a fact, that, for a variety of reasons, let's say, in the period
1946 to 1966, the nature of the society changed in almost absolute terms,
a very, very large number of millions of people came into an income
bracket which they had never had in their families at any time in their
past. Economic growth and a variety of other things changed the nature of the society itself.
And I think that is fairly obvious and fairly clear that that was a
fundamental change. The current situation comes in on top of our
acceptance of that change.
The new middle class, middle income, whatever you want to call
them, that had education, had trades, had professions, whereas in the
whole history of their families there had been no education, no pro-
37
fession, no trade over time. And they really basically existed on the
edg£ of poverty or something very like it.
Now ts
this second
change
coming
sd
cg
g on topp of that does do something
g
to
tti
a b it's evening out,
out II don't know; I am
to th
the expectations,
andd maybe
curious.
Mr. OKTJK. Well, the whole commitment to rising aspirations and
progress and upward mobility certainly were important points in the
very favorable experience of the postwar era. We tend to forget that
the record over the last 30 years certainly, taken as a whole, has been
the best record of performance in American history.
I think it did lead to lots of hopes, lots of expectations, lots that were
realized. And that both the slowdown in real income and the perception problems associated with interpreting one's economic status in an
inflationary world have created a backlash.
They knocked us down from a very high level, so to speak, of social
attitudes.
Representative BOLLING. HOW about you, Mr. Feldstein, or is this
too much of an abstract ? Is this too political ?
Mr. FELDSTEIN. Well, I am not sure that I have any particular competence to comment on the question. But I think what you have said at
the end here about changing aspirations in response to the period of
economic growth is a problem that exists quite apart from the inflation.
Even if we turn around the inflation situation, I think we are not going
to have the same kind of real income mobility in the future, for many
of our citizens, as we have had in the past, simply because we have
run out of opportunities to upgrade education.
Over the last generation it was very typical for sons and daughters
to have much more education than their fathers and mothers, and so
even if the economy grew relatively slowly, they themselves moved
ahead in real terms in comparison to the economic circumstances in
which they grew up.
Now there isn't that kind of automatic dynamics carrying a large
part of the population to a relatively higher standard of living, and
there is bound, as a result, to be greater frustration.
The slowdown in the rate of growth that will come from the exhaustion of the opportunity to simply increase the amount of education and
training in the population, also is going to mean that more people will
slip behind the real income that they had when they were young*. And
that is bound to have uncomfortable consequences for the way in which
people think about the whole economic system.
But I don't know whether that or the current inflation has caused a
greater change in thinking than the experience of the Depression, the
Second World War, or the great growth of income in the postwar
period or the sense of defeat associated with the Vietnam war.
In terms of the impact of all of this on the stagflation problem, I suspect, but I have no way of quantifying that changing attitudes may
have had an important impact on our productivity growth.
Various things that one hears about things like absenteeism, relative
number of hours worked per hour paid, a general change in the attitudes toward risktaking, all of that, if true, and if symptomatic of
much more of the same, would help to explain some of the slowdown in
our productivity that goes above and beyond the reduction in capital
formation.
38
Kepresentative BOLLING. Speaking directly to Mr. Hardy's point, it
would seem to me that one of the implications of the point that he
makes which, I think, is valid, is that we might have a rather different
view of what kind of education should be available for aging people.
We do remarkably ill, we don't really do very well in our education
of younger people. We certainly do desperately badly in our education
of older people. It would seem to me that there was an enormous potential in terms of just plain raw economics if one looked rather seriously
at the problem of the education of the elderly—the reeducation of
the elderly.
One does not have to be very elderly to know the difference between
being young and old. I would be interested to hear what you have to
say.
Mr. ECKSTEIN. Mr. Chairman, before I respond to your question,
could I make two requests ?
One, would you enter my prepared statement as written on the
record ?
Eepresentative BOLLING. Absolutely, without objection that will be
done.
Mr. ECKSTEIN-. Second, I made a comment in trying to illustrate one
portion of my theory in relation to the Teamster settlement. I was not
arguing that that would be a decline in real wages, but rather, that it
was predicated on the belief that we can bring our current extreme inflation under control, that this is temporary, so the settlement would
represent a real gain averaged out over the life of that contract.
I mention that because it's a sensitive matter. On the question of age,
I think Mr. Hardy's point is well taken. The problem will be exacerbated by the inescapable fact that we are, in fact, going to be pursuing
more cautious budget policies.
We are not going to be able to add vast new claims to the budget because in the end, the American people will insist that we reduce inflation by a more conservative approach to fiscal policy.
And we will have to be very, very sensitive to meeting the needs of
the older people. They are still, despite escalation of social security,
the main victims of inflation.
And we are currently for the first time since we began the social
security system, examining how to reduce its benefits. We will have
to do that.
We have been very generous in adding in every revision of social
security law more benefits of this or that type. Some of them of a
rather marginal and questionable sort. We are losing track of the fact
that we are eroding the basic value of the hard-core pension for the
typical American family because we have been very generous with the
low-income benefit, disability benefit, a variety of loosely administered
pieces of it.
And there is a danger in that. So we are going to have to look very
closely at the economic and financial circumstance of the typical
middle-class aging family.
I know there is a White House conference study underway to try to
pull together the facts and figures on that, and as for education of the
older people, to me, that is simply one of many ways in which you
can enrich their lives. I am not an expert on that.
39
I really have no comment on what kind of program should be offered
to the aging. Certainly that is one good one.
Representative BOLLING. Mr. Feldstein.
Mr. FELDSTEIN. I was just going to add one further thing on the
problem of protecting the retired middle-class person.
Social security, as Professor Eckstein just commented, is, of course,
indexed. Private pensions to a greater or lesser extent are able to
protect their value because those funds invested in short-term assets
have at least kept pace with inflation and are not subject to excessive
taxes.
It's the saver who has accumulated some funds and put those savings into a bank account or mutual fund, and who's dependent upon
that income, who suffers most heavily under our current system.
They are not only unable to get interest rates on these small savings
that keep pace with inflation, but on top of that, are taxed on that
nominal yield.
The saver who received 8 percent last year didn't keep pace with the
9-percent inflation, but, nevertheless, was taxed on that 8 percent as
if it were real income.
So I think, if we are looking for ways to try to protect the older
individual who has some savings, we ought to be thinking about policies that other countries follow of exempting some part of interest
income, perhaps restricting that to older individuals, particularly
during this period of high inflation.
Representative BOLLING. What about the question of the need for
the Congress to finally face the fact that it has to provide some kind
of flexibility in the tax system, greater flexibility than the Congress
is able to provide through its own mechanisms?'
Mr. OKTJN. I have become a little less enthusiastic about that in the
last 5 years. I suspect that the most misconceived fiscal proposal in
the postwar era was a proposal for an increase in taxes made by
President Ford in October 1974. I fear that, if he had discretionary
authority to institute it, he would have.
Congress paid no attention to that recommendation, and Congress
was wise in so doing.
Again last year, we had an ultimate tax bill enacted which at least
in its total fiscal impact was a lot more appropriate than the one that
had initially been recommended by the President.
So the question comes down to, are Presidents most likely to be
right, or wrong ? And if oner doesn't want to bet that they are most
likely to be right, perhaps it s wise not to give them excessive discretionary authority.
Representative BOLLING. Isn't the behavior of Congress correct
when it coincides with the fact that Congress likes to cut taxes ?
Mr. QKTJN. It didn't cut taxes nearly as much as President Carter
had initially asked last year.
Representative BOLLING. That's right, because it couldn't figure out
how to pass a bill that would do it.
Mr. FELDSTEIN. What would be your own reaction to an authorization for the President to raise taxes but not necessarily to lower ?
Representative BOLLING. That would not be the approach that I
would take. I still think that we have got to build in some flexibility
that does not depend in essence on a 2-year cycle.
40
I am perfectly aware that Presidents make mistakes, too. But it
seems to me that the system works best when we have a considerable
amount of flexibility. I think we are in a very inflexible situation in
terms of responding to economic circumstances.
I am not sure that that's right. Obviously, the majority of my colleagues surely don't agree with me.
Mr. OKUN. One thing that certainly speaks for your side is the fact
that every time we get into a debate about a cyclical change in taxes,
mp or down, we go through months of agonizing aibout what the right
form and the right distributional aspect of that should be. I t seems
to me that is something one should be ready to argue in the abstract
and one should be ready to argue as a principle for at least some
significant period of time.
We ought to be able to say that we want any tax rise or tax decline
that is meant to deal with a cyclical situation of where we are trying
to cool off the economy, or trying to fight an overly deep recession, to
take a particular form.
We ought to be able to decide on that. There were hearings back in
1966. I think Martha Griffiths, trying to develop some kind of consensus on this. I think as I recall, at least the Joint Economic Committee was able to provide that consensus. But it never sticks.
And the whole can of worms has to be opened and inspected worm
by worm, it seems, every time we get into this.
I mean, what looks like a simple task of arguing this out and settling
on it would save us an enormous amount of time when we are asked to
act fairly promptly on a tax bill.
Representative BOLLING. I suppose that is partly because the political
process is always—involves struggles between groups.
I suppose that the difficulty that we have in dealing with taxes from
year to year is that different interest groups have different expectations
at different times in the overall political process.
Senator, do you wish to become involved in this ?
Senator JAVITS. Well, I came because I do wish to become involved.
Representative BOLLING. I thought so.
Senator JAVITS. But I am just looking over the prepared statements,
so you go right ahead.
Representative BOLLING. One housekeeping matter.
I want the witnesses to be assured that their prepared statements
will appear in full in the record. The staff reminds me that I hadn't
taken care of that problem.
Well, I am beginning to wonder, I am not an economist, of course,
but I have been involved in this committee for a very, very long time.
I'm beginning to wonder if it's possible to separate what I think I am
from what everybody else is, political economists. I don't see how you
can demonstrate as wise as all of you are, and I am not being sarcastic,
I admire each of you, it does not seem to me that we are in a very good
position to really do any predicting as to what is going to happen to
the American economy.
Not because we can't define it in our own terms, but because we have
so little control over the essential aspects of it. I don't see any sign.
of our getting better control.
41
What about the relationship of this economy today to the world as
opposed to the economy of the United States with relationship to the
world economy 30 years ago ? Is there an enormous difference ? Is there
a significant difference? What level of difference do we have in our
situation, our ability to control our destiny in that 30-year period ?
Mr. ECKSTEIN. Congressman, I think there are two massive changes
that have made events less controllable and we will be well advised
to have policy approaches that recognize that.
The first is that the United States 30 years ago was the preeminent
industrial economy and could really have its own way in almost any
matter that it wished. Today we are competing with at least two
major economies that have done a better job of both licking inflation,
and of operating in the world market, Japan and West Germany. And
much of our own ability to revive our productivity growth will depend
upon our talents in matching their industrial strategies to get our
own exports advancing, because we cannot have high productivity
growth without better export performance.
Also, of course, the dollar is no longer what it used to be. We ne
longer have the fixed rates of most post-war periods and we have ne
ability to control the dollar, and it is just as well if we don't try very
hard to do it.
The other area where we have lost our independence—and this is
more decisive, really, is on energy. We see in the current recovery the
moment the world economy really gets going OPEC raises the price
by another, in this case, 39 percent, and brings the world industrial
economy up short.
Until we reduce our dependence on OPEC oil, we are going to find it
impossible, either to get rid of the stagflation or to achieve fell
employment.
Representative BOLLING. Why are Japan and West Germany doing
better than we are? Is there any reasonable answer to that, any
generalized answer that makes any sense ?
Mr. ECKSTEIN. TO some extent it is a historical circumstance. They
were able to weather the OPEC storm better because they did not
have a domestic oil industry and, consequently, simply swallowed the
full bit of OPEC, I mean the full shock of OPEC, and went on from
there.
The other factor is, and I don't think it is a plus, by all means, but
they do have weak unions, again for historic reasons.
In Germany they destroyed the union movement. In Japan they
never let it develop. So the employers are more powerful and are able
to persuade labor that modest wage increases are really in their selfinterest.
We could not operate the way they do. Ours is a much more plural*
istic society, in some regards a freer, more open society with a better
balance of power between management and labor.
Mr. OKUN. May I add a couple things to that ?
One is that Japan has had substantially more inflation than we ha^s
from 1973 to date. It has a lower inflation rate currently; it had a far
higher inflation rate in 1974,1975, and 1976. Some of that is a reflection
of just what Mr. Eckstein pointed out, that they took the whole brunt
of the price increase in oil and took it all at once.
42
You can like that better or you can like it worse, but that is the fact.
Some of the Japanese volatility in both directions reflects a very different kind of labor market. They seem to have a way in which every
spring wages are determined from ground zero, so to speak, whereas
ours have enormous inertia over time with wages following wages in
the nonunion sector, with overlapping 3-year contracts in the union
sector, and so forth.
It is just inconceivable that we could have experienced what they
did, which was wage increases above 20 percent in 1975 and something
approaching 5 or 6 percent last year.
In the German case, I think a critical institutional factor is that they
export their unemployed. The German labor market has operated
throughout the post-war era using a very substantial fringe of foreign
workers. And the consequences of slack, recession,fiscalmonetary restraint in Germany is that those other folks have to go home. They
don't vote. They don't collect unemployment insurance. They don't
do any of the things that American unemployed do that make us a little
more concerned about it.
Representative BOLLING. Did you have something, Mr. Feldstein?
Mr. FELDSTEIN. I agree with what my two colleagues have just said.
But I think it is worth emphasizing that the outcome of this process
that Mr. Eckstein described as employers convincing employees to
"take less" has been over a long period of time that in real terms they
have been getting much more.
What was being described was not real wage increases, but rather
nominal increases that have contributed so much to the inflation increase here rather than in Germany.
Indeed, that has come back to roost, as I understand the situation in
Germany now, because they tend to think more in real wages rather
than nominal wages.
A number of German experts believe that the wage rates have been
sticky in real terms in Germany. That's been helpful for bringing
down wages after a period in which prices rose and then prices
dropped. It was possible to bring wages down without the stickiness to
which Mr. Okun referred, but there is a feeling in Germany that tthe
high unemployment rate they have now is a reflection of the fact that
wages have stuck at too high a level and unless they do something to
increase productivity so their ability to pay wages is commensurate
witih the real wages they are paying, they are going to continue to have
a higher unemployment rate than they are accustomed to.
Representative BOLLING. What about the question of the relative
role of Government in the three countries, the United States, Germany,
and Japan ?
Mr. ECKSTEIN*. I think in Germany the role of Government is greater
than here. In Japan, clearly not. The share of Government in the
GNP is lower in japan than here and is higher in Germany than here.
But one difference is that you do not have the adversary situation
that is normal here. Whether it is a different political system or what.
But business simply finds that Government accommodates itself more
to its needs.
Certainly when they get outside their own country, they are like a
team, whereas ours, we have no team abroad between business and
Government.
43
As a result, they liave had this tremendous export performance.
There is one other point. Both of these countries have had much
higher rates of capital formation, but that was made possible by their
success abroad. So even though we may find it advantageous to have
the Government regulating in a tough-minded fashion what business
ought to do, and I don't think there is any real choice about that,
when you get to the frontier, we might find it smarter to have them
operate as a team.
Representative BOLLING. Mr. Hardy?
Senator JAVITS. I would like to say a few words here, now that I
have gone over j^our prepared statements. The two things that interest me are these:
One, what do you gentlemen think about this statement? We were
not in all that horrendous a situation as long as inflation remained
under the double-digit figure. But we do have great reason to be very
much alarmed now, with this sudden surge.
Or, do you discount my statement. Are there other reasons for it ?
It seems to me that the double-digit level puts the pressure on us much
more greatly ithan we had expected. After I get your views, I would
like to pursue some other questions.
Professor Feldstein, perhaps you could start.
Mr. FELDSTEIN. Well, certainly the experience in the last few months,
with a return to double-digit rates, has made everybody much more
worried. Yet I don't think you would be saying we should be comfortable with 8-percent inflation.
Senator JAVITS. If you would be kind enough to yield, what I am
saying is that 8 percent certainly didn't make us feel comfortable and
gave us great need to deal with the problem. But it didn't give us a
sense of urgency or crisis. That is all I mean.
Mr. FSLDSTEI^T. Maybe it should have. Maybe we need double digit
and should welcome it as giving us that sense of crisis. But I think
our economy suffers very substantially even at rates of 6- or 8-percent
inflation.
So our target should not be merely to get back to the misery of last
year.
Senator JAVITS. DO you agree with that, Mr. Okun ?
Mr.OKUN. Yes.
Senator JAVITS. The same here ? Everybody agrees with that ? That
is, that double-digit inflation has not really changed the situation
except in order of its magnitude.
Mr. HARDY. I would like to make the point that the only change that
is consequential to any human being is the change that occurs in his
lifetime. The change in the language from Chaucerian to modern
English went unnoticed by every generation that participated in it.
But inflation at 10 percent, if you are on a fixed income, halves that
income in about 8 years. That occurs within your expected life. An
inflation rate of 8 halves it in 10 years, slightly more tolerable, but
still it leaves you unable to exist at the end of 20 years.
Senator JAVITS. Well, the two things that impress me from just
glancing through the papers—just to get some concept from all of you
about the situation—are: One, the noticeable impact upon our situation of both the lack of productivity and the lack of an adequate export opportunity to sustain our situation.
44
And, second, the interest in work which Jerry Hardy has raised, I
think in a very important way.
Looking to the first, that is productivity, I think Professor Feldstein points out the difficulty which arises out of our tax law which
fails to take account of replacement cost in the equation of determining corporate profits.
By the way, that has a very, very powerful political effect. Politics
could be given an entirely different twist if the people took it into
their heads that you need to curb business enterprises, as you did in
the 193Q's, without a new surge of business buccaneers scalping the
public for big profits.
By the way, the profit question has a lot to do with the disbelief
about the energy crisis. People think that it is the oil companies that
have got it in their back pockets.
So, what I would like to question, if I may—just to lay it on the
table—is the decisiveness of these positions that give the idea that you
can run these things with mirrors by fooling around with interest rates
and the policy of the Federal Reserve, when we all know that the
only thing that really counts is the bottom line: What do you make
and how much and can you sell it.
What worries me is that we are not pointed at the right target,
which is productivity on the one side and marketing on the other, and
that the marketing suffers from a grave insufficiency of the supply of
development capital to the areas of the world where development is
both politically and economically feasible.
Yet, we have these great examples of middle-income countries
like Brazil, South Korea, Taiwan, and some others around the world.
So my question is this: If you are going to mass your means at a
given target, because that is a military doctrine which is in my judgment very valid, what target should it be ? Should it be productivity ?
Should it be the tax system ? Should it be interest in work, as Jerry
Hardy wishes us to do? Or should it be monetary policy and fiscal
policy ?
Mr. OKUN. I think it should be the wage-price spiral. I think that
has been the fundamental factor in our recent inflation. It has been
somewhat exacerbated by the productivity slowdown.
The productivity slowdown has enormous consequences for our real
living standards over the long run. But it has been a fairly modest
element in the inflation picture so far. And the way it gets into the
inflation picture is because we do have a set of wage targets and wage
institutions which are not lowered by a slowdown in productivity
growth.
m To me the dismal failure of the 1974^-75 recession to produce any
significant lasting effects on the economy are all associated with the
way we make wages and prices in this society. And there isn't anything wrong structurally with that, but it does produce an enormous
amount of inflation inertia.
You have to find a way to talk business and labor, or reward
business and labor, or contrain business and labor from playing a
game that will put oil prices into the price level by putting them into
the wage level. It would then get it into the core inflation rate that
45
Mr. Eckstein talks about. There would be equally serious effects from
putting the productivity slowdown in the inflation rate. I think that
is what we have to prevent.
Senator JAVITS. SO are you for controls right now ?
Mr. OKUN. N O ; I do not believe that a mandatory structure of wage
and price controls would settle the problem. I really think there is
more potential in the program that the administration has advanced
than people are giving it credit for.
So far it has done, I think, a significant amount on the wage front.
I think the failure on the price side has to be looked at much more
carefully.
I do not believe that when you take food and fuel out of the story
that you get a set of price performance which is at all consistent with
the price guidelines. I think there must be enormous violations going^
on out there. I think it is a matter of nailing it down.
Senator JAVITS. Thank you, Mr. Okun.
Professor Feldstein.
Mr. FELDSTEIN. Let me comment first on some of the things that Mr.
Okun has just said. I don't see any real difference in the wage- and
price-setting process now, in the late 1970's, from the process in the
early 1960's.
There may be small changes, but there has been a decline rather than
a growth of private sector unionism. There has been no growth in the
concentration of industry. There has been a greater opening up of the
U.S. markets to world competition. So all of those rigidities, which
I will grant are there, are, if anything, smaller today than they were
before.
Yet our economy managed to function without excessive inflation
during that period because it wasn't overheated by excessive demand.
I don't think we need to change the way in which we have wage and
price setting in order to get back there, either.
Again, I quoted before you came, Senator, just to remind everyone,
that—what the experience was when the economy went through a contraction in 1975. The inflation rate was 12 percent in 1974. It was less
than 5 percent for 1976. Finished goods inflation came down from 18
to 3 percent.
Mr. Eckstein's chart identifies what he refers to as the demand component of inflation, which therefore, takes out things like OPEC spike
in the earlier period. But that shows a 4 percentage point drop over
a 2-year period in the demand component of inflation.
So my sense is that if we have slack in the economy, if we operate
with a margin of safety in the unemployment rate and our labor
markets and our capacity utilization, we will see the inflation rate
coming down.
And that we are not likely to find success by trying to tamper with
the wage-price mechanism.
Indeed, I also wonder whether we should be so optimistic as Mr.
Okun seems to be about the success of the program so far. I don't feel
I fully understand what happened in the Teamsters settlement. But
the number that I have looked at, the first-year number, looks like
11.9 percent.
51-421—7$
46
I don't, frankly, know whether that has in addition to it any cost
of living adjustment if that inflation rate during the first year exceeds
6 percent or if it only takes effect in the futurey but it is at a minimum
of 11.9 percent in the first year.
^
There are going to be a lot of workers who are going to wonder why
they should accept 7 percent for the coming year even though they
have been told that the Teamsters have been in compliance, when in
fact the Teamsters have received close to 12 percent or more.
Let me come back to your where-would-I-miss-my-effort question.
Many of the things you identify are either methods or intermediate
goals. It is clear our long-run goal is the growth of real income. Productivity growth is one way in which we achieve that. Capital formation is one of the ways in which we achieve overall productivity
growth. Tax policy and aggregate demand policy are the ways in
which we can encourage capital formation, by going back through that
route I have indicated the things that I think are important.
I think we need better demand management that gives us that margin of slack so that the inflation rate goes down, and a change in our
tax priorities so that we no longer are penalizing capital formation.
If we do that, I am optimistic that we can increase our rate of
capital formation, although I think there are other things which are
at least as important that would have to be done to get that capital
formation up.
Senator JAVITS. Mr. Eckstein.
Mr. ECKSTEIN. Well, Senator, Mr. Okun and I served together on
the Council of Economic Advisers in the mid-1960's and my job was
the micro aspect of prices and wages and his job was macro aspects.
But I did convince myself that "the specific price-wage dimensions
are really abstractions. When inflation becomes acute, the pressure on
the Government is to do something. One way to relieve that pressure
is to call up Sears and Eoebuck. In fact, however, that is not going
to do much to fight inflation.
Indeed, the only practical way we have of intervening in prices and
wages in a meaningful way is to freeze them. I think that is the only
price-wage policy that can be considered a policy rather than a public
relations gimmick or sideshow.
The battle of inflation will be won or lost in the macro area. We
currently have an industrial boom. Until that boom is over, everything
else will fail. So, to me, you have got to fight the fire you have got,
although our meaning today is to look at the long-run forest rather
than the fire. That fire is an excess demand fire. But that, in the longrun, we must improve our productivity and export performance.
If we straighten those out, our economy will return to the fantastic
material progress we have experienced for 120 years.
Senator JAVITS. I just thought perhaps Mr. Hardy would like to
say a word.
Mr. HARDY. I guess I am focused on what is in peopled heads and
hearts more than I am in what goes on in the numbers that measure
the economy.
If I were trying to focus my firepower, as you said, for greatest
effectiveness, I think I would do those things which would reassure
people that the whole thing is going to stick together. There is a
47
growing conviction that something is very wrong out there, a growing
conviction, I think I said earlier, that somebody is betraying the
promises of a lifetime.
I have no way of measuring it. But in talking both to people and
to businessmen, I find them behaving in the most logical possible
fashion. That logic is the very dangerous logic of self-survival.
Businessmen are now borrowing money in the firm conviction that
if they can get 20-year money they will pay it back with 10- or 20-cent
dollars. People are buying all kinds of things that they know they
don't need today, but are going to need next week or next month or
next year. They are buying because they have an absolute conviction
that things are going to be more expensive down the road. They have
only to watch the automobile companies raise their prices six times
in a single year, and they know they are right. They know what they
are doing is right.
People do behave in a pretty logical self-survival fashion. They are
beginning to lose faith in the whole structure, in my opinion. And I
would try my damndest to find ways to reestablish that faith because
its loss is exhibiting itself in a cynicism about productivity insofar
as commitment to work is concerned.
Nobody wants to do a lot of the jobs that have to be done now. We
know what is happening in New York. It is dirtier than Guayaquil,
Ecuador. That is the dirtiest city I can remember ever having visited.
Pride in the city and pride of work deteriorate together.
We are coming back a little in New York, but we have a long way
to come.
Senator JAVITS. Thank you so much, Mr. Chairman. I deeply appreciate this opportunity.
I might say you have a highly eminent panel. I couldn't think of
four men I would rather have together than these.
Representative BOLLING. Nor could I. And, with that, I think we
will close the hearing with our gratitude to all of you. Thank you.
[Whereupon, at 11:53 a.m., the committee recessed, to reconvene
at 10 a.m., Monday, May 7, 1979,]
STAGFLATION
MONDAY, MAY 7, 1979
CONGRESS OF THE UNITED STATES,
SPECIAL STUDY ON ECONOMIC CHANGE OF THE
JOINT ECONOMIC COMMITTEE,
Washington, D.C.
The committee met, pursuant to recess, at 10:05 a.m., in room 6226,
Dirksen Senate Office Building, Hon. Richard Boiling (vice chairman
of the committee) presiding.
Present: Representative Boiling.
Committee staff present: John M. Albertine, executive director;
Louis C. Krauthoff I I , assistant director-director (SSEC); and
Stephen J. Entin and Mark R. Policinski, minority professional staff
members.
Special Study on Economic Change staff present: George D*
Krumbhaar, Jr., counsel; Douglas N. Ross, senior economist; Richard
D. Bartel, economist; and Sandra Adams, Michael J. Lockerby, and
Carolyn H. Crowley, research assistants.
OPENING STATEMENT OF REPRESENTATIVE BOLLING, VICE CHAIRMAN
Representative BOLLING. The committee will be in order.
This morning, we are continuing the second day of public panel
discussions on stagflation as a part of the Joint Economic Committee's Special Study on Economic Change.
I might explain for those not familiar with the Special Study
project that it grew out of discussions with the majority and minority
members of the Joint Economic Committee and with the leadership in
the House and the Senate.
As I said at the beginning of the hearings last Monday, we prepared a prospectus about 2 ye&vs ago which calls for a 3% year study
to identify the nature of major economic changes occurring in the
United States and the world that may have rendered ineffective the
traditional methods for achieving aims of the Employment Act of
1946. We believe thorough analysis of these profound changes would
yield not only a better understanding of long-term problems confronting Congress, but would also suggest fresh policy options for
our consideration.
On the basis of this prospectus, House Concurrent Resolution 248
was introduced in the House and passed overwhelmingly, then was
approved by the Senate by unanimous consent on July 18, 1977.
(49)
50
The underlying thesis of the study is that economic, social, political,,
international and technical conditions have changed, and are still
changing markedly. This suggests that conventional wisdom and established economic tools may not be equal to the challenge of making
sound policies in the economic sphere.
The so-called laws of economics have not been repealed, but all
guiding principles presuppose certain environmental conditions, customs, and practices. When these change, the implementation of new
policies and modes of adjustment have to change also.
This comprehensive project now has underway papers and reports
on the nature and consequences of economic change in nine major areas:
Human resources and demographics, materials and energy resources,
research and innovation, stagflation, government impact, Federal
finance, State and local finance, pensions, and the international sector.
Today, we continue our discussion of the twin problems of inflation
and unemployment which our study addresses under the heading stagflation. The recent releases of both consumer and wholesale prices
make us all acutely aware of accelerating, double-digit inflation. Westill have to woriy about first stopping the accelerating upward spiral
of prices and then to bring our overheated economy down to a soft
landing.
We are not here today to talk about the short-run aspects of stagflation. What we want to discuss is where will the typical American
family be in the next decade ? How long can they go on altering their
spending and borrowing habits to protect their purchasing power and
standard of living? How long before continuing; inflation corrodes
the basic institutions of our free society and market economy ?
The Joint Economic Committee's Annual Eeport pointed out that
in order to correct deeply entrenched inflation and unsatisfactory levels
of unemployment requires the Federal Government to put its financial
house in order and to meet the major challenges confronting us on
the supply side of the economy.
On the supply side, we look for higher production, not lower. We
take no satisfaction when our index of industrial production rises
little or not at all. We look for more efficient production processes,
more effective management, higher investment, more skilled labor and
higher total productivity. It is our target to achieve price stability in
an expanding economy, not a declining one. We cannot make our peace
with either rising inflation or rising unemployment.
If we do not solve both of these problems of inflation and unemployment, not one but both, we may encounter in these United States
not far down the road challenges to both our economic and political
institutions of a seriousness we have not recently hitherto contemplated. This was certainly a primary concern that emerged from our
discussions last week.
Accordingly, the Special Studv has invited a number of preeminent
economists, business leaders and labor authorities to join us in a dialog
on the longer term outlook and solution to the problems of inflation
and unemployment. As in our hearing last year, we have organized
today's discussion as a panel. Our experience with panel discussions
51
Since the fifties confirms our belief that the democratic process work&
in an intellectual sense. The best ideas, the best insight often emerge
from free exchange from a spirited dialog among a variety of people.
Our distinguished panel last week, after debating the problems of
our persistent inflation and unemployment in the 1970's, suggested noquick fix. They, too, believe our current inflation to be caused by a
complex set of forces, only some of which respond to macroeconomic
restraints. While our earlier panel discussions led to a general consensus that inflation must be attacked simultaneously on a number of
policy fronts, the emphasis on particular policies varied. Fresh, new
policy options, however, seemed as remote as ever.
As a matter of fact, our panelists posed a painful dilemma. On the
one hand, if we allow inflation to persist, social divisiveness may intensify. On the other hand, anti-inflationary policy that triggers severe
economic fluctuations and higher unemployment will also generate
social unrest and political instability. Thus, a do-nothing or a do-toomuch strategy may have equally damaging effects on our traditional
social and political institutions, while undermining the vitality of our
market economy.
We have to recognize that demographic changes may well reinforce
the kinds of social divisiveness that economic dislocation sets loose.
To cite an example, retired Americans will become an increasingly
large group in our population as the turn of the century approaches.
They are the one segment of the population that feels most cheated
by the unjust tax of inflation. Their plans for retirement are destroyed
as inflation wipes out the savings of decades and hopes for a reasonable
living standard in retirement.
In today's panel discussions, we hope our experts will look beyond
the immediate questions of near-term money supply growth and
budget policy and out into the 1980's and beyond. Certainly, our longrange prospects are colored by the shortrun policy options we take
in the Congress today.
But what do you envision for the long-range future? How do you
expect the economy to shape up? What do you feel we should as a
nation strive toward in the more distant future ? Are our current policies carrying us toward those objectives, or do they lead us to quite
unexpected and unintended scenarios for the American economy and
society ?
In the beginning, I would like to state that the prepared statements
of each witness will appear in full in the record.
Without any objection, it is so ordered.
Our first witness will be Mr. Phillip Cagan, professor of economics,
Columbia University, and research associate, National Bureau of Economic Research, an adjunct scholar of American Enterprise Institute, Ph. D. from the University of Chicago, he has served as a member
of the senior staff, Council of Economic Advisers, from 1969 to 1970,
and was a member of the Federal Reserve's Advisory Committee on
Monetary Statistics from 1974-75.
We will be delighted to hear from you, Mr. Cagan.
52
STATEMENT OF PHILLIP CAGAN, PROFESSOR OF ECONOMICS,
COLUMBIA UNIVERSITY, NEW YORK, N.Y., AND REjSEAItCH ASSOCIATE, NATIONAL BUREAU OF ECONOMIC RESEARCH, CAMBRIDGE, MASS.
Mr. CAGAN. Thank you, Mr. Vice Chairman.
My remarks concern my views of the nature of inflation. And I
<3ould bring these across well within your desired 10-minute limit.
STxiGNATION IN THE U.S. ECONOMY
Since 1975 the U.S. economy has been recovering from a severe
business recession and at least until 1978 had considerable unemployed
productive resources. Yet during this period the rate of inflation by
any measure has been appreciable and has been rising, and even began
to rise before 1978 when the economy was still producing far below
its potential capacity. This combination of business recession and
inflation which has come to be called "stagflation" continues to puzzle
and exasperate the public. I believe that economists have previously
offered satisfactory explanations for all but one piece of this phenomenon, however, and I wish to offer an explanation for the missing piece
this morning.
The explanation of stagflation raises two questions: One, why, in
the face of slack demand in the economy, do prices not only fail to
decline but actually continue rising? And two, why do increases, which
decelerate in a business recession, begin to accelerate as soon as business activity begins to recover, long before the economy reaches full
capacity when we might expect inflationary pressures to intensify?
The first question, which economists have been discussing now for
some years, can be answered with the observation that inflationary
movements have momentum. By this is meant that most prices and
nearly all wages are not determined from day to day by^ current demand and supply conditions but are set for a period of time—weeks,
months, or in some contracts for 1 to 3 years The setting of prices
for a period of time is a convenience to buyers and sellers and is necessary except on commodity exchanges or in highly atomistic markets
where prices are the outcome in every moment of current demand and
supply conditions. Price setting largely ignores short-run changes in
demand and tends to follow the anticipated path of prices that is consistent with demand and supply conditions over the long run. Consequently, these prices are based on unit costs of production at normal
levels of output and will continue to rise as costs rise in reflection of
past inflationary pressures irrespective of current demand conditions.
In addition, price setting will tend to follow expected future increases
in costs as well as current increases of input costs reflecting past developments. The influence of past price increases working through the
•economy and passing from earlier to later stages of production as a
rise in costs, plus price and wage increases in anticipation of future
costs increases which pass forward to raise costs in other industries,
combine to maintain the momentum of inflation.
The result is to delay and stretch out the effect of demand pressures
on prices. When aggregate demand rises in a business expaiasion,
53
most industries expand output without raising the path of their prices.
Their demand for resource inputs increases and is passed back along
the. production line. Some markets, and particularly markets for basic
commodities, respond quickly to demand changes, and their prices rise
in the face of expanding demands of a business expansion. These price
increases work forward through the production pipeline to raise costs
and prices along the way. When the prices of finished goods rise to
increase the cost of living, workers receive cost-of-living raises, which
pass forward as further cost increases. When a business expansion
slackens and turns into a recession, these cost increases continue coming
through the system, and prices continue rising despite a falling off
of demand in most industries. In addition, most sellers expect continuing inflation despite a temporary recession and incorporate those
expectations into their price setting.
Notwithstanding this general pattern of price setting, we should
recognize that demand does influence prices, through the prices of
basic commodities and products of atomistic industries which are determined by current demand and supply conditions and which are
passed forward as costs raising prices in other industries. And, of
course, deficient demand produces some price shading and discounts
in nearly all markets. When a business recession develops, therefore,
firms maintain prices and reduce output, but prices of basic commodities and atomistic industries decline and as these declines work forward, other prices rise less rapidly. Wages then decelerate, and expectations of future inflation moderate. All this takes time, however, and
the first stages of a recession do not display much decline in the momentum of inflation.
Yet recessions display a decline in the rate of inflation, reflecting a
reversal for those prices which in the preceding business expansion
were temporarily raised above the basic momentum rate of inflation
due to shortages and demand pressures on raw material supplies.
In 1973-74 the rate of inflation rose above 10 percent per year and in
the subsequent contraction of activity fell by one-half to 5 percent per
year. The former rate was above, and the latter rate was below, the
basic momentum rate of inflation of about 6 to 7 percent as reflected in
wage contracts and subsequent developments.
The important consequence of these cyclical fluctuations in the rate
of inflation is that since they are temporary, they do not affect the
momentum of inflation unless a pressure of deficient demand on prices
lasts long enough to produce perceptible effects.
How long do such effects take ? Past behavior suggests that reductions in the momentum of inflation occur slowly. I estimated that 1
percent excess unemployed resources would reduce the basic momentum
of inflation by eight-tenths of a percentage point a year, and perhaps
less—see "Contemporary Economic Problems 1978," edited by W. Fellner, American Enterprise Institute, 1978—and other studies have
found even smaller effects.
This is the explanation for the rise in the inflation rate when business
recovers from a recession. The recession decline in demand reverses
previous boom increases in some prices, but the reversal, too, is temporary, and as business recovers so do these prices. Any declines taking
place in the momentum rate of inflation due to slack demand in the
54
recession and recovery are too small to be seen immediately and in any
event are swamped by the temporary cyclical fluctuations.
How then do we subdue inflation ? We must maintain some slack in
the economy to impose a persistent downward pressure on prices, allow
the cost increases coming through the system to peter out, keep actual
inflation below the expected rate, and gradually push down the expected rate and thus the momentum of inflation. It is a task that
requires a steady policy over a long period. Overexpansions of the
economy that bring new inflationary pressures must be avoided. If an
average 1 percent excess unemployed resources is maintained over a
business cycle of typically 4 years, the reduction of inflation by the
previous estimate would be 3.2 percentage points.
Expectations play an important role in the momentum of inflation,
but I do not see how we can bring down expectations of inflation until
policy has demonstrated over the course of a business cycle that the
temporary fall in the inflation rate which occurs during the recession
phase will not all be reversed by overexpanding the economy during
the expansion phase. If policy can negotiate one business recovery without allowing overexpansion, expectations will begin to form that policy
will subdue inflation, and the momentum of inflation will decline faster
than is implied by past periods in which the credibility of policy was
gradually eroded. That is why success in combating inflation can breed
further success, and the process may not take as long as past experience
suggests, though I do not wish to soft-pedal the long and difficult road
of subduing inflation.
