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THE PRESENT ECONOMIC CLIMATE Hugh D. Galusha, Jr. President Federal Reserve Bank of Minneapolis Remarks prepared for the American Association of Cereal Chemists, Leamington Hotel, Minneapolis, Minnesota, October 19, 1970 INTRODUCTION The title of my remarks, as it appears in your program, is MThe Present Economic Climate." I should think, though, that you are interested in today's climate mostly for what it suggests about tomorrow's climate; and that, tomorrow's climate is what I want to talk about this morning. You all know that we have had quite a storm and, if I may continue with the metaphor of my title, that it is still raining--quite hard, in fact. what of tomorrow's weather? But I believe that the rain is going to let up and, in the not-too-distant future, stop. Unless economic policy is changed drastically, inflation will end; and, after awhile, unemployment will decreas I am not, however, forecasting fine sunny weather. well remain overcast. The sky could At best, I suspect, it can clear only partly. When we have brought inflation to an end, as surely we can, we will still be faced with the problem of reconciling price stability and full-employment, our two primary and equally important economic goals. But I am not entirely sure that we are going to find a way of completely reconciling these goals. I do not at this moment know of a way of doing so. This is why I say that the sky will remain cloudy or, at best, partly so. Having stated my forecast let me tell you how I developed it. THE NEED FOR CLOUD-SEEDING As I said a few moments ago, we have had quite a storm--one which, if unchecked, might possibly have grown into a hurricane and threatened great destruction. The GNP deflator, so-called, is our broadest measure of inflation and, if not a perfect measure, the one most economists and government officials use. In 1965, the deflator increased about 2 percent. - 2 - By historical standards, this is not a large increase. In 1966, however, the increase was nearly 3 percent; and in 1967, a little more than 3 percent. In 1968, the deflator increased 4 percent. Through 1968, then, we had a storm which was gaining in intensity. Nor is it difficult to find a cause for the storm. of necessity, have to result in inflation. War does not, Citizens can, through their elected representatives, choose to tax themselves to pay for war. We did not, however, get an increase in taxes when the Vietnam war effort was stepped up, so increased government demand started prices moving up. And the increase in government war demand, not offset early on by an increase in taxes, led to increases in private demands. So directly and indirectly, government demand forced a continuing increase in prices. In a full-employment economy, which is what we were approaching in mid-1965, there is no way citizens can escape paying for a war--or, for that matter, any other government activity which requires economic resources. They can pay more taxes directly or, by living with inflation, pay more indirectly. But however much we may lament the income tax, it is a better tax than inflation. It is a less capricious tax; its burden is distributed more equitably, as I am sure you will all agree, than is the burden of inflation. This is why we should have had an increase in taxes soon after the decision to escalate the war in Vietnam was made. It might be argued that we did not need a tax increase; or, in other words, that much tighter money (a sharp increase in interest rates) would have damped private demand and, as it were, made room for a noninflationary increase in defense spending. Perhaps! The Fed did move; you will recall in this connection that discount rates were increased in December 1965, - 3 - before it had become apparent to all that the Vietnam war effort was being escalated. But U. S. economic policy cannot be set by monetary policy alone, for its effect, unless coordinated with fiscal policy (the other half of U. S', economic policy) is highly selective in very unpleasant ways. For example, tight money bears most heavily on housing, and on beleaguered state and local governments. In any event, we finally did get a tax increase in the summer of 1968 and then, in early 1969, a sharp increase in monetary restraint; coupled with a decrease in defense spending which has continued down to the present and will, I think, continue through the near-term future. economy responded. And the Aggregate demand decreased and the dangerous rate of economic growth slowed. THE RAIN WILL END I must admit that in 1969 the GNP deflator increased nearly 5 percent, or more than in 1968. cannot