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19RNMLEASE ON DELIVERY
SEPTEMBER 20, 1979
f.M. EDT
INFLATION AND THE POLICY OPTIONS
Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
1980 Business Outlook Conference
Sponsored by
The Conference Board
New York City
Thursday, September 20, 1979
INFLATION AND THE POLICY OPTIONS
Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
1980 Business Outlook Conference
Sponsored by
The Conference Board
New York City
Thursday, September 20, 1979
Summary and Conclusions
(1) We are underestimating the damage that inflation is doing to
our economy.
Inflation reduces and may ultimately destroy productivity gains.
The losses from that source can far exceed losses from temporary unemployment
and underuse of resources, and they can never be made up.
(2) All government programs that increase prices and costs must be
reoriented toward the objective of restraining inflation.
(3) A new form of incomes policy is desirable.
It would take the
form of a two-stage approach to wage setting that would allow labor to share
in any increase in business profits resulting from initial acceptance by
labor of a low wage guideline.
(4) It is too early for a tax cut, although one will be needed
eventually to offset the move of taxpayers into higher brackets owing to
inflation.
At that time, the best cut would be one that avoids appearing
-2-
to give gifts to business but instead restores normal depreciation based
on replacement instead of original cost.
(5)
Monetary policy should take more account of the expansion
of money substitutes such as money market mutual funds and should aim at
maintaining positive real interest rates over broader periods of lime.
1 am honored to be asked to speak before the 1980 Business
Outlook Conference of The Conference Board on the subject "Inflation
and the Policy Options."
Speaking for myself, I do not feel that we
have many options against inflation, certainly not good ones.
Most
conceivable measures have already been tried at some time and in some
degree or other or at least proposed legislatively.
We will have to
try again and try to do better mainly with the means already at hand.
Inflation Tends to Accc-lerate
I do not consider "benign neglect" of inflation as an opi.ion.
Experience shows that if inflation is not attended to vigorously, it
accelerates.
I would like uc begin by examining the recent cvidcnce on
this a little more closely.
During, the 1973-74 buret of inflation, the
rise in crnsumrr pi.ir.es rcrrlicd a ?atc of o\.r 1?. pcrccnt fcr scvctcl
-3
quarters, somewhat less than during the first half of 1979.
Over the
next year or two, the rate dropped by more than one-half, indicating
significant progress.
But the anti-inflationary measures taken, at
considerable cost in unemployment and widely criticized for that reason,
had little long-term impact.
In 1977 and after, inflation began to
acceleratc once more as capacity limitations made themselves felt.
Thus,
wc went into that new round of price increases from a base level of less
than 6 percent.
At the present time, under circumstances in some respects similar,
but with much less inflationary steam in the economy than in 1973-74, we
have reached rates of inflation somewhat higher than the peaks of 1973-74.
But, and here is the essential difference, none of the forecasts that I
have seen anticipates a reduction of the rate of inflation in 1980 to anything
like one-half.
The administration expects inflation in 1980 to be only
fractionally below 1978, ar measure?
/ *;he GNP deflator.
expects inflation in 1980 to be higi-i ' than in 1978.
The Federal Reserve
Thus, even if the pro
jections are realized, we seem likel? to go into the next expansion from an
inflation level considerably higher
\a»i at the start of the previous round.
Inflation has clearly accelerated.
Inflation is Destroying Productivity
Meanwhile the costs of inflation are being increasingly borne in
on us.
Productivitys as you all knew, has slowed alarmingly.
I do not
believe that it is altogether an accident that the slowdown of productivity
which began in the late 1960's coincided with the emergence of inflation.
-4-
That slowdown, from a rate of over 3 percent during the early 1960's to
something like one percent over the last five years —
I ignore the abysmal
productivity numbers for the last: two quarters -- has, of course, many roots.
Some among them, such as the changing age composition of the population
and government price raising regulations, are not caused by inflation.
On the other hand, inflation has something to do with the slow growth of
investment, the slowing of associated research and development expenditures,
the reduction in savings, the higher tax burden, the entrance into the labor
force of untrained persons motivated by pressures on household budgets, and
the associated shift to less productive service occupations.
These can
all be traced in greater or lesser degree to the pervasive influence of
inflation.
In particular, inflation has reduced corporate funds available
for investment.
Profits have been overstated through underdepreciation
and failure to account properly for inventory profits.