One of the serious mistakes we have made in the past and may
continue to make is to misjudge the position of the zone of increasing
inflationary pressures. Past policy was conducted with the apparent
intention of pushing the economy to the edge of this zone without
leaving any room for the risk of error, with the result that we have
in recent past business expansions overshot the zone and overpressured
the economy. Furthermore, current pronouncements of this zone in
recent CEA reports as being around 5.1 or even 5y2 percent for total
labor unemployment are too low. Past behavior of prices and unemployment, after adjusting unemployment for structural changes in
the labor market, indicate that the zone where inflationary pressures
intensify begins around 6 percent or somewhat-higher. I derived that
estimate in a paper published 2 years ago—see "Contemporary Economic Problems, 1977," ed. by W. Fellner, AEI, 1977—and the recent
surge of inflation when unemployment fell to 6 percent convinces me
that I was right. Moreover, we must hold the economy above that
zone. That means 7 percent or more unemployment, which appears
high, but we must recognize that it is only about 1 percent in excess
of a level of 6 percent that we cannot reduce via aggregate-demand
management without intensifying inflationary pressures. I doubt that
aggregate monetary and fiscal stimulus can reduce the deplorable
pockets of unemployment among youths and minorities. In an effort
to do so, we have exacerbated inflation with only slight benefits in
terms of lower unemployment. Other methods must be used to lower
youth and minority unemployment.
Xo one is sanguine about pursuing a policy aimed at average excess
unemployed resources of 1 percent or more over a sustained period,
but we have misled ourselves into searching for alternatives that do
00
not exist. How much longer are we going to divert our efforts with
various kinds of voluntary or mandatory controls, without success,
before we face the hard fact that subduing inflation requires a steady
dose of monetary restraint on aggregate demand ? What disturbs me
is that I doubt whether such a policy can be carried through unless
there is a clear political consensus behind it which makes it credible
that the policy will be maintained until inflation is subdued. If not,
expectations will not respond in a way that supports such a policy,
which will make it more costly and difficult. Yet I do not yet see such
a consensus. I would hope this committee might start building the
basis for one. As I see it, our choice is not whether to keep the present
rate of inflation or subdue it. Our choice is to subdue inflation or see
it gradually escalate. We cannot hold it at a given rate, as our past
experience has shown.
Representative BOLLING. Thank you very much, Mr. Cagan.
Our next witness is Ms. Leslie Ellen Nulty who has an economics
degree from Cambridge in England. She is an economist for the International Association of Machinists and Aerospace Workers, Washington, D.C. Formerly, she was an economist for the National Economic
Development Law Project and the Exploratory Project for Economic
Alternatives.
From 1973 to 1974, she was a staff economist with the United Auto
Workers, and earlier a consultant to the European Eesearch Bureau
from 1971 to 1973.
Ms. ISTulty, we will be glad to hear you in any way you would like
to proceed.
STATEMENT OE LESLIE "ELLEN NTJLTY, PKOFESSIONAL ECONOMIST, INTERNATIONAL ASSOCIATION OF MACHINISTS &
AEROSPACE WOEKEES, WASHINGTON, B.C.
Ms. NULTY. I hope I can do as well on the time as Mr. Cagan has.
Before I begin my oral statement, there are two corrections in my
prepared statement that I have submitted for the record that I would
like you to take note of.
The paragraph beginning "Between 1972 and 1978 * * * production
of fossil fuels * * *" the comma should become a period and be moved
over to the right one place.
Second, the paragraph beginning "Public policy * * *" the copy of
the paper that I received incorrectly attributed the solar study to joint
sponsorship of the JEC Subcommittee on Energy and the Special
Study on Economic Change. I have been informed that that was corrected in a later print and that, in fact, sole responsibility for that
report lies with the Subcommittee on Energy.
I would like to express my very deep appreciation to the chairman,
vice chairman and members of the Joint Economic Committee for
affording me this opportunity to present my views.
Finding myself to be something of a voice in the wilderness, it is at
least comforting to know there is someone who might want to listen
to what I have to say.
While I do believe that it is possible to make a significant impact
•on persistent unemployment and inflation, I do not believe that the
56
solutions are simple or politically easy. Therefore, I have submitted
a much longer statement for the printed record. And I am sure you
all have copies.
Before getting down to the nitty-gritty, I think it would help clarify
the discussion today to have a brief statement of first principles. In
my opinion, if economics has earned for itself the label the "dismal
science," it is largely because economic discussion in this country at
least has largely been confined to a few narrow schools of thought
which have lamentably little to offer policymakers who are sincerely
committed to doing something about the problems troubling their
constituents.
The U.S. economics profession "runs the gamut," as one professor
has said, "from A to B." My own approach to the evaluation of national
economic performance and the efficacy of public policy is to measure
them directly against their contribution to the improvement in tb«
level and stability of economic well-being of the broad majority of the
population.
In contrast, much of the conventional macroeconomic fiscal and
monetary economic analysis focuses on indirect indicators such as
private capital formation, productivity trends, budget deficits, and so
forth, that reflect a narrow selection of means rather than policy ends
in themselves.
Thus, stagflation is a problem for the economics profession as it is
for the broad mass of the population, but for very different reasons.
Confronted with the contradiction between reality and conventional
theories that do not allow for simultaneous unemployment and inflation, the overwhelming response of our profession has been to dodge*
the issue by claiming that it is really just a measurement problem
rather than to confront the weaknesses of theory.
Thus, enormous effort has been expended on revisions, adjustments
or redefinitions of the unemployment rate and more recently analogous
efforts attempting to estimate overstatement in the Consumer PriceIndex.
Indeed, by some definitions, we have already reached full employment. The 6 to 8 million unsatisfied jobseekers in this country are
merely statistical artifacts beyond the reach of public policy.
While I do not deny that these statistical measurements can stand
improvement, their imperfections do not change the basic facts which
are plain for all to see. We have too much unemployment and too
much inflation. And if anything, in recent years, they seem to be going
up and down together rather than in opposite directions.
I for one hope that we will not have to see oiir cities burn again before
the dismal view that we can never do anything about either inflation
or unemployment without exacerbating the other is discredited and
finally laid to rest.
As guide to policy, these are nonsolutions. For the vast majority
of the American population, the 80 percent or so whose past, present or
prospective major source of income is wages and salaries, the notion
of a trade off between unemployment and inflation is meaningless. The^
loss of purchasing power through inflation has an impact equivalent
to the loss of a job or the threat of unemployment produced by a?
slackening labor market.
57
In both cases, claims to real goods and services are reduced, and the
basic sense of insecurity is heightened. Inflation and unemployment
are, in effect, the same problem. They are simply different manifestations of the general threat to the living standards of working people.
From this perspective, the only effective meaningful solutions to the
problems of unemployment and inflation are joint solutions or at least
policy approaches that recognize their commonality.
I hope that the members of this committee will find that by keeping
the ends of economic policy well focused while maintaining an unrestricted open approach to potential means, even the dismal science
<?an provide a richer and more optimistic forecast for economic progress. Because the recent onslaught of inflation has not been evenly
distributed across all commodities and services and because its major
thrust has been concentrated on expenditure categories that are essential necessities in the household budget, its character has been especially pernicious.
Prices for food, energy, housing, and health care, the four basic
necessities that account for roughly 70 percent of average family consumption budgets, have been going up roughly twice as fast as the
rest of the consumer price index. For these expenditure categories,
we have been experiencing double-digit inflation since the late sixties.
With the tightest squeeze on nondiscretionary expenditures, inflation
is even more painful than it would otherwise be.
While it has long been recognized the poor are hurt most by inflation, the impact of the new inflation reaches beyond the poor. Despite
the popularization of the image of the affluent worker, most workers'
families are among the 80 percent of the population who are most
vulnerable to the new inflation. Indeed, for the working classes, as they
may be called, the new inflation is particularly burdensome because unlike the bottom 10 percent and those over 65—retirees—their income
is just high enough to disqualify them from public subsidies such as
food stamps, medicare and medicaid, or rent allowances that offer
some partial protection.
On the other hand, they differ from the top 20 percent of the income
distribution in that their portfolios of income-producing assets are
much less diverse. The protective devices of hedging, arbitrage, tax
shelters, capital gains, superior interest rates paid on large denomination commercial paper, CD's, or Government securities and selfdetermined professional fees are largely unavailable to them.
Consumer price inflation has been so severe and earnings have lagged
so far behind that pretax average weekly earnings for production and
nonsupervisory workers on nonagricultural payrolls in constant 1967
-dollars are now at their lowest level since 1967.
Of course, because money wages have risen, workers are now in
higher income tax brackets—not to mention the impact of the more
regressive increase in the social security taxes—so that in terms of takehome pay, they are even worse off.
As the purchasing1 power of the wages of traditional head of household is reduced by inflation in the necessities, more family members
have to try their luck in the labor markets in an attempt to maintain
,-a constant standard of living.
58
Thus, it is not surprising .to find, as we have, quite dramatic changes
in labor force participation rates which will tend to raise aggregate
unemployment rates to the extent that new labor force entrants' demand for jobs is not satisfied. For more and more families, one income
is no longer sufficient to protect living standards.
The increased demand for jobs by new labor force entrants, youth,
and married women, pushed as they are to the end of the labor queue,
has resulted in more part-time jobs and an increasing proportion of
jobs offered at the bottom of the wage distribution both in terms of
occupation and industry.
In my prepared statement, I have produced some data to show you
that not only has the distribution of employment shifted down the pay
scale, but the ratio of earnings in lower paid sectors to higher paid sectors has deteriorated very substantially and significantly since the
fifties.
As these earnings become less and less adequate in preserving real
family income under persistent inflation, there will be continuous upward pressure on labor force participation rates. Even though the
teenage "bubble" will eventually mature, this factor may be more than
compensated for by further increases in the labor force participation
rates of future teenage cohorts, not to mention increases in the rate for
adult women.
Despite the effort to counteract the "new inflation" by adding more
family workers, the vast majority of American families have continued to fall behind. Median family income in constant dollars, pretax^
has essentially been stagnant during the seventies, and in 1977 was
below the levels achieved in 1972 and 1973.
As the problem was summed up by one member of the IAM, "the
only trouble with sending your wife out to work is that the law only
allows you one wife."
By looking at the combined effects of inadequate employment opportunities and inflation in this manner, which reflects more accurately
the way ordinary people experience them, one realizes that counterinflation programs that focus on budget cuts, dampening wage increases,
planned recession or attempts to curb the growth of the money supply
by raising interest rates are inevitably going to miss the target because
all of these mean either further cuts in real wages or higher layoff
rates for some, if not all, family members.
Unfortunately, it is not widely understood that even when average
unemployment rates are as "low" as 6 percent, around 20 percent of
the labor force experiences involuntary unemployment during the
course of the year. If policymakers truly want to cut the Gordianknot of stagflation, they must begin by altering the structure of supply, not simply the quantity of supply, and the character of demand
in the four basic necessities in ways that will stabilize employment
and living standards for the majority of the population.
While inflation in each of the necessity sectors has its own special
distinct character, many common elements pervade them. If the common problem elements could be summed up in a few words, they would
be "relatively restricted choice on the demand side, concentration of*
economic power on the supply side."
59
These are not intractable problems. Public policy can make a significant contribution to dispelling stagflation through well-designed sectoral initiatives that aim at increasing the elasticity of demand by
increasing consumer choice on the one hand and increasing the elasticity of supply by reducing corporate market power through a variety
of means on the other.
In my prepared statement I submitted for the record, I have used
a discussion of policy options for the energy sector to illustrate what
a positive counterstagflation program might look like. A counterinflation program that essentially ignores or exempts these four sectors as the administration's guidelines program has done is almost
worse than no program at all.
Any program that fails to address directly the unfilled demand for
jobs is no program at all.
Unfortunately, if recent economic policy is any guide to the future,
one may anticipate protracted and possibly accelerated inflation rates
in necessities, hence perpetuation of stagflation. This prognosis is
made because up to now at virtually every opportunity where a priceor supply-sensitive policy choice has presented itself, the option chosen
for the necessity sectors has been inflation promoting rather than
inflation abating.
Part of this may be attributable to the selectivity with which the
inflation issue has been used; that is, principally to justify the retreat of government and to forestall improvements in occupational
health and safety and environmental rehabilitation, all of which are
part and parcel of enhanced living standards for our population.
Public policy makers have to make choices. If they continue to
work for "them" and against "us," stagflation will indeed be with
"us" for many years to come.
Representative BOLLIKG. Thank 3^011 very much, Ms. Nulty.
[The prepared statement of Ms. iSTulty follows:]
PREPARED STATEMENT OF LESLIE ELLEN NULTY
Problems of Persistent Unemployment and Inflation in the U.S. Economy—Can
Solutions Be Found ?
1. Defining the economic problem—Analysis and policy should focus on the wellbeing of the broad mass of the population.—Before we can determine whether
we can realistically look forward to ending simultaneous unemployment and
inflation, economists and policymakers have first to agree on what the problems
really are. The conventional wisdom of the present only offers trade-offs: inflation it is claimed can foe reduced only through higher unemployment. Unemployment can be reduced only at the cost of higher rates of inflation.
But these obviously are non-solutions. For the vast majority of the American
population, the 80 percent or so whose past, present or prospective major source
of income is wages and salaries, the notion of a "trade-off" between unemployment and inflation is meaningless. The loss of purchasing power through inflation has an impact equivalent to the loss of a job, or the threat of unemployment
produced by a slackening labor market. In both cases, claims to the real goods and
services offered by society are curtailed and the basic sense of economic and social
insecurity is heightened. Inflation and unemployment are in effect the same
problem—they are simply different manifestations of the general threat to the
living standards of working people. From this perspective, the only effective
meaningful solutions to the problems of unemployment and inflation are joint
solutions, or at least policy approaches that recognize their commonality.
60
Confronted with the contradiction between reality and conventional theories
that do not allow for the simultaneous occurrence of unemployment and inflation,
the overwhelming response of the economics profession has been to reduce the
issue to a measurement problem—to attempt to alter the assessment of what is
happening in the real world, rather than to confront the weaknesses of the
theory. Most efforts to date have taken1 the form of revisions, adjustments or redefinitions of the unemployment rate. Very recently analogous efforts attempt- 2
ing to estimate overstatement in the Consumer Price Index have begun to flower.
Indeed, by some definitions we have already reached full employment—the G~8
million unsatisfied job seekers are merely "statistical artifacts" beyond the reach
of public policy.
I for one hope that we won't have to see our cities burn again before this dismal view is discredited and finally laid to rest. To avoid such a prospect one must
first admit that there are real economic problems and to develop explicit statements of what they are.
'
The analytical perspective from which this discussion proceeds is one that
measures the efficacy of public policy and national economic performance against
their contribution to the improvement in the level and stability of economic wellbeing enjoyed by the broad majority of the population. It differs from conventional macroeconomic fiscal and monetary approaches in measuring success directly in terms of the ends of policy, not in terms of indirect indicators such as private capital formation, productivity trends, budget deficits, etc. that reflect a
narrow selection of means. Moreover, unlike conventional macroeconomic fiscal
and monetary policy, which basically assumes competitive, "efficient" markets,
no a priori assumptions are made about market structure, nor is there any a
priori determination of the appropriate limits to government intervention in the
economy 3 each situation is considered on its own merits. I hope that the members of this committee will find that by keeping the ends of economic policy wellfocused, while maintaining an unrestricted open approach to potential means,
even the "dismal science" can provide a richer and more optimistic forecast for
economic progress.
2. Understanding the new inflation—Disproportionately high rates of inflation
in the lasic necessities.—From my own work I am convinced that particularly
with respect to the problem of inflation, macroeconmic policy has failed because
i't proceeds from a much too highly aggregated level. In the words of John Blair:
"To the extent that they have empirical bases, "demand-pull," "cost-push,"
and the "Phillips curve" have been derived from studies involving the use of measures of the general price level. But, as Gardiner C. Means showed some forty years
ago, the distribution of the price structure is U-shaped: that is, the movements
of the overall price series are not indicative of the movements of most individual
prices which have either low amplitudes and frequencies of change or high amplitudes and frequencies. The average is the exception. Moreover, recent evidence
indicates that in recession, different groups of prices change in opposing directions, causing the overall series to conceal more than it reveals. The proper study
of prices, therefore, is prices, not the general price level." 3
It can be argued that inflation has become an issue for the economics profession for two principal reasons: first, because the actual magnitude of the inflation
rates experienced recently have so far surpassed anything in recent memory,
especially in peacetime and during periods of high unemployment, and secondly
because virtually all econometric forecasting models based as they are on changes
in the general price level, failed to predict the phenomenon.
Regrettably the vast body of the profession has yet to come to terms with tiie
special character of post-1960's inflation, namely the dramatic shift both in relative prices and in relative rates of inflation in critically important expenditure
categories.8*
1
Major recent contributions as well as helpful review articles of the most important
work
in this area were published in the March 1979 Monthly Labor Review.
a
cf. comments by Robert J. Gordon and Richard Ruggles in "Inflation: Do We Count
Quality as Part of the Cost," by Art Pine, The Washington Post, Apr. 15, 1979, pp. F l
and F5.
a John M. Blair, "Inflation in the United States," in Gardiner C. Means, John M. Blair
and Alfred E. Kahn, "The Roots of Inflation," Burt Franklin & Co., Inc., New York, 1975,
p. 8a
34.
Interestingly enough, the Carter administration's guidelines program perversely recognized the special character of our current inflation by exempting the most inflationary
components in whole or in part from the price standards. For this reason alone the program
was destined to faiL
61
Because the recent onslaught of inflation has not been evenly distributed across
all commodities and services, and because its major thrust has been concentrated
on expenditure categories that are essential necessities in the household budget,
its character has been especially pernicious. By definition, necessities are items of
consumption for which near substitutes cannot be readily found and for which a
reduction in the quantity consumed represents a net loss of "welfare" (in the
sense that it cannot be compensated for by increased consumption of some other
commodity or service). Because of this especially burdensome aspect, it is convenient to designate the experience of the 1970's as "the new inflation."
As illustrated by Charts 1-4, the disproportionately high inflation rates of the
1970's for food, energy, housing and health care followed a period when their
prices were stable or failing vis-a-vis the Consumer Price Index as a whole.
Moreover, the discrepancy between inflation in the necessities and in the remainder of the CPI has increased year by year. With 1967 as the base year, the
necessities index in 1970 was only 3.5 percent higher than the non-necessities
index. In. 1977, on average, it was 21 percent higher. In 1978, the gap between
the two was 26 percent. For the 12 months ended February 1979 the gap has
continued to widen: necessities prices were increasing at an average annual rate
(12.1 percent) nearly double that of non-necessities (6.6 percent).
Using the data published from the 1972-73 Consumer Expenditure Survey,
(CSS) as shown in Table 1, one can estimate that for 80 percent of our population, expenditures for food, energy, shelter and medical care account for a conservatively estimated 70 percent of the household consumption budget.4 The
CBS was carried out just prior to price explosion in the basic necessities. Given
the subsequent acceleration in inflation in the necessities, it would not be surprising to find the proportions even higher today. Payment for the four necessities is predominately non-postponable; indeed roughly 30 percent of such
payments are billed to households monthly by utility companies, insurance carriers, landlords and financial institutions. Food and gasoline of course are purchased weekly if not more frequently.
3. The impact of the new inflation on households' "budgets—The squeeze on family incomes across eighty percent of the income distribution.—Of course it has
long been recognized that the "poor" are hurt most by inflation and in the charitable tradition of most societies some partial protective devices such as food
stamps, rent subsidies and Medicaid have been put in place in recognition of this
need. (These programs, of course, pre-date the "new inflation" and were adopted
as pure social welfare efforts.)
However, the impact of the "new inflation" reaches beyond the poor. Despite
the popularisation of the image of the "affluent worker," most workers' families
are among the 80 percent of the population who are most vulnerable to the new
inflation. At the time of the CES, as shown in Table 2, families in which the
family head was a non-supervisory worker fell well below the top of the family
income range within which expenditures on the four necessities constitute a
major burden on the budget. For these people, the overwhelmingly major source
of income is wages and salaries (see Table 8). Temporary layoffs or longer term
unemployment shift the family further down the income scale, where necessities
account for an even higher proportion of the consumption budget. Thus the
burden of the "new inflation" extends far beyond the poor and low-income retirees—it bears heavily on the vast majority of the population. Indeed for most
of the "working class" as they may be called, the ''new inflation" is particularly
burdensome, because, unlike the bottom 10 percent and those over 65, their
income is generally sufficiently high to disqualify them from public subsidies
such as food stamps, Medicare and Medicaid, or rent allowances that offer some
partial protection. They differ from the top 20 percent of the income distribution
in that their "portfolios" of income-producing assets are much less diverse. The
protective devices of hedging, arbitrage, tax shelters, capital gains, superior
interest rates paid on large denomination commercial paper, certificates of deposits, or government securities and self-determined professional fees are largely
unavailable to them.
*L. EL Nulty, "Understanding- the New Inflation," Washington, D.C. "Exploratory Project for Economic Alternatives, 1977." Expenditures for the four necessities range from over 40 percent of the consumption budget for families in
the eighth decile to more than the entire consumption budget at the bottom of the income
distribution (illnsrrit.ii)cr that families at the bottom of the income scnie hnvp to fro Into
debt or fall behind in bill payments just to provide themselves with food, energy, housing
and health cure).
51-421—79
r
62
The widespread lack of understanding of just how vulnerable to the new
inflation workers' families are, was recently illustrated dramatically by Alfred
E. Kahn's remarks at the AFL-CIO "Price Watch" conference. An IAM representative had asked Dr. Kahn how one could explain to IAM members that their
wages had to be held to 7-percent increase while prices were rising at doubledigit rates and the Administration was pushing for decontrol of oil prices. Dr.
Kahn replied that he had recommended against oil decontrol at this time,
precisely because he was keenly aware of the burden imposed on family budgets.
He went on to say that he supported some form of compensating relief from the
effects of oil price decontrol for poor families, but not for families of IAM members (who presumably were well enough off not to merit relief). Under the most
charitable assumptions one can only presume that Dr. Kahn was unaware that
the average IAM member earns only around $13,000-$14,000 per year, if he or
she is fortunate enough to work 40 hours a week for 52 weeks. In autumn 1978
it cost $18,546, or 30-40 percent more than an average IAM member could expect
to gross, for an urban family of four (including a non-working wife) to maintain
a moderate standard of living, according to the estimates of the U.S. Bureau of
Labor Statistics.
Jf. Inflation''s effect on the unemployment rate—The impact of increasing labor
force participation rates.—In this inflationary environment it is not surprising
to find as we have, quite dramatic changes in labor force participation rates, which
will tend to raise aggregate unemployment rates to the extent that new labor
force entrant's demand for jobs is not satisfied. For more and more families one
income is no longer sufficient to protect living standards. As the purchasing
power of the wages of the traditional "head of household" is reduced by inflation
in the necessities, more family members have to try their luck in the labor market
in an attempt to maintain a constant standard of living.
Although considerable attention has been devoted to the impact of demographic changes on the apparent persistence of high unemployment rates in
recent years (particularly the "teenage bubble"), a recent study indicates that
since the late 1960's, the effect of higher labor force participation rates on the
overall unemployment rate has increased steadily and dramatically, while
in the
past 2 or 3 years the impact of demographic factors has lessened.5 The basic
thrust of these sorts of studies, however, is they leave one with the conclusion that
if we can all just "sit tight" until the 1980's (when the post-war baby boom
cohorts will have matured sufficiently to enjoy lower unemployment rates) demographic trends will accomplish a substantial reduction in unemployment that
public policy has thus far failed to achieve. In fact, even if we could overlook the
social and economic burdens imposed on the affected population in the inter*
vening years, one cannot be so sanguine about the future.
For a wide variety of reasons, our economy's partial and incomplete accommodation to the demand for jobs by new labor force entrants (youth and married women) has taken the form of more part-time jobs and an increasing proportion of jobs offered at 8the bottom of the wage distribution, both in terms of
occupation and industry. Non-agricultural workers on voluntary part-time
schedules as a percent of total numbers employed has risen from 9.6 percent in
1957 to 14.5 percent in 1977. At the same time, the structure of employment has
shifted, such that relatively lower-paid clerical and sales occupations in lowerpaying service, financial and related industries account for a larger and larger
proportion of employment. As shown in Tables 4 and 5, these trends have been
extremely powerful and have persisted even through our current unprecedentedly
long recovery. Manufacturing's share of total employment has fallen from 34.7
percent in 1948 to 23.7 percent in 1978. The share of employment in services
rose over the same period from 11,5 to 18.G percent. Similar trends are shown for
employment in wholesale and retail trade and banking, insurance and finance.
At the same time, the gap between average earnings in the latter sectors and
in manufacturing has widened: average weekly earnings in trade fell from
76.8 percent of manufacturing earnings in 1948 to (51.5 percent in 1978. In bank6
See Paul O. Flalm, "The Effects of Demographic Changes on the Nation's Unemployment
Rate,"
Monthly Labor Review, March 1979.
0
It cannot be argued that employers are merely responding to the preferences of Job
seekers, in 1977, SO percent of all job seekers were looking for full-time jobs, including
2.5 million adult men (90 percent of all jobless adult men), 2 million adult women (80 percent of all jobless adult women) and nearly 1 million teenagers (60 percent of all jobless
teenagers). Gloria P. Green, Richard M. Devens and Bob Whitmore, "Employment and
Unemployment—Trends During 1977," Monthly Labor Review, February 1978.
63
ing, insurance and finance the percentage fell from 85.6 to 71.6 percent. As these
earnings become less and less adequate in preserving real family income under
persistent inflation, there will be continuous upward pressure on labor force
participation rates. Even though the teenage "bubble" will eventually mature,
this factor may be more than compensated for by further increases in the labor
force participation rates of future teenage cohorts, not to mention increases in
the rate for adult women.
This has certainly been the experience to date. As Table 6 illustrates, the
decade of the 1960's was characterized by a dramatic decline in the labor force
participation rates for youth aged 14-20. That trend was reversed in the early
1970's even for 14 and 15 year olds. Their labor force participation rates are now
at the same level as at the end of World War II and the beginning of the 1950's.
Despite the effort to counteract the "new inflation" by adding more family
workers, the vast majority of American families have continued to fall behind.
As shown in Table 7, median family income in constant dollars has essentially
been stagnant during the 1970's and in 1977 was below the levels achieved in
1972 and 1973. In fact these figures are pre-tax income, not take-home pay, and
do not reflect the recent increases in payroll taxes or the push into higher tax
brackets (let alone the effects of marginal tax rates on additional family earners'
income). The most recent average weekly earnings figures for production and
non-supervisory workers on non-agricultural payrolls show average pre-tax
earnings in constant 1967 dollars for March 1979 to be at the lowest level since
1967. In the words of one member of the IAM, "The only trouble with sending
your wife out to work is that the law only allows you one wife." Moreover, the
$16,000 median in 1977 was substantially below the $17,106 the Bureau of Labor
Statistics estimated it cost an urban family of four (with a non-working wife) to
maintain a "moderate" standard of living (including tax liabilities) in autumn of
that year.
5. The failure of macroeconomic policy.—By looking at the combined effects of
inadequate employment opportunities and inflation in this manner, which reflects
more accurately the way ordinary people experience them, one realizes that
counter-inflation programs that focus on budget cuts, dampening wage increases,
planned recession or attempts to curb the growth of the money supply by raising:
interest rates are inevitably going to miss the target. The appropriate target
being, in this writer's opinion, the real living standards of the overwhelming
majority of the population.
These conventional economic procedures were devised to deal with inflation
that resulted either from the push of rising wage costs or the pull of excess
demand, both phenomenon usually associated with a period of rising real incomes. Similarly, conventional "stimulus" policies, whether they take the form
of deliberate increases in budget deficits (as opposed to "natural" deficits and
surpluses created by the business cycle) or interest rate manipulations, were
essentially devised to reverse economic trends during periods when both money
incomes and prices were falling. They are designed to "inflate" the economy by
calling forth additional output in response to additions to demand, implicitly
assuming that the private business sector goal of enhanced income (profits)
will be met more by increased volume than higher unit prices.
Attempting to use these conventional "tools of the trade" in an era when
an increasing share of production is subject to administered prices, and when
attempts to "inflate" the economy indiscriminately merely contribute to the
decline in real incomes for the majority, is bound to be self-defeating.
If policymakers truly want to cut the Gordian Knot of stagflation, they must
begin by rehabilitating the real incom'es of the broad majority of the American
people, and by altering the structure of supply in key sectors that critically
determine real living standards. The issues involved for each of the four
necessity sectors are sufficiently important and complex to warrant individual
series of Joint Economic Committee hearings—and indeed the JEC can take
credit for sponsoring much good work in many of these areas. Therefore, to
keep the discussion manageable, this paper will merely summarize some of the
relevant questions with respect to inflation in each of the four necessities, energy,
food, housing and health care and use some policy options for the energy sector
to illustrate what a positive "counter-stagflation" program might include.
6*. Inflationary biases in the structure of supply of the necessities.—It seems
as though every year since 1972 food inflation is "explained away" either by bad
weather, acts of God, or acts of villainy on the part of foreign countries. Some-
64
how it strains the imagination to think that none of these kinds of "exogenous
shocks" impinged on domestic food supply in the ''golden years" of the 1950's and
1960\s. The "exogenous shocks" argument also diverts our attention from longerrun problems that are nonetheless more amenable to change through public
action. While recently food inflation has been sustained by increased farm
price supports and supply curtailments supported by both Congress and the
administration, there are deeper underlying reasons for persistent food price
inflation. Among these the trend, since World War II, toward rapid growth in
world d'emand stemming from rising incomes and population overseas; the increasing number of intermediary stages between consumption and production;
and the growing influence of agribusiness corporations such as Beatrice Foods,
Iowa Beef Processors, and Tenneco (many of them conglomerates and some
virtually unknown ten years ago). The first two factors render food prices more
vulnerable to short-run shocks such as climactic conditions or 'arge foreign grain
sales, like the famous sale to the Soviet Union in 1972. The third enables wellplaced vertically integrated corporations to create and extract profits from both
consumers and primary producers, not to mention industry employees.
Although the food sector has traditionally been viewed as a "low concentration" industry, several recent studies identify strong upward trends in monopolytype practices at both the retail and food manufacturing levels which add an
lipwarcX thrust
to price trends, regardless of the state of demand or of raw
:food supplies.7
In housing, far and away the most inflationary components of the shelter
price index have been financing, taxes and insurance costs. For these elements,
attempts to use conventional policy to reduce inflation by curbing growth
through higher interest rates translates directly into accelerated inflation. This
occurs not" only because of the flow-through effects on mortgage interest rates
but because of the high degree of leveraging in the construction industry. Rising
new home prices pull up the price of used homes. Inflated market values in
turn generate rapid increases in property taxes for existing homeowners and
push up rents. Absent public subsidies counteract these forces, builders and
developers are pushed to build for the "upper end" of the market, raising the
median new home price even further and accelerating the spiral. Although it
•would indeed be true that a simple new home price index would fail to capture
such "quality improvements" (hence inflation would be to some slight degree
"overstated") such "quality improvements'- have the effect of completely pricing
many potential buyers out of the market.
A similar "quality" argument is often put forward with respect to medical
care, in which it is alleged that our relatively high cost system of health care
delivery is merely a response to consumer demand, fueled as it is by the "sheltering" effects of third-party insurers that effectively insulate health care consumers from the real cost of their "choice" of treatment. This type of analysis
is at best a misleading presentation of supply/demand relationships in health
care. According to the 1972-73 CES, most average income households paid at
least 50 percent of their medical care expenditures directly (insurance absorbed
the remainder). Even Medicare and Meclicaid typically cover only around 75-80
percent of treatment costs. Secondly, the choice of treatment is made by health
cure professionals, not by patients. Finally, to the extent that insurers offer
better coverage for hospitalization, and little or no coverage for preventive care
or paraprofessionals, the high-cost bias is determined by the carriers, not by
''consumers". Finally, given the power interlocking directorates between hospital
boards and regional hospital associations with medical supply manufacturers,
drug firms, medical schools, etc. it is not surprising to find chronic over-investment and underutilization of plant and equipment.
Clearly, while inflation in each of the necessity sectors has its own special
history and character, many common elements pervade them. If the common
.elements could be summed up in a few words they would be "relatively re7
Bruce Marion, et al., "The Profit and Price Performance of Leading Food Chains," a
study prepared for the use of the Joint Economic Committee, Apr. 12, 1977.
Knsspll1 C. Parker. "The Status for Competition in the Food Manufacturing1 and Food
Retailing Industries." "Political Eeonomv of Food and Energy." Louis J. Junker ed.. University of Michigan Press, Ann Arbor, forthcoming.
Russell C. Parker and John M. Connor, "Estimates of Consumer Loss due to Monopoly
m the U.S. Food Manufacturing Industries," N.C. Proiect 117. "Studies of the Organization
and Control of the U.S. Pood System," University of Wisconsin, September 1978.
65
stricted choice on the demand side; concentration of economic power on the
supply side." A close look at the energy sector shows that these are not intractable problems—public policy can make a significant contribution to dispelling stagflation through well-designed sectoral initiatives.
7. Energy as a case study—Breaking stagflation through changes in the structure of supply and demand.—-In the year of the Consumer Expenditure Survey,
1972-73, energy expenditures averaged over 14 percent of the consumption
budgets of households below the top 20 percent of the income distribution (and
thife figure excludes energy, especially gasoline, consumed for recreational purposes). Since that time energy prices in the Consumer Price Index have increased 93 percent.
In 1975, in testimony before the JEC Subcommittee on Consumer Economics,
Charles Schultze pointed out that recent energy price increases had had powerful income re-distribution effects that were related to the massive recession suffered by the economy at that time:
"The sudden run-up in oil prices drained some $35 billion in purchasing
power from America's consumers. As a consequence they had that much les&
to spend on buying other goods and services. The proceeds of this 'oil excises
tax* went principally to OPEC countries and the domestic oil companies." s
The current proposal for oil decontrol entails an immediate and direct transfer of $17 billion between the effective date of the legislation and October, 1981,
from American consumers to domestic energy companies, for oil already
discovered.
Thus, the principal difference between then and now is that the income disti'Ibntion that was then lamentable is now explicitly enshrined in public policy. The
transfer of real income referred to by Schultze is now seen as desirable, indeed
the lynchpin of energy policy. Decontrol of natural gas prices last year and the
supposedly inevitable decontrol of oil prices in this and ensuing years, bear
witness to a decision that an acceleration of energy price inflation is seen to be a
desiraWe objective. With energy inflation disproportionately high even during a
period of partial government price control, other objectives, principally domestic
self-sufficiency and supply expansion, are now offered ss justification for neglecting the income distribution consequences. The only problem with these is that
they fly in the face of recent experience.
As indicated above, the $17 billion in additional energy company revenues
produced by decontrol can in no way be regarded as an incentive. It is a pure
windfall: the oil has already been discovered. Moreover, the Congressional'
Budget Office estimate of decontrol's effect on domestic supply is a mere 2 to
2V7 percent increase (400,000 to 500,000 barrels a day) over what would be
available under a continuation of existing oil price policy. The Department of
Energy itself concurs with the CBO assessment that most of the projected
additions to supply will be the result of oil being pumped out of the ground a.
little sooner than otherwise, not of more oil being discovered. Moreover, a study
done for the Department of Energy by ICF, Inc., concluded that decontrol of
domestic oil may actually deter oil companies from discovering
new reserves as
they seek to maximize profits by drilling in known reservoirs.9
Between 1972 and 1978, while the CPI for energy rose 93 percent, and combined after-tax profits for the top 15 energy companies rose 123.7 percent.98
domestic production of fossil fuels fell from 5,934 to 5,499 quadrillion BTUs,
despite a significant increase in the total number of oil and gas wells drilled
and in the percentage of successful wells. Over the same period of time, not
only has the import share of domestic consumption increased from 10 to 24.2
percent, the proportion contributed by all of OPEC has risen from 43.5 percent
of all imports of petroleum to 68.5 percent, while the share of all imports contributed by Arab members of OPEC has risen from 10.2 to 35.6 percent.10
8
Statement before Joint Economic Committee, Subcommittee on Consumer Economics^
hearings on the economic impact of forthcoming OPEC price rise and "old oil decontrol.'1"
July
10 and 14, 1975, pp. 65.
9
ICP Inc., "Capital Resources and Requirements for the Petroleum Industry under the
National Energy Plan." study for the U.S. Department of Energy (contract No. EJ-78-C01-2835),
January 1979.
8a
Combined net-income (profits after tax) of Exxon. Mobil. Texaco, Standard Oil of
California. Gulf. Standard Oil of Indiana, Atlantic Richfield, Shell, Continental Oil*
Tenneco, Sun Oil, Phillips, Occidental, Union Oil, and Standard Oil of Ohio as reported in
Fortune
magazine.
10
U.S. Department of Energy, "Annual Report to Congress, 1978," vol. 2, tables 1, 1&
and 18.
\
66
These trends are most plausibly explained by the multi-national, multiresource character of domestic energy corporations and their links to OPEC
governments and each other. They are extremely well positioned to determine
not only the fuel composition of our domestic energy supply, (with profit maximization being the guiding objective, but relative import/domestic shares as
well. While minimizing supply costs to themselves, their extensive vertical integration permits widening margins between production or acquisition costs and
final sales (note the dramatic disappearance, since the early 1970's of independent and franchised gas stations and the recent increase in directly-owned selfservice pumping stations).
With oil price decontrol looming as the one remaining vestige of what was
once called a national energy policy, it is appropriate to ask whether the economic and social costs of sustaining this kind of market power, in a sector as
critical as energy, is worth the highly speculative "benefits". It is even more
appropriate to ask whether there might not be other ways to achieve the same
objectives more efficiently, more equitably and with greater confidence in their
probable success.
There are many such paths that could be followed. To begin with, it seems apt
to take a leaf from the corporate book and begin thinking about minimizing risk
through diversification. From the perspective of the ordinary American family,
what is needed is an increased range of choice with respect to the manner in
which energy is consumed. Like other major undertakings, this objective is not
likely to be accomplished without public subsidy in its early years.
Large corporations, either through retained earnings or through their advantageous position in the financial system, are able to subsidize their own diversification programs. Moreover, many of the largest corporations also continue to
reap benefits from the subsidy provided by federal research and development
contracts, not to mention actual production contracts. A recent study analyzing
the use of government subsidies to promote various forms of energy found that
of the approximately $217 billion spent over the last 30 years (including tax
expenditures), roughly 47 percent or $101.3 billion went to the petroleum industry, 8.3 percent or $18 billion went to nuclear, 7 percent ($15.3 billion) or 3.7
percent ($8 billion), depending on estimating methodology, went to hydroelectric
power (most of which remains publicly owned), 4.5 percent or $9.7 billion to coal,
7.6 percent or $16.5 billion to natural gas (much of which redounds to the benefit of the same corporations that enjoy the petroleum subsidies), and 26 percent
or $56.6 billion to electricity generation and transmission. Over the time
period
studied, incentives for various forms of solar power were negligible.11 In the
current federal budget solar development continues to be dwarfed by allocations
for high risk, capital-intensive undertakings, especially the nuclear program.