be ended overnight. All this means, however, is that inflation Especially is this so if it has gone unchecked for a long while and businessmen and consumers (who are also, for the most part, wage-earners) come to expect that it will continue. I must also admit that, like most public officials, I have been a little disappointed by the increases in prices in 1970. But only a little. It was Lenin, I believe, who said that only those who start with illusions are ever disillusioned. And most public officials, whatever their public pronouncements, did not start with the illusion that 1969 or even 1970 would see a return to price stability. The outlook for the near term is for more inflation, but, what is most important, at a steadily decreasing rate. In early 1971, the rate 4 - of inflation may be only 3 percent. - While I do not regard a 3 percent rate of inflation as acceptable, it is a lot better than a 5 percent rate. In late 1971, the rate of inflation could well be down towards 2 percent, which is very nearly what we have come to mean by price stability. H o w can I say what I have just said when the prospect is for a very considerable federal budget deficit for the current fiscal year, which will end next June? A deficit somewhere in the range of $10-13 billion, where in fiscal 1970, the year which ended last June, we had a small surplus-something less than $1 billion? So again, how can I say that the rate of inflation is going to decrease when the prospect is for a large budget deficit in fiscal 1971? There are two reasons. The first is that the increase in the budget deficit is partly explained by the economic slow-down. Wien the economy slows down, tax receipts fall and, other things equal, the actual budget deficit increases. In fiscal 1970, federal receipts totaled roughly $200 billion; and the estimate is that in fiscal 1971, receipts will total only about $196 billion. The point is that the level of economic activity has an influence on the federal budget. When the rate of economic growth increases, the budget swings automatically toward surplus because as profits and incomes grow, so do taxes. And when the rate of economic expansion decreases, as it has, there is an automatic swing toward deficit. A shift from budget surplus to deficit is therefore entirely consistent with a decreasing rate of inflation, since to get a decreasing rate of inflation requires an economic slow-down; and as I have already indicated, such a slow-down tends, other things equal, to swing the budget - 5 - f r o m surplus to deficit. B e c a u s e the actual b u d g e t is influenced so b y the level of e c o n o m i c activity, it is not a g o o d m e a s u r e of fiscal fuel. A better, although far f r o m perfect, m e a s u r e is w h a t e c o n o m i s t s call the f u l l - e m p l o y m e n t budget. It is calculated b y estimating the r e v e n u e s the g o v e r n m e n t w o u l d receive if the e c o n o m y w a s operating at full e m p l o y m e n t , with the levels of b u s i n e s s profits and p e r s o n a l i n c o m e s consistent with that level of e m p l o y m e n t . It is not influenced b y cu r r e n t e c o n o m i c conditions; it c h a n g e s only w h e n federal spending changes, or w h e n there is a c h a n g e in tax rates. It t h e r e fore furnishes a neutral yardstick to m e a s u r e the inflationary i m p a c t of fiscal p r o g r a m s . W e e s t imate that for fiscal 1970 the f u l l - e m p l o y m e n t b u d g e t w a s in surplus b y about $5 billion a n d that for fiscal 1971 there will still b e a surplus of a p p r o x i m a t e l y $1 billion. Fiscal policy will b e m o r e e x p a n s i o n a r y o n a v e r a g e in the p r e s e n t fiscal y e a r than in the o n e just past. F o r one thing, there is going to b e an i n c r e a s e in federal s p e n d i n g - - a m o d e s t increase, w h e n m e a s u r e d against the trend i n c r e a s e in federal tax receipts, but a n i n c r e a s e nonetheless. B u t a d e c r e a s e of $ 3 - 4 billion in the full- e m p l o y m e n t b u d g e t surplus a p p e a r s rather insignificant in a $1 trillion economy. And besides, private d e m a n d is not increasing all that rapidly. Quite the opposite. W e c a n u s e a little fiscal stimulus, for bringing a n end to inflation d o e s not require r e c e s s i o n of m a j o r proportions; and without s o m e fiscal stimulus, or alternatively g reater m o n e t a r y ease, that is - pr e c isely w h a t w e could get. 6 - It is then a certain w e a k n e s s in private d e m a n d that explains, if only in part, w h y a n i n c r e a s e in federal spend ing a n d a s w i