The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
FOR RELEASE ON DELIVERY THURSDAY, MARCH 8, 1984 6:15 P.M. LOCAL TIME (12:15 P.M. EST) EMPHASIS ON THE LONG RUN Remarks by Henry C. Wallich Member, Board of Governors of the Federal Reserve System at the Swiss Institute of International Studies of the University of Zurich Zurich, Switzerland Thursday, March 8, 1984 EMPHASIS ON THE LONG RUN Remarks by Henry C. Wallich Member, Board of Governors of the Federal Reserve System at the Swiss Institute of International Studies of the University of Zurich Zurich, Switzerland Thursday, March 8, 1984 The purpose of this series of lectures is to examine ways of getting out of the present "crisis" of the world economy. I agree with the definition of the problem if "crisis" is defined in the Chinese manner, as a combination of danger and opportunity. In the more colloquial sense of the word, I do not see the world economy in a crisis at this time, although it may recently have passed through one. In my view, our problem is precisely that we take a short-run, crisis-oriented approach to problems that clearly are of a long-term character. The purpose of my talk is to provide a long-run emphasis that I believe is needed. Economists, during the long life of their discipline, repeatedly have been back and forth over the issue of short versus long-run approaches. The propositions of classical economics, for instance, are almost timeless. -2- They leave unstated how much time particular developments, especially movements from one fundamental market equilibrium to another, are likely to take. The response of population to resource availability, the reaction of investment to innovations and changes in the supply of saving, the elimination of unemployment following a depression, and the response of wages and prices to excess supply or capacity are examples of this time-unspecific approach. One may reasonably assume, nevertheless, that if asked, the old writers on such topics would have agreed that considerable time might elapse before adjustments were complete. This, broadly speaking, was the attitude that orthodox economics took in the face of the depression of the 1930's. have gone wrong that was not easily specified. Something was seen to Whatever it was, economics said that if markets were allowed to work, depression and unemployment would come to an end. This passivity tried the patience not only of the public, but of many economists. "In the long run," Keynes said, "we are all dead." He proceeded to develop a doctrine that promised more rapid cure of the depression. At the same time, national income accountants developed concepts that made it possible to measure the "potential" of the economy and the shortfall from potential that the depression implied. The notion of "potential," often in combination with overly ambiti°uS employment goals, became the basis for a policy of extracting maximum perf°r,na that from the economy. In terms of policy, it had two consequences: the view frequent small adjustments in fiscal and monetary policy -- fine tuning desirable, and the tendency to push the economy too close to its capacity -3- limits. The first, unless in rather exceptional cases the policy was flaw- lessly handled, was likely to destabilize more than stabilize. The second was virtually certain to inject an inflationary bias into the economy. Emphasis on short-run objectives in implementing policies was justified on the grounds that the long run, after all, is nothing but a succession of short runs. Short-run solutions, therefore, could be defended. As time went by, however, the consequences of many short-run actions cumulated. It became evident that the economy was always operating in the long-run backwash of some short-run expediency. Today's inflation was no less painful because it was the long-run consequence of past efforts to end a recession quickly„ Today's (and tomorrow's) unemployed are not helped by remembering that their condition is the ultimate consequence of past efforts to push the level of economic activity to the limit. While the tools of economic policy, therefore, in many cases were being misused, these tools themselves deteriorated in the hands of the operators. Fiscal policy, which since Keynes had been regarded as the wheel- horse of anticyclical policy, proved increasingly difficult to manage in the face of conflicting political forces. Doubts appeared, moreover, whether temporary or indeed any other tax changes could be expected to have strong and lasting results. Suspicions arose that the private sector was taking counteraction to protect itself, by changing its own rate of expenditure in the face of temporary tax changes and perhaps even permanent changes. Fiscal policy, moreover, was seen to be much more dependent on an accommodative monetary policy than was realized by Keynes and his successors, reflecting their since-discarded definition of stable interest rates as a stable monetary policy. -4- Monetary policy, in turn, was seen to have effects not only on output and employment, which were desired, but also on prices, which were not desired. Moreover, the lag with which undesired price effects followed on monetary action seemed to shorten as the market increasingly diagnosed the ultimate consequences of monetary (and other) actions and, through anticipations, accelerated them. Fiscal and Monetary Policy Fiscal and monetary policy are the principal tools that historically have been used -- some would say misused -- for short-run purposes. They are also