Although Congress has enacted tax credits to promote uses of solar energy,
insulation, and other conservation retrofitting measures, tax credits benefit only
those who have the financial means to make the often substantial "up front"
lump sum outlays. It effectively restricts the access of the vast majority of households caught in the squeeze of stagnant or falling incomes. By restricting access,
it limits the size of the market thereby inhibiting development of economics of
scale, more efficient techniques, and ultimately falling costs. Clearly more direct,
"'up front" subsidies are required.
One route is outright grants to households for purchase of existing technology.
However, to accelerate major technological breakthroughs, such as commercialization of photovoltaic apparatus and other renewable energy sources, larger scale
support appears to be necessary.
As a renewable resource amenable to decentralized distribution, solar energydevelopment in all its forms should rank near the top of our energy outlays.
Moreover, as described in a report recently issued hy the JEC's Subcommittee
on Energy and Special Study on
Economic Change, solar development has a
powerful job-creating potential.13 Thus, it should be a major component of
national policy to overcome stagflation, as well as more narrowly defined energy
policy. Yet, solar development continues to play a minor role in national energy
policy.
11
A study prepared for the Division of Conservation and Solar Applications, U.S. Department of Energy, "Analysis of Federal Incentives used to Stimulate Energy Production,"
B. W. Cone, et al., Pacific Northwest Laboratory, Richland, Wash., December 1978.
u
"Employment Impact of the Solar Transition" by Leonard S. Rodberg, a study prepared
for the use of the Subcommittee on Energy of the Joint Economic Committee, Apr. 6, 1979.
67
Public policy for promoting conservation in transportation use of energy is at
present anchored in oil price decontrol. Yet raising the cost of private transportation will merely make it even harder for average-income families to afford
essential transportation; they will simply have to give up something else.
Data collected for the Ford Foundation Energy Policy Project indicate that
middle and lower-income households with cars already log fewer13 miles and
own more fuel-efficient cars on average than "well-off" households. If, as this
evidence suggests, middle and lower-income households do relatively little "luxury" driving, policies that use higher prices to "induce" efficiency in automobile
use will squeeze real living standards for a major part of our population even
harder without reducing consumption. There simply is not very much that
people can do to change the distance they must travel between home and work
or shopping, or about the availability and relative cost of public transportation
over those distances.
Thus, if transportation policy is going to be one component of energy policy,
and if policy is to concern itself with protecting real living standards, in the
face of oil price decontrol, gasoline price escalation must be offset by a vigorous
program to expand and improve public transportation, and some form of gasoline
voucher/''white market" scheme to assure universal access to a basic amount
of gasoline, in recognition of the fact that efficient public transportation systems that provide an adequate level of service are simply not available to the
majority of our population.
The extent to which administered prices can be made to stick depends a great
deal on the elasticity of demand, which in turn is in part determined by the
availability of substitutes. Public transit and solar development are examples
of two relatively job-intensive undertakings that potentially should exert some
discipline on energy price inflation by increasing the degree of substitutability
among forms of energy consumption, thereby increasing the elasticity of demand for fossil fuels. However, depending on the scale of public commitment,
both these undertakings may entail very long lags before they reach a scale
sufficient to have a significant impact at the level of the overall national economy.
In the interim it will be important to introduce some kind of countervailing
power on the supply side to curb the cost-push effects of energy inflation on all
other sectors of our energy-intensive economy.
Substantial shares of the reserves of all fossil fuels are located on Federal
lands. In relinquishing control of the pace, timing and product mix of exploration, production and sale of these resources by essentially handing those decisions over to the energy corporations as has been the case up to now, the Federal Government has actually abrogated its own sovereignty. A Federal Fuels
Corporation (FFC) is needed to make the critical decisions over the disposition
of these increasingly priceless resources in the broad public interest. Creation
of an FFC would not entail nationalization of any existing firms since the resources to be managed are already in the public domain. In addition to its resource management capability, such a body would also be well positioned, through
its control over critical supplies, to intervene in the market, in a manner analogous to buffer stock operations in food supply, (with which we already have
considerable experience), to break up administered price power in the energy
sector.
Such an institution would also have another extremely potent capability: that
of incorporating a domestic policy element into the foreign trade component of domestic energy supply. A Federal Fuels Corporation would be able to negotiate
bilateral barter agreements with technology-hungry less developed countries
(such as Mexico) that will soon be in a position to play major roles in contributing toward world petroleum supplies. In such a manner oil imports could be
increased without adding to the oversees dollars surplus which continues to
exacerbate the balance of payments problem, in turn raising the cost of all imports. Some preliminary work on the details and potential benefits of such a
scheme are already under way at the Congressional Budget Office.
These examples from the energy sector are intended to illustrate that indeed
we are not without good answers, as long as we get the questions right.
Unfortunately, if recent economic policy is any guide to the future, one may
anticipate protracted if not accelerated excessive inflation rates in the necessi13
Cited in "President Carter's Energy Proposals: A Perspective," Congressional Budget
Office staff working paper, June 1977, table X-2, p. 119.
68
ties, hence perpetuation of stagflation. This is not merely because of the long-term
and difficult nature of the policies needed. This prognosis is made because up to
now, at virtually every opportunity where a price—or supply-sensitive policy
choice has presented itself, the option chosen for the necessity sectors has been
inflation promoting rather than inflation abating. Part of this may be attributable
to the selectivity with which the inflation issue has been used—that is principally
to justify the retreat of government and to forestall improvements In occupational
health and safety and environmental rehabilitation—all of which are part and
parcel of enhanced living standards for our population.
Public policymakers have to make choices. If they continue to work for "them"
and against "us" stagflation will indeed be with "us" for many years to come.
/ 4-CPI-W All Items
CHAET 1.— Consumer Price Index for urban wage earners and clerical workers
(1961=zlOO) comparison of all items and food 1948-78
69
#VCPI-W All Items
CHART 2.—\Consumer Price Index for urban ivage earners and clerical worker
(1967=100) comparison of all items and energy 1957-78
70
2 20
21C
<—CPI-W All Items
OHAET 8.—Consumer Price Index for urhan wage earners and clerical worker*
(1961=:100) comparison of all items and shelter 1957-78
71
AU Items
57
60
65
70
75
78
CHART 4.—Consumer Price Index for urban wage earners and clerical worker*
(1967=100) comparison of all items and medical care 1957-78
TABLE I.—EXPENDITURES ON BASIC NECESSITIES BY FAMILY INCOME DECILES 1972-73 (COMPLETE REPORTING)
Average family income before taxes
Less: Personal income taxes
Income after taxes
Less: Pensions and insurance
Less: Gifts and contributions
Amounts available for consumption
Expenditures on:
Food
As percent consumption
Energy
As percent consumption
Shelter
As percent consumption
Medical care
As percent consumption
Total expenditures on necessities
As percent consumption
Bottom 10
percent
2d 10
percent
3d 10
percent
4th 10
percent
5th 10
percent
6th 10
percent
7th 10
percent
8th 10
percent
9th 10
percent
$1, 559
0)
1, 559
108
176
1,275
$3,268
$5,081
487
4,594
262
276
4,056
$7,063
778
6,285
396
345
5,544
$9,112
1,120
7,992
586
377
7,029
$11,244
1,495
9,749
770
403
8,576
$13, 466
1,916
11,550
948
461
10, 141
$16,116
2,437
13, G79
1,139
568
11,972
$19,747
3,178
16,569
1, 408
677
14,434
666
(52.2)
466
(36.5)
728
(57.1)
213
(16.7)
2,073
(162.6)
3,268
165
213
2,890
967
(33. 5)
478
(16. 5)
889
(29.7)
304
(10. 5)
2,638
(91.3)
1,169
(28.8)
580
(14. 3)
972
(24.0)
395
(9.7)
3,116
(76.8)
1,334
(24.1)
635
(11.5)
1,075
(19.9)
452
(8.2)
3,496
(63.1)
i Shown for personal income taxes for the bottom and 2d deciles indicates that less than half the
families reported paying income taxes.
Sources: With the exception of expenditures for medical care, all data are taken from the Bureau of
Labor Statistics, Consumer Expenditure Survey Series: Interview Survey, 1972-73, vol. 1, Bulletin
1977,1978. Medical care expenditures in that volume excluded expenditures on nonprescription drugs
and other medical aids. This data were taken from the Integrated Diary and Interview Survey data,
1,534
(21.8)
700
(10.0)
1, 246
(17.7)
506
(7.2)
3,986
(56.7)
1,690
(19.7)
748
(8.7)
1, 260
(14.7)
550
(6.4)
4,248
(49.5)
1,941
(19.1)
882
(8.7)
1, 409
(13.9)
590
(5.8)
4,754
(47.5)
2,170
(18.1)
932
(7.8)
1,516
(12.7)
634
(5.3)
5,252
(43.9)
2,405
(16.6)
1,0*5
(7.(0)
1,712
(11;8)
739
(5.1)
5,871
(40.5)
Top 10 Average shares
percent lst-8th deciles
$31,974
6,219
25,755
1,955
1,524
22,276
2,905
(13.0)
1,135
(5.1)
2,251
(10.1)
889
(4.0)
7,180
(32.2)
I...
"""I.
27.2
.
14.3
23.7
8.7
73.9
Bulletin 1992. Expenditures for food, shelter and energy exclude recreational or vacation expenditures.
Energy expenditures include fuel oil, coal, bottled gas, gas and electricity delivered by utilities, gasoline
and lubricants. All items reflect actual expenditures made by families purchasing the particular item.
Thus, for example, expenditures on gasoline are not averaged over the entire sample as is the case in
the published expenditure figures, but are adjusted for the proportion of the sample actually purchasing that item.
73
TABLE 2.-OCCUPATI0N OF FAMILY HEAD AND AVERAGE FAMILY INCOME, JULY 1973 THROUGH JUNEJ197*
Occupation of family head
Number of
families
reporting
Percent of
total
reporting
Average
family income
before taxes
Nearest
decile
equivalent
Craftsmen and operatives
Clerical and sales workers
Laborers and service workers
Retirees
Self-employed .
Armed forces personnel.
Professionals and mana£ers
17,917
7, 709
8,576
10, 228
3,675
704
15,772
27.7
11.9
13.3
15.8
5.7
1.1
24.4
512,361
11,213
8,580
5,523
13, 584
11,785
17, 754
6-7
&
4-5
3
7
S
8-9
All families reporting
64, 582
100.0
11,419
6
Source: Bureau of Labor Statistics, Consumer Expenditure Survey, Integrated Diary and Interview Survey data, 1972-733,
Bulletin 1992, tables 6 and 7.
TABLE 3.-S0URCES.0F INCOME—ALL URBAN AND RURAL FAMILIES AND SINGLE CONSUMERS, FAMILY INCOME BEFORE TAXES-COMPLETE REPORTING OF INCOME
Percentage shares of total money income:
Wages and salaries, total (percent)
Self-employment income, total
_
Social security and railroad retirement
Government retirement, veteran's payments, and
unemployment compensation
_—
Estates, trusts, dividends, rental income royalties,
income from roomers and boarders, total.
Income from all other sources, total (welfare and
public assistance, private pensions, Tegular
contributions for support, other income, Including workers'compensation)
„_—_
Total
(complete
reporting)
Lowest 10
percent
2d 10
percent
3d 10
percent
4th 10
percent
5th 10
percent
6th 10
percent
7th 10
percent
8th 10
percent
9th 10
percent
Highest 10
percent
74.9
7.6
4.9
21.0
1.1
45.5
28.6
3.6
36.0
46.1
5.0
22.9
63.2
5.7
11.3
73.0
5.8
6.3
80.4
6.3
3.6
82.9
5.0
2.4
84.9
4.9
1.8
86.4
4.4
1.0
72.6
14.7
.9
2.5
4.7
5.9
5.6
4.7
4.0
2.4
2.3
1.7
1.9
1.4
4.6
4.7
6.8
6.7
6.4
4.7
3.3
2.8
2.9
2.9
7.0
5.2
22.7
19.1
13.5
9.6
6.1
4.7
4.3
3.6
3.1
3.2
Source: Bureau of Labor Statistics, Consumer Expenditure Survey, integrated Diary and Interview Survey data 1972-73, Bulletin 1992, table 6.
75
TABLE 4.—PERCENT SHARE OF EMPLOYEES ON NONAGRICULTURAL PAYROLLS
Manufacturing
1948
1950
1955
1960
1965....
1970
1975.....
1976
1977.....
1978.....
Wholesale and Finance, insurretail trade a nee, real estate
34.7
33.7
33.3
31.0
29.7
27.3
23.8
23.9
23.4
23.7
20.7
20.8
20.8
21.0
20.9
21.2
22.2
22.4
22.5
4.0
4.2
4.5
4.9
4.9
22.6
5.5
Services
11.5
11.9
12.3
13.6
14.9
16.3
5.1
5.4
5.4
5.4
18.1
18.3
18.5
18.6
Source: BLS, Employment and Earnings, March 1979, and Handbook of Labor Statistics, 1970.
TABLE 5.—PRODUCTION OR NONSUPERVISORY EMPLOYEES AVERAGE WEEKLY EARNINGS AS PERCENT AVERAGE
WEEKLY EARNINGS IN MANUFACTURING
Wholesale and
retail trade
Finance, insurance, real estate
76.8
76.4
72.9
73.6
71.5
72.0
66.3
63.9
62.3
61.5
85.6
86.6
84.4
83.7
82.7
84.5
77.7
74.3
72.2
71.6
1948...
1950...
1955...
I960....
1965...
1970...
1975....
1976....
1977....
1978....
Services
»NA
NA
NA
NA
68.4
72.5
70.6
68.6
67.0
65.7
i Not available.
Source: BLS, Employment and Earnings, March 1979, and Handbook of Labor Statistics, 1970.
TABLE 6.—CIVILIAN LABOR FORCE PARTICIPATION RATES FOR PERSONS 16 YR AND OVER, BY RACE, SEX, AND
AGE: ANNUAL AVERAGES, 1948-77
[In thousands}
Item
Total,
16 yr
and 16 and 18 and
17 yr 19 yr
over
All workers:
58.8
1948
.
58.9
1949
59.2
1950
59.3
1S51
_ . 59.0
1952
58.9
1953
58.8
1S54
59.3
1955
60.0
1956
59.6
1957
59.5
1958
59.3
1959
59.4
I960
59.3
1961
, . . 58.8
1962
,
58.7
1963.. _—
- 58.7
1964
—
53.9
1965
59.2
1966
59.6
1967
. 59.6
1968
60.1
1969
60.4
1970
60.2
1971
60.4
1972
_.
60.8
1973
„._ 61.2
1974
61.2
1975
_.
61 6
1976
62.3
1977
_—
41.7
41.2
40.7
42.5
42.7
40.7
37.9
38.5
41.9
40.2
37.3
36.9
37.6
36.3
34.9
34.4
35.1
35.8
38.5
39.0
39.1
40.5
41.0
40.7
42.3
44.6
45.5
44.4
44 6
46.3
63.4
63.3
62.9
62.6
61.2
60.9
60.0
60.7
61.2
60.4
59.4
58.9
50.5
58.4
53.2
58.5
57.2
57.1
58.3
58.4
58.5
59.3
59.9
59.6
62.4
63.6
64.9
64.2
64 8
66.3
20 to
24 yr
25 to
34 yr
35 to
44 yr
45 to
54 yr
55 to
64 yr
65 yr
and
over
14 and
15 yr
64.1
64.9
65.9
64.8
62.2
61.2
61.6
62.7
64.1
64.0
64.4
64.3
65.2
65.7
65.3
65.2
66.3
65.4
66.5
67.1
67.0
68.2
69.2
69.3
70.7
72.6
74.0
73.9
74 7
75.7
63.1
63.1
63.5
64.2
64.7
610
64.3
64.8
64.8
64.9
65.0
65.0
65.4
65.6
65.2
65.6
65.8
66.4
67.1
68.2
68.6
69.1
70.0
69.3
70.8
72.2
73.4
74.3
75 6
76.9
66.7
67.2
67.5
67.6
68.0
68.9
68.8
68.9
69.5
69.5
69.6
69.5
69.4
69.5
69.7
70.1
70.0
70.7
71.0
71.6
72.0
72.5
73.1
73.2
73.3
73.9
74.6
75.0
75 9
76.9
65.1
65.3
66.4
67.2
67.5
68.1
68.4
69.7
70.5
70.9
71.5
71.9
72.1
72.1
72.2
72.5
72.9
72.5
72.7
11.1
72.8
73.4
73.5
73.3
72.7
72.5
72.7
72.6
72 6
72.8
56.9
56.2
56.7
56.9
57.5
58.0
58.7
59.5
60 8
60.1
60 5
61.0
60.9
61.5
61.5
62.0
62 0
61.9
62.2
62.3
62.2
62.1
61.8
61.4
60.1
58.5
58.0
57.4
56 8
56.6
27.0
27.3
26.7
25.8
24.8
24.8
23.9
24.1
24.3
22.9
21 8
21.1
20.8
20.1
19.0
17.9
18.0
17.8
17.2
17.2
17.2
17.3
17.0
16.3
15.6
14.6
14.1
13.8
13 2
13.1
20.0
19.7
20.8
19.9
18.6
17.8
14.5
14.0
16.1
18.9
18.1
18.7
17.5
17.6
17.5
16.4
16.5
16.8
17.6
18.5
18.5
18.5
19.2
19.3
19.4
20.0
20.2
19.2
18 9
20.9
Source: Employment and Training Report of the President, 1978, table A-4, p. 186.
76
TABLE 7.—MEDIAN FAMILY INCOME IN 1970 TO 1977 IN CURRENT AND CONSTANT DOLLARS, AND PERCENT
CHANGE
Median Income
Year
1977
1976
1975
19741
1974
1973.
1972.
197L
1970
Percent change:
1977-76
1976-75
1975-741
1974-73
1973-72
1972-71
1971-70
_
-
_
_
_
In current dollars
In 1977 dollars
$16,009
14,958
13,719
12,302
12r 836
12,051
11,116
10,285
9, 867
$16,009
15,923
15,447
15,855
15,773
16,433
16,102
15,389
15, 399
2 7.0
29.0
26.3
26.5
2 8.4
2 8.1
2 4.2
0.5
23.1
2-2.6
a -4.0
2 2.1
M.6
-.1
1 Based on revised methodology.
Significant at the 95-percent confidence level.
2
Source: Money Income and Poverty Status of Families and Persons in the United States: 1977 (Advance Report), U.S.
Bureau of the Census, Current Population Reports, Series P-60, No. 116, July 1978.
Representative BOLLING. Our next witness is Beryl W. Sprinkel,
executive vice president and economist, with the Harris Trust & Savings Bank, and in that position for more than 25 years. He heads the
economics research office and is a member of the bank's investment
guidance trust investment and asset liability management committees,
member of Time magazine's board of economists, served as chairman
of the Economic Advisory Committee of the American Banker's
Association, also served as consultant to various Government agencies
and congressional committees.
In addition to his Ph. D. from the University of Chicago, he has a
CFA from the Institute of Chartered Financial Analysts.
Mr. Sprinkel.
STATEMENT OP BERYL W. SPRINKEL, EXECUTIVE VICE PRESIDENT AND ECONOMIST, HARRIS TRUST & SAVINGS BANK,
CHICAGO, ILL.
Mr. SPRINKEL. Thank you, Mr. Vice Chairman. I am pleased to
have the opportunity to testify at this committee's important hearings concerning the adequacy of policies for dealing with stagflation—
that is, high inflation and slow real growth.
My basic conclusion is that policies in recent years have directly
promoted high inflation and slow growth and were clearly inappropriate for achieving economic stability. Monetary-fiscal policies fostered excess demand which resulted in high and escalating inflation,
while tax policies encouraged consumption and Federal spending while
discouraging private savings and investment.
In addition, aggressive regulatory and environmental controls also
inhibited growth.
Finally, the present "voluntary" wage and price guidelines tilt
with symptoms and promise to reduce further the efficiency of our
market system, thereby contributing to stagflation.
77
Inflation per se has always resulted from to much money creation
relative to the output of goods and services. This is nothing new.
It has been true of all countries I have observed. It is certainly true
for the United States.
A chart in my prepared statement indicates that the faster the rate
of growth in money per unit of real output, the higher the rate of
inflation. We have had very high rates of monetary growth for many
years, and we are getting our just deserts, unfortunately, on the inflation front.
There is perhaps one difference-—namely, that since the spring of
1975, as a result of congressional initiative, the Federal Reserve has
stated that its objective was to slow gradually the rate of growth in
the money supply until eventually it grew at a pace in line with economic growth. But that hasn't happened. Monetary growth has accelerated. Inflation has accelerated. And the question is why?
Certainly, large and frequently growing deficits contributed to the
problem. The Federal Reserve must be concerned that the Federal
Government have sufficient funds to finance the deficit. Consequently,
there is fairly constant pressure on them to increase the money supply.
The large deficits have not only encouraged more money creation,
but they have also absorbed private savings which reduced the funds
available for the private sector of the economy.
Second, there has clearly been a temptation on the part of policymakers to enjoy the short-run benefits of stimulative policies while
either denying or disbelieving the ultimate price to be paid on the
inflation front.
For example, during this administration in the first 22 months of
office, there were constant pressures b}^ the administration, criticism of
the Federal Reserve policies, that it was too tight even though the
money supply was soaring. This undoubtedly added to money creation.
Third, during this same period and for a long time, the Federal
Reserve has chosen a technique of executing monetary policy which
in my judgment tends to add to monetary growth. The Fed focuses
primarily on the Federal funds rate and other short-term rates. During
a period of expanding business and a period of accelerating inflation,
interest rates tend to go up.
The Fed attempts to prevent the Fed funds rate from rising and in
the process add to Government purchase of securities and bank reserves. Consequently, the money supply rises for those reasons.
There has been significant improvement in employment during this
economic expansion. Yet, unemployment remains high by many measures, certainly well above the long-term objective of 4 percent. It is
my judgment that stimulative demand policies cannot permanently
reduce the rate of unemployment. Inflation expectations inevitably get
in the way.
If we have stable expectation as to the rate of inflation, an increase
in demand in the short-run, we will indeed reduce the unemployment
rate and raise the rate of employment. However, once the marketplace
recognizes that inflation is accelerating—not stable—then, of course,
we move back to the prior natural rate of unemployment.
In my judgment, an -attempt to reduce continuously the unemployment rate by gradually and continuously increasing the stimulus has
the effect of producing runaway inflation, not a permanent reduction
in unemployment.
51-421—79
6
78
Furthermore, unemployment that exists today and typically exists,
is pocketed unemployment to a considerable extent. The Congress unfortunately passed a very high minimum wage, $2.90 currently. This
has a very severe impact on new entrants to the labor force, young
people, teenaged blacks, for example, who presently have 33i/£-percent
unemployment which I personally think is a national disgrace.
At the same time, we have had increasingly liberal unemployment
and welfare benefit payments which make it less desirable to search for
work. Many of those individuals find they are better off not working
than working. And consequently, they end up on the unemployed rolls.
Growth is slow. The major reason for the slowdown in real growth
has been slow improvement in productivity.
In my prepared statement I present some data over the last few
years. And I conclude that productivity improvement has declined
from the 2- or 2%-percent rate which seemed to be characteristic of
our economy some years ago down to somewhere between zero and
one-half of i percent.
That means that with any given level of demand, we get about 2 percent more inflation than we used to believe was the case. It is not a
surprise that productivity has deteriorated. Productivity growth has
deteriorated. So has capital formation.
I present data in my prepared statement which are well known, concerning "Growth in the Nonfann Capital Stock Per Hour Worked."
And it has declined from 2P/2 percent in the decade ending in 1965
down to approximately zero recently.
Furthermore, the United States saves a smaller percentage of its
total income than do other developed nations, and capital investment
as a percentage of total GNP for the decade is the lowest of developed
countries.
In addition, regulatory activities have risen very rapidly in recent
years from 1970 to 1979. Federal expenditures on regulatory efforts
for business were up 568 percent to about $5.75 billion.
Murray Weidenbaum, St. Louis, has estimated business must spend
about $100 billion a year in fiscal 1979 in compliance with Federal
regulations. These regulations may have helped achieve social objectives; they certainly reduce the capacity of this economy for
growth.
Our tax system is a highly efficient revenue generator, but unfortunately, it penalizes savings and investment while encouraging Government spending and consumption. As the inflation comes along, we all
move into higher marginal tax rates, corporations report income which
is not real income, on which they must pay tax.
Consequently, this is a drag upon the savings investment process.
I present a chart in my prepared statement showing that the higher
the effective corporate tax rate on earnings, the lower the trend in our
productivity improvement. This is especially true during the periods
of high inflation which have characterized the last decade.
Obviously, an indexing of the tax system or elimination of inflation
would help on that front. Unfortunately, we have the worst of worlds.
We are promised price stability, yet we continue to get accelerating
inflation and a system that continues to increase the penalty on savings
and investment.
79
How do we get out of this mess? I agree, Mr. Vice Chairman, there
are no quick fixes. Patience and proper policy over several years are
needed to extricate ourselves from high inflation and slow growth.
The GNP-gap analysis, which has been widely used, in my opinion
is almost certain to result in go-stop policies which have been characteristic of the past 15 years or so. And we must get out of the go-stop
syndrome if we are going to correct our basic problems.
If we have a recession this year, as I suspect will occur, I would hope
that the Congress, the Federal Keserve, and the administration will
respond in a moderate, not in a massive way. The real objective so far
as money supply is concerned should be to reduce gradually the rate of
growth in the money supply until, eventually, it does grow at the same
pace as the growth in our real economy. And instead of moving in the
opposite direction that has been characteristic of most recent years,
lower deficits are critical.
This means restraint on Government spending. It might even suggest a cut in Government spending. Certainly, growth in Government
spending below the growth in the total economy is critical.
We must all recognize the lags in the economic process. If we insist
on getting the short-run benefits of stimulus, we will end up with
massive inflation later.
I would hope that the Federal Open Market Committee could move
from concentration on the Federal funds rate to a concentration on
overall growth in the monetary base.
We must tilt the tax system if we want to get out of the slow-growth
syndrome, toward encouraging savings and investment and lass Government spending and consumption.
There is a cost to be paid. That is, we can't live it up as highly as
we have in the past. And we must limit Government spending. But
the benefits will be greater economic growth, more jobs, and higher
standards of living.
There are many things that can be done, and I list several in my
paper, including indexing taxes, restraining Government spending,
lower corporate tax rates, reduced progressivity of personal income
tax so greater savings and savings investment occur, higher depreciation allowances, further reduction in the capital gains tax, elimination
of double taxation of dividends, reduced taxation of savings and investment, moving toward a value-added tax system, and elimination
of Eeg Q, which I think places a very severe penalty on small savers.
We, as bankers, savings and loans associations, and mutual savings
banks are unable to pay a decent rate to people who want to save
money with us, I think this legal restraint should be eliminated, and
I am very pleased to see a discussion taken up by other groups recently.
We must slow down the growth in Government regulation and make
sure that the costs incurred actually have some relation to the benefits
that are to be achieved.
In summary, we can whip stagflation if we are willing to change our
present policy thrust. The costs will be high, but the benefits greater.
Unless we are willing to change our profligate ways, inflation may
threaten the very fabric of our democratic capitalistic system to the
immense detriment of all our citizens.
Thank you.
80
Representative BOLLING. Thank you, Mr. Sprinkel.
[The prepared statement of Mr. Sprinkel follows:]
PREPARED STATEMENT OF BERYL W. SPRINKEL 1
Escapes From the Dilemma of Stagflation
INTRODUCTION
I am pleased to have the opportunity to testify at this Committee's important
hearings concerning the adequacy of policies for dealing with stagflation, i.e. high
inflation and slow real growth.
My basic conclusion is that policies in recent years have directly promoted high
inflation and slow growth, and were clearly inappropriate for achieving economic
stability. Monetary-fiscal policies fostered excess demand, which resulted in high
and escalating inflation, while tax policies encouraged consumption and Federal
spending while discouraging private savings and investment. In addition, aggressive regulatory and environmental controls also inhibited growth. Finally, the
present "voluntary" wage and price guidelines tilt with symptoms and promise to
further reduce the efficiency of our market system, thereby contributing to
stagflation.
INFLATION'S ROOTS
Inflation is and always has been primarily a monetary phenomenon—i.e. toomuch money chasing too few goods. Whenever the money supply
grows at a rate
exceeding the rise in real output, inflation accelerates, but w7ith a iy2 to 2 year
lag. The following chart traces this relationship for the United States from 1915
to the present. Since monetary growth has accelerated sharply in recent years, we
are reaping our just but painful rewards on the inflation front.
Even though monetary growth accelerated until recently, it has been the objective of the Federal Open Market Committee since the spring of 1975 to slow gradually the rate of monetary growth until it was commensurate with the growth in
real output. Why have results contrasted so sharply with stated objectives? Let
me cite three contributing factors, although there may be more.
Money, Real GHPe and Inflation
• i
i
.
;
!
i
•
i
1
^
ney 2 |
Pe Unit of Ou?pu!
•
j;
| ^ ^ = > - -
.| /
/
/ >y
r
•
|
100
85
70
•
Consumer Prices
!
/
1
—
220
190
160
130
!
55
•
,
: I • .:
:
•
40
•
•
I
I
•
25
vi iit
1915
I
20
25
<.
;
30
35
40
45
50
55
11
60
65
70
LJU1JL
75
SO
I Peak ?o trough of business cycles
Taken from: B.Spnnkel and R. Genetski, Winning With Money (Dow Jcnesirwm Inc., Spring, I 977),
1
The views are my own and not necessarily those of my employer, the Harris Trust &
Savings Bank of Chicago.
81
(1) Since 1975 the Federal budget deficit has been large and frequently increasing. Deficits must be financed either with new money creation or savings. Undoubtedly, the Federal Reserve's concern about adequate financing for the Treasury contributed to the high rate of monetary growth while savings absorption
reduced private capital formation.
(2) There exists a political temptation to enjoy the short-run benefits of
rapid monetary growth while denying or ignoring the ultimate inflation price to
be paid. For example, during the first 22 months of President Carter's administration there was frequent criticism of Federal Reserve policies by representatives of the administration who believed the policies were too tight, even though
growth in the money supply was soaring. Undoubtedly, those pressures fostered
excessive money growth and higher inflation.
(3) Finally, the Federal Reserve's technique of monetary policy execution also
tended to encourage excessive money growth during periods of expanding business activity when interest rates were typically rising. The Federal Open Market
Committee's attempt to peg the Fed funds rate at too low a level usually resulted
in excessive purchases of government securities, thereby increasing the monetary base and the money supply. Conversely, during periods of recession, reluctance on the part of the FOMC to permit a decline in the Fed funds rate sometimes severely depressed monptary growth. The current expansion is now 49
months old and until last fall, growth in monetary aggregates continued to
accelerate. This technical complication could be readily avoided if the Federal Reserve focused on regulating growth in the monetary base and permitted
the Fed funds rate to be determined by private market forces.
EMPLOYMENT INHIBITORS
The growth in total employment during the current expansion has been
enormous and the unemployment rate has declined, but the present 5.7 percent
rate of unemployment is well above the frequently stated objective of 4 percent.
Many believed that massive stimulus would inevitably result in declining and
low unemployment rates, but as jet that has not occurred.
The basic reason relates to inflationary expectations. If the inflation rate is
stable and market participants believe it will remain so, demand stimulus will
indeed reduce unemployment. However, once greater inflation develops and expectations escalate, there is no reason for believing that unemployment can be
permanently reduced through further demand stimulus. To achieve such an
objective would require continuous acceleration in the inflation rate, and that
of course would be the route to financial disaster.2
In addition, there have been important structural changes affecting the reported level of unemployment in recent years. For example, sharp escalation in
the minimum wage to the present level of $2.90 denies employment opportunities
to many unskilled workers. The high minimum wage is a direct contributor to
high unemployment among teenagers and especially teenage blacks, who have a
current unemployment rate of 33.5 percent. The sharp increase in transfer payments in recent years has also reduced the incentive to search actively for employment. Liberal unemployment compensation benefits plus rising welfare payments reduce the penalty for unemployment, and in some cases cause lowerincome groups to be worse off by working than by remaining idle.
PRODUCTIVITY DRAGS
The capacity of the U.S. economy for growth has clearly declined sharply over
the past decade. Falling productivity has been the major contributing factor. The
following table indicates the deterioration since 1955.
Productivity improvement1 (annual rates)
Percent
1955-65
2. 6
1965-73
1. 9
1973-78
_
—__ 0. 8
1979 (1st Qtr.)
—4.5
1
Output per hour of all persons in the nonfarm business sector.
Source : Department of Labor.
2
Friedman, Milton ; "Nobel Lecture: Inflation and Unemployment," Journal of Political
Economy, University of Chicago Press, June 1977.
82
At the Harris Bank, our economic forecasting effort places a great deal of
emphasis on productivity trends. Unfortunately, our recent conclusions are very
discouraging. On the basis of our latest research we have concluded that for all
intents and purposes the U.S. economy is no longer experiencing any productivity
gains. This means that today, for a given increase in money, the U.S. economy
will generate 2 to 2y2% less real growth, and therefore, 2 to 2% percentage points
more inflation than we have come to expect.
Capital formation in the United States has been weak for many years and has
contributed to slowing productivity improvement. Growth in the non-farm capital
stock per hour worked has declined as follows:
Growth in nonfarm capital stock per hour worked (annual rates)
1955-65 . „ . .
.
1965-73
.
2 61
1*07
—1.1
I--II~II~I"r™"T
197&-78 ...
"
"
1977-78
™~™~I~
Source: Department of Commerce.
Furthermore, savings in 1977 as a percentage of after-tax income in the United
States were by far the smallest of the six major developed Western countries, and
U.S. investment as a percentage of real GNP for the decade 1966-76 also was the
lowest 3
To compound the difficulties, the cost of Federal regulatory activities have
soared. From fiscal 1970 to fiscal 1979 Federal outlays for regulation rose 568 percent to $5.78 billion, while real outlays rose 269 percent In addition, economist
Murray Weidenbaum, Director of the Center for the Study of American Business,
has estimated that for fiscal 1979, business will spend $97.9 billion on compliance
with Federal regulations. Those funds may have helped achieve social objectives,
but they reduced productive investment
PRODUCTIVITY CHANGES AND CORPORATE TAX RATES
Productivity:
Private Non-Farm Sector
(% Change)
Effective Corporate Tax Rate
•4.5-
71
-4
-5
76
'•
i:». the Torporst? Sector, January f I???.
• "Capital Formation Folio," the American Council for Capital Formation, 1970, Washington, D.C.
83
Oar Federal tax system is a highly efficient generator of Federal revenues, but
it discourages private savings and investment while encouraging consumption and
Federal expenditures.
Actually, our search for the main cause of the recent deterioration in productivity has centered on the impact of high U.S. tax rates. Although our research in
this area is still preliminary, we are finding that there has been a strong relationship between corporate tax rates and productivity changes. As the following chart
shows, the rapid increases in the effective corporate tax rate, as measured by
the National Bureau of Economic Research, has been closely related to the sharp
decline in productivity. As the effective tax rate has risen, productivity has
declined.
The tax effect has been particularly evident over the past decade of accelerating
inflation which resulted in proportionately larger Federal revenues and greater
penalties to the savings-investment process. Either elimination of inflation or
indexing of the personal and corporate tax system would neutralize this pernicious effect.
ESCAPE STRATEGIES
How can we extricate ourselves from the current inflation-low growth dilemma?
There are no quick fixes, but patience, a quality in short supply in our political
arena, and proper policies can come to the rescue in the years ahead.
1. Policymakers must avoid the go-stop monetary-fiscal pattern so characteristic of modern times. There has been a pronounced tendency to concentrate on
reducing unemployment until inflation reared its ugly head and then to concentrate on stopping inflation until a recession and rising unemployment again
changed the target Reference to fictitious GNF gaps encouraged excessive stimulus while high and rising inflation ushered in excessive restraint* If a recession
follows the current pattern of restraint, as I expect, it will be crucial that Congress, the administration and the Federal Reserve Board respond in a moderate
rather than a massive fashion. In particular, monetary growth should be gradually slowed over the next few years until it is in line with secular real output
increases. Lower deficits would reduce the trend toward excessive money growth
and also release savings for the private sector of the economy. Recognition of the
inevitable lags in policy impact should help strengthen the political will. Finally,
the Federal Open Market Committee should be encouraged to focus on control of
the monetary base, not the Fed funds rate. Even with prudence and restraint,
low inflation rates are years away in the absence of a massive depression. Furthermore, such a policy would bring slow growth in the few years immediately ahead,
followed by better performance. Many years of mismanagement brought double
digit inflation, and several years of prudent policies will be needed to restore price
stability. But the results would be well worth the effort.
2. Clearly our tax system must be tilted toward encouraging savings and investment while discouraging consumption and Federal expenditures. The cost will be
a reduced growth in consumption and Federal outlays, but the benefits will be
greater real economic growth, additional productive jobs and a higher standard
of living for our citizens. I favor indexing our Federal tax system, but that isn't
enough. Slower growth or even reduction in Government spending will release
valuable resources for productive private sector utilization. Other tax incentives
for encouraging savings and investment include:
(1) Lower corporate taxes and reduced progressivity in our personal taxes.
(2) Higher depreciation allowances, designed to represent replacement
cost.
(3) Further reduction or elimination of capital gains rates.
(4) Elimination of double taxation of dividends.
(5) Reduced taxation of savings relative to consumption.
(6) Elimination of Regulation Q which prevents savings institutions from
providing a fair market rate for savers, especially small savers.
Finally the escalating trend toward more Government regulation of private
sector activities must be reversed by insisting on effective cost-benefit analysis
and implementation. Regulation sometimes yields social benefits, but these added
benefits must be compared to the added costs. There are no free lunches in this
world of scarce resources.
In summary, we can whip stagflation if we are willing to change our present
policy thrusts. The costs will be high, but the benefits greater. Unless we are
willing to change our profligate ways, inflation may threaten the very fabric of
our democratic capitalistic system to the immense detriment of all our citizens.
84
Representative BOLUNG. Our next and final witness is Mr. Albert
T. Sommers, a 1953-58 student of Columbia with a masters at NYU.
He has been senior vice president and chief economist of the Conference Board for 20 years.
Among the recent articles he has written that seem particularly
relevant to our consideration today are: "Inflation, Unemployment and
Stabilization Policy," September 1976; "Balanced Federal Budget,
an Orthodoxy in Trouble,5' 1978; "U.S. Productivity, Not a Disaster,
but Certainly a Dilemma," 1978; and "A Collision of Ethics and Economics,3' in July of 1978.
We would be delighted to hear you, sir.
STATEMENT OP ALBERT T. SOMMERS, SENIOR VICE PRESIDENT
AND CHIEP ECONOMIST, THE CONFERENCE BOARD, NEW
YORK, N.Y.
Mr. SOMMERS. Thank you.
