View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

4:00 P.M. EST


Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
Yale School of Organization and Management
New Haven, Connecticut
March 30, 1983

Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
Yale School of Organization and Management
New Haven, Connecticut
March 30, 1983

It gives me great pleasure to speak at Yale on the relation of
monetary policy and business. For 23 years, beginning in 1951, it was part
of my job here as professor of money and banking to lecture on this very

As is the norm in economics, the questions have remained the same

in the course of the years but the answers have changed considerably.
in economics is very relative.


In 1951, I would have told you that monetary

policy was an interesting subject, but not a very major element in managing
the economy.

Most of the burden of promoting full employment, growth, and

price stability, I would have said, rested on fiscal policy.

Monetary policy

was not altogether impotent, as many of its critics asserted, but theoretical
reasoning as well as survey results had clearly established that businessmen
paid little attention to interest rates.

Moreover, I would have gone on, the

economy was extremely liquid owing to the backwash of war finance.


changes in interest rates could not be expected to have more than marginal

I might have noted also that during the 1920*8 things had been

2somewhat different.

There had been a time when money seemed to matter, and

when a change in the discount rate was front-page news.

That kind of remark

was always good for a laugh from the better-read students.
Today, things have changed once more.
would indeed be front-page news.
daily in the financial pages.
right monetary policy.

A cut in the discount rate

The prospects of such an event are discussed

Wide differences of opinion exist as to the

But there is little difference as to the importance

attributed to the subject.
I shall not go into the evolution of thought and events which has
brought us to our present condition.

That is taught most ably here at Yale

(if perhaps not from quite as wide a variety of points of view as it was
before Willy Fellner and I left in the early 1970's).

The more recent

evolution of the role of money is related very importantly, although by
no means exclusively, to the inflation that began in the middle 1960's.
Monetary policy has had a good deal to do with this inflation, sometimes
»s f C active cause, at others by its insufficiently restraining stance.


the inflation subsequently was brought down from the double-digit range to
one-half or even less, on the other hand, can probably be fairly attributed
in large part to monetary policy.

In talking a’
»cut the impact of monetary

policy on business, therefore, I shall have to say a good deal about the
impact of inflation upon business.

In the final part of my paper, I shall also

have something to say about how the impact of inflation, and indeed inflation
itself, could be better controlled than we are doing right now.




Inflation and Business
The interaction of Inflation and business has changed in the course
of the years.

The classical view is represented by Joseph Schumpeter.

Schumpeter saw the inflation process driven by the businessman, the entrepreneur,
who borrowed from the bank in order to finance a new project.
increase the money supply, and drive up prices.

This would

Consumer purchasing power

would lag, consumption would lose share in the national product relative to

Once the cycle or succession of cycles had run their course,

the process would be reversed.

Investment and money creation would slow down,

consumption would catch up, prices would fall as new products poured from the

The whole episode could be viewed as beneficial not only to the

businessman but to all participants in the economy.
The Schumpeterian model suggests that business might view inflation
as a positive factor, or at least as an acceptable and probably minor evil*
I believe that until not very long ago that was the representative attitude
of American business.

In the course of the years, to be sure, the positive

effects of inflation seemed to diminish.

But the actions needed to bring

it to a halt, through tighter fiscal and monetary policy, tended to be viewed
as too painful to justify a determined attempt at stabilization.

On a purely

impressionistic basis, however, I believe that this attitude also has changed

Today there seems to be more widespread support on the part

of business for an effort to end inflation.

Because that effort, which has

been going on for several years, impinges with unequal severity upon
different industries and different businesses, reactions are bound to cover
a wide spectrum.

Costs of Inflation
Inflation, of course, is only in part responsible for the course
of the economy over the last 15 or 20 years.

But it has been closely

connected with many of the difficulties we have had.

Few businessmen can

be satisfied with developments as this period progressed.

Over the years,

productivity gains almost disappeared, growth was disappointing, the economy
became increasingly stagnant.

Unemployment is at postwar record levels.

Corporate profits have diminished drastically as a share of GNP.

The value

of American business as measured by stock-market indexes is low by earlier

Even at their recent highs, the levels of the Dow-Jones and the

Standard & Poor's averages in real terms, i.e., adjusted for the rise in the
general level of prices, today are at the levels of the mid-1950's.

At their

lows of last year, deflated, these indexes were at the levels of the early

The market value of total equity in American business, similarly

adjusted, now stands at about the level of 1964.

