"We still do not know how to find that perfect income policy that will spare us the need to choose between the alternatives of full employment and price stability". - Paul Samuelson
In economics, as well as in the physical sciences, there are basic laws of conservation of mass and energy. A society cannot consume more than it produces without drawing down its stock of existing wealth. Consumption is the using up or the wearing out of goods and services. It is regulated by the amount of money that is available to individuals, businesses, and government for spending. Production, on the other hand, is regulated by the level of investment, by the availability of labor and raw materials, and by the efficiency or productivity of the techniques and methods used in the productive process.
Presumably, if income were strictly determined by the amount of goods and services produced, then demand would always equal supply, and prices would remain constant. In the present economic system, however, income is only loosely related to how much is being produced. Wages and salaries are primarily the result of political negotiations between labor and management, or of market demand for specific job skills. Only secondarily are wages related to value-added in production. Wages increases can, and in fact most often do, exceed productivity increases.1 As a result, consumer income tends to rise faster than productive output. This leads inevitably to inflation.
Inflation is nature´s way of maintaining a balance between consumption and production. If consumers receive more in-come than is produced in output, prices simply rise until the purchasing power of income is reduced to equal the value of the output.
Modern economists classify the causes for inflation into two categories -- "demand-pull" and "cost-push." Demand-pull inflation is the classical form caused by too much money chasing too few goods. Excess money causes demand to exceed supply, and prices rise. Theoretically, demand-pull inflation can be cured by monetary and fiscal restraint. If the Federal Reserve restricts the money supply and government spending is reduced, the amount of money in circulation falls, and inflation is brought under control.
In recent years, however, more and more of the pressures for inflation appear to be of the cost-push variety; that is, increasing costs in the production process itself forces the price of goods and services upward.2 If the cost of obtaining raw materials rises or if wage contracts are negotiated that raise the cost of labor faster than productivity increases, then prices must rise. Cost-push inflation responds poorly, if at all, to the classical remedies of monetary and fiscal restraint. In fact, for reasons that will be discussed shortly, monetary and fiscal restraint may actually exacerbate cost-push inflation because these measures tend to reduce productivity and thus actually increase unit-production costs.
It is a matter of much disagreement among economists as to exactly what is causing the present worldwide inflationary crisis. Almost certainly, recent inflation is not purely of the demand-pull variety. If it were, the classical remedies would long ago have shown some desirable beneficial effects.3 Instead, the past decade has produced a serious recession, soaring unemployment, and unprecedented inflation simultaneously.
Productivity and Prices
Clearly, since productivity is a fundamental factor in the cost of production, it must be intimately related to prices. Evidence of the relationship between productivity and prices can be seen in Figure VIII-l. This chart shows that in
Figure VIII-1. Statistical data clearly indicates an inverse relationship between productivity and prices. In industries where productivity gains were high, price increases tended to be low, and vice versa. In industries where productivity gains exceeded the average annual wage increase of 5.6 percent, prices tended to fall.
industries where productivity gains were high, price increases tended to be low, and vice versa. In industries where productivity increases exceeded the average annual increase in wages (that was 5.5 percent for the period for which the figure was prepared), prices tended to fall rather than increase. This tends to support the theory that inflation is the result of wage increases that exceed productivity increases.
It might be suggested on the basis of Figure IV-4 that if the United States investment rate during the 1960-1970 period had been at 21 percent of the output of all industry instead of 14 percent, then United States productivity would have increased at 6 percent instead of 3 .5 percent. If this had occurred, then Figure VIII-1 implies that the United States would have enjoyed an entire decade without inflation despite the 5.5 percent annual increase in wages that occurred during that period.
Certainly a great deal of the overall behavior of prices over the past quarter century can be explained simply by examining the difference between wages and productivity. Figure VIII-2 is a plot of the amount by which wage increases have exceeded productivity gains since 1950. Superimposed on this graph is a plot of the consumer price index over the same time period. Except for the fact that prices did not fluctuate as quickly or as widely as wages and productivity, the two curves correspond very closely throughout the entire period.
