A Plan for Controlling Inflation

An overnight solution is impossible, and might be disastrous if it could be achieved


THE REAGAN ADMINISTRATION HAS CHOSEN TO ATtribute inflation to the growth of the Keynesian welfare state. This simple diagnosis suggests a simple remedy. The administration proposes surgery to remove all the unhealthy tissue: excessive regulation, taxation, complexity, inefficiency, and bureaucracy; overly generous subsidies and special favors. There is reason to believe that the proposed reforms will have at least some effect on inflation, which has been continuous and accelerating since the original New Deal programs were fully established. The particularly sharp escalation in the middle 1960s was synchronous with the introduction of Great Society programs.

But this approach has obvious limitations, ambiguities, and omissions. The quantum leap in our inflation after 1973 was a direct result of OPEC price increases rather than of some misguided new venture in Keynesianism. Furthermore, wars produced enormous inflation for millennia before it could have had Keynesian motivation, and the evidence is overwhelming that the American preoccupation with military spending since the end of World War II has checked productivity growth and exacerbated inflation. History seems to justify this administration’s hope to reduce inflation by pruning welfare-state extravagances, but history also suggests that the growth of defense spending will increase inflation as much as the proposed cuts will reduce it.

If we grant that the application of Keynesian policies has been the prime cause of inflation, we must still answer the question of how one thing led to the other. The administration’s analysis suggests that it is only the excesses of Keynesian policy that have produced inflation. However, a much more plausible interpretation would be that the cause of inflation has been the remarkable success achieved by the leanest essentials of Keynesian policy.

Since the end of World War II, the capitalist world has practiced Keynesian management; the results have been in spectacular contrast with previous history. Periods of economic contraction have been briefer and the contractions shallower than for any comparable stretch of time since the Industrial Revolution. It is not hard to imagine that this altered state of affairs has changed individual economic behavior in ways that have led to more inflation. As businesses became increasingly convinced that government could deliver on its promise to eliminate depressions and attenuate recessions, they became more willing to borrow funds, build new plants, retain a skilled work force. Labor unions, for the same reason, became concerned more about increasing pay levels and less about protecting the level of employment. When demand has slackened, businesses have increasingly maintained prices at profitable levels, confident that government subvention will restore demand without any contribution from them in the form of lower prices.

Over the past fifty years, we have developed a social structure designed to maintain incomes and, consequently, the prices of labor and goods that generate incomes. A system that generally prevents prices from falling but not from rising will inevitably produce a preponderance of price increases. It seems difficult to escape the unpleasant conclusion that the success of Keynesian policy in achieving high levels of prosperity has led by itself to inflation.

It was this analysis that motivated many very liberal Keynesians to support Nixon’s experiment with wageand-price controls. With controls, they reasoned, the policies that had succeeded in vanquishing depressions could be maintained and supplemented with a new policy addressed to controlling inflation. But wage-and-price controls functioned abysmally, and they would do worse today.

The President’s men have dealt with this circumstance by denying that there is inherent conflict between Keynesian security and price stability. They maintain that there is a possibility of having economic “safety nets” sufficient to keep us from falling into depression yet insufficient to yield inflation. But this possibility is a dubious one, especially if we consider the concentrated market power that major corporations and unions enjoy in the real world.

IT IS, OF COURSE, A COROLLARY OF ADMINISTRATION policy that while allowing the Keynesian state to wither away, we will encourage the productive forces of the private sector to flourish.

The Reagan proposals would reduce all personalincome tax rates by 5 percent this year, 10 percent in each of the following two years, and 5 percent in 1984. Finally, business taxes would be reduced in a way that is supposed to encourage more investment. The investmentincome tax cuts are intended to lift a restraint from the shoulders of workers, investors, and entrepreneurs. The expected result is a widespread increase in productive effort that will cause the supply of goods and services to increase more rapidly, thus reducing inflation.

Even if such an effect occurs, it is difficult to imagine that the response will be large or swift. Furthermore, if inflation continues to increase incomes at 10 percent a year, the average taxpayer will occupy the same position in 1984 after the proposed tax cuts as today without them. If outlays and taxes were equally reduced, there would be some reduction in the inflationary intensity of total demand, since individuals would save some portion of their increased after-tax incomes. Suppose that both taxes and expenditures are $200 billion less in the final year of this administration than they would have been under the Carter projections. If taxpayers save a generous 10 percent of this windfall, then total demand will be $20 billion less than it would have been, or about one half of one percent of projected total demand. This is rather a trivial dent in inflation for such a politically heroic accomplishment. Reducing federal expenditures beyond the reduction in taxes, in an effort to eliminate the government deficit, is another story. An inflation rate of 10 or 12 percent measures the fact that households, businesses, and governments are trying to spend an aggregate amount that is 10 or 12 percent greater than the total national income divided among them. The federal deficit—approaching $100 billion, or 3 percent of GNP — is a major part of this phenomenon. Eliminating the deficit by 1984 might have a substantial impact on inflation.

