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For release on delivery
8:00,; PM, EST
Thursday, January 20, 1983

Remarks by

Paul A. Volcker

Chairman, Board of Governors of the Federal Reserve System




before the

American Council for Capital Formation:

Center for Policy Research

Conference on "New Directions in Federal Tax
Policy for the 1980s"

January 20, 1983

We are deluged these days —

and we have been for

some time •— with learned, and not so learned, analyses about
the budgetary problem•

There has been a lot of plain confusion

about the facts and the outlook —

and the reality is that any

budgetary projection cannot approach the mathematical precision
we associate with neat computer printouts.

Much of the discussion

is overlaid and often confused by differing social, security, or
other priorities, which impact the budget.

And there are differ-

ences in economic analysis as well.
All of this has made it harder to reach a consensus,
and to take action in an area where action is inherently difficult.
That is one reason why I welcome the effort you have been making
to clarify the issues.

I believe it is realistic to suggest

that out of discussions like this, a large measure of agreement
is emerging about the nature of the problem, if not yet agreement
about just how to go about dealing with it.
My contribution may fall more in the former category
than the latter, which does raise issues outside the purview of
my own responsibilities.

But, en the assumption that the inter-

action of fiscal with monetary policies is of critical importance
to economic developments, I will not apologize for reviewing
some familiar ground.
We don't yet have the benefit of the Administration's
budget plan or updated projections from the Congressional Budget
Office.

But the general magnitudes involved are familiar enough.

The deficit for the current fiscal year —

and it's probably too

late to do much about it, even if there were a consensus that action




-2-

were desirable —

is generally estimated at $175 to $200 billion.

And, as I will amplify later, the outcome will remain in that
range, or higher, as far ahead as one can see, given present
programs and assuming healthy and prolonged economic growth.
Indeed, the figures have been cited so often that any
sense of alarm may be dissipated by the very familiarity with
the numbers.

The burden of my comments today is that the hazard

is real; that the deficits around 20-25 percent of expenditures
and 5 percent or more of the GNP are unacceptably large in a
growing economy; and that absence of timely action to reduce those
deficits as the economy grows raises a most serious question
as to whether the economic expansion we want could, in fact,
be sustained for long.
Obviously, we are negotiating a most difficult
period in our nation's economic history.
we can lay —

But I also believe

we are in the process of laying —

more vigorous and lasting growth.

the base for

There are now signs that

recessionary pressures in some key sectors have abated.

Certainly,

considerable progress has been made in reversing the inflationary
trend of the previous decade.

Thus, the stage is set for an

economic recovery that can combine the increase in job opportunities
and real income that we all desire with greater price stability
and more stable, accommodating financial markets.

The relevance

of action on the deficit is that it is needed to help reconcile
those objectives; without such a reconciliation, we risk losing
them all.




-3-

As you know, consumer prices rose less than 5 percent
last year, the slowest rate of increase in a decade and a
remarkable improvement from other recent years.

We need to

recognize that part of the improvement reflected unusually
favorable food and energy price developments, low commodity
prices generally, and more intense price competition from
abroad because of exchange rate considerations.

We can't

count on those factors continuing indefinitely.

Moreover, we

must also recognize that we are still far short of price stability;
in fact, inflation is really only back to the pace of 1971,
which was judged so intolerable at that time that wage and
price controls were imposed•
Unlike 1971, however —
1970s

in fact unlike the entire

-•- trends of underlying costs and inflation expectations

are now moving lower; and those trends should be sustainable
as the economy recovers its upward momentum in 1983 and beyond.
In that connection, the recent behavior of productivity is
encouraging.

After declining throughout much of the late 1970s

and into the early 1980s, labor productivity turned up appreciably
last year.

The data are always hard to interpret in the midst

of recession, but there is now quite a lot of evidence that
potentially lasting improvements in efficiency by both workers
and management are underway.

Combined with continuing moderation

in growth of nominal wage and salary payments, the result should
bring long-lasting reductions in cost pressures and expansion
of real incomes.




-4-

I am acutely aware that these gains against inflation
have been achieved in a context of serious economic hardship.
Millions of workers are unemployed, many businesses are hardpressed to maintain profitability, and business bankruptcies
are at a postwar high.

In my view, those hardships could not

have been escaped by simply letting inflation proceed and
accelerate, with all the damage that

would imply to the basic

productive capability of the economy and the social fabric.
But it certainly does emphasize the need to carry through

—

not simply to start a recovery, but to put policies in place
that can sustain an expansion of output and employment over the
years ahead.
It is in that context —

the need to realize the longer-

run promise in our current situation —

that our ability to bring

the ballooning federal deficits under control is critical.
A few figures suggest the perspective.