Except for the present

recovery of the dollar from earlier lows -- itself sharply below the parities
of the 1960's —

U.S. per capita income woulu rank below that of at least a

half-dozen other countries.

Our share in world trade, even though our

economy has become much more open, has shrunk from 18 percent in 1950 to
12-1/2 percent in 1981.

Here at Yale, it seems appropriate to note also

that Mr. Tobin's "q," according to an estimate of the staff at the Federal
Reserve Bank of Boston, dropped below 0.6 in the fourth quarter of 1981 and
even now probably is no higher than 0.7. Meanwhile, foreign competition is
pressing so hard upon us that American business increasingly seems to be going


Accountlng Problems
While the results are plain, the channels through which inflation
affects business, which in turn relate to the impact on business of monetary
policy, seem to have been hard for business to come to grips with.
you know, is the season for corporate annual reports.

Now, as

I have less time to

spend on this literature than I would like, and I generally look for only
two pages.

One is the CEO's opening statement.

this time around ~

When I read —

less frequently

"the year 1982 was another record year for your company ...,"

and I then go on to be informed that the increase of sales or profits was less
than the rate of inflation, my economist's heart sinks.

Is money illusion

really still that pervasive?
I then search in the back of the book for the inflation-adjusted
earnings statements mandated by the Financial Accounting Standards Board since
September 1979.

I am glad to say that the kind of comment one used to encounter

there a couple of years ago —
present these numbers.

We do not believe that they have any significance for

the conduct of our business" —
skeptical tone.

to the effect that "we are required by FASB to

has yielded to a more temperate although still

Of course, the corporation is right that general price-level

as well as current-value accounting are highly imperfect ways of adjusting
for inflation.
cost —

No set of books —

represents "the truth."

and certainly not one based on original

But, of all forms of self-deception in

business, money illusion must be one of the very worst.
It is understandable, of course, that management does not enjoy
seeing a restatement of its accounts that, by revealing

the effects of

inventory profits and underdepreciation, frequently reduces operating profits
by one-half or more, and that often keeps the picture from becoming altogether

appalling only by allowing for gains from depreciation of net debt.


these restated numbers, in effect, are reflected in the profits data in the
national-income accounts adjusted for Inventory Valuation and Capital
Consumption Allowances, i.e., in Operating Profits.

They are reflected

also in the shrinking share of corporate profits in GNP, quite aside from
the fact that some 10 percent of Corporate Profits before Tax now —
in the national accounts —

as shown

are accounted for by the "profits" of the Federal

Reserve System.
Fundamentally, however, one must accept the fact that inflation
makes business planning more difficult and more risky even when a realistic
effort is made to take it into account.

An instance of this that bears

closely on monetary policy is what happens to interest rates during inflation.
Inflation drives a wedge between nominal and real rates.

The real rate is

reasonably observable for short-term debt since the rate of inflation is not
likely to vary greatly over the life of a 90-day loan.

For longer term money,

however, it is the expected rate that counts, and expectations of inflation
can differ.

Surveys seem to show, to be sure, a rather remarkable convergence,

or at least a strong central tendency for inflation expectations.


these expectations, in the course of the last few years, have changed sub­
stantially and, therefore, must have been subject to a wide margin of error.
The failure of the tax system to recognize the difference between
real interest and inflation premium compounds this difficulty.

The higher

the rate of inflation and, therefore, often with a lag, the nominal rate of
interest, the more severe is the distortion that results from tax deductibility
of the inflation premium.

Real interest rates after tax frequently have been

negative for borrowers that have profits and pay a tax.
he is taxable, the same is the case.

For the lender, if

-7These concepts have now entered the President's Economic Report and
the Congressional testimony of the Council of Economic Advisers.

I have been

unable to get a sense of how far they have entered into business planning.
Of course, a negative real rate after tax does not mean that it is
advisable to finance a project having a negative return.

Conceptually, one

must assume that a debt that depreciates with inflation implies the acquisition
of an equivalent asset that appreciates at the same inflation rate.


appreciation would enter into profits and would be taxed for an amount equal
to the tax subsidy received on the debt.

But, there are lags and other

complications that in any specific case very probably distort the result.
Certainly, I find it difficult to believe that the nominal returns on invest­
ments —

carried at original cost — have risen sufficiently with inflation

to offset the impact of inflation on nominal borrowing costs, even allowing
for the tax deductibility of nominal interest expense.
These distortions now have diminished considerably thanks to the
reduced rate of inflation.