In the procedure thus far, I have detected a slight degree of disagreement between Ms. Nulty and my friend Beryl Sprinkel. I am
going to make an effort at reconciliation of that awkward difference.
Representative BOLLING. Good luck.
Mr. SOMMERS. I am particularly encouraged by your opening statement, Mr. Vice Chairman, because the subject of change is a very difficult one for Congress to handle. Much too often, wfe ignore the fact that
the system we are dealing with is a kind of evolving organic whole that
changes greatly over time, partly as a result of inevitable interplay
between our social and political systems on the one hand, and the economic system on the other hand.
The changes that we are dealing with pose terrible problems for a
doctrinal, law-seeking science such as economics. We would like to be
able to prove all our propositions with 30 years of data; the statistical
validity rises as the series lengthens. And then the inevitable question,
how much of the data back in the fifties and sixties has any relevance
to a system that is changing at the rate that this one is ?
Let me offer some brief thoughts on the nature of the changes. Most
of them are referred to in the article in front of you.
We are living through a conscious effoit on the part of this society,
as well as every other developed Western economy, to impose a set of
desired ethical outcomes on a market system that we have inherited out
of a distant past.
What we are after is a more equal distribution of income. We are
after more economic security. We have sought to distinguish the labor
input from all other inputs, a very natural and inevitable thing to do.
It has been going on for 100 years, but we have certainly accelerated the
effort.
We are seeking more economic opportunity. And all of this goes on
in the context of seeking to accommodate to and to keep humanizing a
galloping technology, that has greatly altered the relation of the individual to the society.
If that were not enough, we have sought, I think reasonably, jobs
for all who seek them. These goals or targets are part of a democratic
ethic; wherever democracy has appeared, systems have sought them*
But it is a difficult, painful and ultimately inflationary job.
85
The democratic ethic is basically—egalitarian markets are basically
cumulative. The democratic ethic seeks consumption as an ultimate
measure of its performance. And the market requires investment for
growth.
We could go on at some length to describe the frictions between what
we are seeking to achieve socially and politically while at the same time
we are trying to preserve what I think all of us would agree is a highly
efficient market mechanism for distribution and the allocation of
resources.
But the effort performed as it has been has resulted in lower saving
and investment. It has resulted in an astronomically high-consumption
society, particularly in the United States.
I do not find it surprising that this society runs a budget deficit.
Every other Western democratic society runs a budget deficit.
The reason is very simple. The spending side of the Federal budget
seeks those social goals. But the income side of the Federal budget has
to be restrained in order to prevent or forestall a degree of impairment
of incentive and reward in the system that would reduce its efficiency.
So trying to live with the social goals and with a market system conduces to a budget deficit.
Of course, in turn, the budget deficit conduces to money creation because if we were to force the financing of that deficit on a controlled
supply of funds, we would be pricing out part of the private sector and
reducing its efficiency.
For these reasons and a number of others we can discuss, the objectives of this society have elevated its Phillips curve, That is, it has
produced a situation in which for any given level of unemployment,
we now have more inflation than we used to. And for any given level of
inflation, we have more unemployment than we used to.
Against that background, let me comment on some of the public
policy issues raised in your invitation.
First, with respect to the share of Government in GNP, the deficits
and the growth of money. Given the dilemma I described, I can't characterize our behavior as improvement or grossly irresponsible. The
Government's share in this system has risen relatively modestly. It rises
during cyclical recession. That is inevitable and part of the countercyclical functions of Government.
But measuring the share of Government against our full employment output, accepting for the moment those very dubious numbers, it
really has not risen dramatically. It has not risen faster than in othercountries. And the general level of Government in the United States
relative to the total system is lower than it is in most other Western
countries.
Our tax rates are among the lowest among a dozen or so Western
countries with which we might reasonably compare ourselves. I don't
even find our money growth extraordinary in light of the circumstances
that dictate it.
The supply of Ml money in the United States in a sense has been sort
of indexed. That is, if we adjusted it for inflation, it is no higher today
than it was 10 years ago.
I suspect a response from Mr. Sprinkel on that one.
Representative BOLLING. YOU are getting it.
86
Mr. SOMMERS. As I indicated earlier, I don't think the deficits are
clearly irrational. The growth of our public debt looms very large in
dollars. As a percentage of our GNP, our public debt now constitutes
about 38 percent of a year's output.
At the end of World War II, it was 100 percent of a year's output.
It fell substantially between the end of the war and about 1970. It has
since moved insignificantly; there is no appreciable trend in it.
This is a relatively high percentage. The only higher one I think of
right off is the United Kingdom, but the reason here is simply that
both the United Kingdom and the United States, being victors in
World War II, honored the Government debt incurred in World
War II.
In both West Germany and Japan, we, of course, installed new
governments. And the public debt of those countries was repudiated.
They started the postwar years with a zero relationship. They are now
up to 20 or 22 percent and rising, while we are stable or falling.
Now, it is nevertheless true that those deficits and the financing of
them are what might be called the enabling conditions of inflation. And
I attribute inflation to the social efforts that we have been engaged in.
But neither the inflation nor the growth nor the social efforts could
have been accommodated without budget deficits and rising general
money supply.
With respect to the performance of these policies on the labor
market, I think they have been generally effective. We have the best
growth in jobs in the West. Our employment ratio relative to population has been rising dramatically. It is at the highest level it has ever
been.
Our unemployment rate is certainly higher than we would wish, and
higher than our own estimates of full employment. But these are
technical consequences of the structure of the labor force, on which I
don't think you will hear any disagreement from any of us.
We have a problem of absorbing a very large postwar generation.
We have had a fundamental sociological change in the role of women
in the economy. And we have a large and perhaps growing disadvantaged population. At this moment, we have really no general
u nemploy m ent.
This system is experiencing high prosperity and is, in fact, in imminent danger of labor shortage even in the presence of the 5.7 percent
un?mp!oyment rate.
Next, let me comment briefly on high employment budgeting. I
don't think anybody would say this is a perfect device for policymaking by any means. And the latest revision, just a couple of months
old, revealed many of its defects. In the course of reducing the measure
of full employment potential, we elevated the full employment budget
deficit from about $8 billion, which looked like we were about on target,
to $23 billion, which looks as though, in the high prosperity I am
describing, that is a relatively high full-employment budget deficit.
It is probably true that high-employment budgeting mislead us in
the 1970's, and that it in some degree mislead policies. But it didn't
mislead us in the 1980's and may not in the 1980's.
In any event, it is a useful tool used with the necessary moderation.
And I prefer it to a wholly unquantified hypothetical offering of the
Laffer curve, which seems to me is simply playing hardball in the dark.
87
It calls for immense tax reductions with no quantification of what the
response would be.
Now, I do have some recommendations, and they are hopelessly nonideological. They will frustrate liberals and irritate conservatives. But
I offer them quickly anyway.
First, we have had very bad cyclical experience in the 1970's, more
cyclical than any other Western economy, and more cyclical than our
own experience in prior periods.
I do agree with Mr. Sprinkel that in a way, we have had stop-go. We
have had alternating bursts of fiscal stimulus followed by monetary
restraint. What used to be a natural business cycle that had its uses,
has been amplified by policy, I think unnecessarily, doing a lot of damage to our investment rate. It is easy to consume through these waves
of uncertainty. It is very hard for business to make long-term investment-type and capital-type decisions. I think we can do better on that.
I think we should certainly explore an independent economic commission, isolated as much as possible from politics. We are almost alone
in the world in not having such a long-term planning agency of high
respect available to us.
And I think to do better here, we may well require a greater range
and greater selectivity of both fiscal and monetary powers. We were
born in a revolution against power, and we really have delivered very
little to our Government. This is not a matter of the size of government.
It is a matter of the power of government to achieve public national
objectives.
Second, I agree with Mr. Sprinkel again that we are investing inadequately. I think our saving rate is too low. Our investment rate is too
low. There are alternatives here, not all of them terribly pleasant.
A value-added tax is appropriate for this problem. And I think it
is highly desirable on at least eight grounds.
Then, we have the worst depreciation laws in the Western World.
To get rid of that tail of very low efficiency, but now fully written-off
capacity that exists in most industries, a much faster depreciation
writeoff would be a very useful solution.
I think selective credit restraints deserve to be studied. And I do not
believe that the existing credit control act should be removed from
the books without exploration of its potential.
Third, public capital formation in the United States is sinking
almost out of sight. It is a very little-watched figure, but since the
end of the road-building program and the end of that wave of schoolaged kids through the public educational system, the rate of public
capital formation has subsided so far that I would say we are deferring maintenance on the U.S. infrastructure.
The enlargement of public capital formation which is mainly a construction function, all of it contracted out to the private sector, I think
would reduce the need for the volume of transfers that now moves
through the Federal budget. The transfers are high-consumption
oriented. And we would do well to control them.
Finally, I think that we make less use of public capital in general
than most other countries. I am not speaking about public ownership
of productive resources, although that is rather widespread throughout the West now in response to some of the dilemmas that I have
mentioned. But the Government's role in stimulating investment
88
even if it has to make some tough decisions as it would if we allowed
certificates of necessity, somebody has to decide we need this industry to enlarge from a public interest point of view.
Those are tough decisions to make, but I think we should try to
use our Federal powers in order to stimulate the basic productive
base of the system.
Joint ventures between government and business, very widely used
in the rest of the world, are almost negligible in the United States.
Energy is an obvious instance where such collaboration between business and government might be extremely profitable.
Well, I will rest there. Thank you.
Representative BOLLING. Thank you very much, Mr. Sommers.
[The prepared statement of Mr. JSomrners follows:]
PKEPABED STATEMENT OF ALBERT T. SOMMERS
I am grateful to the committee for this opportunity to offer views on questionsthat confront th'e committee's Special Study on Economic Change. I'm particularly grateful, since I consider the issues posed by your letter of invitation, and
by the announcement of the hearings, to be the right questions, and very important questions. There have indeed been ''numerous and profound changes" in
the U.S. economic system that call for re-examination of economic policies and
objectives, particularly with respect to identifying obstacles in the way of
achieving the goals of high 'employment and reasonable price stability.
I will comment specifically on the questions raised in your invitation. However, it would seem useful to preface those comments with a brief characterization of the "changes" to which the committee's Special Study is directing:
itself. I think it would be a mistake to treat the reference to "change" in the
committee's Special Study as simply indicating a need for the study. "Change"
should be a large, substantive subject of the study itself.
In testimony before the Senate Banking Committee in November 1978, I submitted an article entitled "A Collision of Ethics and Economics," that describes
the nature of the changes in our economic system (and really in all Western
democratic systems) as a continuous stream of legislation, and of policy, intended to accommodate a democratic social ethic to a free-market system. The
article appeared in the publication of the hearings for November 15, 1978. I
have provided copies of the article for the members of this committee. There i&
certainly no reason to summarize it now; I refer to it only because my views on
the achievements and failures of economic policy over the past two decades rest
on the proposition that we have been facing a unique social and economic challenge—a national effort, inevitably by government, to apply ethical criteria tothe outcomes of a market system and to alter those outcomes where they do not
meet the criteria. Nobody should have expected this to be easy, and it has
turned out to be not only difficult, but inflationary.
It is often said by monetarists (often, I'm sure to this committee itself) that
throughout history all inflations have had the same cause—namely, the excessive creation of money. I think that statement is a partial truth, and misleading;
it does not disclose the reasons for the excessive creation of money, and very
different reasons, of differing degrees of respectability, have prevailed in different inflations. If there has been excessive creation of money this time around,
it is because we have wanted the equal opportunity, more equal income distribution, greater security and greater dignity of labor that are part of the democratic
ethic. We have wanted jobs for all who want to work; and we have wanted to
impose these objectives directly on a free-market system that is efficient, but
cumulative, not egalitarian, in its distribution of rewards.
Modern Western inflation is a measure of the friction developed in the course
of this effort. The budget deficits experienced by Western economies result from
efforts to mandate socially acceptable outcomes while retaining the efficiencies
of a market system; the spending side of the budget seeks the social outcomes,
while the revenue side is suppressed to avoi# further impairment of the incentives required for free-market activity. The deficit (and the money creation to
finance it) thus pours oil on the troubled interface between democratic ethical
89
goals and free-market institutions. We'll never know, of course, but I doubt that
Emperor Diocletian, who presided over a great Roman inflation to which monetarists often point as a monetary parallel to our own, would have described his
situation quite that way. Same with Robespierre (who resorted to mandatory
price controls), the rules of the T'ang dynasty, and others who encountered monetary inflation in the course of their careers.
The Full Employment Act of 1946 expressed a social conviction about jobs and
the wide sharing of prosperity. It demanded little or nothing in the way of action
of the part of government, and recollections of the 1.930's were such as to raise
grave doubts about the government's ability to fulfill the commitment. In any
event, nothing much in the way of policy was necessary to maintain the system
at high levels of employment (with occasional business-cycle interruptions) during the first postwar decade; enormous liquidity generated by the war, together
with the deferred real demands from a decade of depression and then a half-decade of war, insured high economic performance. In the late 1950's, this energy
was largely expended. In the early 1960's, the mandate of The Full Employment
Act confronted a stagnant economy, and the stimulative measures undertaken
from 1962 to 1964—the period of the so-called "new economics"—produced a
highly successful return to full employment, in the presence of a balanced budget,
low inflation, and rapid improvement in investment.
The successful application of policy to the commitment of the Full Employment Act seemed to demonstrate that government had the power, as well as the
intention, to achieve and maintain high prosperity. The commitment thus acquired some of the character of a guarantee. The guarantee w^as naturally accompanied by a reduction of perceived risk, and the guarantee was progressively
liquidated by an explosion of private debt, which has resensitized the system to
recession. At the same time, having apparently solved the problems of aggregate
growth and prosperity, policy in the middle 1960's switched heavily to programs
to achieve distributive justice—to the disadvantaged, the ill-housed, the illeducated, the poor.
Now a dozen years or so later, the powers and commitments of government are
very much open to question again. Many of the distributive programs seem to
have produced costs without benefits. The business cycle seems to have escaped
out from under control again, and the assurance of prosperity has disappeared.
Inflation, unaccustoniedly large budget deficits, and a deterioration of productivity have produced a deep disenchantment with activist, goal-oriented economic
policy. The immense respect for the social functions of government that prevailed in the middle 1960's is now dissipated, and there has appeared a large and
.growing subterranean economy that lias opted out of the social system.
Against this background view, let me turn now to the specific questions raised
in your invitation. The first invites comment on the course of fiscal expenditures
and deficits, and of money supply growth, on the inflation rate. I can't characterize those policies, including the role in them played by full-employment budgeting, as plainly improvident. They sought outcomes that all developed Western
democracies have sought. United States tax rates are among the lowest in a
group of a dozen economies with which we might compare ourselves. Popular
•opinions to the contrary? the effective Federal personal income tax rate is no
higher today than it was a decade ago. The share of government in the total
economy is also moderate relative to experience in other countries; in terms of
our own past record, it is moderately higher than it was in the years before
1986, but there has been no important trend in the share since then, either
in terms of the share of actual output or the share of high-employment output.
Our experience with budget deficits is not very different from the experience of
other countries caught in the same wave of social history. The Federal debt
bears about the same relationship to a year's national output today that it did
in 1970, and the relationship is lower than in any earlier postwar year. (It
should be borne in mind that the postwar governments of West Germany and
Japan repudiated the public debt of their wartime predecessors and started the
postwar years from scratch, whereas we entered the postwar years with a debt
equal to 100 percent of annual output,)
Arid similarly with the growth of money. The U.S. money stock has by and
large, risen less rapidly than the money stock of other developed Western countries. Indeed, as measured by M1# the real money stock—that is, the money stock
adjusted for inflation—is no higher today that it was a dozen years ago. and
it has recently been falling so rapidly as to persuade monetarists that a serious
[recession lies ahead.
90
This does not mean that fiscal and monetary policies pursued in the United
States over the past dozen years have had no relation to the inflation problem.
It does mean, I think, that the ethical effort to fulfill democracy has substantially
elevated the United States Phillips Curve, and that the effort to achieve high
employment and low unemployment now involves more inflation, and hence more
money creation, than was required a dozen years ago. In this sense, budget
deficits and their financing in a generally accommodative monetary environment
have become the enabling conditions of both high employment and high inflation.
I do not think the policies have been ineffective in the labor market; on the
contrary, they have doubtless contributed to a substantially successful record
in job creation in the private sector. At this moment, the relationship of employment to population is evidently higher than it has ever been; it has risen
dramatically now for several years, and the bulk of the new jobs has of course
been In the private sector. The unemployment rate, on the other hand, is still
considerably higher than it was at comparable points in past business cycles;
there is wide agreement that upward shift in the unemployment rate is traceable
to structural conditions within the actual and potential labor force—the high rate
of youth entry, the sharp increase in the participation rate of women, and the
continued (perhaps enlarged) presence of a disadvantaged component of the
labor force that is simply out of the reach of aggregate demand policies. Thepolicies themselves have not, it seems to me, been demonstrably wrong; if the
results do not look great, it is because they have been confronting a progressive
deterioration in the relationship of iniflation to unemployment. This is the samepoint that the Chairman of the Federal Reserve was making when he commented on "the limitations of monetary policy as the main bulwark against inflation and the need to mount a broad attack on the economic problems we face"
(statement to the Congress, August 1978). Aggregate demand policies may appear to have been "excessive" by the criterion of inflation; but they do not appearto have been "excessive" by the criterion of job creation and unemployment,
and they do not appear to be excessive in comparison with the policies pursued*
by other economies confronting similar problems.
I offer the Committee the following conclusions, drawn from this view of our
experience with aggregate economic policies over the past decade. In the first
place, I do not recommend that we abandon high employment estimates. They
are admittedly imperfect with respect to both their labor force and productivity
assumptions. The most recent revisions elevated the constructive full-employment
deficit in late 1978 from $6 billion to $23 billion, because of a one-third reduction
in the productivity assumption. The full-employment deficit is now about equal
to the actual deficit. This suggests that we are at full-employment now. But theunemployment rate is still moderately above the assumed full-employment rate;
rising participation rates have elevated the labor force (and employment, and
unemployment) above the projected level.
High employment projections nevertheless constitute a useful guide to policy.
In the early 1960's, they correctly diagnosed the cause of stagflation; wartime
tax rates were calling for a very large surplus at full employment, unattainable
by a private sector that had lost its wartime energies. Now they point to a needr
for reasonably conservative policies. They may have misled us in the 19770's.
But I doubt very much that our social ambitions would have prodiicecL very
different results if we had eschewed such calculations. And in any event they are
far more useful than the Laffer curve, which offers a wholly unqualified promise
of a massive real response to massive tax reduction. The Laffer curve plays
hardball in the dark.
The unemployment assumption on which the high employment estimates are
based should reflect the changed realities of the labor market. Given the present
labor market, an unemployment rate below 5.5 percent is an improbable achievement, and would almost certainly be associated with serious general inflation. The*
approach to that residual unemployment must take the form of structural programs in education, training, government-assisted job creation, and removal of
disincentives to work.
There are a number of other possible courses toward restraining the Phillips
curve that underlies this inflation-unemployment problem.
1. U.S. fiscal and monetary policies could be better integrated; the history
of the past dozen years has been characterized by alternating bursts of fiscal
stimulus and monetary restraint, as the overriding criterion of economic policy
has shifted back and forth between unemployment and inflation. It should be
possible to do much better.
91
2. We could do better if we were to allow ourselves pragmatic, non-ideological
study of ways to improve the equipment of fiscal and monetary policy. For both
arms of policy, American tradition has been limiting; The Federal Reserve is
not among the stronger central banks of the Western world, and American fiscal
policy is far more dilatory than the parliamentary systems that prevail in most
of the West.
3. An independent economic commission, isolated as much as possible from
politics and free of the short-term concerns that occupy the Council of Economic
Advisers, is an inevitable future development in the making of economic policy,
and in recommending changes in policy equipment. Most of our international competitors are equipped with such a body.
4. The United States economy has an apparently insatiable propensity to
consume, and to absorb the supply of capital in consumption-oriented credit.
Restraint on the use of credit in consumption would free real and financial
resources for a higher level of private and public capital investment, and for
faster growth in productivity and output. A value-added tax would work in the
same desirable direction.
In addition, the productivity shortfall that required the revision of the highemployment calculations calls for broad stimulation of investment incentives.
The easiest and fairest way to do this is through a substantial improvement
in the rate of recovery of historical costs of capital facilities.
5. However one might feel about the aggregate spending of the Federal Government, certainly the relationship between its spending on transfers and its
spending on real public capital formation—the infra-structure of the entire
economic system—is sadly distorted; a substantial elevation of such public
capital outlay (mainly construction work contracted to the private sector)
would have a high payoff, and would constrain the need for some of the transfers.
U.S. economic experience does not compare particularly unfavorably with other
Western democracies in terms of aggregative policies; but it compares quite
unfavorably in terms of a low saving rate, an excessive consumption share in
output, insufficient private and public real investment, and in the productivity
consequences of investment. Progress on these fronts, together with more effective approaches to structural unemployment made possible by the educational
experience of the past dozen years, would have a substantial impact on the
Phillips curve and the growth rate, and it would relieve the pressures on both
fiscal and monetary policy to accept the high-inflation consequences of a highemployment goal.
Representative BOLLING. Before we go on to a genera! discussion, I
would like to ask you to give me those eight grounds to support the
value-added tax that I heard you comment about.
Mr. SOMMERS. I am not sure I can get up to eight, but I can get up
to a few.
First, the value-added tax bears on spending of income. For that
reason, it is a marginal incentive to save. You can avoid the tax by not
spending.
And whatever tax relief it offers for other taxes would also provide
relief of the pressure of taxation on incentive.
Second, the tax has certain uses internationally. That is, those who
have the tax rebate it on exports, and impose it on imports. The result
is that even under conditions of floating rates, the presence of a valueadded tax is a small trade advantage.
Third, the so-called subterranean economy which nobody can measure, but I'm satisfied is very, very large
Representative BOLLING. Could you give me an order of magnitude?
Mr. SOMMERS. Well, the common magnitude is $200 billion. It is
calculated out of the apparent insatiable capacity for currency, particularly of relatively large bills, that has appeared lately. The subterranean economy has a lot of difficulty escaping the value-added tax;
09
it is a lot easier to supervise business sellers and retailers and have
them collect the tax. So even if the income is not being taxed, at least
the spending is being taxed.
Representative BOLLING. Very fine. I just wanted to get that in.
Next, I would like to get in the fact that we have at the table with
me a staff that is working on this. And the staff that worked on all of
this on my right, is Jack Albcrtine, the staff director of the Joint
Economic Committee, and has been most helpful and cooperative on
this aspect of the Joint Economic Committee's work, the Special
Study. ^
On my left is the director of the Study, Lou Krauthoff.
To his left is George Krumbhaar who has been very actively
involved.
To my right, beyond Mr. Albertine, is Dick Bartel and John Henderson. Dick Bartel is of our staff; John Henderson is working with
us from the CES.
We are very pleased at the kind of cooperation we have gotten, not
only from internal institutional support, but also from the. outside
where we have had very great cooperation.
Now, what I would like to do is to ask the witnesses if they would
like to have at each other or do I have to stimulate them further?
Because it is very clear that we have some fundamental, important
differences of opinion. And while it is a fact, I think, that Mr. Sommers
has been able to do some pulling together, some good, solid, political
compromising at least in broad, general ideas, I think that we should
argue out a few of these points.
Is there any absolute way of proving that anybody is right or wrong
in any of this ?
Ms. NULTY. The only comment that I would like to make is that
most of the policy prescriptions that I have heard put forward this
morning have already been tried to some degree or other.
I had the misfortune to be living and working in Britain at the time
that a value-added tax was about to be imposed. Shortly after I left, it
was imposed. The result was a tremendous acceleration in the rate of
inflation, and as far as I am aware, no material effect on the rate of
capital formation or investment since those are problems that that
economy continues to grapple with.
With respect to incentives for investment through the tax system, I
think it is quite documentable that the effective tax rate for the
corporate sector has been falling very dramatically in the postwar
period. So if we are looking for incentives for capital formation, that
one has obviously proven its inefficiency.
The third point that I would like to refer to is that I don't think
there is uniform agreement that our market system is efficient, if by
"efficiency," we use the standard that I use for my policy analysis—
namely, how well it provides a stable and secure standard of living
for the mass of the population.
At least with respect to the four sectors that I have studied in depth,
the market system as it exists at the moment has proven to be remarkably deficient because it has been the principal engine of reducing
living standards.
93
As mentioned in my prepared statement, the problem is that these
are very complicated, and the exposition would be quite lengthy. I
didn't want to overweight my longer statement. I certainly don't want
to take up a lot of time this morning going into the details.
But certainly what we found, several studies are finding, in the food
sector which used to be thought to be a very low-concentration industry, quasimonopoly power, whatever you want to call it, basic concentrated market power, has been a very potent engine of inflation.
In energy, regardless of what concentration ratios may show you,
rather more sophisticated and subtle market relationships in the private sector, I feel, are proving to be a major barrier to curbing inflation
in energy.
With respect to medical care, I found it quite interesting that when
the Federal Trade Commission just a few days ago—in fact, last
week—proposed a ruling that would limit the participation of doctors
on Blue Shield boards, the medical profession set up a screaming howl
because basically, it is that kind of concentrated market power that
establishes self-determined fees and prices in the medical sector.
And not only that, but the composition of medical care in the medical
sector.
And I think it is quite remarkable to hear not one other person this
morning address the issue of what is happening to the structure of the
market system because, as far as I am concerned, from my own work,
that is the critical factor in this very new kind of inflation that has
come to dominate the economy.
Representative BOLLING. Well, there are two contrary points flying
around here. I keep hearing, and I think it is probably true, that the
various increases in regulation of segments of the economy have added
very substantial costs to the cost of doing business.
On the other hand, the performance, it is said, of the market is
deficient as has just been said and has an inflationary effect.
It would seem to me there ought to be some discussion of those two
things together rather than separately. And it would seem to me it
would be important to see how much the Government in its attempt to
improve the environment and to regulate monopoly has added to costs
and compare that with how much the market itself has added to costs
without regard to that.
Is that an irrational thought ?
Mr. SOMMERS. I don't think so.
Representative BOLLING. HOW would you go about doing that ?
Mr. SOMMERS. Well, on the points that Ms. Nulty raised in that
connection, you would think that market power would be reflected in
rate of return on profits, rate of return on sales, or rate of return on
investment. And the actual data that I know of do not support the
impression that monopolistic powers exist very widely in this system.
I would not disagree with Ms. Nulty in the fact that the market
system is highly imperfect and there are concentrations of power in it.
I don't think there is any question about that.
We are not living in a world of auction markets such as described in
those old textbooks any longer. But the actual evidence of monopoly
profits is very difficult to find.
51-421—79
94
The falling tax rate that you refer to can only be achieved—you
can only get that result—if you add depreciation back to earnings.
And I am presuming Ms. Nulty is doing that. But depreciation is a
real measure of a rise in aggregate investment. And I don't think you
can just assume that depreciation is an uninhibited cash flow just like
earnings.
Measured without depreciation, I think Mr. Sprinkel can tell you
what the tax rate looks like.
Mr. SPRINKEL. Congressman Boiling, I have some data in the chart
in my prepared statement concerning productivity change and the
effective corporate tax changes. They are not my numbers, but numbers
generated by Martin Feldstein of the National Bureau of Economic
Research. These numbers adjust not only for the effect of inadequate
depreciation and inventory profits, but also for taxes paid by the
recipients of dividends.
The series is an attempt to get an effective tax on income generated in
the corporate sector. And rather than declining or staying flat, taxes
have risen excessively. For example, in the early sixties, the effective
tax rate was about 53 percent. It is up now to somewhere in the 65-70
percent range and rising, and will continue to rise so long as we keep
the tax rate the same and continue to accelerate inflation.
Let me turn to a second issue that was raised. I (think it is very
dangerous to try to explain inflation by isolating particular prices that
have gone up more than the average and say, therefore, the high
risers caused inflation.
For example, if we did that recently, we would have to say this
inflation is brought on by food and fuel. And if we picked out those
sectors that didn't rise as much as the average, we would have to say
those prices are holding the inflation rate down.
What we are interested in, at least what I am interested in, and I
believe this committee is interested in, is why has the average level
of inflation gone up, including both the low risers and the high risers?
You can't explain that by focusing on the ones that have gone up the
most. It turns out if you ask that question, then the answer is no
different than it always has been. And I suspect it always will be.
That is, when we pump in a lot of dough, people are s^oing to spend it,
I am going to spend it, you are going to spend it. And when you pump
money at a faster rate, production goes up, but the price rise will
accelerate.
The question is whether or not market power accounts for this
inflation. I know of no theory that says that there has been more than
a doubling in market power over the last some years.
For example, in the early part of 1977, the inflation rate was down
to about 5 percent. It is now 10 or 12 percent, depending on what index
you want to use and for what month. It is not enough to show that we
don't have a perfectly competitive market; we don't. We recognize
that. The/question is, Is the market getting even more imperfect in such
a way that everybody can automatically raise prices irrespective of
market demand? And the answer is no. There is just no evidence to
support, that point of view that I am aware of.
Particular prices may be higher than they should be in a freely
competitive market. If so, we will be spending more money on that
95
good or service, whether it be medical services or something else. We
will be spending less on something else. And those prices won't go up
as much.
To summarize, then, what I am interested in, what I think we should
be interested in, is why have the average level prices gone up ? That
is what inflation is all about. It certainly cannot be explained by
growing market power on the part of American business.
Ms. NuiiTY. May I respond ?
Representative BOLLING. Sure.
Ms. JSTTJLTY. In my economics education, there was an explanation
of why one would find prices rising irrespective of the state of demand.
And it had to do both with the shape of the demand curve and with
the existence of monopoly power. Conventional economics has a very
ready explanation for that.
Second, my understanding was that these hearings were to devote
themselves to the long-range trends. And what I am referring to are
the long-range trends in the structure of market power and not
whether the degree of monopoly in 1976 when inflation abated was
more or less than the degree of monopoly power in 1974-75.
I am referring to the long-range trends which are very well documented in numerous studies which I have cited in my report. What
happens when you have a concentration of market power is that
whoever has the market power, whether it would be 1 firm or 15
firms, can set their prices to facilitate whatever the particular corporate
objective might be. And that might vary from increasing market
share to increasing rates of return. And it might change from year to
year or from 5-year period to 5-year period.
But basically, they can control what happens to prices more or less
irrespective, and I would qualify that, to the state of demand. We saw
that very graphically during the severe contraction, of 74-75 when
demand for automobiles absolutely plummeted, and the response of
the automakers was to raise prices very substantially, I believe something in the order of $1,000 over the course of 18 months because their
calculations showed that that was the way in which their profit targets
would be achieved.
Representative BOLLIXG. Did that work ?
Ms. NULTY. It sure worked.
Mr. SPKINKEL. It encouraged imports.
Mr. CAGAZST. Mr. Vice Chairman, I want to take very strong exception to the proposition that inflation is a problem of market concentration. I have studied this question extensively. I presented a discussion of this subject on April 25 to the Senate Antitrust Subcommittee.
They were concerned with mergers, and I testified about the relation of
mergers to the inflation problem.
There have been many studies on the question to what degree does
market concentration cause rising prices ? I want to present you with
my present conclusion, which is based on all these studies including
the most recent work that has been done.
If you look at price increases across industries in the United States
and compare them with the degree of concentration of those industries, there has from time to time been a relationship. It used to be
thought that the more concentrated industries raised prices more. You
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may remember that Gardiner Means talked about that in the 1930's,
Subsequently, it was discussed very much in the 1950's.
But, when you allow for costs, as you have to do, and examine the
residual effect of concentration on prices, it turns out that, by and
large, there is no relationship at all. In many years, there is a negative relationship; that is, those industries in which concentration is
highest have less of a price increase. But, by and large, my conclusion
would be—especially in the past half decade when inflation accelerated—there is essentially no relationship.
What is the explanation for this? The explanation is that the
setting of prices by firms so as to cover costs without much response to
shortrun changes in demand is characteristic of practically the entire
economy. The only place where you don't observe this behavior is on
commodity exchanges for agricultural products and basic commodities.
Generally speaking, retail and wholesale trade and the entire manufacturing sector—especially including wages—exhibit such behavior.
Prices are set to be more or less about right for the long run. When a
sudden change occurs, as with recession or a sudden increase in aggregate demand, prices sail along at the same rate to cover costs—or, for
wages, the cost of living. Prices eventually adjust to demand over the
long run, but I think you will find there is no difference between concentrated industries and other industries in this respect.
If we try to cut down the concentration of various industries—which
is practically impossible, since we would have to tear the economy apart
to do it—there will still be no effect on the dynamics of inflation or the
propagation of price increases across the economy. Concentration is
not the source of our inflation problem. Our inflation problem is one
of pressuring the economy too often and too far into an overexpansion
of demand.
Since we tend to be able to focus effectively on only one issue at a
time in this country, we should focus public attention on inflation,
which the polls say is the No. 1 problem for the public, and convince
Congress that this is where they too ought to concentrate their efforts.
We did it in the late 1960's. We had a creeping inflation that everyone said we could never get rid of. Gradually, painfully, it went
away. And in the early 1960's we then enjoyed the benefit of a growing economy without inflation.
We simply let inflation start up again in the middle 1960's. But
now, after years and years of wishing the problem would go away,
it is time to focus our national attention on this problem again. If we
do so, I think it can be solved.
Representative BOLLING. The thing that bothers me about the discussion so far is that we have got two different things going on. One leaves
out, in essence, social consequences which then are turned very rapidly
into political consequences. And the other doesn't leave it out, but it
does not, in effect, play back the social consequences of inflation itself.
And we have got two sets of problems, it seems to me, that we have
to deal with. We have to recognize that the social costs of the relevantly
simple approach to dealing with inflation in a major way are so hifirh
th at we are not really talking about reality.
There are some politicians, except the extreme conservatives, and
there are some of them around now that weren't around before the last
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election, Republican or Democrat, moderate conservative or moderate
liberal, who are going to sit still when there is a very high unemployment.
Now, we haven't developed the techniques for dealing with the
structural unemployment that exists in terms that are satisfactory
to a majority. I am not talking about a majority of the people; I am
talking about a majority of Congress.
Fairly consistently, right or wrong, the minimum wage has gone up.
It may or may not have an overall bad effect. I have been worried about
it for about 30 years. I have never been sure which was correct, the
conservative argument or the liberal argument.
It worked pretty well in the 20 years after 1946. But we were talking
about some solutions that just aren't going to happen. Mr. Nixon, Mr.
Ford, were no more likely to use them than Mr. Truman or Mr.
Eisenhower. So we have to try to figure out as a people some kind of a
compromise that will pull together a viable program.
Now, we came up with a compromise like that once, and it was
remembered largely by the business community. And that was the
Employment Act of 1946. That was the first time that the people of
this country ever, through their policymakers, made a specific decision
that the Federal Government was going to deal with its responsibility
in affecting the economy.
I think that clearly that is no longer an adequate generality. We
have to find some more. I don't know if they have to be more specific,,
but we have to have a different policy mix.
And the curious thing about that is we never seem to be able to join
the debate because the policy mix has to be acceptable both to business
and to labor. Thus, it lias to become acceptable to a political majority.
How do we get that ?
Mr. SPRTNKEL. Well, I agree that it is too much to believe or even to
wish. And I would not suggest that the Congress, the Federal Reserve,
and the President should just sit still and let unemployment grind up
to massive levels. No free society should permit that to happen. And
this one will not permit that to happen.
However, there is another way to say you can't approach a solution
of an inflation problem because of recurring recessions which is to sort
of say we can't learn from the past.
We have learned, I believe, over the past 15 to 20 years that the
policy of massive response with massive growth in the monev supply,
large deficits, does indeed in the short run pull unemployment down
and raise employment and all those good things that all of us want,
but we overdo it.
We forget that the more we stimulate, inflation will accelerate with
a lag. So far as I know, the best data show that a rapid increase in the
money supply will not cause inflation today or tomorrow. It will be a
year and a half or 2 years from now. And if we always opt for the
quick fix, the short-run solution, we suffer inflation in the longer run.
We are not dead. We are here today. And we are in that long run,
suffering from the massive stimulus over the past 2 years and before.
Representaftive BOLLIISTG. Let me get at that. The man who in this
committee raised the question of dealing with unemployment with a
rifle instead of a shotgun, with micro rather than macro, was a Repub-
98
lican conservative named Curtis and a friend of mine. I have seen him
relatively recently.
The dilemma with the solution that is implied, and I think really
more than implied, stated in your prepared statement, is that we can
all agree that if we could be a little bit softer on the macro end and
didn't pour in so much general effect, we would have to be a good
deal stronger on the micro end and have to deal very specifically with
the structural unemployment of young blacks.
But the dilemma is that when you get in it politically, obviously,
that is what I am looking at, and try to get the votes for it, precisely
the same people—I am not saying you would or that anybody in the
room would—who argue that you can't do the macro things to excess
will say, no, you can't afford the money to deal with the problem.
Now, that is going on right now. And if I wanted to, I could
name the groups that are doing it. It is absolutely fascinating. We are
given solutions, but we have no way of getting them implemented because we don't have the compromise between the major groups to the
contest. We don't have the compromise that makes it possible for us to
get viable majorities.
And in this society, when you talk about policy change, you are talking about getting majorities in very specific places.
Ms. NTJLTY. Congressman, I wonder if I could make a comment on
that because I have in the past worked quite intimately at a very micro
level on the problem of job creation and rifle policies for employment.
And while my views are not firmly fixed, I have been exploring certain
ideas in this regard.
One of the tilings that has bothered me whenever we talk about
rifle policies and targeted unemployment policies, we look at who the
job holders will be, and we don't look at the kinds of jobs they are
going to do and what the secondary effects of the Government expenditure on those j ob programs are going to be.
They are very short-run, narrowly focused, envelope-stuffing-type
programs that are basically getting them off the streets and keeping
the violence down.
That is in my opinion what has really been behind all these targeted
job programs. And that being their nature they are ipso facto doomed
to f ailure. I think there is a bridging position.
Eepresentative BOLLING. YOU are not telling me they are worse than
nothing?
Ms. NULTY. No, I am not. But one thing you should bear in mind is
that, especially if you are talking about minority youth—minority
youth have been solving their "unemployment problem" in a very
interesting way by disappearing from the labor force. And in fact, if
we hadn't had a decline in labor force participation rates among
minority youth recently, our unemployment rates would be very
much higher than they are at the moment.
But to bridge what Mr. Sommers has said and to get back to your
earlier question on government regulation, I think there is a tremendous harmony potential, harmony of objectives, between curbing inflation and creating jobs through a targeted capital formation program.
And I would like to see it focused in these four sectors where they will
have the most immediate impact on ordinaiy people's experience of
inflation.
99
Because, as I see it, you have killed several birds with one stone this
way. In my prepared statement, I used the example of a massive solar
energy program.
Representative BOLLING. A la Barry Commoner ?