The burden of taxes,
therefore, has increased and, in the case of inventory profits at least,
cash flow has been less than it appeared to be.
Inflation has reduced the
feasibility of investment projects both by reducing their after-tax return
and by raising the risk premium.
the cost of capital.
It has reduced investment also by raising
Although the cost of debt capital has been low, after
taxes indeed clearly negative, the cost of equity and the implicit cost of
internal funds has been very high owing to the low price/earnings ratio to
which inflation hcc driven equities in the stock market.
Inflation lies
penalised savcrr, helped tc drive down the cavirc ratio to rLnormrl levels,
and pushed thr use of savings into relatively unproductive channels.
-5In addition, lasting damage to our capacity to innovate is done
by inflation through the havoc it has wreaked on institutions of higher
learning and through the damage it has done to the dollar which increasingly
inhibits foreign travel and enhances our national provincialism.
Inflation has done damage also by provoking ill-conceived govern
ment policies such as wage and price controls.
These tend to squeeze profit
margins, hurt investment, and generally cause misallocation of resources.
The unfortunate fiscal and monetary policy mix which has caused us to fight
inflation by tight money and then to offset its effects by easy budgets has
also been adverse to investment and productivity.
Fighting inflation is bound
to have costs just as inflation itself has, but it is possible to minimize
those costs by appropriate policy mixes.
It has sometimes been said that the cost of fighting inflation,
especially by the traditional means of fiscal and monetary policy, is so high
that we cannot afford it.
Examples and studies cited suggest that a reduction
of inflation by one percentage point costs five million jobs and $250 billion
of GNP over five years.
I regard such calculrtions cs invalid for two reasons.
First, the studies assume, that t'l*< eccnoirj ran continuously ojcrctc at
"potential," whereas if operating at this level means inflation that is not
a realistic possibility.
Second, and even more important, the calculation
accepts potential as a predetermined magnitude wheicr.s it is dctxrmincd
very importantly t; tlu functioning cf the cccnomy. The rcccnt slowdown in
productivity gains has greatly reduced the potential of our cconomy contrasted
with what it would have been had productivity gains continued at: thci.r old
rate of 2-1/2 - 3 percent a year.
Inflation bears part of the ultimate
-
responsibility for the slowdown.
6-
It has obviously caused permanent damage
by holding down the growth of potential.
In this way, inflation causes
a loss of output that is almost sure to be much larger than any loss from
temporarily operating below capacity.
The gradual shift from about 3 percent productivity gains during
the early 1960's to about one percent during the second half of the 1970's
implies a loss of 15 percent of the average GNF of that period.
Projected
into the distant future, a 1-2 percent annual loss of GNP growth from lowered
productivity quickly mounts to astronomical levels:
the permanent costs of
inflation promise far to exceed the temporary costs of unemployment.
Inflation poses threats beyond loss of output.
Uncurbed, it will
almost certainly lead to further experiments with wage and price controls.
Over time, imposing and removing controls will scarcely change the speed
of inflation unless something is done about its causes.
But the distortions
and conflicts inherent in controls will work their own brand of damage.
The
survival capabilities of a free enterprise economy under such conditions
strike me as low.
Measures to Restrain Inflation
I would now like to turn to measures that, if we chose, could be
employed to deal with inflation.
They can be divided into three kinds:
(1) abatement of the numerous cost and price raising actions of the govern
ment, (2) incomes policy, and (3) monetary and fiscal policy.
I do not see any real options among available techniques.
shall need all the techniques that are available.
We
Sole reliance on fiscal
and monetary restraint, especially in the face of what has been referred to
7-
as "self-inflicted wounds" through government price raising actions, will
not be adequate.
On these "self-inflicted- wounds," ranging from farm price supports
through minimum wage, health and safety, and environmental regulations, and
psctectirmlsm, to inadequate antitrust action, I have nothing new to contribute.
I would only say that national security considerations must have priority
even over inflation fighting and for that reason I would still welcome it
if the government were to change its mind on immediate oil price deregula
tion.
If progress is to be made in dismantling government-mandated price
increases, defenders of many good causes will have to make painful sacrificcs.
Willingness to accept these becomes, in a way, a measure of one's concern
about inflation.
Incomes policy is as yet a largely unexplored terrain for the war
against inflation.