For instance, the inventory valuation adjustment,

which in 1974 amounted to as much as 33 percent of corporate profits before tax
and in 1980 was 20.3 percent, has shrunk to about 5.9 percent of (a much diminished)
volume of pre-tax profits in 1982.

Inflation expectations as measured by

surveys have come down, although less than inflation as measured by present
price indexes.

All this has been accomplished at great cost and with great

Business planning should be possible now on a firmer basis although

I do not believe that these results are either sufficient or even viewed
generally as sufficiently permanent.

Considerable compensation for some of

the remaining consequences of inflation, to be sure, such as the inadequacy

-8of original cost depreciation,has in the case of new investments been provided
by recent tax changes.

None of this, however, is a satisfactory substitute

for full price stability, or at least for an inflation rate much closer to
zero than we have now.

The Cost of Disinflation
Let me comment briefly on the thorny question of the cost of dis­

Critics of monetary policy frequently measure it in terms of the

shortfall of output and growth from some potential, and in terms of unemploy­
ment in excess of some frictional or inflation-neutral level.

The cost thus

computed is very high, but the premises of the computation are illusory.
do not have a realistic option of ignoring inflation.


We cannot measure the

cost of disinflation by comparing it with some dreamland.

Certainly we cannot

compare it with an economy operating satisfactorily and as if inflation did not

Neither can we measure the cost on the assumption that inflation,

ignored, would stabilize or otherwise become predictable.

As I have noted,

inflation, at any level, imposes costs because reliable expectations cannot
be formed, because the tax system is not adjusted for inflation, and because
existing contracts and the consequences of past decisions cannot quickly be
adjusted if at all.

Inflation ignored by the policy maker, moreover, as a

practical matter is bound to accelerate.
living with Inflation.

There is no satisfactory way of

Business cannot do it, nor can other institutions,

as the financial situation of our universities and the salary and pension
problems of present and retired faculty make very clear.

The cost of dis­

inflation must, therefore, be measured against the realistic option that

inflation, uncombatted, would impose high costs of its own and, moreover,
would almost certainly accelerate.
present-value terms —

I fee.1 confident that the cost —


of letting inflation run is far higher than the

temporary pain of bringing it down.
Again as a practical matter, I doubt that private enterprise and the
market system, at least in our country, can permanently survive with high and
unpredictable inflation.

The role of government is bound to increase as

more enterprises come in need of public assistance, price controls are tried
from time to time, profits erode, and individual saving becomes an unreliable
means of providing for the future.
words, is the loss of the system.

The ultimate cost of inflation, in other
Whoever regards this as, indeed, a loss,

rather than as an extra dividend on inflationary policies, will have to factor
it into his estimates of the probable cost of inflation.

Monetary Policy and the Cost of Disinflation
I now would like to examine some of the reasons for this pain and
to suggest some ways in which pain could have been reduced and could still be
reduced hereafter to the extent that it subsists.
In economics, it is taken for granted that optimum results are
achieved by using all resources up to the point where cost begins to exceed

That rule applies also to the use of economic policy instruments,

all of which have costs of one sort or another.

In politics, unfortunately,

the rule seems to be to let George do it and then blame him for any inadequacy
of the results.

Given that inflation had come about, the best way of dealing

with it would have been by a combination of monetary policy, fiscal policy,
incomes policy, and moderation in the endless activities through which the

10government mandates higher prices, which, in turn, get into wages and COLA's,
running from protectionism, to price supports, minimum wage, regulation of all
kinds, and all the rest.

Instead, virtually the entire burden of dealing with

inflation was thrown upon the Federal Reserve.

This was done on the convenient

pretext that monetary restraint technically is sufficient to prevent inflation
or to bring it down, provided one is willing to accept the side effects.
Therefore, spending and taxing, regulation and all sorts of government-mandated
price increases, as well as private sector price and wage setting, could all
go their own ways without regard to inflationary implications.
During the late 1940's and the early 1950's, such attitudes would have
been very unlikely, given the then prevailing view of the capabilities of monetary

It is a token of the change that has occurred in that reg3:.*d that

today monetary policy is widely expected to be able to carry this entire burden.
And so it can, but at a cost in terms of output foregone and human pain much
higher than would be required if a balanced approach to inflation were taken.
As it happens, many sectors of business, along with large numbers of unemployed,
are among the primary sufferers from this unbalanced approach.
So far as the impact on business is concerned, monetary and fiscal
policies differ in one important point.