Figure VIII-2. The difference between wage increases and productivity increases is strongly correlated with the inflation rate over the past quarter century. This strongly suggests that a primary cause of inflation is wage increases that exceed productivity increases.
It is interesting to note that this correspondence holds true over a time span that includes the Korean War, Vietnam, several recessions, a long period of stable growth, periods of high interest rates and low, tight money, expansionist monetary policy, tax cuts, tax increases, oil embargos, and soaring oil prices. Throughout all of this, the consumer price index followed the difference between wages and productivity very closely. The correlation of the data in Figure VIII-2 contrasts sharply with the complete lack of correlation between inflation and federal budget deficits shown in Figure VIII-3. Contrary to popular political rhetoric, budget deficits seem to have no clear relationship to inflation at all. There appears to be a slight tendency for inflation to precede budget deficits, indicating that deficits may be caused by rising prices, but there is certainly no evidence for the reverse.
Figure VIII-3. Contrary to popular political rhetoric, there is little correlation between inflation and deficit spending by the federal government.
These data strongly suggest that the fundamental cause of inflation is wage increases that exceed productivity gains. The implication is that the only hope for a permanent cure to inflation is to close the gap between wages and productivity, either by reducing wage increases productivity or by increasing productivity gains.
As of this writing, virtually all efforts at closing the wage-productivity gap have been directed toward holding wages in check, either through wage-price controls or by deliberately creating unemployment. This latter strategy is based on the theory that wage increases are a function of the unemployment rate. Every modern economics textbook contains a discussion of the so-called "Phillips curve," that pretends to show how much wages can be expected to rise each year for any given rate of unemployment. Samuelson shows a Phillips curve that requires five-percent unemployment to hold wage increases to a non-inflationary three-percent per year.4 Three percent is, of course, the prevailing long-term productivity growth rate. However, unemployment in the United States has been near or above five percent for over five years and there is no apparent tendency for wage increases to decline.5 Since 1966 wages have increased at a steady seven percent per year with only minor fluctuations.6 The principal result of policies designed to create unemployment has been simply that – unemployment. Very little effect has been apparent in the wages of those still holding jobs. If the Phillips relationship has any validity, it is clear that the amount of unemployment required to hold wages in check is much higher than has been previously admitted.
A Different Strategy
Under the present circumstances a different strategy would seem to be in order. If wage increases cannot be held in check either by controls or by unemployment, why not try raising productivity instead? Raising productivity to equal wage in-creases would have the same effect on inflation as reducing wage increases to equal productivity gains. The principal difference would be that the unpleasant side effects of unemployment and recession would not occur.
Such tactics were actually proposed by President Nixon in his economic report to Congress on January 27, 1972, but aside from the establishment of a National Commission on Productivity to gather statistics, little of tangible significance has been done. Recently, there has been some activity in Congress concerned with measures to increase productivity,7 but there has certainly been no major shift away from a reliance on fiscal and monetary policies towards an overall economic strategy based on productivity growth as the primary economic stabilizer. Yet there are numerous reasons for believing that such a strategy would be much more successful than what is now being pursued.
First of all, increased productivity would attack the root causes of cost-push inflation. Increased productivity in all areas of the economy, but especially in the manufacturing, transportation, and construction industries, could more than offset rising costs of raw materials and energy and could reduce pollution without increasing prices. For example, reducing the cost of dies and molds would offset the increased price of basic metals and plastic resins. More efficient construction techniques would offset rising costs of cement and steel. Modernized railroads and more efficient cargo-handling techniques could offset the rising costs of fuel. Improved methods of smelting and forging could offset the increased cost of pollution control and safety standards. Increased productivity reduces costs, cuts waste, and produces more output for less input.8 This is the only solution to cost-push inflation.
Productivity is also relevant to the fundamental causes of demand-pull inflation. Shortages (i. e., insufficient supply to meet prevailing demand) are the basic sources of demand-pull inflation. The United States and the world are threatened by shortages of every description. The only hope of ever meeting rising demands for participation in the good life is to produce more for less. This can only be done through increased productivity – indeed, it is the very definition of increased productivity.