Ms. NTJLTY. I can't speak to Barry Commoner specifically, but solar
energy development in all its forms combined with massive public
transportation policy in all its forms which gives you a tremendous
public commitment to highly productive capital formation which increases consumer choice on the demand side and, therefore, gives you a
lot more leverage, basically disrupts existing market^ power in the
energy sector, at the same time using a very job-intensive vehicle for
doing it.
There are a tremendous range of policy options that 3^011 could go
with in order to implement this. However, what we see coming out of
appropriations decisions are absolute peanuts for solar and mass
transit, and billions for capital-intensive high-risk technologies like
nuclear power.
In fact, when it comes down to making a decision, the decision that
is taken at the micro level is one that is going to promote stagflation
rather than the opposite that could potentially jointly solve both the
inflation problem and the jobs problem.
Representative BOLLING. Does anybody want to comment on that?
Mi\ SPRINKEL. Congressman Boiling, you spoke of the necessity
of financing job-creating opportunities. Obviously, it doesn't cost much
to reduce the minimum wage. It may be politically impossible, but I
believe, in incentive systems—it works out there if we give it an
opportunity.
I have read numerous stories, as you have, especially in the fast foods
industry where we are forced to lay off youngsters after the rise of the
minimum wage because it was not profitable to hire them. So that is a
very low-cost operation.
Second, I am not an expert on Government efforts to create jobs, but
I talk to experts. And I get some of the same impression Ms. Nulty is
referring to—namely, you train them to do something where there is
no job later on. And it doesn't help them.
So it seems to me the alternative—and we are doing some of that,
and I would like to see us do more—is to create incentives for the
private sector to hire these low-talented people, give them training,
make them more productive, so that they will qualify for wages well
in excess of the minimum.
They don't even get a crack at it under present circumstances. They
remain in the unemployment camp. And some of them drop out so you
don't even measure them. I think that is a tragedy. We should utilize
the same motivation that you and I have and encourage them to be
trained and qualified for higher rates of pay.
^ Ms. NULTY. Mr. Vice Chairman, if the minimum wage, the rise in
the minimum wage, had had a significant effect on job opportunities,
one would have expected to see the results in the lower wage sectors of
our economy. And as I said earlier, in fact, it is those sectors of our
economy that have been growing the fastest in terms of providing
employment opportunities.
So I think there is a problem there of determining just what the
correct relationships between the cause and effect are.
100
Eepresentative BOIXING. Mr. Sommers.
Mr. SOMMERS. Mr. Vice Chairman, I have always wondered what
the resistance is to a higher level of public construction activity than
the level that we now experience, because construction has a labor input
that could be very useful in these circumstances. There is a great deal
of relatively unskilled and semiskilled labor required in construction.
And the usual response is that while you get started on a public
works construction program, and it goes on and on, and you can't turn
it off, when the system gets heated up again, I have never felt a great
deal of conviction about that.
There is no reason why a whole arrangement of public construction
of varying periods for completion couldn't be developed. And there is
no reason why if we get overheated, it would have to be the public
construction that would get cut back anyway.
There are other ways of absorbing such circumstances. But the result
is that public construction is a very small industry in the United States,
and the opportunities, I think, are really large.
Mr. SPRINKEL. Mr. Sommers, as I am sure you are aware, you argue
for more Government spending which always results in larger deficits.
How do you propose tofinancea massive increase in Government expenditures without either creating more money or by increasing the
disincentive to private investment ?
And I agree with the committee's report of some weeks ago that we
have underestimated the supply effects. We create disincentives and
wonder why it doesn't happen. It seems to me that moving toward
massive Government capital formation is not a free good. It has got to
come from someplace. And it is going to either result in more inflation
or less resources for the private sector which I think is at least as
efficient as the Government sector. And I believe more so.
Mr. SOMMERS. Well, a "massive" is your word, not mine. There
is a matter of degree involved here. And anyway, the potential for
restricting the transfer payments through public works construction,
I think you could get a rather substantial offset in a large number of
transfers that now dominate the Federal budget.
If there were a residual excess, that would be a price we would be
paying to get at this unemployment problem which I think we all
agree, you agree, has to be gotten at. It promises more effect than most
of the other ways I know with a moderate cost, with an offset in transfers, and with some real useful output. We have about 30,000 or 40,000
bridges in the United States that have to be crossed very carefully now.
I think a Representative from Pennsylvania has recently introduced
a bill that would partly subsidize die interest cost of municipal issues
directed at public construction. I think that deserves to be looked at.
Eepresentative BOLLING. I remember a long time ago when we were
first working on the interstate highway program foreseeing a little bit
how much it would mess up some cities, perhaps including my own, a
great many communities, but opting in favor of what wefinallyworked
out after 2 years of attempting to compromise of a program that
Eisenhower would accept and we would accept, and opting in favor
of it for exactly the reasons that you outline.
It was a way in which to get a public good broadly effective to the
society. It was certainly not my first priority. There were a number of
others. But it was a way to get a public good at the same time as one
provided an enormous amount of employment.
101
In those days, a good deal more than you would provide to relatively
unskilled people.
But I would like to get some of the staff involved in this. I have
gone on at some length, and you have gone on at some length. I would
like to see if the staff have questions.
Mr. Albertine, you are the leadoff man.
Mr. ALBERTINE. I have one question for Mr. Sommers. How do you
reconcile the notion that we have very little cyclical unemployment,
that perhaps we have been reaching the point of skilled labor shortages, and your call for a substantial or some increase in public works
appropriations, public works projects?
The administration last year tried to organize a so-called soft public
works program. And it ran into enormous difficulties, mostly from
industry people who argued that it was just terribly inefficient use of
public facilities.
I would ask you how do you reconcile the two issues ?
And also with respect to the question of the time period, as I recall,
the Emergency Public Works Act of 1976 was passed sometime in the
middle of 1976.
So-called round one, I believe, was a $2 billion expenditure.
Then, in 1977 we had a $4-billion additional expenditure or round
two.
Here it is in 1979. I don't know the figure, but it seemed to me we
still have something on the order of about $2 billion that is yet to
have been expended.
Mr. SOMMERS. I was thinking of a perpetual reservoir of projects,
not an on-again-off-again countercyclical device, and on reconciling
this with the view that I offered you about the scarcity of skilled labor
now.
I think we are facing the fact in this meeting that the United States
has a discontinuous labor force. It is an education-efficiency-training
relationship to the real world of jobs out there. Employment moves
along just great up to 94 percent of the labor force. Therefore, it tails
off very rapidly.
I intended my suggestion really to be the equivalent of a targeted
unemployment effort.
Mr. ALBERTINE. SO we are advocating something along the lines of
some sort of soft public works program that the administration proposed in which you would try to engage large numbers of basically
unskilled, untrained, construction industry individuals on the projects.
Again, I am confused.
Mr. SOMMERS. I don't know about "soft." I was thinking about
rather brittle public works—bridges- and roads.
Representative BOLLUNTG. Railroads, maybe.
Mr. ALBERTINE. I am still confused about where you get this skilled
labor force to do those massive and very capital-intensive construction
projects. If we are at the point of having labor shortages in that
area, how does that help us structure employment?
Mr. SOMMERS. That is true, there are only a limited number of Cat
diesel drivers, although a lot of the people we are talking about could
learn that skill as well as a number of other construction skills. But, on
input of unskilled labor, there is an awful lot of slogging and carrying that goes on in every construction project.
102
Now, in an overheated time, I suppose it is inappropriate to start
on this idea. But as a long-run way of maintaining the system's infrastructure which has productivity implications, I (think, for the private
sector as well, and of an ongoing source of jobs from low to semiskilled, that, I think, is a long-run continuing opportunity.
Ms. NuiiTY. Can I suggest something ?
Representative BOLLING. Sure.
Ms. NULTY. You know, we hear a lot of discussion, not only this
morning, but in this whole economics realm about finding the right
incentives for the private sector. I would like to suggest that one of the
best training incentives I could think of would be a skilled labor shortage and that if industry has the demand for its goods and services that
it wants to fulfill, it will find ways of training the people it needs. It
has done so in the past.
So that I really wouldn't be too concerned about that as a bottleneck.
In fact, I look at that as a tremendous opportunity that we should—
perhaps that might be putting it too strongly, but we should encourage
the creation of labor shortage if, indeed, we want to upgrade our labor
force.
The labor market segmentation that wefind,I believe, is not inherent
in the personal characteristics of the people at the short end of the
stick, but rather the effects of discrimination and other kinds of social
barriers that have kept them out of apprenticeship and trainee programs in the past.
But if there is a real need for people, they will be brought in.
Representative BOLLING. Mr. Krauthoff.
Mr. KRAUTHOFF. Mr. Sprinkel, you mentioned indexing in terms of
taxation. There has been, as you know, increasing talk of indexing and
some study of it. Aren't you afraid that once you start indexing that it
is difficult to stop ?
What do you think of indexing in general ?
Mr. SPRINKEL. In general, I think it is an excellent idea. And I wish
we would pass that law. I understand that has been debated.
If we have no inflation, which is what we all want, indexing isn't
going to affect the tax system. The only way it has an effect is when
you have inflation.
We sort of had the worst of worlds in recent years—namely, we
wouldn't index, and we kept saying stable prices were just around
the corner. Yet, we pursued policies that make inflation worse. It has
two major effects.
No. 1, as inflation accelerates, individuals, if they are lucky enough
to keep up with inflation in terms of their income, move into higher
brackets, and they pay a higher percentage of their total real income
to Uncle Sam. Corporations do it the same way in the sense that
original cost depreciation becomes less and less realistic.
And they also have profits from inventories which are transient, but
reported as income. The inflation results in paying more tax.
The effect of revenues rising is to stimulate Federal spending. That
is the way the political system works. I understand why it works that
way.
For any one of us out there, any $1 billion expenditure isn't going
to make much difference in our taxes. And I don't want to come down
here and tell you why it is a bad thing. But those who have vested in-
103
terest In that $1 billion expenditure are down here lobbying the Congress. And it is sold as in the public interest.
So, No. 1, without an indexing tax system, Government spending is
encouraged unnecessarily.
And, No. 2, it unduly restrains the incentive to save and invest.
We could well debate why we want more growth but the hearings
imply you do because you are unhappy about slow growth. Then, you
cannot continue to increase the disincentive to savings and investment.
And that is exactly what happens in an unindexed tax system at a
time of accelerating inflation.
I don't believe an indexed tax system causes inflation.
Mr. KRAUTHOFF. YOU don't believe it would lead to indexing across
the board, maybe not all the way to the Brazilian example, but one
index does lead to another in terms of equity.
Mr. SPRINKEL. The only indexing I would like to see is the tax system and savings bonds. It is unfortunate that savings bonds, which we
encourage people to buy, have been a massive ripoff of the poor saver.
I am perfectly willing to let the marketplace take care of the rest
of the indexing, and that is what happens.
In fact, when inflation accelerates, wage payments on average go up.
This is why you can't stop wage increases at 7 percent with a 10-percent inflation. You find all kinds of ways to bend the rules and pay
10 percent or 11 percent.
Interest rates in the marketplace, not because of the law, begin to
anticipate inflation. Now we have great corporations paying 914, 10
percent for their money.
Most of the markets will automatically account for inflation. They
index for inflation. There is no way the market can index a savings
bond and the tax system. The Congress alone can do that.
Representative BOLLING. It has occurred to me that in the various
statements, everybody seems to agree that at least we come very close
to seeing to it that—and I know that this is not completely accurate—
some people are saying that we are paying people not to work with
Government funds in effect by taking away their incentive to work.
I hear that as an interpretation. So in effect, we are paying people
not to work by taking away their incentive.
Now, why then would it be such a terrible step to take. I am not
talking about the disabled because I know there are a great many people
out there that are disabled who have to be supported because they can't
work. So why wouldn't it be better for us to figure out some way—sort
of by trading between the conservatives and the liberals—the business
and the labor community—to go ahead and just pay them directly to do
some work that may be at a slightly higher wage than we would have
otherwise done it to do some work for Government projects or Government-developed joint projects?
You know the irrationality of what the private sector does with a
great deal of Government subsidy is illustrated by transportation. I t
is no mystery that the public has paid for all transportation over time
in one way or another, starting out with railroads and barges or barges
and post roads, coming along with railroads, coming along with all the
modern devices.
The public has paid for that, not the private sector. And if it hadn't
been for the public paying for those things, we wouldn't have had an
104
opportunity for private sector to be anything like as effective as it has
been. It is the entrepreneur.
I mean, when we were an underdeveloped country, we were in pretty
bad shape. As we developed, we got the infrastructure. But why can't
we anticipate that kind of a situation? If not with Ms. Nulty's—and
I am not saying necessarily it should not be—solar and mass transit,
with the whole range of different things, what would be wrong with
that?
Why wouldn't that be to the advantage of everybody involved,
including the free enterprise system ?
Mr. SPRINKEL. Well, I personally have more confidence in the
market system making the judgment as to where the payoff is going
to be than I have in the political process in those kinds of activities.
Representative BOLLING. HOW about on transportation?
Mr. SPRINKEL. On transportation, we started out regulating the
rates that railroads could charge. And it has been a disaster. Who
is to say what would happen to mass transit under Government
sponsorship ?
Representative BOLLING. It didn't start out that way. What kind of
disaster did we have in the railroads before we had any regulation?
Mr. SPRINKEL. Well, I know what the history books alleged. I was
not there.
Representative BOLLING. OK, I won't push.
Mr. SPRINKEL. In fact, we had capitalflowingin from foreign countries, especially the United Kingdom because the rate of return was
very high. And they were willing to spend the money to try to improve
our infrastructure,
I have great confidence in the American system allocating the resources where the rate of return is the highest. I have very little confidence of concluding today on the basis of present knowledge that
solar energy is going to be our solution. It may be, but if so, it should
support itself. We need not have massive Government outlays to arrive
at that conclusion.
Representative BOLLING. Don't forget those alternate quarter sections we gave the railroads.
Mr. SPRINKEL. I read about that, too.
Mr. KRAUTHOFF. The United States defaulted on those first bonds
about 110 years ago and it was a massive default.
Ms. NULTY. Mr. Sprinkel, could I just inform you that every other
energy sector, all the other energy sectors combined—that is to say,
fossil fuels, hydropower, nuclear power, and electricity generation and
transmission, have received $217 billion in public subsidies over the last
30 years.
Mr. SPRINKEL. I suspect your numbers are correct. I am also very
well aware of the fact that we have had price controls on gas and oil,
going back into the fifties on gas, on oil at the beginning of President
Nixon's price controls. We have refused to create incentives to conserve.
We have refused to create incentives to produce. And now we wake up
with a shortfall, and the only way to relieve it is import it from abroad,
which makes us vulnerable.
Representative BOLLING. I don't want to have to do this, but I am
going to have to go. I am going to leave it to you if you want or Lou
if you want. I will leave you in charge.
105
But I would like to say that I am more than ever convinced there
is only one solution with this economic dilemma. And despite your
reference to the private sector, I think it is a political solution. There
has got to be a new treaty. It has got to be worked out because otherwise, we will spend the rest of our lives in this Congress and in the
country, each interest fighting bitterly for its own 100 percent when it
is unattainable, and when the best we will ever get is probably 75
percent for each interest.
And there will be some kind of a compromise. That is the way it
worked for 20 years pretty well. And it hasn't been working very well
in the last 10 or 12 years. Somehow or other, we are going to have to be
able to arrive at that. And I think it is going to be sort of fun if we
can get Ms. Nulty and Mr. Sprinkel to come up with a compromise.
With that, I thank you and leave it to Mr. Albertine.
Mr. ALBERTINE. Are there any policy prescriptions that would bring
i^ou two together? If you were an advisory board to the Joint Economic Committee and Chairman Bentsen and Vice Chairman Boiling
asked you to come up with a convenient prescription for controlling
longrun inflation, could you do it ?
Ms. NTJLTT. Let me just say one thing. I am all in favor of using
incentives where it can be unequivocally demonstrated that those
incentives work efficiently and accomplish their aims.
The only question that I am raising is whether the kinds of incentives
that have been used in the past are in fact efficient for the purposes
we set ourselves at the present. I would just like to say, you know, any
given program I suggest should be judged on its own merits by that
standard. I do not come with any preconceived notion of whether
there is possibility of compromise or not. I just think on any given
issue, one has to look at its merits.
As long as we all agree that we have to judge the efficiency of a policy
by its behavior in the past, I just feel there is a lot of controversy in
some of these areas that certainly can't be resolved this morning, but
at least should be discussed in those terms.
Mr. ALBERTINE. Mr. Sprinkel.
Mr. SPRINKEL. I listened very carefully to Ms. Nulty's testimony.
I have not read her paper. There needs to be much more discussion
as to why inflation was a bad thing. And I certainly agree the poor do
get hurt worse than the rest of us. And that's why it is so critically
important to get inflation under control.
And I listened very carefully for solutions from her testimony, but
the only suggestion I heard was that inflation was caused by market
power, and we have been through that argument.
I think there is no evidence supporting that point of view.
And second, she critized the present control program, suggesting
it should be more general. I know of no control program of inflation
that has worked if officials arbitrarily set lids on prices and wages. And
this one clearly isn't working.
And to make them more massive and mandatory will create additional problems. So I am not certain what her solution would be.
Ms. NXJLTY. No, I am sorry, I did not suggest a controls program, a
massive general controls program. In my paper, I used the energy
sector as an example of what some options were, and they involved
operating on the supply side as Avell as on the demand side.
106
Now, on the demand side, I said that what consumers need is greater
diversity of choice in the forms in which energy is consumed. Energy
is an intermediate product for consumers. They are concerned with
the final services energy provides—heating, cooling, transportation, et
cetera.
What I suggested was that a massive public transportation program
would reduce not only consumer, but national economic dependency on
fossil fuels because it is demonstrably more energy efficient.
This would create some discipline on the market on the demand side.
A similar point was made with respect to solar energy from the
demand side. On the supply side, I suggested in my prepared statement, although I haven't presented it for formal discussion, a Federal
fuels corporation which would not need to expropriate any existing
private property, but would act as an intervenor in energy supply
markets by developing resources on public lands which are quite
significant in terms of total energy supply and probably could become
more so under public aegis, undertake buffer stock operations again
to exert market discipline on the supply side and be well positioned to
negotiate bilateral trade agreements which would provide a mechanism
for reducing the impact of energy price increases on the general balance-of-payments problems which has an inflationary effect in our
country.
So that I have a number of programs that were not suggested to
be comprehensive solutions to our inflation problem. Don't misunderstand me. I am not tryingtooversimplify the issues. I am simply giving
examples of the way in which public policies can intervene to break up
existing market relationships and widen the option of choice on both
sides of the market relationship.
Mr. ALBERTINE. I think we should give each of our staff people one
shot, starting from my right, Mr. Bartel.
Mr. BARTEL. Three of our panelists seem to be concerned with the
large issue revolving about the distribution of national income, in the
short and long run, on the one hand, and on the other hand, the role of
investment in the economy, and the necessity to increase the rate of
investment and the share of investment in GNP, if we want to expand
the economy in the future.
I would like to ask Ms. Nulty how, in her vision of the long-run
future, she would stimulate investment and yet at the same time try
to avoid a reduction in the share of national income that would go
to the household sector and continue to sustain the growth in their
economic well-being ?
It that too large a question ?
Ms. NULTY. It is a rather large question, and I am sure you don't
want an hour-long answer even if I could do it which I probably can't
on short notice like that.
But I think that you basically have a problem of deficient markets.
I have been really quite surprised to hear that the inflation that we
have just been through has been the result of excess demand when all
the figures you can see, at least for 80 percent of the population, has
been falling consumption levels. And there has got to be a way to
resolve that paradox.
I feel that the private sector will invest as long as there is a market
for its product.
107
Now, if the market system is not generating the correct demand
signals to call forth the kind of investment that we think the economy
needs, I see no reason why the public sector through its expenditure
potential should not be in a position to create that demand. If we take
my examples of mass transit and solar promotion, those are two avenues
that would create tremendous market potential which at the moment is
having a lid kept on it. And I can tell you why the lid is being kept on it.
Because the private companies that have started to undertake solar
development don't want to see massive public subsidies that would
let the little guys get a crack in before they can sew up the markets
for themselves.
Now, General Electric, Mobil, Exxon—the list is endless—the top
segment of the Fortune 500, have been buying up solar development
companies as though there were no tomorrow. And yet, we do not see
any outpouring.
We know from various scientific and technological studies that
photovoltaic technology, which perhaps over the long term the most
promising solar technology, is virtually at the point of commercialization. And what is holding it back is a lack of sufficient market demand.
Here is an excellent opportunity for the Federal Government to go
in and create the market that would call forth the investment that
would create a photovoltaic industry in this country which does not
now exist even though the technology exists.
This is the line which I take.
Mr. ALBERTINE. George Krumbhaar.
Mr. KKUMBHAAR. I found these prepared statements extremely interesting. And I am trying to tie them together and find out where
they differ and where they might coincide.
Let me first remark, Ms. Nulty, I am interested in your analysis
of market power and at times observe it myself. When I pay much
more for an automobile than I think it is worth, I grumble about the
automobile companies, saying they have so much market power.
But it works the other way around. I notice, for example, that in
the past 5 years, the cost of babysitters in Washington, D.C., has gone
up by 100 percent. In 1974,1 paid a sitter 75 cents an hour. And now
they get $1.50.
So there must be something more than market power at work. Therefore, I am attracted to what Mr. Sprinkel has drawn our attention
to the fact that the average rate of inflation is going up, arid this is
what we should be worried about.
And I am also attracted to what Professor Cagan calls the basic
momentum rate of inflation, how this changes veiy slowly, and that
once you have it at a high rate, it is a very difficult thing to get rid of.
The problem with the questions raised, or the difficulty with the
questions raised, by some of the testimony is that while acknowledging
that there is a kind of basic momentum rate of inflation or high average rate of inflation, I see this as a profound change which has come
about in the last few years.
Nevertheless, some of the testimony shows, I think, a "there has
been no change" type analysis. For example, Mr. Sprinkel, you say
inflation is and always has been primarily a monetary
phenomenon.
That, to me, reflects a "there has been no change'7 type analysis.
Mr. Sommers, on the other hand, says that such a statement is a
partial truth and misleading.
108
So my question is this: I would like you to get behind your statement, Mr. Sprinkel, that inflation is and always has been a primarily
monetary phenomenon, get behind that statement to tell me why, if
it is just a monetary phenomenon, has it kind of cracked in the last
decade as our control of monetary aggregates has gotten out of hand?
Is it a social phenomenon we are facing that forces the monetary
authorities to lose sight of monetary targets? Is it a fault of policy
that they have their eye on interest rate targets rather than monetary
aggregates ? Where is the change ? Because there has been a change.
Mr. SPRINKEL. Well, the reference to inflation being a monetary
phenomenon relates to a lot of research that has been done. I published
a book a year and a half ago which computed rates of growth in the
money supply, per unit of output for a large number of countries
over a long period of time.
In my prepared statement is a chart for the United States from 1915
to now. I know of no case where inflation sharply accelerated over a
considerable period of time that was not preceded by accelerated monetary growth. I know of no case in which a country pulled its inflation
down over a number of years that was not preceded by a slowdown in
money growth.
Switzerland and Germany are two good examples of that. They
typically have low rates of inflation except back in the sixties, their
money supply got out of control, and so did their inflation. But they
promptly brought it back down. That is what we haven't done. We
just kept going until last November.
So I don't think that is new. We have got evidence back in Roman
days, we have evidence during the height of the Spanish Empire
when they were importing gold into Europe. In all cases, more money
causes more inflation.
Now, there is a sense that Al mentioned in which too much money is
a half truth, but not the whole truth. That is wliy did the money
supply get out of control ? And I suggested three reasons in recent
times. And I said there may be more, and I'm sure there are.
In a highly technical sense, you can say that the Federal Reserve has
the wrong operating technique. I can say that because the technique is
ingeniously designed to create excessive monetary growth during
periods of strong business and not enough during periods of weak
business, monetary policy destabilizes the economy.
It need not be that way, but that is the way they do it. But more
fundamentally, I think is the pressure to do things with Government
spending and the unwillingness to tax to pay for it. We think more
Government spending is a free ride.
It is not a free ride. We are going to pay, the American public is
going to pay one way or the other. And we pay with deficits, and those
deficits can have two kinds of costs. One of them will be inflation if we
finance that deficit with new money. And we have done at lot of that.
But it also drags private capital formation if you finance it out of
privately generated savings. So I don't think that is new.
The only thing that may be new is our unwillingness to pay or our
belief that deficits are not bad things.
Keynesian economic texts have taught us for 40 some-odd years that
deficits are good things. What I am saying is they are bad. They either
create inflation if you finance with new money or they create a drag
109
on private capital formation if you absorb them, if you finance them
by absorbing savings.
So I don't think that is new either. Just because Keynesian texts say
something different doesn't mean it is true. I really don't believe that
the laws of economics have been repealed. We have got a lot to learn
from history, not only in our case, but in other countries. And I look
at that evidence, and I still conclude that inflation is primarily a
monetary phenomenon.
That is an oversimplification, but that is the one most important
simple statement I can make about inflation.
Mr. SOMMERS. You know my protest to that from the copy, but I
don't carry that dogmatic view about the consequences of budget
deficits. The financing of those deficits is not necessarily at the expense
of the capital formation sector by any means.
As a matter of fact, the past couple of years, there has been abundant
supplies of funds available to the capital sector. The heaviest borrowers
in the United States have been the private sector, and the heaviest
among the private sector has been the household sector which is simply
gobbling up American capital at a fantastic rate.
In West Germany, they rim a budget deficit that is about double
ours now. Japan is running a budget deficit that is four or five times
ours. But they finance it with private saving.
And one of the reasons is that the credit extending sectors of those
economies do not simply dump credit on consumers the way we do
in the United States. We have had a lot of discussion today about the
disappearance of the American living standard and the decline in real
income and consumption. I disagree with most of that.
We are consuming at a simply enormous rate and saving in the
household sector at a very low rate. And I don't believe the figures
that suggest that on average, American families are worse off now
than they were 10 years ago. That is certainly not true of the real personal consumption measured in the GNP.
A great deal depends on what you want. There is no sense having
a lot of roads and no cars. And there is no sense having a lot of cars
and no roads.
Ultimately, a public decision about what this society wants and
needs ultimately dictates the spending rate of government. And if we
run a deficit to produce more roads while consumers reduce their automobile outlay for a while and provide the saving to finance the deficit,
I am not saying that is a good or bad tradeoff. It cannot be ruled out on
logical grounds as being inefficient or uneconomic.
No sector of this sj^stem really pays its way as it goes. The aggregate
debt rises a little faster than GNF, This is the long-term history.
The explosion of, debt in the postwar years has not been public
debt; it has been private debt. When we started the postwar years,
public debt was 85 percent of total public and private debt. It is now
about 15 or 20 percent. The massive growth has been in corporate debt
and in individual debt.
I mentioned earlier that I don't see a prima facie case for simply
ruling out additional powers available to the part of our credit system
to deal with what would appear to be for the time being a starvation
of private capital formation in the presence of an enormously high
rate of private and particularly household debt.
51-421—79
-8
110
Eight now at this moment, the government sector in the United
States, including State and local as well as Federal, is in balance. The
debt in the household sector is rising at $170 billion a year, and business debt at $120 billion a year. Again, it is not a prima facie case that
it is government debt that is doing all of it.
Ms. NTJLTY. I am not a monetary economist, and I would be interested, and this may not be the appropriate venue, but it strikes me
there is some merit also in looking into the new credit instruments
that the private banking system or new financial instruments that the
ibanking system itself has created.
I have certainly got the impression from banking surveys I have
read in the London Economist and Business Week that the influence
of the Federal Reserve Board and Government expenditure must by
its nature be reduced by this tremendous outpouring of private
commercial paper, all kinds of new instruments that both the manufacturing corporate sector and banking sector have been able to create
which are completely outside public control as far as I can determine.
Mr. CAGAN. May I briefly respond to the general nature of this discussion and the vice chairman's request that a consensus be developed?
I am concerned that in discussing inflation, because of the broad context of the committee's purview, all sorts of things are brought in at
the same time. The question of slower growth in the economy, the effect
.of taxes on energy and public investment—these are important issues
and should be discussed. But—I support Mr. Sprinkel here—these are
not problems of inflation* through it probably exacerbates them. I
would like to see a consensus develop around the point of view that,
while we have a lot of problems, inflation is No. 1.
We should say that, no matter what else we do about everything else,
we are going to do something about inflation; thus, while we will do
something about unemployment, develop our manpower programs and
do a lot of things, our No. 1 objective is still to subdue inflation. That,
I think, is what is necessary to deal with inflation. If we did start making inroads against inflation, a lot of these other problems would appear to be much less important than they are now.
Mr. ALBERTINE. I think the final word should go to the new director
of the special study whose responsibility is to pull all this togther. And
he has done an outstanding job of setting up these hearings.
I would say specifically to Professor Cagan, the 1975 annual report
.of the joint committee was endorsed by every member of the committee which did in fact say inflation was our No. 1 problem.
Mr. CAGAN. I'm sorry I missed seeing that statement.
Mr. ALBERTTNE. Mr. Krauthoff.
Mr. KRAUTIIOFF. All I want to say is thank you very much for a very
interesting morning.
And we may not have solved the intractable problem, but I think we
are getting it more into focus. And we certainly are going to keep working on it.
And we will be keeping in touch with you. And the next time we get
together in our current endeavor will be on Wednesday morning.
We have a room change. We are going to be in room 5110 on Wednesday morning. And we will meet at 10 a.m.
The committee stands in recess.
[Whereupon, at 12:25 p.m. the committee recessed, to reconvene at
10 a.m., Wednesday, May 9,1 O^O.]
STAGFLATION
WEDNESDAY, MAY 9, 1979
CONGRESS OF THE UNITED STATES,
SPECIAL STUDY ON ECONOMIC CHANGE OF THE
JOINT ECONOMIC COMMITTEE,
Washington, D.C.
The committee met, pursuant to recess, at 10:20 a.m., in room 5110?
Dirksen Senate Offipe Building, Hon. John H. Rousselot (member of
the committee) presiding.
Present: Representative Rousselot and Senator Javits.
Committee staff present: John M. Albertine, executive director;
Louis C. Krauthoff II, assistant director-director (SSEC); Kent H.
Hughes, Paul B. Manchester, and George E. Tyler, professional staff
members; Mark Borchelt, administrative assistant; Charles H.
Bradford, minority counsel; and Stephen J. Entin, Mark E. Policinski, and Peter Turza, minority professional staff members.
Special Study on Economic Change staff present: George D.
Krumbhaar, Jr., counsel; Douglas N. Ross, senior economist; Richard
D. Bartel, economist; Margaret Blaszak, Michael J. Lockerby, and
Carolyn H. Crowley, research assistants.
OPENING STATEMENT OF REPRESENTATIVE EOUSSELOT, PRESIDING
Representative ROUSSELOT. I call the committee to order.
Senator Bentsen is indeed sorry that he can't be here. He suffers
from the problem that all politicians fear the most. And that is laryngitis. We are sorry that he isn't here to participate and thank each of
you for coming.
I have a fairly brief opening statement I would like to make on this
topic of stagflation.
This morning is the final day of public panel discussions on stagflation as part of the Joint Economic Committee's Special Study on
Economic Change. I might explain for those not familiar with the
special study project that it grew out of discussions with the majority
and minority members of the Joint Economic Committee and with the
leadership in the House and Senate.
We prepared a prospectus about 2 years ago which called for a
'31/2-year Study to identify the nature of major economic changes occurring in the United States and the world that may have rendered
ineffective the traditional methods for achieving aims of the Employment Act of 1946. On the basis of this prospectus, House Concurrent
Resolution 243 was introduced in the House and passed overwhelmingly, then was approved by the Senate by unanimous consent on
July 18,1977.
(Ill)
112
The underlying thesis of the study is that economic, social, political,,
international, and technical conditions have changed, and are still
changing radically. While the basic principles of economics still remain
to guidepolicymakers, the interrelationships between economic sectors
have changed, and business firms and households have altered their
market activities in significant ways. Thus, economic policj^, if it is to
be effective, must adopt to a new global environment.
Today, we continue our discussion of persistent inflation and unemployment, sluggish capital formation, and declining productivity
growth which our study addresses under the heading stagflation. The
recent statistics of both consumer and wholesale prices make us all
acutely aware of accelerating, double-digit inflation.
On the other side of the coin, U.S. productivity growth, according to
recent statistics, has not just slumped to zero, but has turned negative
in the first quarter of this year. Poor productivity growth means the
U.S. economy is not improving productive efficiency.
Higher wages are not being offset by higher output per worker.
Consequently, this spells more price inflation and even slower real
growth in output for the future.
How do we get that much-needed productivity growth? Investment
in capital goods, more modern factories and improved labor skills all
enhance our productive efficiency. Indeed, as indicated by the Council
of Economic Advisors, the drop in our rate of capital investment may
have shaved as much as half a percentage point from U.S. annual productivity growth.
The influx of unskilled and inexperienced workers into the labor
force, the rapid rise in energy costs, and a slowdown in innovation have
also cut into productivity growth. Overcoming these drags in our productive efficiency is not only a key to curbing inflation over the long
term, but essential to the growth of national income.
The American people can expect continued improvements in our
standard of living only with corresponding improvements in our productive efficiency.
I might add that the urgency of our stagflation problems this year
led to an important consensus among Democrat and Republican Joint
Economic Committee members and the first unanimous report in 20
years.
The committee's annual report pointed out that in order to correct
deeply entrenched inflation and unsatisfactory levels of unemployment
requires the Federal Government to put its financial house in order and
to meet the major challenges confronting us on the supply side of the
economy.
In seeking policy options, we look for measures to enhance the supply
side of our economy that contribute to real growth in output and
employment. We look for more efficient production processes, more
effective management, higher investment, more skilled labor, and higher total productivity. It is our target to achieve price stability in an
expanding economy, not a declining one. We cannot make our peace
with either rising inflation or rising unemployment.
To join us in a dialog on the longer term outlook and solution to
these stagflation problems, the Special Study has invited a number of
preeminent economists, business leaders, and labor authorities. Our-
113
first two distinguished panels, after debating the problems of our
persistent inflation and unemployment in the 1970's, suggested no
quick fix.
They, too, believed our current economic malaise to be caused by a
complex set of forces, only some of which respond to macroeconomic
policies. A general consensus emerged that stagflation must be attacked
simultaneously on a number of policy fronts.
The emphasis on particular policies certainly varied. Fresh, new
policy options, however, seemed as remote as ever.
One interesting theme, developed in Monday's discussion, highlighted the way in which Government policy on balance seems to
encourage consumption at the expense of saving and investment.
The choice of less investment today means slower growth in living
standards tomorrow.
Indeed, in recent years, improvement in our standard of living has
ground virtually to a halt. Meanwhile, U.S. investment as a component
of GNP has fallen far short of the Japanese and German ratios. And
this has contributed to our failure to compete effectively in world
markets.
In today's panel discussions, we hope our experts will look beyond
the immediate questions of monetary and budget policy and out into
the 1980's and beyond. Certainly, our long-range prospects are colored
by the shortrun policy options we take in the Congress today.
But what do you envision for the long-range future? How do you
expect the economy to shape up? What do you feel we should, as a
nation, strive toward in the more distant future? Are our current
policies carrying us toward those objectives, or do they lead us to
quite unexpected and unintended scenarios for the American economy and society?
Now, my understanding is that Mr. Leontief is our first witness.
All right, Mr. Leontief.
STATEMENT OP WASSILY LEONTIEF, DIRECTOR, INSTITUTE FOR
ECONOMIC ANALYSIS, NEW YORK UNIVERSITY, NEW YORK,
N.Y.
Mr. LEONTIEF. DO I have about 10 minutes ?
Representative ROTJSSELOT. Ten or fifteen.
Mr. LEONTIEF. Congressman, the effect of technological advance on
employment has been debated for over 168 years since desperate
workers in the textile town of Nottingham, England, led by a certain
Xed Ludd wrecked newly invented knitting machines that threatened—so they thought—their livelihood. The mill owners of course
disagreed and were supported by economists who proceeded to
"prove" once and for all that unemployment caused by technology
can be nothing but an illusion.
There were, however, notable exceptions, among them John Stuart
Mill—the author of "On Liberty"—who, after arguing first that
workers displaced by machines in one line of production would necessarily find equally good employment opportunities^ in some other,
later changed his mind and admitted that both the introduction of
machines and their increase in numbers and efficiency can, indeed,
depress the aggregate demand for labor.
114
Thirty years ago, it took several thousand switchboard operators
to handle 1 million long-distance telephone calls; 10 years later,
it took several hundred operators; and now, with automatic switchboards, only a few dozen or so are required. The productivity of
labor—that is, the number of calls completed per operator—is increasing by leaps and bounds; it will reach its highest level when only
one operator remains, and become infinite on the day that operator is
discharged.
The usual measure of the "productivity" of labor is the total output
divided by the number of workers, or even better, by the number of
hours of work required for its production. The peculiar nature of this
conventional measure, used in many official publications and referred
to in public policy discussion, becomes clear if one tries to apply it,
say, to describe and to assess the effects of the progressive replacement of horses by tractors in agriculture. By dividing the successive
annual harvest figures, first, by the corresponding gradually increasing number of tractors and then by the steadily tailing number of
horses, we arrive at the paradoxical conclusion that at the time of
transition, the relative "productivity" of tractors tended to fall, while
the "productivity" of horses replaced by them has steadily risen. In
fact, the cost effectiveness of horses, of course, diminished steadily
as compared to that of the more and more efficient tractors.
Technological advance is uneven. Some sectors of the economy are
more affected by it than others; some types of labor are replaced faster
than others. Less-skilled workers, in many instances but not always,
go first; skilled workers, later. Computers taking on the jobs of whitecollar employees perform first simple, then increasingly complex,,
mental tasks.
From the time that the steam engine was invented, successive waves
of technological innovation have brought about an explosive growth
of total output accompanied by rising per capita consumption and, upuntil the middle 1940's, a progressive shortening of the normal working day, working week, and working year. Although increased leisure
(and for that matter cleaner air and purer water) is not included in
the official count of goods and services used to measure the gross national product, it has certainly contributed greatly to the well-being
of blue-collar workers and salaried employees. Moreover, the reduction
of the average workweek in manufacturing, from 67 hours in 1870
to 42 hours in the middle 1940's, combined with longer schooling
amounted to a large-scale withdrawal from the labor market of many
millions of working hours. At the end of World War I I , the situation
changed. Successive waves of technological innovation continued to*
overtake each other as before and the real-wage rate continued to sro
up, but the length of the normal workweek today is practically the
same as it was 35 years ago. In 1977, the normal workweek—adjusted
for growth in vacations and holidays—was still 41.8 hours.
