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December 28, 1983

We Can Survive Prosperity

Remarks by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System




at the
Joint Meeting of the American Economic AssociationAmerican Finance Association
San Francisco, California

December 28, 1983

Economists, by profession, have a well-earned reputation
for nay-saying.

The "dismal science" is built around the

simple proposition that burgeoning desires exceed limited
means —
at once.

that we can't have everything, certainly not all
I suppose central bankers have a reputation for

preaching that lesson to the extreme.

it seems to me ironic,

under the circumstances, that economists are wont to meet
together in the midst of the holiday season —

and then to

invite a central banker to address you.
Of course, on this particular occasion, looking backwards,
we all have a good deal to cheer about.
about our capacity to forecast.

Not, on the record,

But it is pleasant, for once,

to find things turning out significantly better than almost all
had anticipated, measured both by rising output and employment
and by less inflation.
The last reported statistics summarize the story:
unemployment down more than 2 percentage points from the
peak; industrial production up 16 percent in twelve months;
no increase in producer prices and only a 0.3 percent increase
in consumer prices in November, one year into recovery.
Certainly, those data provide a happy contrast to other recent
years.
We also know that any sense of ebullience over those
numbers must be tempered by knowledge of what came earlier:
one of the longest and deepest recessions of the postwar
period.




We have indeed been experiencing a sharp business




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recovery, consistent with progress against inflation.

But

excess capacity of both men and machines here and abroad has
helped restrain prices.

In a sense, that cyclical phase is

the easiest part, and it's about over.
not the past but the future.

The issue today is

Can we negotiate not just

recovery, but lasting expansion —

an expansion that will bring

in its train the rising real incomes, the investment and
productivity, and the sense of stability, that we want?
My thesis is simple.

We now have a rare opportunity —

an enormous opportunity —

to set in train a long period of

growth and greater stability.

A decade that began with the

heritage of accelerating inflation and soon fell in the
slough of recession —

developments that seemed to make a

mockery of the bright hopes and expectations of economists
ten or fifteen years earlier —
and strength.

can end with renewed confidence

To put the point another way, we can reverse

the experience of the 1970's —

we can demonstrate that an

economy that seemed to be going downhill, with one adverse
shock begetting another, can go up as well.
I am not about to suggest that happy vision will
somehow come about by itself, that we can now sit back and
let events take their course, counting on a hope that the
recent good news will produce a lasting momentum of its own.

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3-

After all the difficulties and disappointments of the past
decade, that kind of optimism doesn't "wash" today —

under­

standably so.
But I do not share the doubts and skepticism of many —
indeed the deep cynicism of some —

about our capacity as a

nation, to learn from bitter experience and draw practical
lessons for the future.
I fully realize there are some new and unprecedented
threats and risks to sustaining progress —

the enormous budget

deficits, the international debt problem, the gaping and still
growing imbalance in our international accounts, the strong
forces of protectionism, and, not least, the temptation to
return to behavior patterns bred in the years of inflation.
But those threats are not exactly hidden —

and once understood,

they can be met.
And, we also have in place some elements of a strong
start:




o

Most importantly, for the first time in many
years, the rate of inflation has been
ratcheted down.

o

That progress is undergirded by greater restraint
on underlying costs in most sectors, accompanied by
signs of more emphasis on efficiency and productivity.




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4-

There is a strong sense that major industries
and markets are and will be under greater
competitive pressures than before, both because of
less regulation and the intensity of international
competition.

■> We can see the beginnings —

no more than that —

of a rebuilding of corporate balance sheets, of a
strengthening cash flow, of a return to levels of
profitability more normal historically, and of an
improved climate for risk capital and innovation.
The obvious need is to build on that progress while
dealing with the threats.
Easy to say; hard to do.
The greatest challenge of all, in my judgment, is to
face up more openly and directly to the need to find ways to
combine continuing growth with continuing progress against
inflation.

Sometimes we seem to be so steeped in analysis

that suggests it is hardly possible that we almost refuse to
think about it.

Yet, we also can sense that once we accept

an inflation tradeoff, the inflationary process will tend to
accelerate, and ultimately defeat growth as well.
Obviously, the effort to restore reasonable price
stability does not mean we need to make progress toward a
zero price statistic every year.
are not so refined —

Our various price indices

and never will be —

that a change of

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a point or so over a particular year is meaningful.

Different

measures may show different results, as during 1983.

Important

"shocks" at home or abroad can disturb a trend or upset an
equilibrium.

Cyclical changes in the degree of pressure on

capacity and labor markets will usually be reflected, with a
lag, in cyclical changes in prices.

