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6:15 P.M. LOCAL TIME (12:15 P.M. EST)


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


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.


purpose of my talk is to provide a long-run emphasis that I believe is
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.


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

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
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



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

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

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.


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


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.


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

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

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,


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

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

The long-run damage from spreading the work probably would be


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.


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.


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

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 —


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

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


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.


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


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


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.

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.


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



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


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.

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


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

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


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.

I believe that solutions

By their nature, they will have to be

Short-run expediencies will not cure the deficit.