the areas where in many countries there has been progress toward more long-run-oriented policies. The lesson has been learned that excessively expansionary policies quickly lead to inflation. Particularly under a system of floating exchange rates, the possibility of temporarily exporting inflation and importing stability, which was implicit in the fixed-rate system, has largely vanished. The danger of vicious circles developing, with inflation driving depreciation and depreciation further driving inflation, has become widely understood. In many countries today, fiscal and monetary policies are indeed on a long-run track. Efforts are being made to improve the structure of government budgets and to reduce deficits, even though unemployment is still very high. The structural approach is beginning to prevail over the short- term cyclical approach. Of the case of the United States, which does not a c first glance seem to fit this positive assessment, I shall speak later. -5- Monetary policy also has backed away from the fine-tuning approach of earlier years. Many countries now have money-supply targets, set for periods of a year0 In most cases, moreover, it is evident that changes in these targets must be in a downward direction, because the targets themselves still accommodate some inflation. stabilize interest rates, nor should they. Money-supply targets do not But they protect central banks against the prevailing temptation inherent in an interest-rate target to set that target too low and to keep it too low too long. The low speed of the recovery outside the United States, and the high rate of unemployment, create pressures for vigorous expansionary actions on the fiscal and monetary fronts. If policymakers were to yield to these pressures, they would be inviting a return to the stop-go policies of the past. Short-run gains would come at high long-run costs. The policies that are being pursued seem to imply an endorsement, in most countries, of priority for the long-run approach. Given these long-run policies, new ways naturally are being sought to address the problem of unemployment without reigniting inflation. Spreading the Work to Cure Unemployment? A frequently heard proposal to end high unemployment is a shortening of the workweek and spreading of available work over a larger number of people. It is a prime example of a short-run expediency certain to cause long-run damage. That remains true regardless of whether hourly wages are held constant, so that weekly pay declines, or instead weekly pay is maintained, by raising hourly wages, or something in between. If hourly wages go up, -6- inflation will revive. If they do not go up, inflation can be avoided, but in the long run output will suffer as the total of work hours which the economy could generate at full employment is reduced. While I have strong doubts about the concept of an economy's economic "potential," this is a case in which that potential, whatever it may be, would be clearly reduced. The long-run consequences of the shorter workweek would make themselves felt as soon as economic activity once more reached high employment and firms were forced to make mandatory overtime payments. The often- heard view that unemployment would remain permanently high has been reflected in business cycle after business cycle. In the United States, little more than a year's recovery brought a reduction in unemployment from 10.7 to 8.0 percent. The long-run damage from spreading the work probably would be permanent. It is hard to see a shortening of hours being reversed at any future time. If spells of high unemployment cannot be cured by expansionary policies, and if it is unwise to remove it by sharing the work, what other options are available? General agreement seems to exist that real wages are very high in Europe, having risen during much of the period of mounting unemployment except perhaps very recently. This contrasts notably with conditions in the United States, where real wages have not risen substantial^ since the early 1970's, and where real interest rates are high. Excessively high real wages contribute to unemployment, whatever other cyclical and structural factors may also be involved. As a consequence of high real wages, profits have generally not been high and often indeed very low. -7- The share of national income going to labor has tended to increase, that going to capital to decline. Unemployment-creating consequences of high real wages, therefore, are twofold. They reduce employment not only directly, by raising costs, but also indirectly by reducing incentives to invest,except in automation, and by diminishing the financial resources available for business investment. As long as there was strong pressure from the labor side for sizable annual real wage increases, it was difficult to see how the balance of wages and profits could be much improved. There are, however, promising indications in the United States and elsewhere that here and there a new attitude in wage bargaining is emerging. As inflation has receded and unemployment has mounted, wage demands have moderated. It remains to be seen whether this moderation will continue as unemployment declines and profits mount. Some firms, however, for instance the Boeing Company, have found ways of adding to labor's pay that do not necessarily involve permanent increases. payment of a kind of bonus. existence for many years. One technique is the In Japan, of course, that practice has been in So it has been among many Wall Street houses. bonus may