During the

1970s, the federal deficit averaged around 2 percent of GNP#
rising to a peak of 4 percent in fiscal year 1976 in the
middle of the deepest recession of the postwar period.

We

thought those figures were high, and in historical perspective
they were.

In contrast, the deficit in the current fiscal

year could reach about 6 percent of GNP.
While hardly comforting, that figure is still not
the crux of the problem.

The current deficit reflects the effects

of unsatisfactory economic performance and high unemployment.
In that sense, well over half —
cyclical factors.

perhaps two-thirds —

reflects

The heart of the difficulty is that there is,

as things stand, no reasonable prospect that we can grow out of the

deficit.


Even if the economy expands at or beyond inost projectionsr

over the next few years and with satisfactory price performance/
the deficit is not likely to fall below 4-5 percent of GNP over
the rest of the decade, assuming no change in current policies.
Even those estimates may be a bit low.
It has become fashionable (and useful) to talk in terms
of "cyclical" and "structural" deficits.

These often are not well-

understood concepts, and it would be useful to review them briefly.
The cyclical portion reflects the effect of current
business conditions on the deficit.

In a recession, the deficit

is temporarily enlarged as slack activity and high unemployment
cut into revenues and raise outlays for certain programs, most
notably «~~ but not exclusively —

unemployment benefits.

When

activity is depressed these cyclical deficits can help support
spendable incomes and reduce the fluctuations in activity.

Today,

that explains a large portion of the deficit, and it can be reasonably agreed at least that portion is benign, supporting income
during recessionIn contrast, calculation of the structural deficit
attempts to abstract from the cyclical stage of the economy.
It reflects the imbalance that would remain even if the economy
were operating at a fairly high level.
The reason the total deficit will not recede significantly
as business recovers, and could even grow larger, is that the
structural portion threatens to grow at least as fast as recovery
reduces; the cyclical component.
It is tempting to suggest that the budget problem is
a statistical artifact related to "pessimistic" economic forecasts and can be eliminated by stronger economic growth than



-6-

is expected by most forecasters.

But that is wishful thinking;

under any reasonable forecast for sustained growth and without
further policy adjustment, the deficits will remain historically
huge unless we nake the unacceptable assumption that we will also
revert to an historically high inflation rate.

I would point

out that deficits of the size projected would feed on themselves
because, in those circumstances, interest payments on the debt
will remain a rapidly growing budget category, even in an
environment of reasonably declining interest rates.
Ironically, the budget difficulties over the medium
term are compounded by our success in bringing down inflation.
Although there is little doubt of the longer-run benefits to
the economy (and eventually the budget) of lower inflation,
the transition to lower inflation for a while widens the deficit.
In terms of revenues, the adjustment to reduced inflation largely
is contemporaneous, as receipts quickly reflect the slov/er
expansion of nominal income.

On the spending side, however,

the response is considerably slower and possibly smaller.
Outlays in indexed programs —
a third of the budget —
with a lag.

which comprise about

respond automatically to inflation, but

At the same time,

a large share of the budget is

set in nominal, not real, terms.

In logic, appropriations should

be cut to reflect a lower rate of price increase; in practice,
that response to disinflation is likely to be imperfect.

Specific

action must be ^.aken to pare outlays to reflect the lower prices,
and inertia works against the process.




One example of this problem

has recently received attention in the press:

how to "spend"

the dividend of lower inflation for defense programs.
In this connection, I would note that price performance last year was far better than expected by many forecasters.

While that has had short-run budgetary consequences,

we are still obviously some distance from price performance
that could be called "reasonable stability."

Realistically,

it seems to me, we can and should look to further declines in
the inflation rate, and take account of that in our budgetary
planning.
As I suggested earlier, we can all try to refine
estimates, looking at different growth and inflation rates,
as well as more technical considerations.

But what stands

out in the present situation is that, whatever those particular
assumptions, we now have a federal budget situation in which
current spending plans for years ahead outrun the revenue base
by a wide margin.

The problem will not go away as the economy

recovers from the recession.
Left unattended, that situation poses a strong
potential for a clash between the need to finance the deficit
and the rising financial requirements for housing and the
business investment that is crucial to healthy and sustained
recovery.

In the end, all those needs have to be met out of

saving, and all our experience suggests there isn't likely to
be enough to go around.




-8-

Savings —

net of depreciation ~- has typically

run at .10 percent or less of the GNP.