The wage and pricc standards seem to me to have had some
beneficial effects.
¥i? personal preference is for a tax-oriented incomes policy.
The
edrcinistration's projrersr.l for real-wage insurance is a particular genus of
fl-ic sptcies, embodying whrt is known as the "carrot" approach.
My own
E i.cfeircuce would be for a "stick" approach, involving an increase in the
ccr:poi&{ e iucomc tax for firms giving excessive wage increases.
Of course,
1 am cwcxc. that the approach lacks political appeal, both for business and
for labor.
For that reason perhaps one could claim that it is evenhanded.
I expect that, once the inflation-curbing effects of the present economic
slowdown have worn off, and the full struggle to contain inflation resumes,
we shall hear move, of tax-oriented incomes policies.
-
8-
A New Version of TIP
Many versions of this technique have been proposed.
I would
like to suggest an additional one, in the hope that it may be politically
more acceptable, although without backing away from my original preference.
The most serious obstacle to acceptability of TIP, in the light
of recent experience, seems to be labor's concern that acceptance of a wage
guideline might lead to excessive profits for business.
historical experience, this concern may seem unnecessary.
In the light of
Prices have
tended to follow unit labor costs closely except when events
or oil price increases have broken the relationship.
:ke bad crops
Ordinarily, fixed
mark-up pricing ties prices to unit labor costs with profit margins fairly
constant over the long run.
Nevertheless, labor's concern needs to be met.
My new version of TIP proposes to do this by means of a two-stage
approach to wage setting.
In the first stage, wage increases are to be
restrained by a guideline.
In the second stage, if, contrary to expecta
tions, profits have increased abnormally following wage restraint, there
is - secondary wage increase or equivalent that, in economic terms, amounts
to a form of profit sharing.
This could be accomplished either at the micro
level, by renegotiation of individual wage contracts, or at the macro level,
through an excess profits tax and a cut in lower bracket tax rates.
If the scheme is carried out at the micro level, a guideline would
have to be set for a "normal" increase in profits.
Firms that had profit
increases in excess of the guideline would renegotiate wages so as to share
the "excess" with their employees according to some formula.
If that
formula were set during the I n i t ^ L a ^ e negotiation, it would save
9
negotiating effort later and perhaps create incentives for greater
productivity.
Some nationwide formula for the sharing of the excess
is also conceivable.
The share of profit being distributed to the
employees would, of course, have to be tax deductible to the company.
The advantage of this micro approach is that it adapts itself
easily to individual company circumstances.
A disadvantage is that some
companies may have no above-normal profits while others do.
The employees
of both types of companies, on the other hand, would be affected equally
by rising living costs.
In that case, protection against rising living
costs would be unequal.
A macro approach, as an alternative, would proceed by levying
an "excess profits tax" on above-normal profits.
The proceeds of the tax
would be used to reduce income taxes in the lower brackets, or alternatively
to compensate the employees of the tax-paying companies in proportion to
their wage shortfall with respect to profits.
The excess profits tax would take the form of an increase in the
regular corporate income tax for all corporations, whether they had abnormal
profits or not.
The increase would be aimed at keeping constant the share
of corporate profits in GNP, or bringing that share closer to some benchmark.
This would involve a rise in the corporate rate probably of only a few
%
points, without major disincentive consequences.
A benchmark for the
appropriate share of corporate profits in GNP would be required.
These alternative versions of TIP have some similarity with the
principle of real wage insurance that has been before the Congress.
They
differ, broadly, in avoiding its budgetary burden, by limiting the compensation
-
10-
pa id to employees to a share in abnormal profits or the proceeds of a tax
thereon.
The proposals also resemble present wage guideline principles
and the guaranteed real wage proposal in recognizing that, in order to
break into the wage-price spiral, somebody has to move first, but that
there will be no loss to the first mover, provided this move is not
followed by a redistribution of income.
A Tax Cut Is Premature
Finally, I come to fiscal and monetary policy.
the wheelhorses of any effort to contain inflation.
They have to be
They should not have
to carry the full burden, but the other approaches can in no way be sub
stitutes for the orthodox techniques.
At the present time, there is growing discussion of a tax cut.
In my view, that is entirely premature.
At some point in the future,
assuming continued inflation, a tax cut will be needed simply to reduce
fiscal drag.