This means that we have to face the prospect of technological unemployment^ turning from its past benign "voluntary" state into.a?virulent involuntary phase. With this would come an inevitable increase in the social tensions resulting from the slowly but steadilyincreasing pressure of structural, as contrasted with passing cyclical,,
unemployment.
115
In complex systems like the modern economy, there is no such thingas a single cause of a problem. While without technological change
there could, of course, be no technologically caused unemployment,
neither would such unemployment exist if the total population, instead of growing slowly, begin suddenly to shrink, or if workers
agreed to accept lower and lower wages. Those who want the current
population trends reversed are likely to proclaim that population
growth is the actual cause of unemployment; those who would like to
see profits rise and wages go down can be expected to declare that high
wages are its real cause. The remedy favored by the "keep your hands
off the free market" libertarians is wage cuts brought about by systematic reduction of the power of trade unions as well as a curtailment
of unemployment payments and welfare benefits.
While in many operations even dirt-cheap labor could not compete
effectively with very powerful or very sophisticated machines, a drastic general wage cut would temporarily arrest the adoption of laborsaving technology. But unless the introduction of the cut was interdicted by specially erected barriers, the old trend would be bound to
recur. Even a most principled libertarian might hesitate to have the
wage question settled by cutthroat competition among workers under
continued pressure of steadily improving laborsaving machines.
Some advocates of full-employment policies have proposed that
labor-intensive processes be given preference over laborsaving technologies. If administered persistently, such Luddite medicine would
slow down technical progress and bring about difficulties even more
menacing to the health of our economic and social system than the
disease it is intended to cure.
Stepped-up investment can certainly provide additional jobs for
people who otherwise would be unemployed. However, under conditions of laborsaving technological advance, creation of one additional
job 20 years ago might have required $10,000 j today, $20,000; and 20
years from now easily $50,000, or more, even if inflation is controlled.
A high rate of investment is indispensable to satisfy the expanding
needs of a growing society. But it can make only a limited contribution
to solution of the problem of involuntary technological unemployment particularly since the greater the rate of capital investment, the
higher the rate of introduction of new; laborsaving technology.
In connection with the work in which we are presently engaged, a
member of my research team had to visit recently a modern recently
constructed copper smelter. What he saw was a gigantic plant, the
construction of which cost $450 million; the total labor force required
to operate it consists of less than 50 men per shift.
One must conclude that it would be sensible to explore the possibility of resuming the interrupted process of the gradual reduction of
the length of the labor day, labor week, and labor year—or even labor
life.
Once, voluntary sharing of technological unemployment—that is,.,
progressive shortening of worktime—was accompanied by a steady
rise not only of hourly wage rates and monthly salaries but also of
total annual, and even lifetime, take-home income. It appears that
because of the greatly expanded opportunities to replace labor by
increasingly sophisticated machinery, the impersonal forces of the-
116
market will not favor this solution any more. But humans are not
horses—they can reason, and in our democratic society they can vote.
Up to the middle 1940's, American families chose, as their real
income rose, to enjoy it not only through increased consumption but
in the form of a shorter workweek and more leisure. Without the
increase in leisure time, the educational and cultural advances that
have marked the first 40 years of the 20th century would not have been,
possible. Americans probably would have continued to absorb potential technological unemployment in this voluntary way had real wages
risen during the next 40 years even faster than they have.
Government policies designed to bring about a steady rise in real
wages sufficiently large to induce workers and employers to resume
continuous voluntary reduction in the length of the normal work week
once could have been considered. Under present conditions, such policies would require so large an increase in labor's share of the total
national income that there would be a decline in productive investment, and this would result in an unacceptable slowdown of economic
growth. The other alternative policy consists of a two-pronged approach combining direct action toward progressive reduction in the
length of the normal workweek with income policies designed to maintain and steadily increase the real family income of wage earners and
salaried employees.
We are already practicing such income policies by gradual changes
in the structure of our tax system and through social security, medical insurance, welfare payments, and unemployment benefits. The system should be redesigned and expanded so as to reduce the contrast
between those who are fully employed and those who are out of work.
Let us remember the widespread European practice of paying supplemental benefits to wage earners who work less than the normal number
of hours per week.
A reasonable and effective response to the incipient threat of involuntary technological unemployment should aim at bringing about an
equitable distribution of jobs and income without, however, obstructing, even indirectly, technological advance.
But, would not the admittedly far-reaching measures proposed
above contribute to inflation? Such a question is being asked nowadays
whenever one speaks of better environmental protection, improved
transportation, or simply of advancing the clock to summertime on
June 1 instead of May 15.
In anticipation of such a question, I take the liberty of concluding
my testimony with a few words on the subject of inflation.
Inflation that has been plaguing for some time this and several—
but notably not all-—other advanced free market economies is, in my
opinion, not primarily a technical economic, but essentially a deepseated social problem. While an effective combination of fiscal and
monetary policies is indispensable for effective management of a
modern economy, their success is predicated not only on tacit mutual
understanding, but institutionalized day-by-day cooperation between
business and labor.
West Germany—a country whose successful stabilization policies
we envy—is usually thought of as an example of ideal unregulated
free enterprise economy. In fact, the success of Chancellor Schmidt's
117
anti-inflation policies is built on the firm foundation of institutionalized joint labor-capital participation in the management of German
industry. The bylaw requires that one-half of a board of directors of
large corporations represent the shareholders while the other half are
elected by labor. Among the latter, most are elected by that corporation's own labor force; but some—the outside labor directors—represent essentially the national trade union. In Germany, as in the United
States, wage and employment questions constitute only a small part of
management problems which the corporate board of directors has to
decide. That means that employers and employees maintain a working
contact at the very grassroots of German industry. That cannot be but
of crucial importance from the point of view of determining the
nature and implementation of agreements reached in national wage
negotiations; across-the-board wage negotiations between the employee organizations and unions are conducted in Germany essentially
on a national level.
In Austria, another country that successfully resists inflationary
pressures, the institutional set-up is very similar to that described
above except that the Government plays a greater role in across-theboard negotiations between trade unions and employers' organizations. It does so by contributing rather detailed input-output type projections of economic outlook for some years ahead.
The economic, social, and political situation and historical tradition
in labor management relationships in the United States is obviously
so different from that which exists in Europe that the institutional
arrangements that will have to be devised to bring about a closer dayto-day cooperation between—organized—labor and management are
bound to be very different from those described above. But I have no
doubt that without such cooperation, all attempt to contain inflationary pressures, through monetary and fiscal measures, by suasion
or by legislation, even if they might succeed temporarily, are bound
to fail in the long run.
Thank you.
Representative ROUSSELOT. Thank you very much.
Mr. LEONTIEF. I'm sorry to take so much time.
Representative ROUSSELOT. Well, I don't serve in this body; I serve
in the other. We have a problem over there with time also, we have
a 5-minute rule. But, we gave you an extra 5 minutes.
Mr. LEONTIEF. Thank you.
Representative ROUSSELOT. Mr. Wachter, will you proceed. We
would appreciate having your comments.
And thank you, all of you, for joining us. We appreciate your doing
it.
STATEMENT OP MICHAEL I . WACHTER, PROFESSOR OP ECONOMICS, UNIVERSITY OP PENNSYLVANIA,
PHILADELPHIA,
PA.
Mr, WACHTER. Thank you for the invitation to appear today.
I see the stagflation problem as essentially having three components—high unemployment, high inflation, and slow real growth. I
believe that in many respects, these are distinct problems. In the short
run, they may be closely related, with periods of declining unemploy-
118
ment being associated with rising inflation and more rapid real growth.
In the long run, the relationships among unemployment, inflation, and
real growth are more complex and are likely to be different than they
are in the short run. Hence today, we have high unemployment and
inflation and low real growth.
A major point of emphasis, in my discussion, is that traditional
Keynesian monetary and fiscal policies deal essentially with only the
demand side of the economy. In the short run, Keynesian solutions
allow policymakers to expand the economy, reduce unemployment, and
increase real GNP growth. The only cost appears to be a higher rate
of inflation. The problem is that in the long run, the economy is only
left with the legacy of higher rates of inflation. Keynesian policies
cannot permanently lower the unemployment rate below the equilibrium or sustainable level, not permanently increase the real rate
of growth of the economy.
The political problem is that Keynesian solutions are very attractive because they do improve the shortrun economic outlook. But
will the political process accept longer run solutions even though
they don't have the quick benefits that you get from highly stimulative monetary and fiscal policy? This issue is of critical importance
because shortrun Keynesian solutions worsen the longrun problems.
Let me deal first with the issue of high rates of unemployment.
I believe that the unemployment problem today is largely a noncyclical one. It is primarily related to demographics. In part, this is
an indication of how successful Keynesian policies have been, The
use of Keynesian policies have enabled us to bring the cyclical unemployment rate essentially down to zero. The major deviations from
zero cyclical unemployment have been associated with conscious attempts to reduce the inflation rate.
In today's terms, my own research indicates that the full employment-unemployment rate or the noncyclical unemployment rate is
somewhere between 5*4 and $y2 percent for the U.S. economy. In
my prepared statement, I show that the equilibrium unemployment
rate has increased from around 4 percent in the early fifties to the
area of 5.5 to 6.5 today. The U*l series, which is my lower estimate,
is based on the demographic shift related to the great influx of younger
workers as well as the impact of Government labor market programs.
The 17*2 series, which provides an upper bound, is, by construction,
that unemployment rate which would be required to stop inflation
from accelerating.
To deal with noncyclical unemployment, Keynesian policies are
simply not successful. If they have an impact, it is likely to be adverse.
By increasing inflation without improving real growth, pressures
are created to battle inflation through recessionary policies. The result is an increase in uncertainty which is likely to worsen the longrun
economic climate.
To deal with these problems, we need to adopt structural policies.
In particular, we need to deal with the demographic adjustments associated with the great influx of younger and less skilled workers. I
"believe that manpower training and employment tax credits have
considerable potential. Although manpower training is generally
viewed as an old, unsuccessful policy, that is not the case. Training is
119
always included in manpower legislation, but receives relatively little
attention in practice.
Most of the funding is for direct job creation, work experience
programs, and summer youth programs for employing young people.
Few serious attempts at manpower training have been made.
For example, the young person in the structural unemployment
pool is frequently someone who has dropped out of high school at the
age of 16 or 17, and has been kicking around the labor market for 3
or 4 years. The traditional Government manpower program hires that
person for 3 or 4 months and attempts to retrain him in that period.
I would argue that this type of labor market problem is not going to
be improved by a 3- to 6-month program or direct job creation effort.
It certainly will not be improved by "make work5' summer jobs.
Training programs that might be successful would have to last at least
1 year and perhaps as long as 2 years. My own view is that the employment tax credit measures that have been suggested recently are also
promising in terms of programs to reduce U*.
Taking a somewhat longer run view of the equilibrium unemployment rate, I think there is a fair chance that we are going to get substantial improvement even if Government programs are otherwise
neutral. The demographic forces, after working toward higher unemployment rates over the last 15 years, are about to shift. The percentage of younger workers will begin to decrease as the baby boom
generation moves from the youth to the nonyouth age category. This
should result in a reduction in youth unemployment and in the overall
equilibrium unemployment rate.
As the youth unemployment picture improves, however, the economy
will face the new problems created by the baby boom generation age
20 to 40.
With respect to the second issue, high inflation rates, the initial
problem is the diagnosis. I believe that too much time is devoted to
blaming unions and oligopolies for the inflation problem. In my
research over the last 10 years and my reading of the literature, I have
found very little evidence that either unions or oligopolies contribute
in any significant amount to the inflation problem.
I think OPEC is a factor in the short run, but there again, it cannot
explain how we have moved from a 1-percent inflation rate in the early
sixties to the 9- or 10-percent inflation rate today. I believe that the
answer to the secular increase from 1 percent to 10 percent has to do
with overexpansionary monetary and fiscal policy. These policies have
reduced unemployment too low relative to the equilibrium unemployment rate and GNP too high relative to potential output.
Table 2, of my prepared statement, presents the old potential output
series that ?was used as a target by the Council of Economic Advisers
in the 1960 s. Table 3 shows the current Council of Economic Advisers'
potential output series. Presumably, this series is now being used as a
target for monetary and fiscal policy. If you were to believe these
measures of potential output, it would be the case that the economy has
rarely experienced overheating. Indeed, according to the old CEA
•series, the United States has always been below potential output.
On the new CEA numbers, there are 2 or 3 years where the economy
has exceeded potential output. But by and large, both the old and
120
new CEA measures of potential output are simply too high. By the*
time that the economy reaches or even approaches those measures of
potential output, the inflation rate is accelerating. These measures of
potential output cannot be used as targets for a policy that wants to
avoid accelerating inflation.
My own research efforts as well as others' have been directed at
finding a measure of potential output which is compatible with a
stable inflation rate. My upper bound series, POTj is shown in table 3
and my pessimistic series, POT 2 is shown in table 5.
Those series suggest that the U.S. economy essentially reached potential output some time in 1978. That is, cyclically unemployment is
now zero or negative. These numbers can help to explain why the
economy has had accelerating inflation during 1978 and 1979.
Personally, I am somewhat amused at the image of a Democratic
administration blaming labor unions for accelerating inflation in
1978-79 when I see almost no evidence that labor unions are at all
the source of the problem.
For the long run, the solution to the inflation problem has to be
geared to reasonable targets on unemplo3^ment and potential output.
I believe that if my measures of unemployment and potential output
are correct, we overestimate the costs of unemployment rates of 6 percent and overestimate the benefits of unemployment rates of 4 to 5
percent.
Using my calculations, the output loss when the unemployment rate
is 6 percent is essentially zero. At 6 percent unemployment, the pool of
unemployed workers is heavily weighted toward the frictionally unemployed and those who want to work part time or have a low attachment to the labor market. Creating permanent jobs for these workers,
in an attempt to reduce the unemployment rate to 4 percent, will only
yield increasing inflation. That is, the apparent labor surplus disappears if one tries to maintain too low an unemployment rate.
One of the major policy questions today is whether policymakers
should induce a recession in order to lower the inflation rate. My own
view is that we should not run a recession. Although recessions do
reduce the inflation rate, I think it does so at a cost. Once unemployment rises above 6 percent, there is an output loss. The cost of a recession is thus reduced investment and hence reduced availability of
capital goods and trained labor. Given the concern with secular low
real growth rates, this is a serious cost. I would argue that the appropriate policy over the long run is not the continuation of stop-go
measures. Policymakers avoid running recessions for a couple of
years and then bouncing back from them by overstimulating the
economy.
The appropriate policy is to stay as close to potential over the long
run as possible. While remaining close to potential, the growth rate of
the money supply should be reduced slowly over time and the budget
deficit should be reduced to zero.
There is no doubt in my mind that the budget deficit is currently too
high. If full employment is 6 percent, then the budget should be in
balance today. It is not in balance. But I would not favor moving in
1 year from a $30 billion deficit to a balanced budget because that would
121
most likely result in a recession. On the other hand, it would be beneficial to have a commitment to a balanced budget over the business
cycle.
The third part of the secular stagnation problem is longrun real
growth. This is perhaps the major part of the problem. In terms of
popular perceptions of economic problems, inflation receives the most
attention. But inflation itself does not prevent standards of living
from improving. I believe that people are really most unhappy with the
slowdown in real growth which has meant unchanging and even declining per capita, after tax, real standards of living.
In the Japanese economy, where occasionally high growth is combined with high inflation, there are fewer complaints about the impact
of inflation. There is a recognition that high real growth rates allow
individuals to keep ahead of inflation.
In our economy today, the problem that is probably causing the most
unease is slow real growth. Living standards, as currently measured,
have stopped increasing. Although many see inflation as the cause of
the problem, the immediate issue is a slow real growth rate.
If we are going to deal with the underlying economic problem of
slow growth, Government policy has no alternative but to shift from
encouraging consumption to encouraging investment.
I believe that policies over the last 20 years have not been neutral.
Even if neutral policies with respect to consumption and investment
were adopted, policymakers would have taken important steps to solving the stagflation problem.
The question, as always, is how do you get from the short run to the
long run given the fact that the shortrun solutions seem so attractive
and the longrun solutions seem so unattractive.
Two very different examples of currently popular policies that can
cause longrun problems are the work registration program and national
health insurance. The major impact of the work registration program
is likely to be an increase in the measured unemployment and equilibrium unemployment rates. It does very little for the potential output
of the economy because the affected welfare population is a relatively
low-skilled group. More important, you cannot make people work.
You can only make them register for work. The result is to reclassify
individuals who are actually not in the labor force into the unemployment category.
Another policy, which represents a prototype policy of the investment consumption tradeoff, is national health insurance. Certainly,
the less ambitious national health insurance policies do not pose a
problem. The more ambitious measures that have been suggested, however, although popular, must be viewed as alternative to high growth,
high investment policies.
The Government cannot do all things in the short run and this is
where the tradeoff occurs. In the short run, it may seem more attractive to adopt national health insurance than a high investment policy.
In the long run, however, I believe that the low-income population
will benefit more from the high investment policies than from the
comprehensive national health insurance programs that have been
suggested.
Let me conclude with a few general points.
122
First, a high-investment strategy need not hurt the poor. I t need not
redistribute income from the poor to the wealthy. I t is possible to
devise a high-investment policy that will be relatively neutral with
respect to the income distribution.
Second, although the types of policies I am discussing are occasionally referred to as the new conservatism, that is a misleading label.
I t is not clear to me why progrowth policies should be viewed as
conservative. In addressing the problems of the poor and the disadvantaged, overexpansionary monetary and fiscal policies have not
worked. Although the poor are better off than they were 20 years ago,
the improvement is not the result of overexpansion and Keynesian
policies.
Hence, I believe that the old liberalism is no more liberal than m
the new conservatism. Indeed, I would question whether the old liberalism is not in some ways more destructive for the groups that it means
to help than is the so-called new conservatism.
My argument is that the policies that will best aid the poor and the
disadvantaged, over the next one or two decades, are high-growth
policies.
Thank you.
Representative ROTTSSELOT. Thank you, Mr. Wachter. I appreciate
your very thorough testimony. And I assume you want your prepared
statement submitted for the record with all your graphs and charts ?
Mr. WACHTER. Yes, sir.
[The prepared statement of Mr. Wachter follows:]
PREPARED STATEMENT OF MICHAEL L. WACHTER
The Nature of the Stagflation Problem
I . INTRODUCTION
The problem of stagflation encompasses a broad range of interrelated economic topics. The three crucial ingredients are low real economic growth, high
unemployment and high rates of inflation. The problem of unemployment is only
indirectly related to the stagflation issue. Current high levels of unemployment
are due to changes in the equilibrium rates and are not due to inadequate demand. Policies to deal with this type of unemployment need not have any affect
on the rate of real growth of the economy or on the rate of inflation.
The problem of secularly rising inflation rates is due largely to failures of
government policy. With respect to long-run inflation issues, short-run shocks
such as OPEC oil and food price increases are not important. The central problem is the tendency of policymakers to underestimate the sustainable unemployment rate and to overestimate the potential output of the economy. These
policy mistakes are due to a lack of recognition, both of the rise in the sustainable (or equilibrium) unemployment rate and of the slowdown in the rate of
growth of potential output.
The problem of slow real growth is a major concern and may be the core of
the three issues. The factors that account for the increase in the equilibrium
unemployment rate and the increased inflation rate are both explanatory elements in the slowdown in real growth. A related causal factor is the gradual,
almost unperceived shift in government policy toward encouraging consumption
at the cost of investment. These policies are generally adopted to deal with
short-run problems of inadequate demand. Their side effects, however, appear
over the longer-run in the form of reduced real growth. The U.S. economy is
currently growing at approximately 3 percent per year, and most of this growth
is attributable to the increase in the size of the labor force. Standards of living
have virtually stopped improving. The solution to this problem involves shiftine:
123
away from demand oriented and toward supply oriented stimulus policies. In*
general, the solution to the overall stagflation problem requires the recognition
of the pivotal importance of stimulating productivity, investment (in both
capital and people) and hence real economic growth.
I I . UNEMPLOYMENT
Although unemployment is often viewed as the largest problem of stagflation
this is not the case. To an important extent the high unemployment in the United
States over the past decade is largely unrelated, except indirectly, to stagflation.
As I have argued elsewhere, the current unemployment rate and level of
GNP indicate that the United States has fully recovered from the 1974r-75 recession. The high level of unemployment which persists in our economy is
approximately equal to that unemployment rate which can be maintained without accelerating inflation (for ease of exposition, I hereafter refer to that as
the equilibrium unemployment rate or U*).
The equilibrium rate of unemployment, which I estimate to be between 5.5
and 6 percent, is the lowest unemployment rate that monetary and fiscal policy
can achieve without rekindling inflation. At that level, the pool of job seekers
is heavily unbalanced toward unskilled workers. The unemployment rate of
skilled workers (broadly defined) is commensurate with our notion of frictional
unemployment. Therefore, any overall expansion of labor market demand is
inflationary because it increases the demand for skilled workers and capital
and these inputs are not available at current money wage and price levels.
An indication that U* may be above 5.5 percent is the shifting relationship
between capacity utilization and the unemployment rate. It appears that for
any given unemployment rate today, capacity utilization is much higher than
it was in the 1960's. Whereas the availability of labor was the constraining
factor in the 1960's, the availability of capital is the constraining factor today.
Inflation in the Wharton model tends to accelerate when capacity utilization
is around 93 percent. In the current Wharton forecast, capacity utilization in
1979 will be just above 93 percent and unemployment will be approximately
6.2 percent. That is, we will reach the inflation point on the capacity utilization
rate when the unemployment rate is still 6.2 percent.
The evidence suggests that several factors have been operating since the early
1960's to increase the equilibrium rate of unemployment. Of particular importance is the demographic shift toward younger and female workers. Young
workers, both male and female have been increasing as a percentage of the
labor force as a direct consequence of the baby boom of the late 1950's.
As a consequence of the baby boom and the changes in government labor
market programs, a pattern of high frequency-low duration bouts of structural
unemployment has become the norm. The low-skilled worker is unemployed
frequently, but for short periods. For example, over the past year, the average
duration of unemployemnt was slightly over two months, but approximately
half the unemployed were out of work for less than five weeks.
In the current pattern of structural unemployment, there are two main reasons
for being unemployed. First, if workers' potential earnings, based on their skill,
are below the minimum wage, they may have difficulty finding stable employment. The minimum wage law reduces the demand for low-wage workers in
the covered sector.
Second, because of the increase in the level of transfer payments, some lowskilled people may not want to work full time. It is sometimes argued that
these unemployed are malingering and that the work ethic should be strong
enough to force them to work all the time. For the most part, low-wage workers
do not have opportunities to work at enriching, pleasurable, creative jobs. They
might want to work part of the time in order to remain eligible for public
assistance or unemployment compensation, and to retain their skills. But to
work all of the time, when society is willing to provide the present level of
support, is not "rational" in the economic sense of the term.
Furthermore, many of the structurally unemployed will "outgrow" their
•unemployment problems. The low work attachment of this group is often associated with the fact that they are teenagers, who do not have family responsibilities, or females that are heads of households who have too much family
responsibility. Both groups will alter their working behavior as they f\%e.
124
TABLE 1.—ACTUAL AND ESTIMATED EQUILIBRIUM UNEMPLOYMENT RATES
1955
1956
1957
1958
1959
1960
1961.".'
1962
1963
1964
1965
1966
1967
1968....
1969
1970
1971....
1972 .
1973.1
1974
1975....
1976
1977"
1978
_
_
—
_.._
_
_
_
__
_
_
_
_
_
_
_
_._
_
_
_
_
_
_
_
_
_
_
_
. .
_
_
_
_
_
_
.
_
_
_
_
_.
U (Actual
unemployment rate)
Ui*
Ui*
4.37
4.13
4.30
6.84
5.45
5.54
6.69
5.57
5.64
5.16
4.51
3.79
3.84
3.56
3.49
4.98
5.95
5.58
4.85
5.58
8.47
7.68
7.03
6.00
4.01
4.04
4.05
4.08
4.15
4.23
4.27
4.28
4.39
4.52
4.65
4.78
4.83
4.87
4.97
5.09
5.22
5.35
5.45
5.49
5.50
5.53
5.55
5.55
4.19
4.22
4.24
4.28
4.35
4.55
5.14
5.29
5.41
5.56
5.73
5.89
5.95
5.94
5.75
5.83
5.98
6.12
6.23
6.28
6.31
6.34
6.36
6.40
Ui* is the equilibrium rate adjusted for demographic factors and Government labor market policies.
Us* is the equilibrium rate that satisfies the condition of nonaccelerating inflation in a wage equation.
Source: Jeffrey M. Perloff and Michael L. Wachter, Carnegie-Rochester Conference on Public Policy (supplement to
Journal of Monetary Econpmics), 1979, "A Production Function-Nonaccelerating Inflation Approach to Potential Output:
is Measured Potential Output Too High?"
Two alternative estimates of the equilibrium unemployment rate are shown in
Table 1. The first Ui*, assume that the equilibrium rate in the mid-1950's was
4.0 percent and then adjusts for changes in the demographic composition of
the unemployment rate. It indicates that the current level of Ui* is 5.5 percent.
The second estimate U2* is obtained by solving a wage equation for the U* that
satisfies the condition of nonaccelerating inflation. The Us* series is consistently
above Ui* and is currently 6.4 percent.
The labor market policies stressed by Congress and the Administration, however, are those geared to problems of aggregate demand. There is little attempt
to attack the structural problems. Aggregate demand policies have successfully
dealt with the cyclical unemployment from the 1974-75 recession, but there has
been no dent in the non-cyclical component of unemployment—that is, the remaining 6 percent.
To solve the structural unemployment problem, the skill level and hence the
market wage of less skilled workers must be increased relative to the level of
transfer payments; that is, the cost of being unemployed must be increased. I
am not recommending that public assistance and minimum wages be lowered.
The economy can afford a relatively high guaranteed income floor for people who
have very low skills or who cannot work. Society is wealthy enough and the
social product of low-skilled people is small enough to afford a high level of
public assistance as well as high market wage.
Public policy should focus on increasing the skill levels of the group of workers
who have suffered on account of the baby boom. That includes not only the
young workers, but also disadvantaged workers who were caught in the secondary
labor market when the baby boom arrived.
The indirect relationship between stagflation and the high current levels of
unemployment is due to the slow growth of productivity, potential output and
real wages. That is, government policy has been oriented toward the short-run
problem of propping-up aggregate demand. These policies have tended to encourage consumption over investment. That is, the short-run policies to increase
demand have served to slow the long-run real growth rate of the economy. As
a result of the slower real income and wage growth, given the growth rate of
transfer payments, the equilibrium unemployment rate has increased;
125
The intermediate-term outlook for unemployment, however, is favorable, even
if government policy is hereafter neutral. As the baby boom ages and the baby
bust cohort enters into younger age groups, the equilibrium unemployment rate
will decline. My calculations suggest a decline of between .75 and 1.00 percent in
the equilibrium unemployment rate over the next decade. This gain will be due
solely to the demographic factor. Government policy and external events can
operate to either offset or further this projected decline in the equilibrium
unemployment rate.
The relatively distinct nature of the unemployment and stagflation problems
are indicated by this projected decline in the equilibrium unemployment rates
over the 19S0's. Slow growth and high inflation can remain as problems even
as the demographic factors operate to lower the unemployment rate.
III. INFLATION
The current level of inflation is largely due to overexpansioiiary monetary and
fiscal policies. Exogenous shocks such as the food and fuel price increase during
the 1970's can only lead to ongoing inflation if they are validated by aggregate
demand policies. For example, although the large OPEC price increase in 1973-74
and again in 1978 can cause a short-run increase in the inflation rate, the price
level should eventually settle down at the new high level dictated by higher
energy prices. If the increase in OPEC prices, however, leads to a higher rate of
monetary growth and a large full-employment deficit, inflationary expectations
will increase. The result is that a short-run spike in the inflation rate becomes
a long-run increase in the level of inflation.
The inflationary bias of government policy can be seen by evaluating the GXP
and unemployment targets of policymakers relative to attainable levels of potential GNP and equilibrium unemployment. For example, the government's own
unemployment rate target is below the 5.5 percent figure. In the late 1060's the
government target was 4 percent and the equilibrium rate was between 4.9 and
5.4 percent. By the mid-1970jS, when the government target was lifted to 4.9
percent, U* had increased to between 5.5 and 6.0 percent. This is a key ingredient
in the increase of the inflation rate, from an average of 1.5 percent in the ^u-ly
1960\s to approximately 9 percent today. Moreover, the "full-employment" budget
surplus is seriously overstated by calculating that figure on the basis of a 4 or
even 5 percent equilibrium or full-employment, unemployment rate. The result
is a tendency to believe the fiscal policy is more restrictive than actually is Hie
case.
The same factors are relevant to potential output. 'Table 2 shows the Government's measure of potential output that was utilized during the 19G0's. That
series is denoted Old CEA. (Where CEA refers to the Council of Economic Advisors) According to this table, potential output was always greater than achral
output or GNP. But if the economy always had economic slack, what explains the
increase in the inflation rate over the past fifteen years?
More recently, the Government has reduced its measure of potential output.
This new variable (denoted, New CEA) is shown relative to GNP in Table 3. Although GNP is now occasionally above potential, this is still rarely the casi-. A?
increase in the ongoing or built-in inflation rate cannot occur if the economy is
constantly operating with the kind of slack indicated by NEW CEA. However, if
the Government uses monetary and fiscal policy to achieve a potential output
target which is too optimistic, the result will be accelerating inflation. In addition, the economy will still rarely have a GNP which reaches the target level of
potential. If the correct measure of potential is below the target level, the expansionary policies will lead first to accelerating inflation and overheating and
second to recession as the government moves to slow the inflation rate.
My optimistic estimate of potential output is shown in Table 3 and denoted
POT-i. It is well below the Government's current measure of potential and it indicates that GNP was close to potential by the end of 1978. This is shown in Table 4,
According to my pessimistic potential output estimate, the economy was overheating early in 1978. This pessimistic estimate of potential differs from POT\,
in part by using the U2* series instead of Ui*, to construct the potential labor
series. This series, denoted POT2, is shown in Table 5.
51-421—70
0
126
TABLE 2.—GNP AND THE ORIGINAL COUNCIL OF ECONOMIC ADVISERS MEASURE OF POTENTIAL OUTPUT
GNP
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
______
__
___
654.80
668.80
680.90
679.52
720.45
736.80
755.30
799.12
830.72
874.37
925.92
981.02
1,007.70
1,051.80
1,078.80
1,075.30
1,107.50
1,171.10
1,234.90
1,217.80
1, 202. 30
1,271.00
1,332.60
,
_
__
_
_
.
__ _ _
__ _ __
„ _
OldCEA
653.63
676.60
700.38
725.00
750.49
776.87
804.17
832.51
863.07
895.59
929.33
964.34
1,000.69
1,038.35
1,079.13
1,122.53
1,167.63
1,214.58
1,263.40
1,314.18
1, 367. 03
1,421.95
1,497.10
TABLE 3.—GNP AND ALTERNATIVE MEASURES OF POTENTIAL OUTPUT
GNP
1955
1956
1957. __
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967 __
1968
1969 _.
1970
1971
1972
1973
1974
1975
1976
1977
__ _.__
-
_
_
_
_
__ _
_
_
.
_._
_
_
654.80
688.80
680.90
679.52
720.45
736.80
755.30
799.12
830.72
874.37
925.92
981.02
1,007.70
1,051.80
1,078.80
1,075.30
1,107.50
1,171.10
1,234.90
1,217.80
1,202.30
1,271.00
1,332.60
POTj
New CEA*
651.20
667.07
687.52
712.70
732.12
757.75
786.86
815.17
842.01
872.86
SOI. 79
941.96
928.48
1,014.90
1,047.30
1,082.70
1,122.90
2, 160.90
1,202.30
1,249.40
1,280.40
1,324.30
1,368.20
651.41
673.91
697.18
721.26
746.16
771.93
798.59
826.43
857.08
830.34
925.00
960.77
996.25
1,031.70
1,068.30
1,106.20
1,145 40
1, 186.1C
1,228.20
1,271.70
1,316.90
1,363.60
1,412.00
|3 percent J3.3 percent
1978
1979 _
1980
1,385.70
._
__
...
__.
1,409.20
1.451.50
1,495.10
1,413.40
1,460.00
1,508.20
1,462.10
1,513.90
1,567.60
Key: POTi is the potential output series derived in Jeffrey M. Perloff and Michael L. Wachter, Carnegie-Rochester Conference on Public Policy (supplement to Journal of Monetary Economics), 1979, "A Production Function-Nonaccelerating
Inflation Approach to Potential Output: Is Measured Potential Output Too High?"
*New CEA is the current potential series used by the Council of Economic Advisers.
fThe series was extrapolated by assuming 3 percent growth rates per annum.
JThe series was extrapolated by assuming 3.3 percent growth rates per annum.
127
TABLE 4.—QUARTERLY GNP AND POTENTIAL
GNP
1976:
1st quarter..
2d quarter..
3d quarter..
4th quarter..
1377:
1st quarter..
2d quarter..
3d quarter..
4th quarter..
1978:
1st quarter.
2d quarter..
3d quarter..
4th quarter.
1979:
1st quarter..
POTi
1, 255. 5
1, 268. 0
1,276.5
1,284.0
1, 307. 4
1,316.0
1,332.6
1,341.3
1, 306. 7
1, 325. 5
1, 343. 9
1,354.5
1, 352. 6
1,362.2
1,375.2
1,382.9
percent
t 3.3
percent
1.354.2
1,382.6
1,391.4
1,414.7
1, 393. 2
1, 403.1
1,416.5
1,424.4
1, 397. 2
1,407.2
1, 420. 6
1, 428. 5
1,417.3
1,435.0
1,443.3
* The series was extrapolated by assuming 3 percent growth rates per annum,
t The series was extrapolated by asssuming 3.3 percent growth rates per annum.
TABLE 5.—GNP AND A "PESSIMISTIC" POTENTIAL OUTPUT MEASURE
GNP
1955..
1956..
1957..
1958..
1959..
I960..
1961..
1962..
1963..
1964..
1965..
1966..
1967..
1968..
1969_.
1970..
1971..
1972..
1973..
1974.
1975..
1976..
1977..
654.80
668.80
680.90
679.52
720.45
736.80
755.30
799.12
830. 72
874. 37
925. 92
981.02
1, 007. 70
1,051.80
1,078.80
1, 075. 30
1,107.50
1, 171.10
1,234.90
1,217.80
1,202.30
1,271.00
1,332 60
POT2
650.36
663.14
681.60
706. 22
723. 54
747.77
775.64
802. 33
827.85
857.24
885. 24
924.22
963.53
395.09
I, 026. 70
1,061.50
,102.20
,139.20
,180.60
,218.70
,258.40
I, 299 40
I, 340. 60
* 3 percent
1978
1979
1980
..
1,280.82
. . . 1,422.24
1,464.91
* The series was extrapolated by assuming a 3-percent growth rate,
t The series was extrapolated by assuming a 3.3-percent growth rate.
Source: See the reference in table 3. The POT2 was constructed in Perloff and Wachter, op. cit.
t 3.3 perceni
1,384.84
1,430.54
1,477.75
128
Given this view of inflation, what is the intermediate run outlook for this
variable and what are the costs of ongoing inflation? The outlook is simply impossible to predict because it rests squarely with the future decisions of the
monetary and fiscal authorities.
One of the major problems in the anti-inflation battle is that the appropriate
unemployment rate target for stabilization policy is not known with certainty.
How far can the monetary and fiscal authorities push ?down the unemployment
rate without causing accelerating inflation? In the 1960 s it was argued that uncertainty about the length of the lagged response of economic activity to aggregate demand policies was the key problem in fine tuning the economy. The problem still exists, but I would argue that it is small compared with the issues raised
by the uncertainty over the level of the sustainable unemployment rate. My
equilibrium unemployment rate of 5.5 percent is a point estimate with a large
standard deviation. The unemployment constraint could easily be over 6 percent.
A commitment to fighting inflation suggests that the government avoid using
monetary and fiscal policy to push the unemployment rate below 6 percent. The
C percent unemployment rate target, however, is only the target for monetary
nnd fiscal policies. The goal should be to achieve a lower unemployment rate and
a faster GNP growth rate by adopting structural measures aimed at improving
(he supply side of the labor and capital markets.
In order to reduce the inflation rate, the evidence suggests the need for a longrun commitment to avoid overheating the economy. Within this context, however,
it is not necessary to run a recession. Rather, the evidence suggests the adoption
of a policy which maintains unemployment close to 6 percent while the money
supply growth rate slowly decelerates and the full-employment surplus, properly
defined on a 6 percent unemployment rate, is brought into balance. This policy
wiU require several years before the inflation rate is significantly lowered, but the
alternative seems to be a continuation of accelerating inflation combined with
occasional recessions that are precipitated in abortive and short-lived attempts to
reduce the inflation rate.
One problem with using recessions to cure inflation, is that they reduce the
rate of capital accumulation and investment. The optimal monetary and fiscal
policy to encourage maximum supply side growth is a policy which minimizes
the variance in GNP growth rates. The adoption of this approach also requires
using reasonable targets for potential output and equilibrium unemployment.
IV. IXORE.VSlTsr. TIT!'] TJATK OF GROWTH OF REAL OUTPUT
The major element in the stagflation picture is the slowdown in real economic
growth. The current inflation and unemployment rates would be considerably
less painful if the rate of real economic growth were increased. At present the
rate of growth of potential output (using POTT or POT2) is approximately three
percent. In per capita terms, after adjusting for the growth in the labor force,
this is a dismal record.
The general shape of policies to increase real GNP growth rates are well known.
The basic requirement is a shift away from policies which encourage consumption
townrd those which encourage investment. This would require a major overhaul
in the tax structure as well as a change in priorities for government expenditure
pro.n-ams. Contrary to conventional wisdom, such policies need not increase the
gap between high and low income families. Incentives for increased savings rates
can be targeted at the middle class and government expenditure programs can be
aimed at increasing the "human capital" of our lowest skilled workers. Obviously,
even outlining the details of a high growth rate policy is beyond the scope of my
testimony.
Over the long-run the success of a high growth rate policy is improved if the
inflation rate is reduced. A reduction in the level of inflation, given our economic
institutions, also means a reduction in the variance of the inflation rate. Business
and individuals can best make long-run investment decisions in a noninflationary.
stable environment. The experience of some western European countries and
Japan, however, indicate that high inflation does not rule out high long-run
growth rates for real income.
More important to improving the real growth rate is a commitment to ending
the unending budget deficits. Keynesian economics, properly applied, argues for a
deficit during recessions and a surplus during expansions. Given the inappropriate
use of too low an unemployment target, the U.S. economy has consistently run
budget deficits during expansions as well as during recessions. The U.S. budget
129
should be in balance when me unemployment rate reaches 6 percent. The current
policy results in "crowding-out" of business investment by government consumption.