Of course, an inflation-fighting strategy based on increasing productivity would have many other benefits besides stabilizing prices. The increase in investment required to improve productivity would reduce unemployment and end recession. The construction of new plants, machines, and transportation facilities would create jobs and stimulate business. Through increased investment we could mobilize our nation to overcome shortages, feed the hungry, house the poor, and, in general, make this land a delightful place in which to live. By increasing productivity through increased investment, we could defeat inflation while solving many other problems at the same time.
There is a great deal of evidence to indicate that productivity in the United States could be significantly increased over what it is today. The data in Figures IV-4 and IV-5, as well as similar data from other sources, strongly suggests that the low rate of United States productivity growth is a direct result of our low rate of capital investment.9
Figure IV-4 demonstrates that productivity growth rates of six, eight, and even ten percent are sustainable in mature industrialized economies for periods of a decade or more. There is a great deal of pent-up technology today that is unexploited simply due to a lack of risk capital. High interest rates and tight money policies over the past ten years have virtually eliminated the type of long-term investments that finance improvements in basic technology and yield major productivity gains over a period of many years.10 The institutional mechanism provided by the NMF would not only supply the necessary investment capital, but would do so in a way that would ensure that the benefits were distributed in an equitable manner. Increased investment through the NMF would not merely make the rich richer, but would make us all richer together.
In the near term when new plants, new machines, and new facilities are being constructed, NMF investment would stimulate business and reduce unemployment. As soon as new technology embodied in modernized capital equipment came into use, productivity would rise and inflation would be brought under control. Over the long run, after these investments begin to pay back, the NMF distribution of profits through public dividends would create a stable, long-lasting prosperity based on increased consumer income derived directly from profits on increased productive output.
Investment-Payback Delay
This optimistic scenario, unfortunately, contains one major problem that must be solved before a policy of fighting inflation through increased investment could be put into practice. That problem is the investment-payback delay. With any investment, there is an unavoidable delay between the time when the investment is made and the time when the effects of increased efficiency begin to be felt. During this interim period, investment spending tends to create short-term demand-pull inflationary pressures.
Investment spending, like all other types of spending, creates demand. Demand, in turn, increases employment, and stimulates business activity; however, it also tends to cause prices to rise. Investment spending is unique in that, once the investments begin to payoff, supply also rises and prices level off or even decline. However, the delay between investment and payback can cause prices to fluctuate widely.
The reasons for inflation during this time delay are easily understandable. For example, while building new factories, construction workers are paid for their work immediately, while months or even years may pass before products from these new factories appear for sale on the retail market. Many more years may pass before the total value of the new products equals or exceeds the cost of the original investment. Thus, investment spending stimulates demand long before it increases supply to meet that demand. Whenever demand exceeds supply, prices tend to rise. Only after increased production pays back the cost of the original investment does supply catch up with demand and prices stabilize or decline.
The fact that investment spending influences demand immediately but does not affect supply until a later time tends to cause economic instability in the face of large rates of investment. The economy is a massive system with many interacting feedback loops. It is characteristic of such systems that they become unstable when significant time delays are introduced in critical places.
In a typical business investment, as much as five years or more may pass before increased production repays the cost of the investment. This time lag between investment-created demand and investment-created-supply has historically been responsible for the classical oscillations in economic activity known as business cycles, or alternating periods of boom and bust. During periods of boom, expectations are high and businesses tend to borrow heavily and invest at a high rate. This causes demand to increase faster than supply, and prices rise. High prices classically mean high profits leading to even more optimistic expectations and still higher investment rates. After a boom period of several years, however, investments begin to payoff and supply begins to overtake demand. This leads to the bust part of the cycle. Oversupply causes prices to decline, and profits are reduced. Falling profits dampen business optimism and investment spending begins to decline as well. Thus, while supply is rising, demand is falling. The result is that prices fall dramatically and losses or bankruptcy occur to any business that borrowed too heavily during the boom period.