Monetary policy works principally on

investment, fiscal policy principally on consumption.

Monetary policy, working

principally through interest rates, thereby affects business investment and
housing, along with some durable consumer goods.

Fiscal policy, working

through tax changes and government spending for wages, salaries and transfers,
affects primarily consumption, since most income goer, for consumption rather
than saving, and since tax reductions predominantly have been applied to
personal, not business, income.

-11Therefore, by putting the burden of restraining inflation on
monetary rather than fiscal policy, an implicit decision is made to pay for
disinflation through relatively less investment rather than relatively less

This has damaging consequences for the capital stock of the

economy, for future jobs, and for future growth, which I need not spell out
in detail.
On the other hand, when diminishing inflation allows interest rates
to come down, it is in the first instance investment that is stimulated.
are now in that situation.


However, so long as the budget deficit remains

very large and fiscal policy in that sense very stimulative, real interest
rates will be higher and investment lower than would be the case with a more
balanced policy.
Monetary policy sometimes is said to impact also with particular
force on durable consumer goods, especially automobiles.

The fact is, of

course, that a policy instrument that at times makes it cheaper and at others
more expensive to finance a purchase, necessarily affects goods that tend to
be financed rather than bought out of income.
is that durable consumer goods —

A more fundamental fact, however,

and in even higher degree housing —

by their

nature cater to wants that are either postponable or at least capable of being
satisfied in alternative ways.

Thus demands for products that meet these wants

are likely to be interest elastic and sensitive to monetary policy.
In order to gear up for its task, monetary policy has had to move
toward ever tighter methods of operation.

After relying for many years on the

relatively mild technique of making small changes in interest rates, in the
early 1970's

it moved to controlling the money supply, albeit still in a

manner that tended to limit volatility of interest rates.

When, in 1979,

this method too did not seem to have the necessary muscle, the Federal
Reserve moved to control of the money supply through control of reserves.
It was realized and stated at that time that the new techniques would lead
to wider swings in interest rates.
The expectation of higher interest volatility, unfortunately, was
fulfilled in very high degree.

In addition, however, the move to a stricter

control of the money supply also led, at certain times, to higher levels of
interest rates than had prevailed in the past.

When the market was given

the function of adjusting the demand for money and credit to the supply
provided by the Fed, it turned out that at times this balance could not be
attained without very high rates.

This has had a severe impact on borrowers,

especially those not sheltered in some way by the tax system.

However, while

recognizing the cost, the new technique did the job of bringing down the
It has been argued by some that even this tighter control of the
money supply was not sufficient.

Indeed, even under the new technique, there

have been considerable fluctuations in the rate of growth of the various
monetary aggregates.

It does not follow, however, that still tighter control,

which might reduce this volatility of money growth, would also reduce
volatility of interest rates.

It is argued by some that there is some stable

rate of money growth that would also stabilize interest rates, some broad
highway, as it were, along which money growth and interest rates might
gradually and stably move down toward lower levels, with inflation declining
in step.

In that view, the Federal Reserve has quite unnecessarily taken the

-13scenic route of jagged peaks and troughs i < money growth and interest
In my view, there is no such happy highway.

The economy itself

ic not stable, be it by the week, the month, the quarter, or the year.
Neither are the demands for money and credit that arise from the economy.
Moreover, there is randomness in the demand for money and credit even after
allowing for fluctuations in the economy.

That randomness can show up in

volatility of interest rates given a stable volume of money and credit,
or else in volatility of the volume of money and credit given a stable
interest rate.

Monetary policy can push the instability, vithi;? limits,

out of the money supply and into interest rates, or in reverse.

It cannot,

in a market economy where tens of millions of households and firms borrow,
lend, and shift their assets about, eliminate the random element.


poses, of course, the question what distribution of instability between
money supply and interest rates is optimal, and whether that distribution
has been achieved in practice.
In this regard, it has been alleged that both volatility of interest
rates and volatility of money growth have contributed to higher interest rates.
To me, it seems intuitively plausible that volatility of interest rates would
cause lenders to demand some kind of a risk premium which on average would
raise rates.