Specifically, the months

of virtual stability in producer and consumer prices during
the early part of this year, in the immediate aftermath of
the recession and the decline in oil prices, should not, and
were not, expected to persist through a vigorous upswing.
Nor would small cyclical effects on prices in 1984 necessarily
be inconsistent with extending a trend toward greater
stability over time.
A workable definition of reasonable "price stability"
would seem to me a situation in which expectations of generally
rising (or falling) prices over a considerable period are not a
pervasive influence on economic and financial behavior.

Stated

more positively, "stability" would imply that decision-making
should be able to proceed on the basis that "real" and "nominal"
values are substantially the same over the planning horizon —
that planning horizons should be suitably long.
To some, that objective has a moral content —

it is a

responsibility of government to provide "honest money."
I will not debate that point —




I am addressing a convention

and




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of professional economists, not moral philosophers or political
scientists.
Analyzing the issue as a matter of economic engineering,
I believe that the experiences of the 1970's here and abroad
have demonstrated the practical difficulties of sustaining
growth and productivity on the shifting sands of a progressively
weakening and uncertain currency.

The Phillips Curve that

looked so persuasive when based on historical data without a
long-term inflationary trend turned out to be unstable over
time when policy was heavily influenced by the implied premise
that we could "buy" prosperity with a "little" inflation.

In

time, unemployment trended higher, even as inflation accelerated
to the point where it became seriously distorting, with
expectations at the end outrunning even the reality.
I realize sophisticated arguments are made that a
steady, relatively low rate of inflation can be tolerated as
a kind of background noise that, because it is generally
anticipated, will cause few distortions.

I don't know of any

precedent in this country for that kind of "steady state"
inflation —

indeed, psychologically, I suspect it is a con­

tradiction in terms.
once accepted —

The natural tendency for inflation —

seems to be for it to rise on the simple

premise that a government or a nation ready to tolerate a
"little" inflation will always be prepared to tolerate a
little more

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For now, to some degree, that insidious pattern has been
broken; the recent progress in bringing inflation down is
reflected not just in price statistics but also in the evidence
we have about expectations and behavior patterns.
the job is not complete —

far from it.

But plainly

The years of inflation

and failed anti-inflation programs have understandably left
deep scars, not least among those responsible for investing
money.

As the economy grows, as jobs are easier to find, and

as profits return to more normal levels, there will be stronger
temptations to anticipate inflation in pricing and wage
decisions —

it is symptomatic that some wage contracts that

keep up with recent inflation are labeled "concessional."
Economists are aware that deceleration of inflation during
the first year of economic recovery is not unusual —

that

the progress is more typically reversed in the second year of
expansion, with further acceleration expected before the next
recession.
The question, of course, is how to change that pattern —
how to maintain the progress against inflation while maintaining
growth during the transition period toward stability.
Certainly, I would accept, with most of you, the simple
proposition that success in the effort against inflation requires
appropriate restraint on the growth in money and credit.
that sense, monetary policy is at center stage.

In

Ultimately,

money should increase no faster than the needs generated by







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real growth at reasonably stable prices.

But I think we have

to recognize, too, that such "appropriate" restraint on growth
in money and credit —
in curbing prices —

while unambiguously effective in the end
can in the real world collide with the needs

for money and credit generated by a combination of rising
economic activity and the momentum of an established trend
of rising prices.

In such circumstances, as we have seen,

the result can be abnormally high interest rates and adverse
consequences for employment and growth.
The point is sometimes made that the prospects, for any such
"collisions" will be greatly diminished if expectations —
thus behavior patterns —

and

adjust more quickly to prospects for

greater price stability.

The much debated question of the

"credibility" of monetary policy is relevant to this question.
Some have argued that the Federal Reserve can achieve
the necessary credibility —

in the sense of quickly changing

expectations -- only by an unambiguous commitment to some simple
and fixed rule.

Suggestions are made to preset a narrow

growth path for some monetary aggregate for years ahead, to
defend a particular price of gold, to enforce stability in
the price level of a basket of commodities, or perhaps to
target a gradual reduction in the growth of nominal GNP to a
rate consistent with our capacity for real growth.

The

appeal is obvious; if only we could be fully convincing that
we have found a certain path to the promised land, and we

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stick to it through thick and thin, the natural forces of the
marketplace will work toward our objectives, speeding their
achievement.
We can find instances in history, usually after hyper­
inflations or savage depreciation of a currency externally,
when a dramatic national commitment to a new standard did,
seem to help in speeding restoration of stability.

indeed,

These

programs were not painless; they were typically accompanied by
strong action to close budgetary deficits and to achieve
structural changes in the economy; and they were undertaken in
a context of perceived crisis, political and economic, when
extreme measures were widely accepted as justified.
That strong sense of crisis may be lacking today.