This classic cycle of boom and bust was characteristic of the early days of capitalism and for a long time was accepted as inevitable. However, the severity of the bust in 1929 leading to the Great Depression of the 1930´s finally convinced world economists that something had to be done to prevent, or at least, smooth out the peaks and valleys of the business cycle. Since the time of the Great Depression, a number of policies have been developed that tend to keep economic growth more or less under control.
Unfortunately, all of the techniques that are presently used for price stabilization operate on the basic principle of reducing demand by limiting investment. If the NMF were to embark on a policy of drastically increasing investment spending, especially through money borrowed from the Federal Reserve Bank, it would be working at complete cross-purposes with all of the existing price-stabilization mechanisms. This is undoubtedly one of the reasons why the strategy of fighting inflation by increasing productivity has never been tried. It is certainly a reason why some new mechanisms for limiting short-term demand will be required before efforts to increase productivity can be seriously considered as a practical method for fighting inflation.
In the next chapter, just such a new mechanism will be proposed. It involves a system of mandatory savings for controlling short-term consumer demand while NMF investment spending is being increased. This savings program would allow major increases in the investment rate while preventing substantial inflationary pressures from being generated during the time interval between investment and payback. First, however, the currently used methods for inflation control will be reviewed so that the reasons (at least in this author´s opinion) for their current ineffectiveness can be pointed out, and the provisions in the proposed demand-control technique can be more easily explained.
Monetary Policy
Of all the currently used methods for economic stabilization, monetary policy has the longest history and is regarded as the traditional, or classic, solution to price instability.11 Simply stated, monetary policy is the regulation by the nation´s banks of the amount of money in circulation. According to monetary theory, the amount of money in circulation determines aggregate demand. Since prices are largely governed by the ratio of supply to demand, the proper regulation of the nation´s money supply theoretically can control demand and hence produce price stability.
The inflationary impact of investment spending is obviously minimized if investment capital is derived from savings rather than from new money created through borrowing. Savings represent income that is not spent. Thus, investment spending from savings is merely a diversion of demand from the consumer to the investment market. Total demand is unaffected, and there is little inflationary effect. If, however, investment capital is derived from borrowing in such a way that the total supply of money is increased, then inflation is likely to be a problem due to an increase in aggregate demand before a commensurate increase occurs in supply. The management of the amount of new money allowed to be created through borrowing is the heart of monetary policy.
The money supply of the country is controlled by bank-lending policies and by Federal Reserve open-market activities. The Federal Reserve Bank can influence the amount of new money created by banks by regulating the prime interest rate and the reserve requirements of its member banks. The Federal Reserve can also influence the money supply by open-market purchases or sales of government securities.12 Thus, theoretically at least, the money supply, and hence, demand can be regulated by monetary policy.
Unfortunately, the classical techniques of monetary policy such as changes in interest rates and manipulations of the securities market do not always affect prices in a predictable way. Tight money tends to reduce investment spending, and thus, overall demand. But in the long run, reducing investment is counterproductive in the extreme. Reduced investment spending reduces future productive output and thus assures that future supply will be reduced, as well as present demand. In addition, reducing demand by monetary restraints produces business slowdown, recession, and unemployment. These effects cause current, as well as future, productive output to fall. Thus, it is quite possible that restrictive monetary policies may reduce supply even faster than they reduce demand. If this happens (that it did in the 1969-70, and again in the 1973-74 period), monetary restraint will produce not only recession and unemployment, but continued or even increased inflation.
Furthermore, the control of inflation by monetary restraint, even when successful, exacts a terrible price. Short-term price stability is achieved at the cost of a long-term decline in the production of wealth.
Monetary policy understandably tends to be popular in conservative circles, particularly among bankers and established businessmen. Monetary restraint typically results in high interest rates and slow economic growth. These effects are seldom injurious and often are decidedly beneficial to those who have already amassed secure fortunes. Tight money and slow growth make it difficult to start new businesses and unprofitable to modernize old ones, and lead to increased levels of unemployment. These all work in favor of established wealth. High unemployment tends to hold labor demands in check and low rates of investment and modernization tend to minimize competition to well-established corporations. High interest rates, of course, also bring large profits to those in the business of lending money.