The Reagan cuts in taxes and spending address longstanding sources of inflation; however, they do not attack the specific cause of deteriorating productivity and inflation since 1973. In the past eight years, the international price of petroleum has increased more than 1,000 percent: this has had multiple disruptive consequences for our economy. The effect on political decision-making was equally devastating for the first seven years.

The oil-price increases of 1973 and 1979-1980 contributed directly to inflation by raising the price of an important product and an important component of other products. The indirect effects may have been even more significant. At the time of the first OPEC price increase, in 1973, the United States had tangible capital assets with a value of about $3.4 trillion —more than two and a half times that year’s gross national product and more than fifteen times that year’s very high level of expenditure for new physical assets. These capital goods—automobiles and highways, airplanes and airports, houses and commercial buildings, power plants and washing machines, steel mills and breweries—had all been built, designed, and located on the assumption that, regardless of overall price inflation, a barrel of oil would be worth one or two bushels of wheat, or one hundredth of a ton of steel, or less than half an hour of skilled industrial labor. However, a barrel of oil today is worth eight or nine bushels of wheat, one fifteenth of a ton of steel, and more than two hours of skilled labor. These changes have made it uneconomical to operate much of 1973’s physical plant the way it was intended to be, or, in some cases, to operate it at all; much capital and labor goes unemployed or mal-employed. OPEC’s price increase is thus a principal explanation for the high levels of unemployment that we have experienced since 1973. And unemployment leads to more inflation. Government policy becomes more expansive to combat increased unemployment, and succeeds, in part, by inflating the prices of everything else, so that the 1,000 percent increase in the dollar price of oil becomes “only" a 500 percent increase relative to the price of steel or labor. Another inflationary impulse comes from the interruption of productivity growth caused by sudden shifts in the relative price of oil. Contract negotiators on both sides of the table are still used to terms that incorporate inflation plus a “normal” rate of increase in productivity. When the anticipated increases in output per worker do not materialize, employers can maintain profitability only by increasing prices.

Paradoxically, this analysis of the relationship between OPEC and inflation provides hope for the future. The energy policy for which the Carter Administration obtained ratification last year appears to be one of its few enduring legacies. The essence of that policy is to permit the prices of oil and gas products to reflect world prices and to impose a windfall-profits tax on the sale of previously discovered petroleum. Higher prices for final products have begun dramatically to reduce consumption of oil and gas relative to total economic activity. And higher prices for new discoveries have already caused maximum feasible increases in exploration. Partly for these reasons, there is little effective opposition to the core of our new energy policy.

The grounds for optimism are straightforward. The effects of oil-price increases are sharp and short rather than continuous. A couple of years after an oil-price increase, most of the effects on inflation, unemployment, and productivity have been felt. Thereafter, there is a good chance of resuming normal productivity growth, which, indeed, happened for a while after mid-1975. There is every reason to suppose that a similar resumption of normal productivity increases will be apparent before the end of the year. And the resumption should be permanent if we are spared a third oil-price shock.

The link between OPEC and productivity problems suggests that the current bipartisan enthusiasm for encouraging more investment is misguided. It is based on a critically inaccurate perception. From 1966 to 1973, the first half of our recent inflation experience, investment was at record-high levels by any standard. Inflation in those years was caused not by an inability to produce more but by an immense corporate appetite for transforming more goods and services into machines and factories. Since 1973, investment has been about average for the post-World War II period, as a percentage of GNP or as a rate of increase in the capital stock. It has not been high enough to raise the amount of capital per worker; but during this period, the work force expanded enormously, owing to the maturation of the “baby boom” generation and the increase in the number of women seeking employment. Both phenomena have already abated, so a continuation of the investment levels of the past eight years will once again yield increases in the amount of capital per worker.

It is true that inflation has dissipated the effect of corporate depreciation allowances intended to provide nontaxable sources of funds with which to replace wornout or obsolete capital. The Reagan solution is to permit faster depreciation of investment goods—larger tax write-offs each year for a smaller number of years. At the same time, the diverse range of depreciation lives currently recognized for different kinds of plant and equipment would be drastically consolidated and simplified.

Unfortunately, the effect would be to penalize those industries where rapid technical progress is causing obsolescence of equipment ahead of the schedule provided for in the Reagan plan. Industries with stagnant technology and long-lived equipment would receive the biggest tax benefits. It is not probable that the declining industries will invest more, nor is it necessarily desirable for them to do so. It is certainly not good public policy to inhibit those sectors that are doing the most to combat inflation.