A decision to adopt a high growth rate policy, if made at all, will be politically,
difficult. Popular expenditure programs may have to be cut back. A test case over
the next few years will be the congressional decision on national health insurance. In its current form, this is the prototype program that is popular, consumption oriented, but at the margin will crowd out high growth policies. Given scarce
resources, and a current low growth rate of potential output, the economy faces a
clear trade-off between new expenditure programs such as national health insurance and pro-growth policies.
V. THE RELATIONSHIP BETWEEN WELFARE PROGRAMS AND HIGH GROWTH RATES
POLICIES
Ail important issue is whether a high level of welfare payments is a barrier
to a supply side policy of increased capital accumulation, productivity growth
and lower equilibrium unemployment rates. Do increasing Federal Government
outlays or welfare program exert an inflationary bias by suppressing incentives
to work and by shifting funds from relatively high savers to high consumers?
This is a complex question with considerable merit. It can, however, be pushed
too far.
As discussed above, the increase in transfer payments (such as AFDC, food
stamps and unemployment compensation) as a percentage of market wages should
lead to an increase in the equilibrium unemployment rate. This cannot be shown
unambiguously because of the poor quality of the data on transfer payments, but
the debate in the economics literature is over the magnitude rather than the sign
of the effect. The decline in the cost of being unemployed is one of the factors
that is partially captured in the Ui* measure presented above.
In addition, almost all income transfer programs reduce the aggregate savings
and investment rate since they presumably are designed to transfer income from
wealthier to poorer families and individuals. Although there is little data on the
issue, it is safe to assume that families on AFDC or other transfer programs are
not saving significant amounts out of their transfer income. These programs are
specifically designed to support the nonproductive members of society by providing a minimum income floor.
The income transfer programs affect two groups of individuals. The first group,
those serviced by welfare programs, are among the lowest skilled individuals in
society. The cost to society of having these individuals not working is measured
by the income transfers they receive. The level of transfer payments in the U.S.
are not out of alignment with those paid by Western European countries. Wealthy
societies can afford to maintain a relatively high guaranteed income floor. Bringing these individuals back into the labor market will contribute little to GNP
beca use of their low skill levels.
For example, I would argue that the work registration programs, aimed at
forcing welfare mothers back to work, is misplaced. The Government can force
someone to register to work, but cannot force them to work. The result will be an
increase in the labor force and a resulting increase in the equilibrium unemployment rate. Moreover, since welfare mothers tend to have low skill levels—which
is why some are on welfare rather than working—the lost GNP is extremely small.
As a result, this type of program is likely to be counter-productive ; its main effect
will be to increase the equilibrium unemployment rates even further above the
target levels of U* used by monetary and fiscal authorities.
The unemployment insurance system deals with the second group of individuals.
Since unemployment compensation is a percentage of the market wage, high as
well as low wage individuals may be receiving benefits. The economic evidence
suggests that unemployment insurance does tend to increase the duration of
unemployment. A component of this increase in duration may improve productivity. It may allow young workers to search for a job in which they are likely to be
most productive. In addition, it allows cyclically displaced workers to await recall
to their old jobs. Where specific training is important, productivity over the cycle
will be improved by encouraging workers to await recall rather than to take a new
permanent job.
On the other hand, the unemployment compensation system encourages firms to
layoff workers during a recession and it subsidizes seasonal industries. These distortions reduce productivity and increase the equilibrium unemployment rate.
51-421—79
10
130
The appropriate policy is to adjust the unemployment compensation tax schedules
so that virtually all firms face additional taxes (somewhat in relationship to the
cost of the benefits) if they layoff workers. Too many firms, especially seasonal
firms, are at the maximum tax rate so that there is no additional tax charge for
an additional layoff.
The unemployment insurance system also encourages those who have lost their
jobs but do not want another job to stay unemployed so as to maintain eligibility
for unemployment compensation. That is, individuals who want to work part-ofthe-time are encouraged to report themselves as unemployed than out of the labor
force. This again serves to increase the equilibrium unemployment rate but has
little impact of productivity.
Since the benefits for unemployment insurance usually extend for 26 weeks
(when the economy is not in a recession), it is unlikely that relatively skilled
workers who want full-time jobs would use the system as a way of avoiding
work. Indeed, for workers on temporary layoff the option of turning down a recall almost always results in the termination of benefits.
A potential cost of the transfer programs is the work disincentives to the tax
payers. That is, welfare programs not only reduce the work incentives of the
payees of the transfer system, but also of the tax payers. For both groups, the
marginal tax rates on the wage income are increased. The negative impact on
work incentives would yield a reduction in potential output. But the work disincentive effect is general to the overall income tax system and the variety of programs it supports. It is unlikely that the taxes collected to pay for the welfare
program have different work disincentive affects for the taxpayers than other
government programs.
The Nation's welfare and unemployment compensation systems, although reasonably liberal, need not be viewed as having an inflationary bias. If the government were to recognize that its transfer policies have the effect of increasing U*
and possibly reducing potential output, there would be no additional inflationary
pressures. Of course, this means that the Government would have to allow the unemployment rate to increase to the level of the new higher equilibrium rate.
To summarize, the existence of relatively generous welfare and unemployment
insurance systems increases the equilibrium unemployment rate and it shifts
resources from more to less productive members of society. The increases in the
equilibrium unemployment rate is a problem, however, largely because its changes
are not easily monitored and the Government tends to ignore increases in U*. If
the Government were to recognize the effects of its policies on U* and potential
output, the welfare system could be characterized as inflation neutral.
The recent reduction in the growth rates of potential output and productivity
and the increase in the equilibrium unemployment rate, could be offset by a switch
from high consumption to a high investment economy. Investment tax credits,
accelerated depreciation, manpower training, employment tax credits, and a reduction in marginal income tax rates, could all be part of a pro-investment package. Moreover, the transfer system, excluding social security, is sufficiently small
so that these policy changes could be made without reducing the relative level of
welfare payments. Over the long-run a high investment policy would yield higher
wage rates, lower equilibrium unemployment rates, and consequently a reduction in the welfare population.
Representative
totem pole.
ROUSSELOT.
Mr. Meltzer, I guess you are next on the
STATEMENT OF ALLAN H. MELTZER, MAUKICE FALK PEOFESSOE OF ECONOMICS AND SOCIAL SCIENCE, CAENEGIE-MELLON*
UNIVEESITY, PITTSBUEGH, PA.
Mr. MELTZER. Thank you, Congressman Rousselot. I appreciate the
opportunity to present my views on the topics of the special study.
I will read parts of my prepared statement and shorten my remarks.
We are deep into the era of relatively high measured unemployment rates and high rates of inflation that isdescribed by that inelegant term "stagflation." Growth rates of real output fell in Western
131
Europe and the United States just at the time that the growth rates
of the labor forces increased.
The rate of increase in productivity has fallen, so real incomes have
either fallen or risen more slowly than in the sixties. Inflation and
progressive tax rates financed further increases in the relative size
of the public sector with the result that current and prospective taxes
have grown more than incomes.
The combined effect of rising prices, higher unemployment, higher
taxes, and slower growth in real income produced the dissatisfaction
and malaise that makes "stagflation" a widely discussed problem.
Governments appear unable to reduce inflation without increasing
unemployment or to reduce unemployment without, sooner or later,
increasing inflation.
Nowhere does this outcome seem more apparent than in the United
States where the rates of inflation and unemployment rise with each
succeeding round of expansion and recession, and where measured
productivity growth in the private sector has remained close to zero,
on average, for the past 2 years.
The appearance of a positive relation between the cyclical average
rate of unemployment and the cyclical average rate of price change is
misleading. There is no necessary relation between the two, and any
existing long-term relation between the two in the United States
could be eliminated by a decision to index the tax system.
Stagflation appears to have two distinct meanings. One is the
apparent longer term relation between the average unemployment
rate and the average rate of inflation just mentioned,. The other is
the very limited reduction in inflation—and relatively large increase
in unemployment—that occurs in the first year or two following a
shift in political priorities from reducing unemployment to reducing
inflation.
The reason that unemployment responds to policy change more
quickly than prices is very different from the reason that average
unemployment and inflation are higher than in the past.
I discuss the lessons to be learned from long-term experience in
Britain and the United States, and draw some conclusions.
Although stagflation is a relatively new problem, some of its principal features can be found in earlier periods. Two periods are of
special interest. The interwar experience of Britain helped to shape
many of the beliefs now commonly held about unemployment.
The depression of the 1930's seemed to show that the interwar experience of Britain was a general phenomenon, applicable to many
countries. Countercyclical fiscal and monetary policies were used on
a much larger scale than ever before, and the groundwork for postwar
economic policies was laid in that era.
The lesson from the experience of Britain in the 1920's and in the
United States during the thirties is that high rates of unemployment
coexist with rising prices, falling prices and stable prices. There is no
reason to expect an association between the average unemployment
rate and the average rate of price change, and none is found.
This does not mean that nothing can be done. There are policies
that lower the rate of unemployment, but if we understand the reasons
for unemployment, we may not want to adopt some of those policies.
132
Reducing real tax burdens, slowing the growth of Government
spending to the rate of growth of output or lower, reducing the size
of transfer payments or their rate of increase, and lowering the minimum wage relative to the average wage rate are all means of reducing the average rate of measured unemployment and the number of
discouraged workers. The decision to take these steps is the responsibility of the Congress. If they are taken, the average rate of measured
unemployment will decline.
Failure to reduce the relative size of the government sector by permanently lowering tax rates, or to reduce unemployment benefits relative
to wages, or to take other steps that increase the after-tax returns to
labor and capital raises unemployment rates.
If we can remember that the higher average unemployment rates
and slower growth of output are, in part, a result of our tax and transfer policies, we will avoid one of the major mistakes of economic policy
in this decade—using fiscal and monetary policies to pump up spending with the aim of reducing the average unemployment rate or eliminating some arbitrary measure of the output gap.
Professor Wachter has spoken and written about the arbitrariness
of these measures of the output gap, and he has produced numbers
which in my judgment are far more meaningful than the numbers
used as a guide to policy.
I believe one of the more interesting phenomena of the last 2 years
has been the fact that much of the apparent output gap, about which
the committee heard a great deal, vanished without being eliminated.
It was simply erased from the books when the Council of Economic
Advisers decided that their previous measures were inappropriate.
Yet, policies were geared to the elimination of that output gap. And
much of our current inflation is due to the fact that we persisted in
policies to close an output gap which has now vanished from the books.
To raise standards of living, we must have increasing capital for
workers and increased productivity. Since 1973, both of these traditional sources of growth and living standards have been modest. Productivity growth has averaged less than 1 percent a year since the
previous peak in 1973.
I believe that the most effective programs that the Congress can enact to increase long-term productivity growth are these:
One, permanent tax reductions for individual and corporate taxpayers, accompanied by
Two, permanent reduction in the growth of public spending and
transfer payments and a combination of
Three, deregulation; and
Four, the establishment of rules for regulatory agencies that are
as clear, definite, and long lasting as the Congress can provide.
The Congress has made enormous grants of authority to the regulatory agencies who provide an enormous amount of variability in the
expected returns to capital and the opportunity for labor.
We have built a system in which very high rewards go to those who
find ways to circumvent regulation or to reduce its burden on firms or
groups. Firms often have a greater opportunity to reduce costs by reducing the burden of regulation than by improving production
techniques.
133
Skilled personnel, our most talented individuals, are attracted to
fields or endeavors that are much more valuable to firms or groups than
to society as a whole. One step in a program to restore productivity
growth is to reduce the social cost of regulation. The other main step
is to slow the relative growth of government and the anticipated
growth of taxes.
Let me now turn to the problem of cyclical stagflation.
Whenever political priorities change from stimulus to restraint, the
size of the budget deficit, or the public sector borrowing requirement,
and the growth rate of money change. The first effect of the shift
toward less expansive economic policies is on employment. Inflation
starts to fall only after restraint has been maintained for some time.
Sometimes, a year or more passes before the policy of restraint has
any noticeable effect on the rate of inflation. The converse is also true.
A policy shift toward greater stimulus first affects output, then employment, and later prices.
The problem with the types of policies on which we have relied is
that they have not worked as promised. Whatever confidence people
may have had about the ability of fiscal and monetary authorities to
keep the economy near full employment without inflation eroded long
ago. The policies failed because they were based on incorrect beliefs
about the way in which the economy works.
There are two principals, and I believe, fundamental errors in the
theory of inflation and employment or unemployment that guide
policymakers. One is the failure to recognize that workers in cyclically
sensitive industries expect periods of unemployment.
The other is that workers, on average, choose to accept unemployment in preference to wage cuts as long as they believe that unemployment is temporary.
Workers in cyclically sensitive industries know that fluctuations in
employment have occurred in the past and will occur in the future.
They are uncertain about the timing and duration of recessions, but
not about their occurrence. ~No one knows precisely when a recession
will start, how long it will last or how severe it will be.
However, few of us are unaware that there have been recessions,
and few doubt that there will be future recessions.
At the start of a recession, workers who are "Laid off" regard the
experience as consistent with their belief that the layoff is temporary.
They do not, in most cases, search for new jobs at lower wages, but
instead use their time to take a vacation, to fix up their houses, to do
odd jobs. They wait to be recalled.
If, on average, a worker experienced layoffs or unemployment of
this kind for periods of 0 or 8 weeks every 3 or 4 years, he is not
surprised to be laid off when recession occurs. He does not start to
look for permanent employment elsewhere at lower real wages. He
waits.
It is true, as many economists have noted, that workers could offer
to reduce their real wages in periods of low demand for their services
to maintain their jobs. Workers agree to reduce real wages, as many
examples show, when they believe that the alternatives area permanent loss of employment or search for a different job at lower paw
134
The response to a permanent loss of employment resulting from
changes in tastes, technology, or international competition is very
different from the response to the temporary changes in employment
that occur during recessions. Employees most readily agree to cut
wages when the alternative is a plant closing.
Unfortunately, changes in employment do not come with neatly
typed labels indicating that they are permanent changes. Workers
and employers—people in general—must repeatedly solve a complex
inference problem to decide on the proper course of action. Offering
to supply labor at lower real wages repesents a loss of lifetime income if the education in demand is temporary.
Failing to cut real wages when the reduction in demand is permanent also means a loss of lifetime income. The proper choice is not
always clear at the time, sometimes not immediately obvious afterwards. This is one reason that workers and firms are slow to adjust
prices and money wages up or down.
Suppose that a government of good intentions responds to every
recession by pushing up spending to stimulate the economy. Each time
this is done, output recovers, employment rises, but the rate of inflation
is higher at each trough than at the previous trough and higher at each
peak than at the previous peak.
Experience of this kind, and it is our experience, teaches the public
two lessons. First, whether the decline is temporary or permanent, the
average rate of price and wage changes rise from cycle to cycle. Resistance to relative wage and price reduction increases in recessions.
The other side of the coin is that anticipated inflation increases and
the demand for higher wages rises.
Second, all temporary recessions are expected to be offset by stimulative Government policies, and the costs of unemployment are expected to be reduced by unemployment compensation benefits. There
are fewer reasons to look for employment at lower real wages and
more reasons to wait for stimulative policies to restore employment
at the old job once these policies are anticipated.
The use of variable monetary and fiscal policies adds an additional
dimension to the already complex inference problem. Uncertainty
about the future course of monetary and fiscal policies add to uncertainty about present and future tax rates and uncertainty about
inflation.
People who want to know whether tax rates will rise or fall in the
future must guess, or infer, whether the bulge in Government spending
during a recession is a portent of permanently higher spending and
tax rates or temporary higher spending. Past experience gives some
guidance, but it is very imperfect guidance.
Yet. differences in anticipated tax rates often are the deciding factor
in decisions to invest in durable capital, to invest in land or other
tax-sheltered capital or to consume.
"With hindsight, it is easy to identify the sustained change in money
growth that lead to higher or lower inflation. I assure you that there
is irmeh less certainty when the turning points occur. Our current
uncertainty about the rate of monetary growth is an extreme, but;
nevertheless useful, example.
135
We have been through four or five cycles in which governments have
made explicit commitments to end inflation. Is it unwise for the public
to treat such commitments skeptically ? I believe not. After four or
five cycles in which promises to end inflation were followed by higher
average rates of inflation, credibility is strained.
The experience of 1966-67 is informative. The 6-month average rate
of change of wholesale prices fell from 4 percent to minus 2 percent in
1 year, and a similar average for consumer prices fell from 3.8 percent
to 1.8 percent. People believed the anti-inflationary policy that had
been announced and implemented would be maintained.
The retardation of the economy was so brief that the episode is not
recorded as a recession. The anti-inflation policy worked quickly because inflation was a relatively new phenomenon, and the Government
had not reduced its credibility by promising to end inflation while
acting to increase it or by abandoning policies that slow inflation
when unemployment increases.
The rest of my remarks suggest some policy to reduce cyclical stagflation. These policies are policies I have advocated on several occasions
before.
The principal recommendation is, by now, familiar. My colleagues
on the Shadow Open Market Committee and I have asked repeatedly
for a commitment from government to a preannounced policy of sustained, gradual reductions in the growth of money by 1 percent per
year until a noninflationary rate of money growth is achieved.
A similar recommendation has now been made, unanimously, by the
House Committee on Banking, Currency, and Urban Affairs. Chairman
Miller has recognized on many occasions that inflation cannot be ended
in less than 3 to 5 years.
Recognition of the problem is not enough. The Congress should
require the Federal Reserve to adopt a policy of this kind, and the Congress should endorse the policy. If a commitment to an anti-inflationary policy is made by the Federal Reserve, the Congress, and the administration is followed by implementation, beliefs about future inflation will erode more rapidly and the cost of ending inflation will
decline.
To supplement monetary policy and make it credible, other steps
must be taken. A commitment by Congress and the administration
to hold the growth of public spending below the growth of output implies that the average tax rate will fall in the future.
But the commitment also implies that the Federal Reserve will not
be called upon to finance larger Government deficits by raising money
growth. A commitment to slower growth of government reinforces
and complements the commitment to maintain a monetary policy that
ends inflation.
There are many policy changes that can help to reduce the problem
of cyclical stagflation. I would like to conclude, however, by pointing
to two current risks that cannot be avoided without congressional
action. I refer to the risks of a major error in monetary policy and
the risk of a financial panic following a run on one of the noninsured
financial intermediaries that now hold assets that formerly were held
in insured commercial banks and thrift institutions.
136
The risk of a major error in monetary policy arises because the numbers now added together to form Mi, M2 or any other M do not have
the same meaning that they had before the development of automatic
transfer systems, NOW accounts, overnight repurchase agreements,
money market funds, and many other assets.
Currently, money growth may be pushing the economy toward substantially higher inflation or deeper recession than we know or believe.
The risk of an error in interpretation cannot be reduced, at current
rates of inflation, unless Congress agrees to repeal regulation Q, to
repeal the prohibition against interest payments on demand deposits
and to permit interest payments on required reserves.
The Congress has heard testimony on these proposals for more than
a decade, but it has not acted. The failure to act now to lower the risk
of a potential crisis is inexcusable and costly, in my opinion.
Suppose some larger seller of commercial paper, Eurodollars or
other financial instrument defaults. These instruments are held indirectly by individuals and small firms through their participation in
some of the substitutes for demand and time deposits that are now held
by many people. The substitutes are not insured.
Here, we have the ingredients for the type of financial panic that
we have not experienced since deposit insurance started more than 40
years ago. This risk can be reduced by removing controls on interest
rates at banks and thrift institutions and by a clear statement from
the Federal Keserve that it will serve as lender of last resort to the
entire financial system.
The probability of a panic is small, but it is larger than it need be.
And the probability is increased by the failure of Congress to remove
regulations and restrictions.
Thank you.
Representative ROUSSELOT. Thank you very much, Mr. Meltzer.
[The prepared statement of Mr. Meltzer follows:]
PREPARED STATEMENT OF ALLAN H. MELTZEB
The Problem of Stagflation
We are deep into the era of relatively high measured unemployment rates and
high rates of inflation that is described by that inelegant term "stagflation."
Growth rates of real output fell in Western Europe and the United States just
at the time that the growth rates of the labor forces increased. The rate of increase in productivity has fallen, so real incomes have either fallen or risen
more slowly than in the sixties. Inflation and progressive tax rates financed
further increases in the relative size of the public sector with the result that
current and prospective taxes have grown more than incomes.
The combined effect of rising prices, higher unemployment, higher taxes and
slower growth in real income produced the dissatisfaction and malaise that
make "stagflation" a widely discussed problem. Governments appear unable to
reduce inflation without increasing unemployment or to reduce unemployment
without, sooner or later, increasing inflation. Nowhere does this outcome seem
more apparent than in the United States where the rates of inflation and unemployment rise with each succeeding round of expansion and recession and where
measured productivity growth in the private sector has remained close to zero.
on average, for the past two years. The appearance of a positive relation between
the cyclical average rate of unemployment and the cyclical average rate of price
change is misleading. There is no necessary relation between the two, and any
existing long-term relation between the two in the United States could be eliminated by a decision to index the tax system.
137
Stagflation appears to have two distinct meanings. One is the apparent longerterm relation between the average unemployment rate and the average rate of
inflation, just mentioned. The other is the very limited reduction in inflation—
and relatively large increase in unemployment—that occurs in the first year or
two following a shift in political priorities from reducing unemployment to
reducing inflation. The reason that unemployment responds to policy change more
quickly than prices is very different from the reason that average unemployment
and inflation are higher than in the past. One concerns the level of the averages,
the other their rates of change. I discuss the two separately.
LONG-TERM STAGFLATION
Although stagflation is a relatively new problem, some of its principal features
can be found in earlier periods. Two periods are of special interest. The interwar
experience of Britain helped to shape many of the beliefs now commonly held
about unemployment. The depression of the 1930's seemed to show that the interwar experience of Britain was a general phenomenon applicable to many countries. Counter cyclical fiscal and monetary policies were used on a much larger
scale than ever before, and the groundwork for postwar economic policies was
laid.
In Britain during the years 1925 to 1929, measured unemployment rates
remained remarkabiy stable at about 10 percent. Prices were stable also; the
relatively high rate of unemployment leaves no imprint on either the rate of
change of prices or the rate of change of money wages. The failure of real wages
to fall in the face of persistent unemployment was puzzling. Recent work by two
economists at the University of Washington, Levis Kochin and Daniel Benjamin,
helps to resolve the puzzle. Kochin and Benjamin present evidence suggesting
strongly that the introduction of unemployment compensation in the 1920's
raised the rate of measured unemployment. Unemployment compensation, and
other benefits to the unemployed, were low by current standards but high relative to the wages at which many of the idle would have been paid for work. The
evidence suggests that much of the increase in unemployment that occurred in
Britain during the twenties can be explained in this way.
In the 1930's, budget deficits and monetary expansion were used as part of a
policy designed to move the economy from recession to prosperity. The economy
recovered from 1933 to 1937 but did not surpass the previous peak in real output
despite four years of Federal budget deficits that were rarely less, and often
more, than total Federal government spending at the 1929 peak. After the recession of 1937-38, the economy moved forward sluggishly, even though the budget
remained between 17 percent and 35 percent of Federal spending. As is wellknown, the unemployment rate remained above 15 percent through much of the
decade and did not decline until wartime increases in production and in the
armed forces absorbed large numbers of persons into the military and civilian
labor force.
The lesson from the experiences of Britain in the 1920's and in the U.S. during
the thirties is that high rates of unemployment coexist with rising prices, falling
prices and stable prices. There is no reason to expect an association between the
average unemployment rate and the average rate of price change, and none is
found.
The average rate of measured unemployment during a decade depends on a
large number of factors. Demographic factors—as reflected
in age, marital status
or the like—affect the supply of labor and the rate at wThich the labor force turns
over. Political and social decisions reinforce or offset the demographic factors
by changing the real wages at which workers choose between labor and idleness
and the prices at which potential investors choose between consumption and the
accumulation of capital. Spending and transfers by government have increased
relative to output in all Western countries during the past quarter century.
Taxes, whether paid directly or through inflation, must rise faster than output
to pay for the increased spending, so after-tax returns from work and after-tax
returns from investment are held down. Transfer payments to welfare recipients,
food stamps, medical programs, and higher unemployment compensation lower
the cost of unemployment to the worker. Together higher taxes and increased
transfers lower the return from work and the cost of idleness. Many of the
idle are counted as unemployed. Clarkson and Meiners have noted that, under
the food stamp program, some recipients must register for employment to main-
138
tain their benefits. Legislation of this kind increases the average rate of measured unemployment, so we could expect some of the unemployment to vanish if
the law were repealed.
Reducing real tax burdens, slowing the growth of government spending to the
rate of growth of output or lower, reducing the size of transfer payments or their
rate of increase, and lowering the minimum wage relative to the average wage
rate are all means of reducing the average rate of measured unemployment and
the number of discouraged workers. The decision to take these steps is the responsibility of the Congress. If they are taken, the average rate of measured
unemployment will decline.
Failure to reduce the relative size of the government sector by permanently
lowering tax rates, or to reduce unemployment benefits relative to wages, or to
take other steps that increase the after-tax returns to labor and capital raises
unemployment rates. If we can remember that the higher average unemployment rates and slower growth of output are, in part, a result of our tax and
transfer policies, we will avoid one of the major mistakes of economic policy in
this decade—using fiscal and monetary policies to pump up spending with the
aim of reducing the average unemployment rate or eliminating some arbitrary
measure of the output gap.
This committee heard testimony in 1977 and 1978 about idle resources and
output gaps that were to be removed by expansive economic policy. The amount
of idle capacity was overestimated because of an error in assessing the effects
on the economy of the 1974 oil shock and the effect of tax and transfer policies
on unemployment and potential output. The gap between actual and potential
output vanished without being filled, but the attempt to close the gap by using
expansive policies left us with high inflation, a devalued dollar, a large budget
deficit and a high rate of inflation. I believe that the rate of inflation would be
lower, the dollar would not have been devalued in foreign exchange markets in
1977 and 1978 and the unemployment rate would be little different if we had
avoided the excessively expansive policies of 1976,1977 and 1978.
Let me restate a previous conclusion in a different way. One reason we now
have high inflation is that we used excessive fiscal and monetary expansion to
reduce the average rate of unemployment and increase the growth of output.
Moderate policies throughout the decade would have left us with about the same
average rate of unemployment for the decade, possibly less, and less inflation.
The average rate of unemployment and the average rate of inflation are best
regarded as unrelated. The failure of policymakers to accept this conclusion is
one of the principal reasons we have long-term stagflation.
A brief comparison of changes in prices and in industrial production in major
countries for the current decade shows, as expected, that there is little relation
between the two. Percentage increases in industrial production are listed in
descending order and are compared to percentage increases in consumer prices.
Rankings are shown in parentheses. A cursory examination shows that high or
low rates of increase in industrial production, used to measure the growth of
employment opportunities, occur with relatively high and relatively low rates
of increase in consumer prices.
TABLE 1 — RATES OF INCREASE IN INDUSTRIAL PRODUCTION AND PRICES, 1969 TO AUTUMN 1978
Percentage increase,
industrial production
Country:
Japan
Canada
France
United States
Italy
Germany
United Kingdom
„
54
44
38
33
32
29
14
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Percentage increase,
consumer prices
131
89
(3)
(5)
The longer-term problem of stagflation for the United States is that the relatively modest average growth of industrial production occurred during a period
in which the growth of the labor force increased. Increases in output provided
mainly by growth of the labor force leave little room for rising standards of
living. To raise standards of living, we must have increases in capital per
139
worker and increased productivity. Since 1973, both of these traditional sources
of growth in living standards have been modest. Productivity growth has averaged less than 1 percent a year since the previous peak in 1973.
I believe that the most effective programs that the Congress can enact to
increase long-term productivity growth are: (1) permanent tax reductions for
individual and corporate taxpayers, accompanied by (2) permanent reduction in
the growth of public spending and transfer payments and a combination of (3)
deregulation and (4) the establishment of rules for regulatory agencies that are
as clear, definite and long-lasting as the Congress can provide.
We have built a system in which very high rewards go to those who find ways
to circumvent regulation or to reduce its burden on firms or groups. Firms often
have a greater opportunity to reduce costs by reducing the burden of regulation
than by improving production techniques. Skilled personnel, our most talented
individuals, are attracted to fields or endeavors that are much more valuable to
firms or groups than to society as a whole. One step in a program to restore
productivity growth is to reduce the social cost of regulation. The other main
step is to slow the relative growth of government and the anticipated growth of
taxes.
CYCLICAL STAGFLATION
Whenever political priorities change from stimulus to restraint, the size of
the budget deficit, or the public sector borrowing requirement, and the growth
rate of money change. The first effect of the shift toward less expansive economic
policies is on employment. Inflation starts to fall only after restraint has been
maintained for some time. Sometimes, a year or more passes before the policy of
restraint has any noticeable effect on the rate of inflation. The converse is also
true. A policy shift toward greater stimulus first affects output, then employment
and later prices.
Were it not for this pattern of delayed response in prices, cyclical fluctuations
would not have their well-known pattern. If the price level, interest rates and
wage rates adjusted instantly to changes in tastes, productivity and government
policy, we would not have the fluctuations in output and employment known as
business cycles. Instantaneous adjustment of prices to changes in the demand
for or supply of output would eliminate the effectiveness of economic policies
but would also eliminate any need for stabilization policies.
Contemporary economic policies are based on a Keynesian view of fluctuation^
Money wages and prices are assumed to be rigid, or slow to change, so policies
that increase spending raise output first and the rate of change of prices and
money wages later. Policies to slow an inflating economy work through the
same mechanism. Output falls and, later, the rate of change of prices and wages
falls.
Policymakers who follow this approach, as many have, regard most cyclical
changes in employment as "involuntary," the result of insufficient spending by
the private sector. Even if the unemployed receive compensation equal to their
real incomes, it is believed that society loses all of the output that the unemployed do not produce. Hence government policies to eliminate unemployment
are regarded as policies that have low cost and large social benefits. Because
the rate of inflation is regarded as slow to adjust, policymakers believe, or are
advised, that there is no reason to expect inflation to increase until full employment is reached.
Repeated attempts to use fiscal and monetary policies to stimulate output first
and slow inflation later have left a residue of higher inflation. Widespread public
dislike of inflation forces policymakers to respond and often to overreact, thereby
creating another recession, another attempt at stimulus and another round of
stop and go. We may be, once again, in the process of shifting from excessive
expansion to excessive contraction.
The problem with the types of policies on which we have relied is that they
have not worked as promised. Whatever confidence people may have had about
the ability of fiscal and monetary authorities to keep the economy near full
employment without inflation eroded long ago. The policies failed because they
were based on incorrect beliefs about the way in which the economy works.
There are two principal, and I believe, fundamental errors in the theory of
inflation and employment or unemployment that guides policymakers. One is the
failure to recognize that workers in cyclically sensitive industries expect periods
of unemployment. The other is that workers, on average, choose to accept unemployment in preference to wage cuts as long as they believe that unemployment
140
is temporary. Recent work with my collaborators, Karl Brunner and Alex
Cukierman, has explored these issues in detail, but the basic idea can be summarized readily.
Workers in cyclically sensitive industries know that fluctuations in employment have occurred in the past and will occur in the future. They are uncertain about the timing and duration of recessions but not about their occurrence.
No one knows precisely when a recession will start, how long it will last or how
severe it will be. However, few of us are unaware that there have been recessions, and few doubt that there will be future recessions. At the start of a recession, workers who are "laid off" regard the experience as consistent with their
belief that the layoff is temporary. They do not, in most cases, search for new
jobs at lower wages but instead use their time to take a vacation, to fix up their
liouses, to do odd jobs. They wait to be recalled. If, on average, a worker experienced layoffs or unemployment of this kind for periods of six or eight weeks
every three or four years, he is not surprised to be layed off when recession
occurs. He does not start to look for permanent employment elsewhere at lower
real wages. He waits.
It is true, as many economists have noted, that workers could offer to reduce
their real wakes in periods of low demand to maintain their jobs. Workers agree
to reduce real wages, as many examples show, when they believe that the alternatives are a permanent loss of employment or search for a different job at lower
pay. The response to a permanent loss of employment resulting1 from changes in
tastes, technology, or international competition is very different from the response to the temporary changes in employment that occur during recessions.
Employees more readily agree to cut wages when the alternative is a plant
closing.
Unfortunately, changes in employment do not come with neatly typed labels
indicating that they are permanent changes. Workers and employers—people
in general—must repeatedly solve a complex inference problem to decide on the
proper course of action. Offering to supply labor at lower real wages represents
a loss of lifetime income if the reduction in demand is temporary. Failing to cut
real wages when the reduction in demand is permanent also means a loss of lifetime income. The proper choice is not always clear at the time. This is one reason
that workers and firms are slow to adjust prices and money wages up or down.
Suppose that a government of good intentions responds to every recession by
pushing up spending to stimulate the economy. Each time this is done, output
recovers, employment rises, but the rate of inflation is higher at each trough
than at the previous trough and higher at each peak than at the previous peak.
Experience of this kind, and it is our experience, teaches the public two
lessons. First, whether the decline is temporary or permanent, the average rate
©f price and wage change rises from cycle to cycle. Resistance to relative wage
and pricQ reduction increases in recessions. The other side of the coin is that
anticipated inflation increases and the demand for higher wages rises. Second,
all temporary recessions are expected to be offset by stimulative government
policies, and the costs of unemployment are expected to be reduced by unemployment compensation benefits. There are fewer reasons to look for employment at
lower real wages and more reasons to wait for stimulative policies to restore
employment at the old job once these policies are anticipated.
The use of variable monetary and fiscal policies adds an additional dimension
to the already complex inference problem. Uncertainty about the future course
of monetary and fiscal policies adds to uncertainty about present and future
tax rates and inflation. People who want to know whether tax rates will rise
or fall in the future must guess, or infer, whether the bulge in government
spending during a recession is a portent of permanently higher spending and
tax rates or temporarily higher spending. Past experience gives some guidance,
but it is very imperfect guidance. Yet, differences in anticipated tax rates often
are the deciding factor in decisions to invest in durable capital, to invest in
land or other tax-sheltered capital or to consume.
With hindsight, it is easy to identify the sustained change in money growth
that lead to higher or lower inflation. I assure you that there is much less
certainty when the turning points occur. Our current uncertainty about the rate
of monetary growth is an extreme but nevertheless useful, example.
We have been through four or five cycles in which governments have made
explicit commitments to end inflation. It is unwise for the public to treat such
141
commitments skeptically? I believe not. After four or five cycles in whicfo
promises to end inflation were followed by higher average rates of inflation,
credibility is strained.
The experience of 1966-617 is informative. The six-month average rate of
change of wholesale prices fell from 4 percent to minus 2 percent in one year
and a similar average for consumer prices fell from 3.8 percent to 1.8 percent.
The retardation of the economy was so brief that the episode is not recorded
as a recession. The anti-inflation policy worked quickly because inflation was a
relatively new phenomenon, and government had not reduced its credibility by
promising to end inflation while acting to increase it or by abandoning policies
that slow inflation when unemployment increases.
SOME SUGGESTIONS FOR CHANGE
I have suggested some explanations of long-term and cyclical stagflation.
Earlier, I proposed some policies to increase long-term growth and stability.
I will conclude with recommendations to lower the cost of ending inflation.
The principal recommendation is, by now, familiar. My colleagues on the
Shadow Open Market Committee and I have asked repeatedly for a commitment
from government to a pre-announced policy of sustained, gradual reductions
in the growth of money by 1 percent per year until a non-inflationary rate of
money growth is achieved. A similar recommendation has now been made, unanimously, by the House Committee on Banking, Currency and Urban Affairs.
Chairman Miller has recognized on many occasions that inflation cannot be
ended in less than three to five years.
Recognition of the problem is not enough. The Congress should require the
Federal Reserve to adopt a policy of this kind, and the Congress should endorse
the policy. If a commitment of this kind by the Federal Reserve, the Congress,
and the administration is followed by implementation, beliefs about future inflation will erode more rapidly and the cost of ending inflation will decline.
To supplement monetary policy and make it credible, other steps must be taken.
A commitment by Congress and the administration to hold the growth of public
spending below the growth of output implies that the average tax rate will fall in
the future. But the commitment also implies that the Federal Reserve will not be
called upon to finance larger government deficits by raising money growth. A
commitment to slower growth of government reinforces and complements the
commitment to maintain a monetary policy that ends inflation.
There are many policy changes that can help to reduce the problem of cyclical
stagflation. I would like to conclude, however, by pointing to two current risks
that cannot be avoided without congressional action. I refer to the risks of a
major error in monetary policy and the risk of a financial panic following a run
on one of the non-insured financial intermediaries that now hold assets that
formerly were held in insured commercial bonks and thrift institutions.
The risk of a major error in monetary policy arises because the numbers now
added together to form Ml, M2 or any other M do not have the same meaning1
that they had before the development of ATS, NOW accounts, overnight repurchase agreements, money1 market funds and many other assets. Currently, money
growth may be pushing the economy toward substantially higher inflation or
deeper recession than we know or believe.
The risk of an error in interpretation cannot be reduced, at current rate of
inflation, unless Congress agrees to repeal regulation Q, to repeal the prohibition
against interest payments on demand deposits and to permit interest payments
on required reserves. The Congress has heard testimony on these proposals for
more than a decade, but it has not acted. The failure to act now to lower the risl:
of a potential crisis is inexcusable and costly.
Suppose some large seller of commercial paper. Euro-dollars or other financial
instrument defaults. These instruments are held indirectly by individuals and
small firms through their participation in some of the substitutes for demand
and time deposits that are now held by many people. The substitutes are not insured. Here we have the ingredients for the type of financial panic that we have
not experienced since deposit insurance started more than 40 years ago. This
risk can be reduced by removing controls on interest rates at banks and thrift institutions or by a clear statement from the Federal Reserve that it will serve as
lender of last resort to the entire financial system.
142
The probability of a panic is small, but it is larger than it need be. And the
probability is increased by the failure of Congress to remove regulations and
restrictions.
Representative ROTJSSELOT. Our final witness is Mr. Alfred S.
Eichner.
STATEMENT OP ALP&ED S. EICHNEE, FILGPESSOU OP ECONOMICS, STATE TTNIVEKSXTY OP NEW YO&K, PURCHASE, N.Y.
Mr. EICHNER. Thank you, Congressman Rousselot.
I want to thank you and the rest of the committee for the opportunity to appear here today.
I also want to commend the committee for its willingness to look
beyond the public concerns of the moment and focus on the problems
likely to dominate policy discussions in the 1980's.
As will become clear from my remarks, I believe this is precisely the
shift in time perspective that is needed.
The feeling is widespread today, just as it was in the 1930's, that
economics as an academic discipline no longer offers a solution to the
Nation's economic problems. Only among economists themselves does
the faith in the standard textbook arguments and conventional policy
prescriptions still run strong.