But

the need remains to convey a sense of conviction —

a conviction

that is expressed not just in words but in action.

To the

extent rules and guidelines, set out in advance and widely
understood, can help us convey our intentions and discipline
our decisions, we should be sympathetic to them.

And, in

that context, the recurrent debate about which rule is best
can be healthy.
Important technical judgments are involved.

But it is

not just a technical question to be answered by internal or
academic research.

The effectiveness of any rule in affecting

expectations will depend, in the end, upon the basic logic
as perceived by the public at large.




In that sense, the




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eraphasis in recent years on targeting of money and credit
growth has been justified by wide public and Congressional
understanding, as well as a long history of more technical
analysis and research.

That experience has also suggested, however, some of
the potential pitfalls in relying too slavishly on a narrowly
defined rule.

Quantitative rules for money depend upon our

ability to maintain a fixed definition of money over time, and
upon a certain predictability in velocity, if not for periods
as short as a quarter or two, then for a year or longer.
in the midst of rapid change —

But

institutional or economic —

we know the relationships among any specific measure of money
and economic activity and prices can shift quite significantly
in the short run, and the underlying trends may change as well.
The years 1982 and 1983 showed just such shifts, beyond the
range experiencaed earlier in the postwar period.

There are some

signs today that more normal patterns may be reasserting
themselves, but only time can confirm the point.
Other possible "targets" appear to have comparable or
greater deficiencies today.

Technically, we do not know, within

a wide margin, what gold price would be consistent with
progressive stabilization of the general price level, or
whether stabilizing a basket of commodity prices at current
levels would indeed be consistent with more general price
stability.

Imposing a rule of uncertain technical validity

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that had little understanding or support by the public could
easily be counterproductive, undermining rather than supporting
credibility over time.

I need not remind you in that connection

that it was only a little more than a decade ago that the
United States departed from its commitment to a fixed price
of gold after much of the economics profession, rightly or
wrongly, had come to question its rationale and thus undermine
its legitimacy.
In sum, I do not believe we can bootstrap our way
to combining price stability with growth simply by committing
ourselves at this stage to a mechanical rule.
to it than that.

There is more

Confidence will be built and maintained as

a result of demonstrated progress toward stability, and that
progress will be speeded by a clear consensus on the validity,
and the reality, of the objective.
The decision of the Administration, preparatory to its
annual economic and budgetary messages, to project declines
in the inflation rate after 1984 should contribute to that
consensus.

Of course, such medium-term projections, to be

meaningful, must provide a base for, and be consistent with,
actual policy formation.

One implication, among others, of

achieving further progress toward stability is that growth in
nominal GNP and money and credit will need to be reduced over
time







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For reasons I have already suggested, I do not believe
an attempt to schedule reductions in the money supply with
precision, year by year for several years ahead, is useful.
But I do believe that both our policy decisions in the Federal
Reserve, and your expectations, should be strongly conditioned
by that broad objective and strategy —

I am tempted to say

by that "general rule."
The question remains as to how long a transition period
is required for reduced monetary growth to work toward price
stability, and whether that transition will be consistent with
satisfactory economic growth, rising employment, reasonable
profits, and -- given the weight of the American economy and
financial markets on the international scene —
world economy.

a healthy

The answer to that question lies in major

part on circumstances outside the control of monetary policy.
Those circumstances will also inevitably bear on the ease or
difficulty of maintaining appropriate monetary policies.
Obviously, the state of the Federal budget is one case
in point.

Large deficits, currently and prospectively, are

a burden on credit markets and absorb historically unprecedented
fractions of our domestic savings.

That is one reason interest

rates today are far higher than is healthy from the standpoint
of balanced growth domestically.

From an international

perspective, the problems stemming from high interest rates
are still more pressing.

The level of dollar interest rates

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plainly aggravates the strains on the international financial
system —

strains apparent in the heavy debt burdens of many

developing countries and in the persistent and growing flow
of capital into the united States, with its counterpart of a
widening trade deficit.
The basic outlook and its implications for the United
States and other countries are too familiar for me to linger
over today.

Suffice it to say that I do not share the comfort­

able assumption of some that working —

forcefully and steadily

toward better budgetary balance is a task that can wait a year
or more.
With nominal interest rates so far above observed inflation
a natural expectation should be for interest rates to fall.
But the burden of the Treasury financing works in the opposite
direction, both directly in the marketplace, and by helping
to maintain inflationary expectations at a higher pitch.

We,

in all our sophistication, can try to explain to the American
people that in the end it is money creation, not deficits,
that feed inflation.
instinct —

But I am afraid they have a strong

and there is a lot of experience around the world —

that the two often go hand-in-hand.
The Federal Reserve ultimately is indeed capable of
avoiding excessive increases in the money supply.