Needless to say, monetary restraint is less popular among the non-wealthy. The social costs of high interest rates and high unemployment fall most heavily on the poor. Thus, liberal politicians have traditionally sought other techniques for controlling prices that exact fewer hardships on middle and lower income groups. One technique popular among liberals is tax policy.
Tax Policy
The concept of regulating consumer demand through raising or lowering taxes is the heart of the so-called "New Economics" of Keynes. The basic idea is that, since consumer spending is a large and very constant percentage of disposable income and since consumer demand is the largest single factor in aggregate demand, prices can be controlled by regulating income taxes. According to Keynesian theory, taxes should be lowered to stimulate demand when overall demand is sluggish and should be raised to reduce demand when overall demand is excessive.13
The fact that at least hail of this theory works was demonstrated in 1964 when, shortly after President Kennedy´s death, the Johnson Administration lowered taxes. Demand, indeed, increased impressively, and the economy quickened. The other side of the formula, however, is fraught with political difficulty. It is unpopular to raise taxes at any time, and particularly so when consumers are feeling the pinch of rising prices. Thus, even though the correct remedy for inflation (at least for demand-pull inflation) may be to raise taxes, such a policy is almost impossible to administer successfully. In the late 1960´s, it took the Johnson Administration more than two years to obtain a tax surcharge for combating inflation caused by the Vietnam war, and, by the time the tax increase finally took place, it was much too small to produce the desired effect.14
Historically, it seems to be easy to cut taxes in order to stimulate demand, but it has proven virtually impossible to raise them quickly enough or by a sufficient amount to stop inflation.
Budgetary Policy
A third method used in attempting to stabilize prices is budgetary policy; i.e., the regulation of government expenditures. Budgetary and tax policy are sometimes lumped together under a single heading entitled fiscal policy.15 However, as a practical fact in the real world, budgetary appropriations and taxes are only very loosely dependent on one another (as evidenced by a long history of federal budget deficits).
Government spending does, of course, create demand, but unfortunately the manipulation of government expenditures for purposes of price stability is largely impractical. Although government spending is the second largest factor in overall demand, only a negligible fraction of the federal budget is subject to manipulation for purposes of price stabilization. Government spending is primarily dictated by such considerations as defense or social needs or by fixed expenses such as social security payments or interest on the national debt. Contrary to popular political rhetoric, very little of the federal budget is subject to political control except in the most general sense. Very few budgetary expenditures can be increased or decreased for the purpose of regulating overall demand.
Unfortunately, one of the few areas of the federal budget that is readily subject to budgetary control is research and development expenditures. Research monies are usually among the first casualties of any serious budget-cutting attempts. Thus, new technology, that is the long-term source of most productivity gains, is typically curtailed at the very beginning of any program of fiscal restraint. This is exactly what happened at the beginning of the Vietnam inflation. Research and development spending was sharply curtailed in 1965.16 The intention, of course, was for the reductions to be temporary since no one expected the war to last more than a few months. However, most of those cuts have yet to be restored.
Of course, budgetary policy, like monetary policy, affects both supply and demand simultaneously. Government expenditures not only create demand, but they also affect the production of goods and services. This is a fact frequently over-looked. Government spending for school and hospital construction affects the supply, and hence, the price of education and medical care. Government spending for highways, air-flight control, subways, and shipbuilding affect the cost of transportation and, as a result, the price of practically everything.
The reduction of government expenditures as a method for combating inflation is often self-defeating. Reduction of federal spending in one area frequently forces corresponding increases in retirement benefits, social security, and unemployment payments. Of course, these payments are smaller than salary dollars, so there is a net decrease in consumer demand. But there is also a simultaneous decrease in the production of government services. Thus, the overall effect on prices is ambiguous. Cutbacks in government regulatory agencies often result in less protection for the consumer and lead either directly or indirectly to higher prices and less services. Cuts in poverty programs often mean that potential taxpayers are thrown into welfare or, worse, into a life of crime. Thus, in many cases, reductions in government expenditures may actually contribute more to the overall cause of inflation than to its prevention.