I come before you this morning as one of a small, but growing, number of economists who believes that economics took a fateful wrong
turn in the years immediately following World War I I . Rather than
carry out the fundamental reformulation of economic theory which a
true Keynesian revolution would have required, economists preferred
to seize upon only a few ideas which could easily be incorporated into
the old analytical framework and to reject the rest.
The debate between the so-called Keynesians and the monetarists
is largely over how few of Keynes' ideas need to be taken seriously.
This patched-up analytical framework has served well enough as a
guide for avoiding the widespread unemployment which occurred in
the 1930's, but it has proven increasingly inadequate as the basis for
coping with the problems of an expanding economy which fluctuates
more or less short of full employment.
The post-Keynesian group to which I belong takes issue with the
dominant fraction within the economics profession on almost every
important theoretical point. These conceptual differences have been
spelled out, not only in the paper prepared for this committee on the
problem of stagflation, but also in the series of articles currently appearing in Challenge magazine.
In my brief remarks tliis morning, I want to emphasize primarily
the policy differences.
Macroeconomic policy in the United States since the end of World
War I I , guided by the dominant view among economists, has focused
almost entirely on shortrun demand management. And I underline the
words "shortrun demand management."
At certain times, the diagnosis has been that aggregate demand is
too low, this by way of explanation for the rise in unemployment.
At other times, the explanation has been that aggregate demand is
too high, this by way of explanation for the rise in prices. And I might
143
add parenthetically that today's suggestion we redefine "full employment" is merely a way of saying that there is exists no problem at all.
But whichever the malady, the cure is always seen to lie in altering
the level of aggregate demand. What controversy has arisen among
economists—and it has certainly been considerable—has centered on
one, what is the optimum balance between unemployment and inflation ; and two, whether fiscal or monetary policies can better achieve
that balance.
The efficacy of shortrun demand management as the policy focus
has seldom been questioned.
Post-Keynesian economists like myself reject this framework for
macroeconomic policy on several grounds.
First, we would deny that inflation is due solely or even primarily
to the economy becoming "overheated"—the result of well-intentioned,
but misguided, efforts to reduce unemployment.
We therefore question on both theoretical and empirical grounds
the validity of the Phillips curve and the supposed tradeoff between
unemployment and inflation implicit in that putative relationship. We
would instead assert that the processes determining the expansion of
employment and output are separate and distinct from those determining the rise in prices, and that it is a fundamental error in economic
analysis to view the two as being one and the same.
There is thus no inherent economic reason that we can see—there
may, of course, be political and social reasons—why employment cannot be expanded, along with the output of goods and services, without
this leading to inflation. Indeed, the Nation's experience during the
first half of the 1960's attests to this very possibility.
Second, we would argue that the key to employment expansion lies
in a set of policies which focus on long-term supply enhancement—and
again, I underline the words "long-term supply enhancement"—relegating shortrun demand management policies to a secondary and supportive role.
It is through additions to the economy's production capacity that not
just the demand for labor, but also the output of goods and services,
can be increased over time. These additions to capacity require investment, both private and public.
Thus, it is the level and composition of investment which is critical
to the ability of the economy to expand over time, and it is the level and
composition of investment which should be the focus of public policy.
Shortrun demand management policies, to the extent they discourage
capital outlays on the downswing and favor other types of expenditures in generating the upswing, work against the long-term enhancement of supply capacity.
What is needed in my judgment, to reverse the undue emphasis on
shortrun demand management policies, is a quasi-governmental body
to serve as a clearinghouse for capital spending, plans, both private
and public. The function of this new entity would be to see what the
various plans, when examined altogether, add up to.
Will the aggregate level of investment be sufficient to assure the desired long-term expansion of the economy? Are bottlenecks likely to
arise because of the inconsistency of the different plans ? Are important
144
areas for investment, vital to the future direction the economy is likely
to take, being ignored ?
It is a serious deficiency in the existing structure for economic policy making that there is now no body, official or otherwise, responsible
for answering these questions. Certainly, if the problem of inflation is
one of excess demand—and there may indeed be times when this is part
of the story—then clearly the better solution is to assure an adequate
supply beforehand rather than to curtail demand as a belated response.
The Employment Act of 1946 needs to be reinterpreted as placing
on Government the responsibility for overseeing the adequate expansion of the economy's supply capacity over time, and not just an obligation to intervene with demand management policies on a crisis basis.
If every large corporation and nonprofit organization which prides
itself on good management has a unit charged with the responsibility
for long-term forward planning, no less can be expected of the institution—and here, I am referring to Government—responsible for the
economy as a while.
Third, post-Keynesian economists like myself would argue that the
problem of inflation needs to be disentangled from issues of shortrun
demand management. Inflation needs to be viewed as a problem of excessive money claims against real output, with prices rising to bring
the money claims into line with the available real resources.
The United States, ever since its formal commitment to full employment goals, has relied on either market forces or the bludgeoning
effect of deliberately induced recessions to hold down the growth of
money claims. But it should now be clear, after three decades of experience, that neither device can be counted on to bring a wage-price inflationary spiral to a halt once it has been initiated.
Trade unions have more than sufficient collective bargaining
strength to obtain higher money wages, this «s a way of protecting the
real income of their members and assuring them and other workers a
fair share of any gains in real output. Trade unions are not dissuaded
from this course by the stick of higher unemployment.
Industrial enterprises, meanwhile, have more than sufficient market
power to obtain higher prices, this a^ a way of protecting their profit
margins in the face of rising costs. Thev are not dissuaded from this
course by the stick of reduced sales and lower operating rates.
Both market forces and deliberately induced recessions being incapable of bringing a wage-price inflationary spiral to a halt, it is now
time to try a different approach.
Like other post-Keynesians, I believe that different approach involves some form of incomes policy. But not an income policy which
simply attempts to hold down money wag^s. leaving business profits
and other forms of household income unchecked.
And not an incomes policy which is simply imposed by Executive
order, giving business, organized labor, and the other groups that
must support the policy little or no voice in its formulation.
And finally, not an incomes policy which precedes, rather than follows from, certain new institutional arrangements.
Just as monetary policy cannot be effectively implemented without
a central bank and fiscal policy without congressional budget committees, so an incomes policy cannot be expected to succeed in an institutional vacuum.
145
One of the institutions that an incomes policy requires is the clearinghouse for capital spending plans already mentioned. As post-Keynesian theory makes clear, not only are the rate and composition of
investment critical to the long-term enhancement of supply capacity,
they also have important consequences for the distribution of income.
These consequences, along with the other considerations outlined in
my paper for the committee, need to be taken into account before an
incomes policy can be formulated that will enable the economy to
proceed along a noninflationary growth path.
However, the technical analysis which the professional staff of the
clearinghouse would be able to provide would not be enough to assure
the success of an incomes policy. There must also be some means of
arranging for a dialog to take place among the various private interest
groups which have to lend their support to an incomes policy, together
with key public officials.
For while the technical experts from the clearinghouse would be
able to indicate what margin exists for increasing money claims without precipitating a wage-price inflationary spiral, there are still important choices to be made within those limits. These choices require
that a bargain be struck at the top among all the affected interest
groups, with that bargain then ratified as part of a "social contract,77
through the subsequent actions by public officials.
Agreement must be reached, not just on the tradeoff between current and future consumption levels, but also on the tradeoff between
work and leisure which Professor Leontief mentioned today, and
between public and private consumption which I think some of the
other panelists mentioned.
Thus, the long-term solution to the problem of stagflation lies in
the creation of a new set of political-economic institutions.
One of these institutions should be a social and economic council
on which would sit representatives of all the private interest groups
significantly affected by an incomes policy, together with key public officials.
Another of the institutions should be a professionally staffed quasigovernment body which could provide technical backup support to
the social and economic council while serving as a clearinghouse for
all capital spending plans.
To function most effectively, both the social and economic council
and the technical support unit and clearinghouse linked to the council should be formed with the support and encouragement of public
officials, but outside the formal structure of government. In that way,
questions of representation and other matters could be resolved on'a
gradual and pragmatic basis.
Not until these two prerequisite institutions are in place can an incomes policy be successfully implemented, and not until then will
the economy be able to proceed along a noninflationary growth path.
This country presently finds itself unable to cope with the problem
of stagflation, not just because of the bad advice it receives from
economists, based on a,faulty understanding of the economy, but also
because of the institutional vacuum which makes it impossible to
formulate effective supply enhancement and incomes policies.
51-421—79
146
My principal recommendation to the committee this morning, therefore, is that it see what steps can be taken to fill that vacuum. And I
would just add parenthetically, since this is a committee concerned
with long-term problems, it needs to be concerned, not with what can
solve the problems in the next year or so, but what can lead to a
permanent solution to the problem of stagflation.
Congressman, I thank you and the committee for your attention,
and I invite any questions you may have.
Representative ROTTSSELOT. Gentlemen, thank you for your very
thorough statements. This has been a fascinating group of witnesses.
And Mr. Eichner, I agree with your closing comment that we here
in Congress are sometimes confused by all the advice we get from
economists.
Mr. EICHNER. SO are economists.
Representative ROUSSELOT. I am just delighted. And I am afraid
we have followed some of it too long as some of you have suggested.
And I want to thank each of you because this has been a fascinating
panel. I have a couple of questions, and then I will turn it over to Jack
Albertine who can allow the staff to ask some questions.
I do have to go back to the House for some meetings that I had
committed myself to before I realized I was going to be chairing.
Otherwise, I would have canceled the whole day and been here.
But thank you, each of you, for your participation, especially your
emphasis on the supply side of our economic equation.
You each know that our Joint Economic Committee annual report
this year gave greater emphasis to that than we have ever given. Each
of you has placed a certain amount of emphasis on it. And I hope that
this Special Study will have a followup with more participants like
each of you who have given a new emphasis to this.
Mr. Eichner, I am fascinated by your comment that the Employment
Act of 1946 needs to be reinterpreted, placing on Government the
responsibility for overseeing the adequate expansion of the economy
supply capacity over time and not just an obligation to intervene with
demand management.
You are right, but we can't get everybody here in the Congress to
listen to that. We are kind of in afixationon that subject.
Let me see if I can suggest a couple of thoughts here. I really would
like to ask an awful lot of questions on all this fine testimony. Mr.
Meltzer and Mr. Wachter, you seem to favor raising rates of return for
business, while savers and investors prefer lowering tax rates. We have
a problem every time we suggest that in Congress. They say that we are
going to cause huge reductions in revenues, and this will be a catastrophe all through the economy.
Would you like to comment on that a little further? You have
already done it, each of you, in your testimony, but how do we get our
colleagues who fear that, seem to fear that, reducing tax rates, how
can we assure them that this is not going to be another 1930 depression ?
You know the usual word we get. Would either of you or any of you
like to comment ?
Mr. WACHTER. I would suggest that, first of all, it needs to be done
slowly. I think one of the things——
147
Representative ROUSSELOT. We aren't even doing it very slowly.
Mr. WACHTER. We are moving in the wrong direction. As income
goes up, we have increasing tax rates, rather than decreasing.
Representative ROUSSELOT. The spender seizes upon that as a wonderful chance to spend more money,
Mr. WACHTER. The consensus I see emerging is one that favors
stable Government policies rather than rapid shifts.
In terms of reducing tax rates, the stress should be on across-theboard decreases. The changes should be neutral with respect to the
income distribution, but should increase the taxes on consumption
relative to savings. I see no evidence that supply side policies need to
hurt the poor.
Representative ROUSSELOT. Let me interrupt at that point. That
isn't the information we always get from economists, especially in
the administration.
Mr. WACHTER. I think by and large, some of the measures that are
introduced can have that effect, but certainly we can encourage relatively more saving by the middle class than we do now. For example,
the tax exemption on dividends and interest can be increased to $2,000
or $3,000. Further, the capital gains tax can be reduced to zero for
those with incomes below $15,000 or $20,000. That would directly
encourage the middle class to save.
At the same time, I think that spending cuts should not be oriented
toward transfer programs for the poor. By and large, we can afford the transfer levels we have today. What is needed, is to get
the Government out of subsidizing middle-class and upper-class expenditure programs.
Representative ROUSSELOT. Some of us don't even talk about expanding. We just talk about restraining the increases. And we can't
even get that done.
Mr. WACHTER. I believe that national health insurance will be the
next test case. It has great public appeal. But some of the current
suggested policies will lead to an unending drain on the budget and
a continuing shift of resources into the consumption of medical care
and away from investment.
Representative ROUSSELOT. Thank you.
Mr. MELTZER. I would like to add to that. There are some things
that should be considered. I know the chairman has introduced an
amendment to balance the budget. What we need is certainty. And
we need long-range policies to deal with long-range problems.
Supply side problems are not going to be solved by a series of
gimmicks which patch up the framework. The kind of policies we
need are policies of the kind that have been recommended in the national tax limitation amendment. These say, "Let's put a ceiling on
the growth of Government spending." That would be a way of making sure that, eventually, we get the budget into balance.
I have suggested other steps that could be taken. Without endorsing
a particular amendment, I would say that a reduction in the size of
Government is a first step.
The important things to emphasize about these proposals is not the
specific details. It is the nature of the change. If we can agree on a
148
restriction so that people will know what the long-range tax climate
is going to be, what it is going to be like when that electric powerplant
is producing energy 20 years from now or when the steel mill or
aluminum mill is producing 10 or 20 years from now, and get some
better ideas of what the after-tax return is going to be in that climate,
we will be taking a major step toward stability.
Many of our problems arise because we don't have that climate.
We have a series of very quick responses with no clear indication as
to what the general direction of the growth of Government will be
relative to the private sector. We know it has risen.
Representative ROUSSELOT. Rather substantially.
Mr.
MELTZER.
Yes.
Mr. EICHNER. I wonder if I might just interrupt there.
I think from what I have read of the testimony before this group
that there seems to be fairly general agreement that one can't achieve
higher rates of growth of productivity without the higher rates of
investment. There is substantial agreement on that.
I think the problem arises as to how one can obtain higher rates of
investment. A number of the panels have suggested that lowering
tax rates might achieve that goal.
My reading of the empirical evidence would indicate that skepticism
is required before one goes down that path very far. But I don't
believe that we ought to sit and talk about that question here because
I think the fundamental issue is what is the appropriate mechanism'
for getting a resolution of that type of question.
That is, it seems to me—and I go back to my notion of the clearinghouse for investment—that we have to see what the levels of investment currently are. Are they in the right sectors? Are they in the
sectors where we want investment to give us growth in the future?
Where, in fact, is investment inadequate?
Then, we ought to be able to take up the question of how.
Representative ROUSSELOT. Who would make that judgment, then?
Say the Federal Reserve Board?
Mr. EICHNER. I am trying to indicate I don't think right now we
have the mechanisms. We are operating on the assumption there is a
machine out there to press the lever, and that is going to solve the
economic problems we have. I am trying to suggest we don't have
the lever yet. We haven't built the machine.
We have two level's we can pull—the monetary fever or the fiscal
lever. And we have two parts of that fiscal lever. We can raise taxes
or lower taxes, raise Government spending or lower Government
spending. Those are the only levers we have.
And I am saying those levers are not enough to give us the types
of growth rates that we want to achieve. That is why I think we
have to move toward some new mechanism, whereby we can coordinate investment planning, coordinate a whole series of policies on the
supply side.
There is continual criticism about Government policies deterring
investment in given areas. We don't have any single forum within
which all -of thqge different types of arguments are put together so
they can be considered in toto rather than %ach one being considered
individually on its own merit.
149
That is the point I am trying to make. We really can't intelligently
decide these questions in this forum.
Representative ROTTSSELOT. In your testimony, you suggest some
kind of a commission or something; isn't that correct ?
Mr. EICHNER.. I am suggesting
Representative ROUSSELOT. Government appointed or what?
Mr. EICHNER. It is elaborated in my prepared statement for the committee, but my recommendation would be to try to bring together all
the different groups which are currently feeling the effects of inflation
and low-growth rates, not just labor and industry, but farmers and the
whole spectrum of private interest groups.
Representative ROTJSSELOT. Who would appoint all those people that
would make the final decisions?
Mr. EICHNER. I am not suggesting they make final decisions; I am
suggesting they go through an exercise—it could be a foundation or
some group outside Government.
Representative ROTJSSELOT. This would be outside?
Mr. EICHNER. I would suggest we do it once or twice on the outside
of government as an exercise to see whether or not this leads to any
productive results.
Representative KOUSSELOT. What is wrong with the marketplace?
Mr. EICHNER. The marketplace does an outstanding job in many
areas. But we need to focus on the areas where it doesn't do a good
job because those are the things that hurt. I am suggesting that this
is one of the areas in which we cannot rely on the marketplace.
The market does a fine job of telling a company if it should invest
In a given area because either its sales go up in that area or not. But
when you have to coordinate investment between different branches
of industry, the market doesn't always give us the appropriate signals until too late to take the next corrective action.
Representative ROTJSSELOT. I am glad Senator Javits is here. I appreciate your comment.
I was trying to understand. I did follow your testimony about your
suggestion for some kind of an indication. Your first idea is that it
would be outside of government ?
Mr. EICHNER. AS an exercise because we have efforts to do this sort
of thing, and they fail. And we are stuck with the remnants of that
•organizational structure. I am suggesting we try to do this on a nongovernmental basis with strong governmental support, but on a nongovernmental basis.
Let's see, it may be a crackpot idea, who knows ? Let's see if It works.
It may not have any payoff. If it works once or twice outside government, then we can decide how best to incorporate it into the governmental structure.
But what we have is a tremendous amount of knowledge and expertise which never gets brought to bear on these problems because
there is no institutional mechanism whereby these types of issues can
'be discussed calmly and in an environment where we can make these
decisions in the same manner they are made in, say, a corporation.
When corporations decide what their long-term expansion plan is,
they don't do it by having the accounting department and the other
departments fight" it out politically. They try "to reach some calm and
sane judgments based on an assessment of the facts.
150
Representative ROUSSELOT. Their decisions are pretty much made—
let me give the analogy of the corporation—on the basis of the marketplace that they serve, aren't they ?
Mr. EICHNER. No, they get eventual feedback from the market. They
know 5, 10 years later they have made a mistake, but they are forced
to go ahead and make judgments without
Representative ROUSSELOT. If they are losing money, they learn
pretty quickly.
Mr. EICHNER. After a while.
Representative ROUSSELOT. Yes, Mr. Meltzer.
Mr. MELTZER. I would like to make two comments.
One, I would not like Mr. Eichner's comments on tax cuts and the
stimulative effects on investment to pass. I think it is very important
to distinguish between permanent and temporary tax cuts. People
know countercyclical tax cuts will be eroded in a very short time because on average, Government spending is rising. And people recognize that rising Government spending means business and consumers
are going to be paying higher taxes in the future.
People may not know the timing of these events, but they understand that is a temporary tax cut. I think the effects are quite different
for permanent tax cuts.
After all, we do know there is a positive association between rates
of return and investment.
The second comment that I would like to make in respect to Mr.
Eichner's experiment is that his experiment has been tried and has
failed in a large number of countries. We have a vast number of
countries with socialism ranging from India and countries with that
type of planning to countries like the Soviet Union where investment
is all planned.
We certainly don't want to emulate those countries. We would, I
think, generally have to conclude the results of those experiments
have been poor.
Our problems may be immense, but they are not so serious that we
should throw away the advantages we currently have.
Representative ROUSSELOT. Thank you.
Mr. Leontief, did you want to comment on the general discussion?
Mr. LEONTIEF. I would suggest that before following Professor
Meltzer's advice, we should see what will be the results of Mrs.
Thatcher's radical policies in England.
Mr. MELTZER. We don't have to wait for Mrs. Thatcher. We do
have some experience in the first 155 years in this country.
Mr. LEONTIEF. Let me say
Representative ROUSSELOT. We certainly couldn't.
Mr. LEONTIEF. West Germany—which succeeded in
mastering inflationary pressure more effectively than any other advanced Western country except Austria—is anything but a land of unhampered
competition and free rugged enterprise.
Representative ROUSSELOT. Of course, Germany hasn't been increasing their supply of money as rapidly as we.
Mr. LEONTIEF. Contrary to what the readers of our financial press
are lead to believe, the relationships between capital and labor—far
from being settled through the operation of impersonal market forces
151
of supply and demand—are in fact governed in West Germany by
special institutional arrangements established by law.
One-half of the members of the board of directors of every large
West German corporation is elected by the shareholders—while the
other half is elected by the workers. Moreover, 7 out of 10 of the
labor members are chosen by workers employed in that enterprise,
while the other 3 represent the national labor unions. In other words,
these are the "outside labor" directors who are the counterparts of
the "outside directors" elected by the shareholders. And mind you,
the labor representatives take active part in the determination of all
corporate policies—not just those pertaining to employment conditions and labor relations.
These legal arrangements provide a firm institutional basis for
effective day-to-day implementation of national wage, price, and income policies. It is my considered opinion that without formal cooperation between capital and labor—not only on the national and
industrial, but also on the individual corporation level—monetary
and fiscal stabilization policies would, in the long run, be as ineffective in West Germany as they proved to be in the United States.
Mr. MELTZER. Since this was a comment on my remarks, I will take
the opportunity to reply.
Mr. LEONTIEF. Excuse me; I didn't finish.
In Austria, similar, but somewhat more formal arrangements seem
to work even better. Mr. Kreisky was reelected recently on the basis of
an enviable economic record characterized by the maintenance of a
high rate of economic growth, practically full employment and an upward price drift of not more than 2 or 3 percent per annum.
Here, in the course of annual top level negotiations between the central employers' organization and equally well organized labor—without formal participation, but with a technical, essentially fact finding
assistance on the part of the Government—the past performance and
the future prospects of the economy are surveyed, and after a hard bargaining process, a general agreement is reached on next year's rise in
real wages. In the process of these negotiations, due attention is payed
to assessment of the needs for additional productive investment. Being
able to negotiate the level of the real—rather than only nominal
money—wages, the unions have neither the need nor a justification to
press for an unreasonable rise in money wages. Businesses, on the other
hand, assured of the necessary investment, find that they have no reason to initiate inflationary price increases.
Monetary and fiscal management can, under such conditions, play
effectively its indispensable supporting role,
I join Professor Eichner in his observation that to secure for our
economy and our society a safe passage through the shoals that this
country will have to navigate in the coming years, we cannot and
should not rely exclusively on the operation of the blind market mechanism. The contest of the conflicting interests should be settled at the
negotiating table and institutional legal provisions should be made for
implementation of the agreement reached through informed, well
coordinated public action.
Representative ROUSSELOT. I thank you for your comment, but maybe we ought to wait until Mrs. Thatcher has been in a while because you
152certainly weren't implying by that that we have had a good example to
follow in England for the last several years?
Mr. LEONTIEF. Let's see, how to
Representative ROUSSELOT. By saying to wait and to watch what
happens in Mrs. Thatcher's government, you are not saying what has
preceded has been bad ?
Mr. LEONTIEF. NO, no; not at all.
Representative ROUSSELOT. I wanted
to be sure.
You wanted to comment on that ?
Mr. MELTZER. I just wanted to make two points to correct perhaps
some of the impression given by Professor Leontief.
First, the experiment in union and management participation on
boards of directors of Germany is relatively recent. It is interesting
to observe that the growth rate of output during this period has been
relatively low, not high. The rate of investment in Germany is probably lower than it is in the United States; a large capital outflow partially stimulated by the fears of this experience in social control of the
corporations by union and management jointly will lead to low
rates of return in the future. Therefore, investment opportunities are
more attractive in places like the United States, Canada, Brazil, and
some other parts of the world.
If we are waiting for the outcome of Mrs. Thatcher's experiment,
we misrht also await the outcome of the German experiment which is
of relatively recent vintage and has contributed very little to the
growth rates of output in Germany.
Second, I would sav in response to the statements about union/
management cooperation that I place primary emphasis on the fact
there are clear, announced, and definite programs on the Government's part which are carried out. These programs are about ending
inflation and about the budget and so on. If we are going to copy
something from Germany, we ought to copy the idea that when the
Government makes statements about its policies, it carries them out.
It doesn't change its policies like a will-o'-the-wisp in a few weeks or
months.
Representative ROUSSELOT. Thank you.
I regret I have to move on and turn the chair over to Senator
Javits who, had he been here, would have been chairing. And I thank
you all for your comments and testimony. And I do hope that this
committee can act again as a catalyst to give better economic advice to
our colleagues on both sides of the aisle.
Senator, I will turn this over to you now. You get to be chairman
now.
I regret I have to leave.
Senator JAVITS [presiding]. Thank you. Gentlemen, I apologize
for not having been here, but as usual I have four committee meetings
this morning, and I have something else in 10 minutes. But I would
like to engage you in this question, and I hope you will please be perfectly free to tell me whether what I ask has already oeen covered.
We have now, in place, the German experiment which began immediately after the war, so that Germany has had about 30 years of these
joint boards in the iron and steel industry.
I notice you shake your head, Mr. Meltzer, but I was there in 1947
so I know what I am talking about.
153
The other thing that interests me which I would greatly appreciate
comment on is this: We have now incorporated in a number of States a
provision for labor/management committees to deal with the value of
work life problems. And we have some very extraordinary examples of
that in my own State of New York. That is why I have been so very interested in this matter.
One example relates to the States that have the CETA law, at least
that part of the law which relates to private enterprise and training
of the structurally unemployed, for which we are going to put on $100
million. And the other one is in an effort to keep kids in school by applying the work/study technique at lower than the college and university level.
Both of these examples have provisions for labor/management committees.
In addition, we have a very extraordinary example in the State of
New York. The city of Jamestown was one of the worst economically
hit cities in the early 1970*s, and it was a very bad labor town, so people
avoided it.
Through the enterprise of the mayor who, by the way, was a Democrat, and with my cooperation, a labor/management public committee
was formed. And the town completely turned around. It is now one of
the best labor towns in New York.
That doesn't mean nonunion. It is simply one of the best labor towns
in New York. It has attracted a major manufacturing industry from
the Middle West to set up a new plant and put countless new workers
into Jamestown which is not a terribly large city.
This example has since been emulated by Elmira and other cities in
New York.
Now, that is a practical application of what Mr. Leontief was talking about. One of the laws which we have now provides that the
Federal Mediation Service will stimulate the promotion of these committees through the country. I am hopeful. We have appropriated
some $10 million for them to get started.
It is in the pipeline right now. There is an application of the idea
which is possible. It is a small application, and I am for a much
bigger one. But I just lay that before you because it is an experimental idea.
Yes, Professor.
Mr. EICHNER. I think that is pretty much the gist of what I was
trying to suggest about the problems of inflation, stagflation, economic
growth. These problems cannot be resolved except through the coming
together of labor, management, and other groups.
And I think it is not helpful to label this as some form of socialism
or the like; that this is really true throughout the entire OECD community of nations.
There was a conference on inflation sponsored by the American
Council of Life Insurance, I believe, where one of the key recommendations to come out of that group was an endorsement for this very idea
of tripartite attempts to solve the problem of inflation.
I think they have sent this committee a copy of their recommendations. It turned out that one of the members of that council had himself served on a similar committee during World War I I and recalled
that experience as perhaps being helpful in the present context.
154
I understand that others have recognized the need to bring different
groups together to focus on economic growth. And I think we can't
wear ideological blinders on this any longer. You think about Japan,
Germany—all the countries that have been most successful. It is because they have found one way or another to achieve better cooperation among different groups in their society; and to reject that idea on
ideological grounds seems to me to be counterproductive.
Senator JAVITS. IS it being rejected on ideological grounds, Mr.
Meltzer ?
Mr. MELTZER. I did not reject anything on ideological grounds. I
think we are falling into the fallacy of composition. It is very possible
for Jamestown to improve its labor relations climate and improve its
investment. What we were talking about is how the United States as
a whole can improve its labor productivity and investment.
To increase investment we have to either grow at a more rapid rate
or we have to shift resources from private consumption and government into investment. And we have to find ways to improve productivity.
I believe that the level of cooperation between union and management can make a difference for the rate of productivity growth and,
therefore, it is a useful thing. To the extent that individuals are able
to cooperate, it is useful.
To freeze such schemes into law or to believe that the experiments
have a lesson for national planning or teach something we should try
to do on the national level is a wholly different matter. I believe the
schemes would not succeed.
Now, in the case of the steel industry in Germany, that is a good
example. For a while, the steel industry^ in Germany was very productive and did very well. At the present time, the German steel industry
is certainly anything but an inspiration. It is certainly not the resuit
of national planning we would want to have. It doesn't seem to be able
to solve its present problems. It seems to have certain tendencies that
are common in steel industries in other countries, and particularly the
countries where there is a large amount of public participation in the
steel industry—namely, to demand large subsidies and sell a lot of
steel on the market and produce certain number of problems, not only
for the steel industry, or for Germany, but also steel industries in the
large part of the rest of the world, including the United States.
Senator JAVITS. Mr. Leontief.
Mr. LEONTIEF. AS I see the problem of the steel industry, I think
the problem is worldwide. And the basis of it is that 60 years ago, textile industry had similar problems where 60 years ago textile industry
was a flourishing industry of advanced countries. But slowly, the
less advanced countries learned how to make cloth. And slowly, this
industry developed, not the most advanced country, but catching up
slowly. *
The same thing, I think happening now with steel industry. Steel
industry is not any more the premier industry, the honorary steel industry. It still grows in Brazil, India—all over the world. And the
response to it, if we do it in a concerned, intelligent way, is slowly go
down on the brakes, but the economy is very inflexible.
155
Nobody wants to give up. And there are two ways of introducing
flexibility.
One, aJbolish laws. All regulations, let bankruptcy take off adjustment. This is one old-fashioned way of adjusting if an industry suddenly goes bankrupt. Stockholders lose their money, workers lose their
jobs.
Other way, more humane way, which is smarter, I think, on concept
of model social conscience, try to help a transition. And this, only
Government can do.
So to say let's reduce Government and let market take care of everything is, I think, a very risky business. We are only the way when I
don't get excited about it because I am sure we won't abolish government. The Government will grow, and people will complain about it.
And what we should do is try to improve cooperation of Government.
This, I think, applies to inflation and to economic development and
technology.
Senator JAVITS. Professor Wachter.
Mr. WACHTER. Senator Javits, I think that you gave two of the
examples where I believe the Government can be most effective in
dealing with market problems.
One is in structural unemployment areas and manpower training.
And the other is in location problems where there are considerable
market failure problems.
I believe, however, that Government policy dealing with the incentive mechanisms for plant location should be differentiated from Professor Eichner's suggestion of meetings where people would decide
how much investment might be made (by different industries.
If one gathers people together to make investment decisions by
industry, the investment monies will flow into steel and into textiles.
Those industries have the labor-management constituency to dominate
newer, high potential industries such as semiconductors and computers.
In fact, most of the investment needs to be done precisely in those
areas that will be least popular because they will have the smallest
constituency.
Let me finish, by saying as a resident of the State of Pennsylvania,
where we have a great deal of investment in older industry, I only
wish that someone would bring Texas Instruments or new industries
into Pennsylvania rather than subsidizing inefficient steel mills. If
the Pennsylvania economy is going to grow over time, it will have to
attract growing industries, not declining industries.
Senator JAVITS. Gentlemen, if I may raise just one other question,
then I am sorry, I must leave you.
Senator JTubert Humphrey, of revered memory, and I developed
an indicative plan with a rather interesting mechanism to divorce it
from the problem which Professor Wachter just mentioned.
Is there any sentiment here for anything like that as a way in which
indicative planning—you all understand, I'm sure, that means nonmandatory planning—is there any comment on that in terms of using
this mechanism for the purposes we discussed ?
I would like to mention to you that I was the author of the plan
originally, and I will tell you what got me interested in it.
156
In the fifties, we had a Commission called the Paley Commission
which analyzed our potential for the future, in terms of natural resources. That Commission anticipated the oil crunch, but it was in
Eisenhower's time. The report was a very good report, but it was written, filed, and gathered dust on the shelf. No one paid any attention to
it, obviously because there was no mechanism in the country which
could give any indication of what we needed.
I am reminded also of a comment made to me by a state planner in
a Communist country—I think you all realize I have been in this
field a long time—very long time—he said, "Suppose that it becomes
most profitable to run gambling casinos. If that is the most profitable
thing to do, in your capitalist society, are you going to allow all of your
investment to go into gambling casinos to the exclusion of food, clothing, shelter, steel and everything else?"
It is a very, very provocative question.
So I -just would like to momentarily lay that on the table.
Mr. EICHNER. Senator, I think the burden of my argument is in support of some form of indicative planning. I don't think it is a good
solution. I think it has all sorts of problems. But I don't know of any
other solution.
And I think that the entire postwar experience has shown that it
is a necessary solution. We have tried every other possible way of
dealing with these problems. We have been the last to even think
about some form of indicative planning.
And, while we may not make a decision this year or next year in favor
of this approach, I am absolutely convinced, as someone who has
studied these problems for at least a decade, there really is no alternative.
Senator JAVITS. We will come to you, Mr. Meltzer. I assume you;
will be opposed, but I want to get the pros first.
Mr. LEONTIEF. Anything new is very difficult. And if 3^011 start
razing the houses down, it is particularly difficult.
My feeling is it would be possible very quietly, very thoughtfully, ta
begin to put together some, to say a mechanism, particularly where
analysis mechanism, because at the present time, our Government
knows very little is happening. It just is chasing up to it by a couple of
indexes moving up and down. There is very little understanding what
happens in the country.
And that, I think, I know I am on an executive board of a science
advisor council of the EPA, $20 million operation. I see what is happening. Very few people know what is happening because we don't
have enough analysis putting it together, not just to kind of an indices,,
not everyway, but actual analysis of the situation.
And I think this type of thing should be undertaken. It will cost $100
million. All right, it costs $100 million. It is less than an airplane,,
a good one.
And ultimately, I am convinced it will come to it as a result of Mrs.
Thatcher's experience. English socialists didn't have anything like that.
English socialism is consisting of nationalizing industries. What is the
difference, nationalized or not? Usually, you cannot nationalize because business does not resist nationalization which makes very largelosses.
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The reason I socialize my losses, nationalize my losses, it is always
good. But you think this is the way in which slowly—I didn't talk
about it for a long time because I saw what the climate was not like
that so why ? That is all we can do.
Thank you.
Senator JAVTTS. Professor Wachter.
Mr. WACHTER. The Government can influence the overall level of
investment in society by determining the incentives to invest, the rate
of return and by altering the consumption/investment ratio.
An overall policy group could determine what sort of public policies
•could be used to alter the incentives to invest so as to bring the level of
investment, as a percentage of GNP, up to desired levels.
My concern, though, is that any attempt to deal with investment
decisions at a micro or industry level, would certainly be counterproductive to the future growth rate of the United States. It will
introduce tremendous uncertainty for firms making investment
decisions.
If I am in the computer industry, I would have to decide if the
Government, 5 years from now, is going to make a decision to double
the investment level and subsidize that investment in a competing
industry. The result would make any current investment in computers
much more risky.
If the Government goes into the business, even if it threatens to go
into the business, of determining investment at an industry level, the
effect would be to substantially increase the uncertainty for every
industry. I believe that the result would be to significantly reduce the
investment level and the productivity of the U.S. economy.
Senator JAVITS. Professor, by way of correction, I would say the
machinery was Government/private machinery. Of course, you can
say private would be overwhelming. But it was Government/private
machinery.
Mr. Meltzer.
Mr. MELTZER. Certainly what we know about productivity growth
is very limited. But we do know this: We know that the success of this
country has been achieved with steady, slow, average rate of progress
amounting to 2 to 3 percent a year more than 120 years. That has been
the history of our progress.
And that progress has been achieved with the leadership of vastly
different industries from one period to another.
We also know that the experiences with planning have not been
uniformly good. We have the experience of Britain which Professor
Wachter referred to when he talked about the steel industry. There
has been a large amount of indicative planning and direction of
resources and investment. And most of the resources have gone into
industries which would have failed otherwise.
Perhaps it was humane to do that, but it certainly has come out of
the growth in income of the British public. And that is a major reason
why we now have Mrs. Thatcher instead of Mr. Callaghan,
We have greater apparent success for some kind of indicative planning in France. People didn't follow the indicative plans, but the
growth rate in France where indicative planning has been talked
about, has been relatively high.
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We have the example of a large amount of government policy
Involvement in the investment and consumption decisions in Sweden.
At one time, Sweden was held up as an example of the good things a
state can do, but it is no longer so.
We have, I think, in the developing economies a very rich experience with Government involvement in the economy. We have Brazil,
for example, where the Government controls about 50 percent of the
investment with very, very good success in terms of a high rate of
growth but little planning. We have Korea where the Government is
involved heavily in the decisions about resources in the economy, and
there is a very high growth rate.
But we also have large numbers of examples where the exact opposite is the case. Hong Kong is one example. So it isn't just a matter of
whether the government is involved or whether the government is not
involved. The simple answer is, we do not know how to measure the
gains and losses of Government involvement in planning, and doesn't
seem to me, to be a very useful experiment for us to perform.
We do know that individuals respond to personal incentives about
aftertax rates of return in deciding whether they want to work more
or work less or whether they want to invest more or invest less. It
seems to me that is a process which we know something about, which
works in many^ countries independent of political structures.
If we are going to make an experiment, let's think of an experiment
that provides a certain tax climate, that restores some of the mechanisms of the market which produced some of our past growth. That
isn't to say we should not try to improve labor-management relations
and do other things, but to suggest that the Government has the wisdom to decide where the next computer industry is going to be and to
do it better than the market, that is incorrect.
I would like to emphasize that particular aspect. You know, it isn't
difficult to get the Government to decide to invest more money in steel
or in another industry that is developing or even failing. The difficult
problem is to choose the industry that is going to be a great growth
industry of the eighties and nineties; to have the wisdom and foresight
and the willingness to accept risk by investing in that industry now.
That is something at which governments generally have not been successful. The record of the United States is that 200 years of market
determination has worked tolerably well, and we ought to be careful
about replacing the market.
Mr. EICHNER. May I make one quick comment ?
Again, I think we have sort of gone off on a tangent here. I don't
think: the suggestion was that the Government attempt to control or
regulate investment in individual industries, although we do a fair
amount of that, certainly, in the regulated industries. That now
happens.
But if one thinks ahead about the major supply bottlenecks of the
next decade, it seems clear that both energy and to some extent transportation are going to be critical.
I can envision a substantial amount of direction, to investment, in
both the energy and transportation fields, which would in turn create
the needed climate for private investment. I think if one reads the his-
159
tory correctly, one will see that it was because of judicial strategic investments in transportation and other areas that this country has been
able to provide a favorable climate to private investment.
I think, again, we should not be ideological about this.
Senator JAVITS. Gentlemen, I have to leave. I would just like to conclude by saying that indicative planning would have to be an agreedupon mixture of private and public input. And beyond that, what does
puzzle me is why it is good for A.T. & T. and IBM and not good for
the United States of America.
Thank you all very much.
Mr. ALBERTINE. Ths
hank you all for coming.
[Whereupon, at 12:30 p.m., the committee adjourned, subject to the
call of the Chair.]
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