TO RECAPITULATE: WHATEVER THE ADMINISTRATION does to diminish the welfare state will reduce inflation. The most significant reductions would come from attacking the most essential elements of modern economic policy, and they would be accompanied by equally significant costs, in the form of unemployment, economic failure, and hardship. Whatever the administration does to enlarge the welfare state will increase inflation. The inflationary effects of the 1979-1980 oilprice shock are about to end. There is an excellent chance that productivity is about to improve. The President’s program for simplifying and shortening depreciation schedules is neither helpful in combating inflation nor just.

What if all the seeds of Reagan economics were to come up roses? Output per hour of work would resume its historic growth of 2.5 percent a year. A balanced budget would reduce excess demand and inflation by three percentage points. Cuts in spending and taxes would account for a further reduction in the inflation rate of half a percentage point. Because it was paid for out of current taxes, increased military spending would have no inflationary consequences.

Even if this fairy tale came true, we would see the elimination of only six percentage points of inflation by 1984, or about half of the current rate. What about the other half? This is supposed to disappear because people expect it to disappear. But why should any rational person expect inflation to drop by 10 to 12 percent when all the measures now planned could not possibly do more than half the job? Relying solely on Reagan’s proposed changes would be analogous to expecting to restore electric current by unplugging the offending extra appliances after the fuse had blown. None of Reagan’s proposed changes would affect the self-generating aspects of inflation. Expectations of continued inflation are built into our economic structure in ways that make it both difficult and dangerous to attempt a precipitous termination of price increases.

Consider a typical large American corporation. Of the revenues that it retains after buying things from other corporations, roughly 8 percent is profit before taxes and after adjusting for the distortions of inflation. By contrast, some 67.6 percent is used to pay compensation and fringe benefits to employees. The vast majority of these payments are made pursuant to three-year collectivebargaining agreements with major unions. Now suppose that inflation is brought to a miraculous, instant halt. With zero inflation, total revenues of the typical corporation would also be constant. However, the typical labor contract calls for wages to increase by about 7 percent a year before any adjustments for inflation. If the average contract had a year and a half to run on the day inflation stopped, then the average employer would find wages increasing 10.5 percent before the contract expired. Wages would increase from 67.6 percent of available revenues to 74.7 percent. The increase would come out of profits, which would decline from 8 percent to less than one percent in eighteen months. Firms whose contracts extended two and three years into the future would be still more devastated. Even those firms whose contracts expired immediately after inflation’s demise might have trouble persuading the auto workers or the steel workers to forgo increases when the coal miners were still enjoying large raises won previously.

Profit-making firms would not passively accept this destruction. They would try to protect their profits by raising prices sufficiently to cover their increasing costs. If they succeeded, inflation would be resumed. If they failed, they would still attempt to protect profits, by firing expensive employees and reducing the unprofitable production. These cutbacks would further reduce corporate and consumer demand. Cutbacks and continued price stability would lead only to further cutbacks. Businesses and consumers would begin to default on their substantial debts. Lenders would foreclose on property and offer it for sale in weak markets. In this way, a sudden end of inflation could quickly become a pandemic of deflation and depression, similar to that in the 1930s.

It is for these reasons that knowledgeable people speak of an “embedded” rate of inflation, currently around 11 percent. And it is for these reasons that the Reagan Administration, like all of its recent predecessors, contemplates only a prolonged and gradual decline in our inflation.

A SUCCESSFUL ATTACK ON INFLATION MUST BE REAListic—equipped with methods of both enforcement and inducement, and therefore believable.

It is not realistic to suppose that the inflation rate can prudently be reduced any faster than by about two percentage points a year, so we are talking about a six-year plan. And it is clear that high levels of employment coupled with rapid growth in real output and productivity would make it possible to reduce inflation more rapidly and painlessly; thus, a continued Keynesian commitment to high levels of capital and labor employment is an important element in the economic and political realism of any plan. Another essential ingredient is that the plan be neutral with respect to the distribution of income.

Incorporating these features into a six-year plan would require assumptions about real growth and productivity. If the projected rate of labor-productivity increases were unreasonably high, this would be viewed, correctly, as justifying increases in real wages at the expense of profits. Conversely, if no increases in labor productivity were assumed, this would amount to asking workers to accept six years of frozen real wages, with all the benefits of any increased productivity going to employers.