The alternative view is that volatility of money growth makes

the market uncertain about the future rate of inflation, and that it is this
uncertainty that generates an interest-rate premium.

There is some evidence

on this question, from a survey of approximately 500 financial decision makers
who were asked about the reasons for high long-term rates.

Neither factor was

regarded as one of the two most important causes of high long-term rates by
more than 3.6 percent of the respondents, and within this small minority those
stressing interest-rate volatility considerably outnumbered those stressing
money-supply volatility.

The two reasons mentioned with overwhelming frequency

as most important causes of high rates were fear of resurgence of inflation
and the high prospective budget deficit.

It would appear, therefore, that

instability of interest rates while unquestionably a problem for business,
is not regarded by itself as a major cause of high rates.
Interest rates have come down substantially as the rate of inflation
has come down.

Over the long term the Federal Reserve can control interest

rates only by what it can do to control the rate of inflation.

The close

correlation of the rate of inflation and the rate of interest was discovered,
conceptually, here at Yale by Irving Fisher some 80 years ago.

Fisher thought,

at that time, that there would be lags of many years before investors had formed
an opinion about the direction of prices.

It is a measure of the extreme

inflation consciousness of our day that this lag between inflation and
long-term interest rates seems to have almost entirely disappeared.


during the inflationary spurts of the late 1940's and middle 1950's, those
long lags still seem to have discouraged an immediate adjustment of interest
rates to inflation.

Meanwhile, we have built into the behavioral responses

of our markets something that demands a much more disciplined policy from the
responsible authorities —

the quick reaction of markets today not only to

inflation itself, but also to its expectations.

Given the power and the

present inflation-oriented nature of expectations, the scope for fine tuning
has greatly diminished.

-15It is partly for these reasons that real interest rates have remained
high, particularly at the long end when measured in terms of actual inflation
rather than expectations.

The survey of financial officers, which I mentioned

before, placed expected inflation for the years 1982-87 at slightly over
6 percent, and for the following five years at close to 7 percent.


in response to a question about the probability of hyper-inflation within
the next 10 years, the average response was a one-third probability.


seems that the generation that has lived through double-digit inflation may
be scarred for life by that experience.

Given such expectations, it is

questionable whether the average taxable investor is receiving a positive
real interest rate after tax.

Interest Rates and the Budget
The enormous budget deficit contributes in two ways to high real
interest rates —
all that high.

if indeed in the light of what I have just said, they are

First, the deficit nourishes the fear of high inflation.

Given the circumstances of political life, there is no way in which the
central bank can acquire a degree of credibility to totally calm this fear.
Second, the demands of the Treasury on the financial markets and on the very
limited net savings of the economy create concern about increased "crowding
out" as the economy recovers.

In this sense, fiscal policy is much more

important for business than is monetary policy.

Monetary policy cannot,

other than quite temporarily, affect real interest rates.

Fiscal policy


In comparing the size of the deficit with the saving of the economy,
it is sometimes argued that it is gross rather than net saving that counts.
Gross saving, which includes business and homeowner depreciation, as well as
state and local government saving, was approximately $565 billion or 19 per­
cent of GNP in 1982, while net saving, which excludes depreciation, was $207
billion or about 7 percent of GNP.

A deficit of about $200 billion, such

as now seems in prospect from 1983 through 1985, would absorb a very large
part of net saving, even after allowing for some growth of amounts saved
and for some amount financed, in effect, by foreign capital inflows.

The absorption of gross savings would, of course, be less.

The argument

is made that depreciation, after all, is not necessarily reinvested,
and often not reinvested in the same kind of asset.

Hence, more money

would be seen to be available to finance the deficit if we include the
proceeds of depreciation.

However, this would be at the expense of

deterioration in the existing capital stock, which would tend to depress
growth of output.
In recent years actual investment may not have been seriously deficient
in terms of the resultant capital stock, although higher investment probably
would have produced higher productivity gains and growth.

Investment from

depreciation allowances permitted by the tax system, however, has been
insufficient to finance maintenance of the capital stock, owing to original
cost depreciation, even though the inadequacy of this form of depreciation
has been moderated by accelerated depreciation methods and investment tax

Many businesses, therefore, have had to borrow in order to maintain

their capital stock, or, if you like, to pay the dividends they had not earned.