n g f r o m b u d g e t surplus to deficit is not inconsistent with a d e c r e a s e in the rate of inflation. O n m y b a d days, I do w o r r y a little, I m u s t confess, about C o n g r e s s forcing an e v e n larger i n c r e a s e in federal n o n d e f e n s e s p e n d i n g than is presently in prospect. T h e r e will b e s o m e increase, as T h a v e said, but w h a t w o r r i e s m e is a further s h a r p increase. e v e r y indication it will resist. T h e A d m i n i s t r a t i o n h a s given But if C o n g r e s s should p r e s s successfully for sharply higher n o n d e f e n s e spending, then w e will not b e able to h a v e the easier m o n e y whic h , in m y opinion, this e c o n o m y needs. T h e Federal R e s e r v e will h a v e to m o d i f y its decision, m a d e earlier this year, to b e m o r e g e n e r o u s in providing funds to the e c o n o m y . And if it d o e s h a v e to, then state an d local g o v e r n m e n t s will again c o m e u n d e r p r e s s u r e a n d our national h o u s i n g goal will r e m a i n w a y b e y o n d o u r reach. The margin created b y relative fiscal restraint--a m a r g i n w h i c h has m a d e it possible for m o n e t a r y policy to relax without havi n g to w o r r y e x c e s s i v e l y about a dding to inflation p r e s s u r e s - - w i l l b e seriously n a r r o w e d . It is therefore v e r y i m p o r t a n t that the A d m i n i s t r a t i o n s u c c e e d in k e e p i n g n o n d e f e n s e s p e nding u n d e r control. If it d o e s not, then there could well b e a little m o r e inflation than there o t h e r w i s e w o u l d be. inflation will still decline, but not quite as rapidly. F e d e r a l R e s e r v e will step into the breach. T h e rate of T h e point is that the O f this I a m entirely confident* - 7 - A n d yet if it is f o r c e d to, then housing, school construction an d i n v e s t m e n t spending will suffer. W h a t I a m saying c a n b e put simply: T h e e c o n o m y needs s o m e relief f r o m tight m o n e y ; but if the rate of inflation is to b e slowed, the only w a y to get easier m o n e y is b y holding federal spending d o w n to the level currently in prospect, I should h a v e p r e f e r r e d holding it b e l o w this level a nd h a vin g that m u c h easier a m o n e t a r y policy. THE COST OF CLOUD-SEEDING I h a v e likened inflation to a rain s t o r m , to a s t o r m w h i c h threatens to b e c o m e e v e r m o r e violent; a n d I h a v e likened e c o n o m i c policy intended to c h e c k inflation, the tax i n c r e a s e of 1968 an d the e x t r e m e m o n e t a r y restraint of 1969, to cloud-seeding. c l o u d - s e e d i n g is. but there is a cost: A n d s u c h a policy is costly, just as T h e r e m a y b e n o bills for rented airplanes an d gasoline, lost output or, alternatively, i n c r e a s e d u n e m p l o y m e n t . In D e c e m b e r 1968 the u n e m p l o y m e n t rate w a s S e p t e m b e r 19?0 it w a s 5. 5 percent. 3. 3 percent. In L a s t m o n t h r o u g h l y 1. 8 million m o r e individuals w e r e u n e m p l o y e d than in D e c e m b e r 1968. H o w e v e r bad our u n e m p l o y m e n t statistics are, there is no d e n y i n g that slowing the rate of inflation ha s b e e n costly. Actually, the u n e m p l o y m e n t rate has i n c r e a s e d m o r e than m o s t experts expected, "t is m y i m p r e s s i o n that s o m e t i m e b a c k the m o o d of b u s i n e s s m e n ch a nged, p e r h a p s f r o m ex c e s s i v e o p t i m i s m to equally e x c e s s i v e - 8 - p e s s i m i s m , a n d that w h e n this h a p p e n e d they predictably l a u n c h e d a m a s s i v e cost-cutting effort. to e n h a n c e c o r p o r a t e profits: Predictably, b e c a u s e there are only t w o w a y s b y increasing sales or b y cutting costs. D e n i e d the f o r m e r b y the f orced s l o w - u p in the e c o n o m y , they h a v e t u r ned to the latter. T h e y are doing it successfully; unit labor costs ar e d e c reasing. But, and this is a v e r y large qualification, this cost-cutting effort ha s h a d the effect of increasing u n e m p l o y m e n t . A n d since cost-cutting efforts are likely to continue, u n e m p l o y m e n t could for awhile continue high e r than on e m i g h t h o p e for. D o not m i s u n d e r s t a n d m e . I a m not inveighing against cost-cutting. I a m all for cutting costs, especially since I believe that w i t h p r o p e r e c o n o m i c policies w e c a n p r o v i d e job opportunities for those w h o as a result b e c o m e u n e m p l o y e d . Cost-cutting