take many forms — A it can be negotiated in advance, it can be made dependent on profits during the year, it may be provided with or without regard to performance of the individual employee or the profits of the enterprise. One important characteristic of bonus plans is that the pay- ment does not enter into the wage base. In other words, the bonus does not raise the base from which the next year's pay increase starts. the advance of pay scales. to raise prices. It slows It accordingly reduces the need for the employer -8- The bonus is a form of profit sharing, and could readily be converted to a more systematic form of profit sharing. That method of compensating labor also has been making some progress in the United States. Important examples are the recent profit-sharing payment of $640 per worker at General Motors and $440 at Ford. Going one step further, profit sharing could be cast in the form of employee stock ownership, if firms facilitate the purchase of stock by employees or pay bonuses in the form of stock. In the United States, progress in all these directions has been modest so far. Stock ownership is not popular with union leadership because of concern that the loyalty of employees might become divided. Actually, quick calculation usually demonstrates that the employee's interest is far more closely related to his wage than to any bonus or dividends he might receive, and concern over alienation from the union accordingly is much exaggerated. On the company's side, concern has sometimes been voiced about the prospect of ultimate employee control of the company. It should be recognized, nevertheless, that what matters for the enterprise is not primarily how total factor compensation it split up between labor and capital. The functional interest of the enterprise is in how this compensation is divided between rigid and flexible payments, and how it influences the volume of resources available for reinvestment in the company* When the flexible component becomes too small, and when too little left m the hands of the company or of recipients capable of reinvesting, the company may have liquidity problems in the short run and find it difficult to grow the long run. If some part of factor compensation now going to labor in the form of wages could be converted to flexible payments, be it in the f°rin -9- of bonuses or dividends, the company's liquidity and growth-financing problems would be eased. A more cooperative atmosphere between manage- ment and labor might also result. There have, of course, been discussions of techniques of this kind in some European countries, which have gone well beyond the modest practice so far observable in the United States. Japan, as so often, seems to be ahead with its coprorate bonus system, although it works somewhat differently there. The difficulties of generalizing this kind of labor compensation, of course, are enormous. But it would seem preferable to explore the possibilities of solutions along such lines rather than yield to temptation or pressure to spread the work. Protectionism In the area of international trade, the world is in clear danger of making a disastrous choice in favor of the short run and at the expense of the long run. Protectionism is mounting, often for very different reasons. In the United States, the excessively high value of the dollar creates problems for many domestic import-competing and exporting industries that, with the dollar at a level that would more nearly balance the current account, would be strongly competitive. In addition, there are basic industries that have difficulties of their own. Whether because of a lag in investment and technology, or because of subsidized foreign competition, or disproportionately high wages, or more fundamentally because low-technology industries inevitably tend to be crowded out in a high-technology country, the result is the same. These industries,along with those hurt by the high dollar, are demanding protection. - 10- In many European countries, protectionist pressures are mounting, in part for reasons not present in the United States. valuation can be a factor only in a few countries. Currency over- The high value of the dollar reduces U.S. competition in domestic as well as foreign markets. But the low level of economic activity fuels protectionist demands, as well as competition from newly industrializing countries. For such ailments, however, protection can only be a short-run palliative that postpones fundamental solutions and stores up greater trouble for the future. In the long run, a reduction of trade all around is likely to result if these pressures are not resisted. Inefficient industries will have less incentive to modernize or shift their operations to other products or geographic locations. Development of new industries would be slowed. Export industries -- generally the most productive sector -- would suffer. All these consequences have long been understood. The adverse results of inhibiting trade have been so well known that a great part of the effort at international cooperation during the years since World War II has in fact been directed toward reducing barriers to trade. Successive tariff rounds and negotiations to cut non-tariff barriers document the earlier attachment to long-run policies. It is difficult to deny that in the field of international trade there has recently been a retroregressive movement in the direction of short-run solutions at the expense of benefits. long-term -11- Lending to Developing Countries A choice between