The prospective

structural deficits later in the decade could well absorb
as much as one-half of that amount.

Gross savings

that is, including capital consumption —
the net.

—

are roughly twice

But the prospective deficits would still preempt as

much as a quarter of the total.

Looked at either way, the

diversion of savings would be without peacetime precedent for
relatively prosperous years.
Of course, the government will be financed.

It will

be financed in the market, and the unavoidable implication is
that interest rates will in real terms be bid higher than otherwise.

The higher interest rates will dampen private investment

and housing.

They may also attract funds from abroad, supplementing

our domestic savings.

But a net transfer of savings from abroad

implies a current account deficit —

in other words, relatively

weak exports and high imports, hardly a happy prospect.

The long-

run implication is both a weak investment and a weak balance of
payments structure, with a lower level of output over time.
That, essentially, is the "text book" analysis.

In

the real world of today, the adverse consequences are likely to
be exacerbated.
After years of inflation, sharp fluctuations in interest
rates, and unsatisfactory economic performance, an atmosphere of
exceptional caution and uncertainty about future planning by
business is understandable.




I don't think there is much doubt

-9-

that the prospect of huge budget deficits contributes to that
mood in a way that cannot be precisely measured —

lingering

concerns about a sharp rebound in interest rates from already
relatively high levels, continuing strong pressures on monetary
policy, or a reversion to inflationary policies "forced" by the
deficits.
The point is reinforced by the sense of uncertainty
in financial markets and institutional strains domestically and
internationally, strains that are aggravated to the extent that
the basic level of interest rates is higher than otherwise
necessary.

We fortunately have a strong and effective govern-

mental apparatus undergirding the stability of the financial
structure.

But we work at cross purposes to encouraging recovery

to the extent that anticipation of future excessive budgetary
deficits add to market pressures.
In that respect, let me emphasize again that my
concern is much more about the growing structural deficit than
the present cyclical deficit.
In the fiscal policy environment we became accustomed
to in the postwar era, the expansion of federal budget deficits
in periods of economic slack certainly did not prevent interest
rate declines in recession, and interest rates have, of course,
declined in 1982 despite a larger deficit.

in circumstances like

those, private credit demands drop, helping to offset the impact




-10-

of the deficit.

Moreover, in the past the reasonable expectation

that large deficits would recede as business activity turned up
sustained confidence about the stabilizing role of the federal
budget.
The current atmosphere is quite different in that
respect.

To be sure, it can be said that most of the recent

and current budget deficits are recession-induced, replacing
rather than competing with private credit demands.

But we

cannot now look forward to a return to balance or low deficits
as the economy expands.
That is one reason, despite the large recent declines,
interest rates remain high by historical standards.

Moreover,

concern is expressed that interest rates have neared their
cyclical lows and could rise again as economic activity recovers,
even though they remain well above current inflation rates.
The question naturally arises, if all that is true,
whether monetary policy shouldn't do something about it in the
interests of speeding lower interest rates and recovery.

In

approaching that question, I must first emphasize that monetary
policy cannot itself create real savings and correct a structural
deficit.

The basic savings-investment balance —

implications for future real interest rates —

with all its

is simply beyond

our influence.
We can, indeed, influence the growth of the money
supply and other liquid assets and the degree of current pressure
on bank reserve positions.




In fact, growth in the monetary

-11-

aggregates has been relatively high in recent months, and
exceeded the targets set early in 1982,
have been minimal.

Reserve pressures

Under all the circumstances, that result

has seemed appropriate, given the evident desire to hold
more liquidity, and fully consistent with the needs of the
economy and progress against inflation.
But there are limits to the process of credit and
money creation.

Beyond a certain point, the result would be

to create further doubt about the prospects for further disinflation and lower interest rates, aggravating the uncertainties in those respects related to the budget deficit.
In the end, excessive monetary growth would put us back in
the same unsatisfactory situation of more deeply ingrained
inflation expectations and greater skepticism about the
ability of our nation to manage its economic affairs.

The

effects on interest rates <— particularly long-term interest
rates —

and on prospects for sustained recovery would thus

be perverse.
There was a time when the American public felt
confident about the ability of government to maintain stability
and improve its economic situation.

The events of the past

decade and more undermined that sense of conviction, and we
must restore it.

In some ways —

against inflation —

notably in the progress

we are making progress.

But fears that

excessive budget deficits will undermine financial discipline
work in the opposite direction, and those fears would only be
compounded by excessive monetary expansion.






Let me puv. the point another way*

We are exposed

co fears of "out-of-control" structural deficits, and the
result is upward pressure on interest rates, particularly at
the longer end of the maturity spectrum, for reasons beyond
measurable economic effects.