Finally, it must be pointed out that the statistical evidence presented in Figure VIII-3 does not support the contention that budgetary policy has any appreciable effect on inflation one way or the other. If that is true, then all of the political crusades against inflation based on cutting federal spending are almost totally irrelevant. Whatever effects may be traceable to budgetary policy are largely overwhelmed by other, more important effects elsewhere in the economy.
Price Guidelines and/or Controls
During the Johnson Administration, wage and price guidelines were employed in an attempt to control the inflation brought on by the Vietnam war. President Johnson used his personal powers of persuasion to cajole and threaten business and labor leaders into holding price and wage increases within prescribed guidelines – a practice that came to be known as "jawboning." Jawboning is based on the theory that inflation can be controlled by persuading unions and management to voluntarily limit their wages and profits below what the market would otherwise allow. The most remarkable thing about this strategy is that anyone thought for an instant that it would work.
During the mid-1960´s, the increase in military spending brought about by the Vietnam escalation increased the demand for labor and manufactured goods. At the same time, cuts in the investment rate made productivity increases difficult. The result was that inflationary pressures of both the demand-pull and cost-push variety were generated. To expect that such forces could be contained by verbal exhortations was like whistling into a hurricane.
During the latter half of the 1960´s, presidential jawboning was notably unsuccessful as along-term stabilizer of prices.17 It perhaps could be credited in a few cases with delaying price increases by several months, but, over the long term, the inexorable pressures of inadequate supply and increased demand brought about by the Vietnam war forced prices upward.
During the Nixon era, inflation continued. For about three years the Nixon Administration relied on the classic techniques of monetary restraint. The result was a predictable rise in unemployment and slowdown in business. There was also a continued decline in capital investment that predictably led to a decline in productivity. Unsurprisingly, inflation continued to be a serious problem, and finally in August 1971 the President imposed price and wage controls. Prices stabilized temporarily but eventually began to creep upwards again since the imposition of controls had done nothing to remedy the basic problem of low productivity and excessive demand. Many types and phases of price and wage controls were subsequently tried and discarded, but the result was always the same. Supply was insufficient to meet demand, and prices rose irrespective of controls.
Time for a Change
Out of all this one lesson seems clear. None of the current inflation-control techniques are capable of dealing with cost-push inflation. They all attempt to close the gap between wage increases and productivity increases by holding down wages. But wages no longer respond to such pressures and, perhaps even more significant for the years ahead, neither do raw material costs. The time has come for a new strategy. We must realize, first of all, that productivity is within our power to control and, secondly, that increased productivity offers the only hope for a decent quality of life in an overcrowded world. We no longer can afford to fight inflation by policies designed to reduce investment and create unemployment. Already people are starving and shortages are growing worse. A continuation of economic policies that deliberately restrain production and induce recession may very well lead to disaster.
Today Western civilization is in a state of arrested progress, if not actual retreat. We are being tested. We have no guarantees that were not given to Rome, or Egypt, or Assyria.18 The world has never been a benign or stagnant place and certainly is not today. If the Western nations cannot solve the basic problem of stable economic progress, other nations, perhaps in the Far East, the mid-East, or Africa, eventually will.
The economic dogma that inflation can only be cured by breaking the back of rising expectations may be the Achilles´ heel of Anglo-European civilization. Another decade of monetary and fiscal strangulation could easily lead to a shift in the center of world power from the West to the East.
The time has clearly come for a change in strategy. Our entire civilization is threatened by shortages and by rising costs of raw materials. Surely the proper response to such a threat is to get people to work, to increase production, and, most important of all, to increase efficiency and reduce waste. To suppose that such actions are incompatible with price stability is to totally misunderstand the central driving function of the entire industrial revolution – increased productivity.
Inflation will recede whenever we produce as much as, or more than, we consume. That this can be done by increasing productivity, as well as by reducing wages, seems clear. The secret lies in increased investment. Capital investment is truly the goose that lays the golden egg. It is the life-blood of a technological civilization. Increased investment for increased productivity is the only solution to our current economic troubles. It may be our only hope for survival.