short-run expediency and longer-run advantage presents itself on both sides of the relationship between lending banks and borrowing countries. For some countries, at the peak of their difficulties, there may have been a temptation to go for a unilateral solution. banks, there may have been — and still may be -- a temptation to withdraw altogether from international lending. of view has largely prevailed. For many On both sides, a more long-run point Many borrowing countries are making strong efforts to adjust, which indeed could serve as an example to some of the industrial countries, including my own. They are doing this in the interest of recovering access to the international capital markets and protecting their trade against the possible consequences of default. This will ensure the prospects of long-term growth. On the side of the banks, taking the long-term view means to maintain some degree of capital flow to the borrowing countries, although at a much reduced pace. Such lending, which has been going forward, helps to protect the loans already outstanding. It is in their own best interest as well as in that of their stockholders, most of whom have economic interests at stake that go beyond the profits of the individual bank. A long-run approach also suggests the need to develop less short-run-oriented techniques of rescheduling, as well as moderation in fees and spreads. view, too, seem to be coming to prevail. These points of -12- The U.S. Dollar The foreign-exchange markets seem to be an area in which emphasis on the long run is conspicuously lacking and where, indeed, very short-term considerations seem to prevail. "fundamentals." Supposedly the exchange markets respond to Daily observation suggests that instead today they respond principally to very short-term factors, such as small changes in interest rates and random events that may influence interest rates. The prevailing view about fundamentals seems to be best expressed in the dictum that the dollar is "overvalued." I would prefer to say that the dollar is overvalued with respect to the level that would give the United States a sustainable current-account position. The current-account deficit of about $40 billion registered in 1983, and the deficit of as much as $80 billion that may be expected for 1984 cannot be considered sustainable. The short-run orientation of the exchange market, and its neglect of fundamentals, makes it impossible to predict how the market would behave if the dollar should begin to move in a downward direction. Overshooting of equilibrium rates has been characteristic of exchange markets in recent years. Such an attitude toward the dollar would be just as unfounded on the downside as it is now on the upside. pin the dollar. There are great elements of strength that under- Inflation is low, the economy is growing vigorously, the American economy is open, offers good investment opportunities and a positive attitude toward business enterprise. Even the current-account deficit, bad as it is, may create an exaggeratedly adverse impression. Part of that deficit reflects the fact that the U.S. economy has been expanding vigorously in a world that has been recovering slowly. Parts of it may even reflect -13- inconsistency of reported world surplus and deficit balances, which should add up to zero but fail to do so by a margin of the order of $100 billion. These "fundamentals" deserve to be borne in mind as the exchange marke ts try to evaluate the dollar. Economic Policy in the United States The budget deficit of the United States, of close to $200 billion into the distant future in the absence of remedial action, is at the root of some of the problems I have discussed. to be corrected. Everybody agrees that it needs In dealing with the U.S. budget, a long-run point of view will also be needed. First of all, a long-run view of the budget tells us that a deficit of this order is not sustainable indefinitely. It causes the public debt to rise at a rate much faster than the gross national product. The interest on such a debt ultimately would become unmanageable. Part of the debt that the deficit creates today is foreign debt. If this continues, which would mean that the dollar would stay high and the current account would stay in deficit, the foreign character of the debt would make its burden all the harder to bear. But if the current account should come into balance, capital inflows would cease, necessarily. The force of the crowding out, which is now borne by the foreign sector and the investment sector jointly, would ultimately fall wholly on the investment sector. Growth would become very modest in an economy in which the government absorbed far more than one-half of net savings. calls for action on the budget. The threat of such long-run prospects -14- But that action, too, must be guided by a long-run point of view. In the United States, as elsewhere, the public sector has been absorbing an increasing share of the economy's output. This trend can be halted if the reduction in the budget deficit takes the share of the public sector into account. To close the deficit merely by raising taxes is technically possible, but would perpetuate the prospect of an ever-growing public sector. Cutting expenditures must be at least part of the solution, if not the whole of it. Very difficult political issues must be faced. will be found, but they will take time. lasting. I believe that solutions By their nature, they will have to be Short-run expediencies will not cure the deficit. #
@FedFRASER