What it

cannot do is create the savings necessary to support both a
large deficit and high investment or relieve the pressures on







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interest rates implicit in an approach that leaves so much of
the burden for containing inflation to monetary policy alone.
To achieve price stability in the midst of prolonged market
strains, low levels of investments, and a stop-start economy
would be a hollow "victory."
As important as Federal financial policies are, they are
far from the whole story.

There is the question as to whether

the strong efforts to cut costs and increase efficiency,
first born in recession, will carry into the expansion process.
Can, in fact, the new sense of discipline survive
prosperity?
On the encouraging side, we can point to significantly
lower average nominal wage increases, and to the fact that
over the first three quarters of 1983 large collective
bargaining agreements had first year wage settlements averaging
only 1.7 percent, the lowest since the data began to be
collected in the mid-1960's.

But the statistical evidence is

still ambiguous.
I know some knowledgeable analysts of labor markets
remain deeply skeptical about whether there has been lasting
change in fundamental behavior patterns and expectations
developed out of earlier experience —

patterns that, once

established, tend to maintain an inflationary momentum.

They

point out sharp reductions from the earlier trend in nominal
wages have been largely centered on industries under intense
market pressures.

About half of the large new settlements,

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in industries where the recession did not bite so hard, ran
to 6 percent or more, only moderately below the earlier
trend.

Settlements of that magnitude —

which have been

characteristic of utilities, finance, and other important
industries -- at the moment imply large increases in real
income, but, if generalized, would place a rising floor under
costs.
Concerns of this sort in the past have often led to
a call to impose discipline by an "incomes policy," involving
governmental norms for wage and price increases.

But neither

the past record nor the public mood suggests that is a
practical, or desirable, approach.
But I do believe we can see signs that a more
competitive marketplace can produce a more viable sort of
"incomes policy" of its own.

Trucking, airlines, communications

each a large growth industry that had been sheltered from
competition —

have had to adjust in a way without parallel

in the postwar period.

Other industries long characterized

by relatively high cost and wage structures have found them­
selves particularly vulnerable to the ready availability of
goods and aggressive pricing from abroad.
I know some of that pressure is exaggerated currently
by the exceptional performance of the dollar, and there are
dangers of a strong protectionist response.




But I suspect




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that such fundamental forces are at work that the United
States is likely to remain a far more open economy than ever
before.

And, there should be no excuse for maintaining

the barriers to competition that now exist —

whether reflected

in quotas on imports or in domestic legislation —

in the

absence of restraint on costs and wages.
Appropriate public policies in these areas can, I believe,
help nurture an environment in which discipline can be maintained.
In the end, that environment will have to be reflected
in new attitudes and new approaches permeating a whole range
of private decision-making, approaches rooted in our own
market system and political environment.

In that connection,

I welcome the new interest in profit-sharing arrangements or
other ways of rewarding workers when things are good, without
building in an inexorably rising floor on costs.

The concepts

of quality circles, experimentation with worker representation
on boards of directors, methods of encouraging employee stock
ownership, and other initiatives -- often born in adversity —
carry promise for changing the confrontational nature and
brinkmanship characteristic of so much of our industrial
relations.
My basic point is that our economy will not work well
for long as a house divided —

with a monetary policy designed

to restore stability, but with other policies —

public and

private -- inflating credit demands, building in strong cost

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pressures and imposing a high degree of rigidity in labor or
product markets.

I believe we have learned, from hard experience

here and elsewhere, that no lasting solution to such an impasse
can be found by simply turning on the monetary valve, further
entrenching the inflationary process.
I suspect nearly all of you would accept those general­
izations.

But still, after the long years of inflation, there

is also a great timidity in accepting the implications,

in

setting our standards high, in supporting with vigor the
measures that can help reconcile growth with stability.
We often seem almost oblivious to the fact that through long
stretches of history,

inflation was not a way of life, and

need not be now.
We have, as I argued a few moments ago, gone a long way
toward changing the trends of the past decade and more.

We can

build on that base.
In all of this, monetary policy has an indispensable role
to play.

And it is right and proper that our actions should

be tested and debated in the crucible of professional scrutiny.
But I also hope that emphasis on monetary policy will not lead
to neglect by the economics profession in investigating and
emphasizing what is necessary, in other public and private
policies, to deal with the tradeoffs in reconciling growth
and stability that we are so fond of describing.







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A successful effort will in the end need to rest on a
national consensus that the goal is in fact valid and obtain­
able -- that over long periods of time a sense of stability
is essential to lasting growth.
As Patrick Henry might have said, were he an economist
today, if this be economic heresy, then make the most of it.
It is the way the economy is supposed to work.
it work that way again.

*******

We can make