At a minimum, they have had far less retained profits to work with than their
accountants claimed to think.
inadequate by inflation.
government borrowing —

Tax depreciation, in other words, has been made

This inadequacy —

while it has helped to hold down

has nevertheless thrown an added burden on business.

Although it has had a zero net impact on the capital market, it has contributed,
in effect, to such "crowding out" of new investment as there has been.

It is

already accounted for in a lower federal deficit and higher business demand
for credit.

Therefore, it cannot be looked to as a factor helping, on balance,

to reduce the pressure of the federal deficit on the supply of saving.


situation has undergone some change very recently, as accelerated depreciation
coupled with the decline in inflation has enabled tax depreciation to exceed
economic depreciation.

International Effects of Monetary Policy
Returning to the effects of monetary policy, business has been
impacted also through the effect of monetary policy on the international
value of the dollar.

Under a regime of floating exchange rates, some

variability has to be expected.

A rigorous control of the money supply,

however, is likely to widen these fluctuations.

Volatility of interest

rates leads to volatility of exchange rates, although the relationship of
interest rates and exchange rates does not seem to be all that close.
Furthermore, as inflation has been brought down relative to inflation abroad,
the dollar has tended to appreciate.

This has helped in reducing inflation.

But when the level of the dollar pushes the balance of payments into a large
current-account deficit, it evidently is above its normal past relationship
to other currencies.

The United States then is becoming a capital importer.

-18That reflects neither its historical role nor its character as one of the
world's richer countries.

It reflects merely the capital shortage created

by the budget deficit.
As inflation comes down worldwide, there is reason to expect that
exchange-rate fluctuations will diminish.

Moreover, pursuit of a money-

supply target need not inevitably be at odds with efforts to reduce exchangerate fluctuation.

Some central banks, like the German Bundesbank, have been

able to pursue a money-supply target successfully while also giving weight in
their monetary policy to the foreign-exchange rate.

In part, this has been

accomplished by allowing for some variability of money growth within the
target band.

Some compromise between domestic money-supply targeting and

foreign-exchange-rate considerations, therefore, seems possible and would, in
my view, be desirable.

Wide swings in exchange rates that are quickly reversed

obviously are of no value other than for the purpose of limiting capital flows
and equating them to the surplus or deficit in the current account.

Incomes Policy Against Inflation
In closing, I would like to address myself to one area of policy
that I have not dealt with —

incomes policy.

The first thing to say about

incomes policy is that there seems to be no good one.

Leaving aside our

disastrous experience with wage and price controls, which I do not consider
an incomes policy, we have accumulated a record of at least three partial
or total failures —

the Kennedy-Johnson guideposts of the early 1960's, the

Carter guideline of 1978, and the legislative proposal for "real wage insurance,"
submitted by the Carter administration but not enacted.

We also

have had considerable debate about tax-oriented incomes policies (TIP) of
which the real wage insurance proposal was one version.
Of incomes policies it has often been said that they do not work,
and if they did they would not work in the United States.
true, and perhaps it is vain to pursue the topic.

Perhaps that is

But, with 11 million

people unemployed, it seems to me that no possibility should be left

Surely there must be better ways of dealing with inflation

than we have pursued so far even though I rule out the alternative of
letting the inflation run.
The dictum that an incomes policy holds least promise in the United
States is based on the great size and diversity of the economy, the vast number
of conflicting interests involved, and the absence of cohesive employer and
labor organizations that could negotiate and make responsible commitments.
But in one other respect the United States has an advantage for the application
of wage-price agreements that other countries lack:
closely tied together.

wages and prices are very

Increases in either variable tend to be followed by

increases in the other, making allowance for productivity gains.
happens on the way down, as we are now observing.
can disrupt the relationship.

The same

Oil shocks and food shortages

So can movements in the dollar.

relatively low dependence of the economy on imports —

But given the

although it has increased

the United States does not experience the massive changes in living costs as a
result of changes in import prices to which many other countries are exposed.
Wages and priccs may part company also when changes occur in the
shares of labor and capital in national income.

Over many years, however,

this distribution has not changed very much in the United States.


over time has been getting about 75 percent of national income, although since
1940 there has been a perceptible trend in the direction of a greater share
for labor which in 1982 reached 79 percent.

In the absence of such shifts and

cyclical swings, any increase in wages that labor can get must eventually equal
productivity gains allowing for changes in terms of trade.