Taxpayers are being pushed into higher tax brackets by
rapid inflation.
That is why the so-called high employment budget is moving
into higher and higher surplus.
But the reality is that we arc at full employ
ment, and we have an effective deficit of around $40 billion.
The chimerical
surplus, of course, is simply due to the manner of its computation.
convey a meaningful signal through its rate of changc.
It docs
But that wc still
base our calculations on unrealistic benchmarks of this sort shows how much
progress we still have to make in bringing our thinking up to date.
If
we want to arrive at a structurally sound budget, it is too early for a
tax cut.
-11-
Replacement Cost Depreciation
Neither do I find particularly attractive the specifics for a
tax cut that are sometimes being proposed.
As much of a hypothetical cut
as is politically possible, I agree, should be designed to stimulate
business investment.
But why, instead of seeming to make gifts to business
through investment tax credits or accelerated depreciation, would it not be
better to allow business to have no more than ordinary depreciation, but
base it on realistic bookkeeping?
Depreciation based on original cost
makes very little sense in 10 percent inflation, when the half-life of a
dollar is about seven years.
Underdepreciation, according to the Depart
ment of Commerce, amounted to $45 billion last year.
The tax paid on this
overstatement of profits, at 48 percent, amounted to $22 billion.
ment cost depreciation would remedy this.
Replace
It seems simpler, and less
vulnerable to criticism, to eliminate taxes that should not have been paid
in the first place rather than collect these taxes and try to offset them
with what looks like special favors to business.
The much discussed cut in payroll taxes also seems less desirable
than a cut in personal income taxes.
If we start to hold down the consumer
pricc index by reducing payroll taxes, we may eventually find ourselves doing
so by subsidizing the cost of food or other items that could be used to
manipulate the CPI.
Moreover, shifting part of social security to the
general fund, as would be implied in a cut in the payroll tax, destroys
the insurance character of the social security system and opens it up to
limitless financing through the income tax.
In any event, I must not allow
my interest in discussing the specifics of a future tax cut to create the
misleading impression that I meant to argue for it at this time.
I do not.
-12-
Monetary Policy. Quasi-Money, and Real Interest Rates
In conclusion, a word about monetary policy.
I have great
sympathy with the proposal to bring down the growth rate of the monetary
aggregates gradually but steadily.
Gradualism is essential.
A policy of
sudden drastic restraint would almost certainly be counterproductive
economically and politically.
But gradual reduction of the monetary
aggregates is no easy task even if one is fully prepared to face the
consequences.
The monetary aggregates have ceased to be a reliable guide
to monetary policy, because they have ceased to sustain a stable relation
to economic activity.
At 10 percent inflation the losses on demand deposits
are so horrific that their holders will exert enormous ingenuity to discover
alternative means of managing their liquidity.
How the various quasi-monies
that are exploding on all sides -- RPs, Eurodollars, ATS and NOW accounts,
money market mutual funds —
from M-l to M-7 is debatable.
should fit into the liquidity spectrum running
If, with appropriate avoidance of duplication,
they were included in M-l, they would drastically accelerate its growth rate.
Tncluded in higher aggregates, which are much larger than M-l, the impact
on growth rates would be less, but still significant.
Thus, the recorded
growth particularly of M-l may lead us into seriously underestimating recent
monetary expansion.
To guard against such errors, it is helpful to focus on the
behavior of real interest rates.
It can reasonably be argued that interest
rates that are negative in real terms are excessively expansionary.
We
should not, I believe, be deterred from using real interest rates by the
-13scruples of theoretical economists who point out, correctly, that they
depend upon expectations.
clearly observable.
Short-term real rates, in any event, are
Anyone who held short-term assets during the first
half of this year can readily, albeit roughly, compute with the help of
the CPI whether the real rate was positive or negative.
Complications
arise, to be sure, in computing real rates after taxes, but after taxes
most interest rates today are heavily negative.
In advocating real interest rates as a guide to monetary policy,
and in proposing that we should aim at keeping them positive, I am not
suggesting that interest rates should follow every wiggle of the CPI.
Monthly and even quarterly aberrations seem unavoidable.
But monetary
policy that allows real interest rates to be negative for prolonged periods
strikes me as much more likely to stimulate rather than to restrain inflation.
That is the lesson that a real interest rate guide can have for monetary
policy.
@FedFRASER