is an offset--a s h o r t - r u n offset, but an offset n o n e t h e less--to m o n e y w a g e increases. A n d in t o d a y ’ s climate, w e can be grateful that cost-cutting has b e c o m e a favorite indoor g a m e of b u s i n e s s m e n . I should not b e so optimistic about o u r returning to r e a s o n a b l e price stability if I did not believe this. Cost-cutting has, h o w e v e r , as I h a v e said, m a d e the u n e m p l o y m e n t p r o b l e m worse. A n d it is difficult to see u n e m p l o y m e n t d e c r e a s i n g in the m o n t h s i m m e d i a t e l y ahead. T h e u n e m p l o y m e n t rate will li k ely go o n increasing for s o m e m o n t h s , I think, but happily at a n e v e r s l o w e r rate. F o r awhile yet, w e will b e p a y i n g a h igher a n d higher price for slowing the rate of inflation. - 9 - L o o k i n g a little further into the future, to b e y o n d m i d - 1971, I do see a d e c r e a s e in the u n e m p l o y m e n t rate. m o r e expan s i o n a r y . E c o n o m i c policy has b e c o m e T h e i n c o m e surtax c a m e off at m i d - y e a r a n d m o n e t a r y policy is certainly m o r e e x p a n s i o n a r y than it w a s in early 1970. T h e r e is a lag in the effect of e c o n o m i c policy, but the e c o n o m y d o e s respond. The real g r o w t h rate is h i gher t o d a y than it w a s earlier in 1970 a n d t h r o u g h 1971 will, I suspect, continue to increase. A n d w h a t is m o s t important, the rate of inflation will go o n slowing as the rate of real e c o n o m i c g r o w t h i n c r e a s e s a n d the u n e m p l o y m e n t rate decreases. T h e steady p r o g r e s s could b e derailed, t h a v e t o u c h e d u p o n the d a n g e r of relaxing fiscal restraint too fast in d o m e s t i c p r o g r a m s . The M i d d l e E a s t is a w o r r y , an d Southeast A s i a is a long w a y f r o m settled. Hysteria, h o w e v e r induced, will continue to b e a w o r r i s o m e threat. Modern m a n m a y look like, a n d s o m e t i m e s act like, the super-rational e c o n o m i c m a n s o m e y o u n g p eop l e deride. T h e y n e e d not w o r r y . E m o t i o n is still a d e t e r m i n a n t of h u m a n behavior, e v e n in financial m a r k e t s : Policymakers, at least in the short run, h a v e to m i x an a w a r e n e s s of p s y c h o l o g y w ith economics. Tn s o m e parts of the Ninth District, there are those w h o a r e p r e p a r i n g for the e nd of the financial w o r l d at 9:30 a . m . N o v e m b e r 13, b e c a u s e they r e a d it s o m e w h e r e . o n Friday, Tn o n e c o m m u n i t y , following a recent n e w s s c o r y , the b a n k s w e r e confronted b y a s u c c e s s i o n of w i t h d r a w a l s f r o m savings accounts, a n d the local b r o k e r a g e office h a d a flood of sell orders. T h e y o u n g r e p o r t e r w h o h a d n e v e r d r e a m e d his story w o u l d - 10 p r o d u c e that kind of r e s p o n s e has, P m - sure, a feeling of kinship with the radio station in N e w J e r s e y that y e a r s ago ca r r i e d the fictional play b y O r s o n W e l l e s about the m e n f r o m M a r s w h o l a n d e d in N e w Jersey. B u t lest w e b e too h a r d o n either o u r Ninth District c o m m u n i t y or those in N e w Jersey, the irrational r e s p o n s e of large, e m i n e n t l y r espectable investors to the P e n n Central collapse w a s no different. P e n n Central failed b e c a u s e of appalling m i s m a n a g e m e n t ; but all of a s u d d e n the w h o l e c o m m e r c i a l p a p e r m a r k e t b e c a m e a s h a m b l e s , w ith acute p r e s s u r e s f o c u s s e d o n t w o w e l l - r u n c o m m e r c i a l p a p e r issuers, C h r y s l e r A c c e p t a n c e a n d C o m m e r c i a l Credit. T h e F e d m o v e d quickly to bolster financial c o n fidence, a n d the crisis w a s averted. Tt c a n a n d will continue to p e r f o r m that role of b a n k e r of last resort to m a i n t a i n o r d e r l y financial m a r k e t s , but it h a r d l y m a k e s easier the p r o g r e s s t o w a r d l o n g - t e r m e c o n o m i c goals. T o a point, then, I a m rather optimistic. I see the rate of inflation d e c r e a s i n g steadily o v e r c o m i n g c a l e n d a r q u a r t e r s and, after awhile, the rate of u n e m p l o y m e n t d e c r e a s i n g too. restrictive. E c o n o m i c policy h a d to b e c o m e v e r y T o c h e c k inflationary p r e s s u r e s , the rate of e c o n o m i c g r o w t h h a d to b e d e c r e a s e d . W e h a d to create a large g a p b e t w e e n the e c o