If prices are

stable, wages will tend to rise at the productivity rate, on a national

If there is inflation, wage increases will tend to run ahead of

it by the productivity margin.

Labor under these conditions gets its share

of the increase in output, and so does capital.

That is all there is, and

all either can get.
Under these circumstances, it seems plausible that if wage increases
were to slow down, price increases would slow likewise.

In real terms, labor

and capital would both get as much as they would had prices continued to rise.
At the present time, this slowing of wages and prices is being brought about
gradually and painfully by monetary restraint.

If it were done by voluntary

cooperation of labor and business, much of the pain would disappear.


possible framework for such cooperation might be the following.
Business firms might give annual wage increases in two steps.


first step would be a moderate increase, only partly allowing for inflation.
If this pattern were widely followed, inflation would diminish.

The firms in

question would then have no incremental profits from wage restraint, and the
employees would have no loss in real wages.

If, nevertheless, prices continue

to rise unchecked, businesses are likely to have incremental profits from the
initial wage restraint.

There would then come in to play a second pay increase

to compensate for the real wage loss, which might take the form of profit

A framework for this, if not the full particulars, might be laid

down in the wage contract.

A difficulty in negotiating plausible wage agreements on this
basis is that the real wage gain of labor depends on the general movement
of prices, while the incremental profits of a firm depend on the movement
of its own prices.

In other words, what is true of the economy on average,

need not be the case for each firm.

A firm might have negotiated such an

agreement, and might have held down its prices in line with its more
moderate wage increase.

There would then be no incremental profits from

which to pay a second-stage wage increase.

Yet that second-stage increase

would be needed if the initial pay increase had left the employees with a
real wage loss, given subsequent inflation.

Spelling out the nature of the

difficulty, however, may exaggerate the precision of the procedure, and
reasonable wage agreements of this kind may nevertheless be feasible.
A necessary condition for the success of this technique is that it
be widely practiced.

The more moderate wage increase in the first step will

hold down the general price level only if the cost relief affects a large part
of private output.

In that case, if inflation follows wages down, the second-

stage wage increase would be small or zero, with no impairment to real wage

If only a small minority of firms were to practice the approach,

the price-restraining effect would be small.

A second-stage wage increase

then would be expected of these firms, nullifying whatever initial favorable
effect on prices had occurred.

Moreover, these firms might have difficulty

financing the second-step wage increase, since they would not have raised
prices and would not have incremental profits.

The expectation that a firm

might find itself in this position might cause the firm to raise prices along
with the general rate of inflation even if the first wage step justified a

-22smallec price increase.

This would make the procedure ineffectual and probably

unacceptable to the employees.
It is far from clear, therefore, whether such a plan could be
instituted without some form of governmental action.

Perhaps a broad-based

understanding between business and labor would suffice, which unfortunately
is harder to negotiate in our country than anywhere else.

Perhaps there is

an opportunity here for development of an industrial dialogue that we have
not had in the past.
A prototype of the two-stage wage increase is the bonus system
practiced by many firms in Japan.

Hie bonus, as I understand it, is negotiated

as part of the annual agreement, but it may nevertheless be contingent on sub­
sequent profits.

It helps to protect Japanese labor against unexpected

inflationary developments during the course of the year.
A procedure along these lines might take some of the pressure off
monetary policy.

It would permit a faster rate of economic growth with a

given rate of money growth, as the inflation component of nominal growth
diminished and the real component expanded.

It would indeed involve a

temporary suspension, a kind of truce, in the continuing struggle over
income shares.

I doubt that in the long run it is either feasible or

desirable to seek to minimize this effort, which has been one of the driving
forces of productivity gains.

But, at our present level of unemployment, it

does not seem unreasonable to ask that those who are employed moderate their
demands so that those looking for work can find it.

-23In conclusion, it is obvious that, to deal with today's inflation
and recession, we must rely on the tools we have even though we should not
give up trying to develop new ones.

Monetary policy has been the principal

tool, and its impact on business, therefore, is an important consideration in
business planning.

Monetary restraint, in the nature of things, has had to

bear down particularly hard on business investment spending.

As the economy

recovers at a lower rate of inflation and lower interest rates, the need for
a resumption of business investment is urgent.

A sustained recovery is

possible only if the initial impulses coming from the cessation of inventory
reduction are eventually replaced by the stronger business spending.


job of monetary policy will be to promote this development consistent with
further declines in inflation and long-term interest rates.