A reasonable compromise would be to plan for increases in output per worker of between one and 1.5 percent a year—halfway between the flat performance since 1973 and the happy results for the previous quarter-century. With the labor force growing at 1.5 to 2 percent a year, this assumption implies that real GNP could grow at about 3 percent a year while maintaining a high rate of employment. Wages and all categories of retirement benefits and transfer payments would be planned to increase at the assumed rates of inflation plus about one or 1.5 percent. If actual productivity exceeded the assumed numbers, the plan should assure that these unanticipated gains were shared equitably, through proportionate increases in producers’ profits and further deceleration in consumer prices.

Thus far, the obligation of the federal government inherent in such a plan would be a long-term commitment to increase the money supply at rates consistent with the assumed growth of real GNP and deceleration of inflation; to manage taxes and expenditures, on Keynesian principles, in a manner that would provide 3 percent real growth and high employment of resources; and, finally, to alter the incentives or disincentives for investment so that increases in capital per worker would be sufficient to yield the expected increases in output.

SO MUCH FOR THE CARROTS. WHAT ABOUT THE sticks? Government in America already carries a very persuasive club. It accounts for one fifth of all final purchases of goods and labor services, and it takes an additional one seventh of national income out of the pockets of some and gives it to others. Even if the magnitude, growth, and abuse of this power are prime causes of inflation, government power is nevertheless not going to be dissipated in the next half-dozen years. It makes little sense to shut our eyes to such an evident reality. Why not use government power to attack the inflation that it helped to cause?

As the direct employer of almost 20 million people, government could commit itself to raising the average wages of those employees exactly in accord with a national plan for the next six years. As a purchaser of weapons systems and other goods, the government could substitute for the present “cost plus” and inflation-escalation clauses an agreement to increase future prices only in accord with planned inflation, wage increases, and productivity gains. Future Social Security benefits could be indexed to the planned rate of inflation rather than the actual rate; future unemployment benefits could be geared to the planned level of wages; and so forth, for every category of transfer payment. Instead of the President’s program, we could legislate changes in the tax brackets for the next six years designed to eliminate the effects of the planned rate of inflation, so that prieeand-wage increases in excess of the plan would penalize those who initially benefited by placing them in a higher tax bracket. Tax policy should also be used to reward particular groups for conforming to the plan’s standards or to penalize specific groups for violating them.

So far, I have ignored an extremely important and troublesome aspect of any such plan. About two thirds of all government employees and government purchases are accounted for by the fifty states and their tens of thousands of political subdivisions. Yet only the federal government has the means and the motive to develop a comprehensive, sustained anti-inflation program. We have learned a lot—especially in the past ten years—about how Washington can draft local governments into its own causes, from traffic regulations to wage-and-price controls: the federal government need only make funding for the state and cities contingent on their compliance with specific federal programs. As federal funds have grown more important in local budgets, the power of this persuasion has grown apace. As a provider of grants and loans, and as a regulator, government has similar powers over universities, banks, utilities, airlines, railroads, and many other sectors. But the President has repeatedly made it clear that he is diametrically opposed to this coercion, because it is an apparent violation of the spirit of the Constitution. There are few concerns that I share more earnestly and wholeheartedly with Ronald Reagan. Still, I am a pragmatist. So is the President. It is worth sacrificing ideological purity to end inflation.

President Reagan’s outstanding accomplishment has been to broadcast his optimism with a force that has engulfed both public debate and individual thought. At the time of the Inauguration, it was still very much in style for commentators of all political perspectives to indulge in fatalistic hand-wringing. Now the modish question is, What can we do today to make life better tomorrow? My quarrel is not with the President’s question but with the answers provided by his economic policy-makers. These are often disingenuously labeled as anti-inflationary when their real purpose is to redistribute income in favor of the rich. Sometimes they seem to be based on a faith that inflation can be transcended by the mere incantation of conservative writ.

The approach I have described involves some cost. Although it attempts to minimize coercion and maximize the use of market responses to economic stimuli, there would still have to be a prolonged period of increased government power and planning at a time when almost everyone would like to see the role of government reduced.

The costs of continuing inflation are greater. Inflation is capricious and unjust, rewarding speculation and luck instead of prudence and hard work. Two families of equal income may find themselves in radically different circumstances simply because one bought a house five years earlier than the other. If we do not end inflation in a way planned to minimize damage and hardship, inflation will end eventually on its own, and such unplanned endings have been convulsive in the past. Logic suggests that this would be the case again. Ironically, the inevitable response to such a cataclysm would be an increase in the economic role of government.

We are left with the difficulty always experienced by a democracy when it is called upon to make the slightest sacrifice today in order to avoid future woe. And we are paralyzed by our social atomization. Since the postwar years, only a few fleeting and increasingly infrequent events have been able to overcome our narcissistic insularity and stimulate a sense of nation, of history and future, of communal cohesion. These are the unfamiliar virtues that are needed to join us in a prolonged and planned effort to eliminate inflation.