n o m y ’ s capacity output a n d actual output, or in other w o r d s force s o m e i n c r e a s e in the u n e m p l o y m e n t rate. tained. B u t this large output g a p d o e s not h a v e to b e m a i n W e c a n r e d u c e it, an d t h e r e b y the u n e m p l o y m e n t rate, and still a c h i e v e further d e c r e a s e s in the rate of inflation. - THE OUTLOOK: 11 - CONTINUED OVERCAST It might seem from what I have just said that I am indeed looking for a return of sunny skies. differently: I should prefer, though, to put my forecast the rain will stop, but skies will remain overcast. Why should I refuse to admit of a disappearance of the clouds and the appearance of the sun? It is just that I wonder x^hether we will be able to proceed back to full-employment--to a 4 percent unemployment rate which is the conventional definition of full-employment--and remain there, while at the same time enjoying price stability. Possible by proceeding only very slowly back to full-employment, we could remain there and still have stable prices. There are some economists, very experienced in economic policy, who believe this. I should like to be a believer, but have not been able, try as I might, to rid myself of doubt. The evidence, such as it is, suggests that full-employment, 4 percent unemployment, and price stability are irreconcilable goals; or, in other words, that both cannot be achieved. back to the early I 9 6 0 1s. It is not reassuring to look We had price stability over a stretch of years, 1960-64, but with an average unemployment rate of nearly 6 percent. Over the years 1965-69 the unemployment rate averaged a little less than 4 percent. But over those years there was, as I have said, a very considerable increase in prices. Nor is it acceptable to argue, as some have, that we should accept whatever unemployment rate is consistent with price stability, be it 5 per cent or, worse, 6 percent. That is too easy a way out. For one thing, the burden of a high unemployment rate is very specific; it is shared only by those who are unemployed. Keeping inflation in check benefits many; certainly - 12 - all those who have retired and those who remain employed, but at the expense of those who, to keep inflation in check, have become unemployed. And it cannot be maintained that the unemployed are unemployed because they are unwilling to work. Is it possible that in less than two years 1.8 million more individuals suddenly became too lazy to work? think not. policy. I Beyond a certain margin, unemployment is the result of economic And it is not good social policy, I submit, to have a small pro portion of the population bear a very considerable economic burden — unemployment — so that the much larger proportion can enjoy price stability. There are some who would have mandatory wage and price controls imposed. Most emphatically, ho\\Tever, I do not count myself among those who would. I shudder when I think of the bureaucracy that would be required to assure even partial — not complete, but partial — compliance. be different if a successful appeal could be made to patriotism. It might And we are not smart enough, it seems to me, to regulate wages and prices without badly allocating economic resources or causing economic waste. In brief, then, I should prefer inflation, or even excessive unemployment, to mandatory wage and price controls. Among those whom I greatly respect, there are some — many — who favor voluntary wage-price guidelines. another try at voluntary restraint. accomplish much by trying. perhaps And perhaps we should have I, though, am a little doubtful that we Also, I dislike policies which, so to speak, put those who are willing to cooperate at a disadvantage. If the goal of 4 percent unemployment rate and the goal of price stability are inconsistent, as I sometimes think they are, and if a policy - 13 - of voluntary wage-price restraint will do little if any good, then the economic outlook is not all that bright. It clearly behooves us to do all that we can to make our overriding goals of economic policy, full-employment and price stability, more compatible. Labor mobility might be improved further, perhaps with the help of government. Trade quotas and tariffs might be eliminated or at least reduced. But as I said at the outset, I do not know how full-employment and price stability can be made fully compatible. Perhaps the experts do. All I know is that even after inflation has been stopped, a problem may remain and that, unless a way of reconciling full-employment and price stability is found, our free market economy will be impaired.
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