The budget is a plan:

as such,

it is a powerful symbol of the government's resolve to follow
a disciplined non-inflationary course*

To the extent the

budget deficit appears to be intractable, the burden placed
on monetary policy to demonstrate the government's resolve
to restore stability is increased, and our flexibility in
responding to current developments is reduced, not enhanced.
The converse is equally true *-- meaningful action to demonstrate
the government's economic discipline on the fiscal side would
reduce concern about future inflation and future interest rates.
In the process, it would reinforce confidence that monetary
policy over the years ahead can do its job in maintaining a
course consistent with price stability without intolerable
market pressures.
The focus on monetary policy —

together with the

understandable urge to seek a relatively simple, comprehensible
and desirable measure for "policy" in the interest of maintaining
confidence —

has spawned a number of proposals for a fixed

rule, whether a pre-set monetary target for years ahead, a fixed
price for gold or other commodities, or keeping interest rates,
real or nominal, short or long, within some band.
stand and sympathize with the desire.

I can under-

But I am skeptical, to

-13-

say the leastr that in so complex and changing an economy as
ours, the policy problem or the policy objective can be reduced
to so simple and unvarying a measure.

The recent distortions

in the monetary aggregates relating to purely institutional
change —

the introduction of new high-interest deposit

instruments on the border of "money" and "savings" —
one kind of difficulty that arises from time to time.

reflect
More

significant over time may be shifts in established relationships
in trends in the "target" and the real world of economic activity
and inflation.

We can all appreciate the desirability of laying

out policy intentions as clearly and simply as possible.

But

I doubt that we can, in effectf ever put policy on "automatic
pilot," and that any simple rule for monetary policy can effectively
substitute for a coherent overall policy approach, of which the
budget is inevitably an important part.
I also don't want to suggest there is a simple
"tradeoff," as sometimes suggested, between future budget policy
and current monetary policy.

Reducing the threat of those large

structural deficits stretching out to the end of the decade, in
and of itself, should have favorable effects on current interest
rates and in damping concerns about future increases.

In this

setting, the old maxim about virtue providing its own rev/ard
should be measurable in a tangible way.
broader benefits.

And there can be

The lower the structural deficit the greater

the confidence, not just of the financial markets but of the
community at large -— labor and management, storekeeper and




-14-

shopper, at home and abroad —

in the government's will to

follow a disciplined course.

This should reinforce the dis-

inflation process, even as recovery proceeds.

It will support

moderation in wage bargaining, caution in pricing policies,
confidence in financial markets —

and, of course, lower real

interest rates.
None of that would justify monetary policy moving
in a contrary direction —

abandoning our continuing and

necessary concern with restoring reasonable price stability.
That point remains central.
outlook —

At the same time, a better fiscal

with all it implies —

would certainly provide a

better environment for the conduct of monetary policy, relieving
concern about the longer-term implications of every twist and
turn in the monetary aggregates or short-term policy actions.
As things stand, fear of growing deficits clouds the future and
contributes to market pressures and inflationary uncertainties,
adding to the burdens on monetary policy.
I am conscious that I have taken too long to identify
a problem with which you are broadly familiar.
resolve the problem.

The need is to

We have time, in the sense that we are

talking about changes that should only begin to take effect
in 1984, with full impact in 1985, in 1986, and the years beyond;
an abrupt change in 1983 is neither feasible, nor in the midst
of recession and with the structural portion of the deficit still
limited, desirable.

But it is also true that if those future

deficits are to be controlled, the process must start now and




-15-

with energy and force.

Basic budget trends take time to

change, and the knowledge that they will be changed is what
will affect markets now.
The amounts involved are large, but certainly not
beyond our capacity.

The necessary changes can be phased in

over a two or three year period.

Our capacity to save and to

finance is large enough so that some residual deficit can be
managed•
It is obviously beyond my competence, or the province
of the Federal Reserve, to deal with all the particular priorities
that must be balanced -- national and social security, entitlements
and taxes.

The sheer arithmetic of the Budget does suggest that

some changes will be necessary in all the major budget components,
and we are all aware that initiatives have already been proposed
in a number of areas.
I do not for a moment underestimate the task before
the Administration and the Congress in reconciling the competing
claims, and achieving the necessary legislation.

But I also

believe the problem is now well recognized, and that the bleak
budgetary picture I have described earlier will not, in fact,
be permitted to materialize.

We have come a long way toward

laying the groundwork for lasting expansion,, and we can and
will deal with this challenge.