March 28, 1973
Page 9971
BEWARE PHASE III
Mr. MUSKIE. Mr. President, I commend to my colleagues an article written by Gardiner Means, former economic analyst and fiscal adviser to the Truman administration. Writing in the Washington Post "Outlook" section on February 18, Mr. Means point out that because of faulty diagnosis of the causes of inflation, the administration's planned stagnation of 1969-70 turned into a recession. According to Mr. Means, the inflation we were experiencing then – and still labor under – arises from price and wage pressures in concentrated industries. He terms this phenomenon "administrative inflation," in contrast to standard "demand inflation" or "reflation" which is part of economic recovery. He warns that phase III "may turn out to be so weak that it will allow substantial administrative inflation."
I ask unanimous consent that Mr. Means' article be inserted in the RECORD.
There being no objection, the article was ordered to be printed in the RECORD, as follows:
BEWARE PHASE III
(By Gardiner C. Means)
(NOTE.-Charts referred to in text not printed in RECORD.)
While Congress complains that the White House has been usurping its powers, the peril in the economic field is that Congress might give President Nixon a blank check for Phase III of his anti-inflation program – a plan that may well put more people out of work without curbing rising prices and further weaken confidence in the dollar.
The dangers in Phase III arise from a faulty diagnosis of the forces creating today's inflation. The Nixon administration, which appears ready to repeat its earlier mistake of relying heavily on monetary and fiscal policy, is still treating inflation as if it were the result or aftermath of too much money chasing too few goods, a textbook inflation stemming from excess demand. But in the past four years there has been no excess demand. Indeed, in the past 20 years, when prices rose 50 percent, there was only a year and a half, during 1967 and 1968, when there was excess demand.
Rather, most of our price increases have come from two quite different types of inflation, both of which are operating today.
INFLATION IN RECESSION
The first, which is our major problem, arises from the exercise of market power. It can be initiated by business managers in an effort to widen profit margins, it can be caused by labor leaders seeking excessive pay increases. In either case, it is an "administrative" inflation that does not rely on classic supply-demand forces.
Such inflation can occur whether employment is full or less than full, and whether we are in a recession, as we were in 1969-70, in stagnation, as in 1971, or in a recovery. In any of these periods administrative inflation can show up in price rises for autos, steel, machinery and other products of the concentrated, less competitive industries.
The first clear case of an administrative inflation occurred in the 1950s. From 1953 to 1958, the wholesale price index climbed 8 per cent (see Chart 1 on Page B4) at the same time that manufacturers idled an increasing portion of their production capacity and joblessness became excessive. What we had, in short, was simultaneous inflation and recession, something impossible, according to the textbooks.
It is clear that the major cause of the wholesale price was a 36 per cent boost in steel prices and substantial price increases in steel-using industries; together, these accounted for more than half of the wholesale advance. Subsequent information has also made it clear that the steel price boosts involved a considerable widening of profit margins.
REFLATION: A GOOD THING
The second inflationary force we are experiencing today is the "reflation" of prices that occurs in periods of recovery, which explains part of the recent rise in food prices.
In a recession, flexible prices such as those for food, cotton and hides tend to fall sharply. But administered prices, especially in the less competitive industries, tend to fall little. In a recovery, the reverse tends to happen: Prices for food and other flexible items tends to bounce back the most, while prices in the steel, auto and other concentrated industries tend to rise the least.
This is precisely what happened in the Depression and post-Depression period (see Chart 2), and price data collected from buyers by the National Bureau of Economic Research show that it also happened in the recession-recovery cycles of 1957-58 and 1960-61. It is similarly involved in the current recovery from the 1969-70 recession.
Reflation is a necessary part of the recovery process and should be considered a good thing that helps restore balance in both prices and employment. During the Depression, for example, joblessness hit almost entirely in the concentrated industries whose prices had fallen the least; the later job recovery also came mostly in these industries. What happened was that rising demand during the recovery lifted the more sensitive market prices while it increased employment in the concentrated industries whose prices were least sensitive, thus restoring the pre-Depression price balance and full employment.
The current reflation thus should not be interfered with. The big problem today is to prevent or minimize administrative inflation. And it is the failure to recognize that we are faced with administrative inflation, and the failure to apply the lessons of the past, that constitute the current danger.
DISMAL FAILURES
On two past occasions, the effort to treat administrative inflation by measures deigned to control demand inflation resulted in dismal failures. In1957, the Federal Reserve Board sought to control the administrative inflation of the 1950s through a tight money policy that more than halted the growth of the nominal stock of money and produced a 10 per cent drop in the real stock of money. This precipitated the recession of 1958.
The failure of this effort arose from the fact that, while a tight money policy can control demand inflation, it cannot control an administrative inflation. This was acknowledged in 1959 by the chief economic adviser to the Federal Reserve Board, Woodlief Thomas, who noted that "Recent discussion of the influence of administered prices, stimulated by ...the Kefauver Committee has made a significant contribution to a better understanding of the problems of inflation and fluctuations in economic activity and employment. This contribution is in pointing out that there are unstabilizing forces in pricing actions of the private economy – on the part of both labor and management – that cannot be effectively controlled or corrected by government actions in the area of fiscal and monetary policies."
The Nixon administration's first attempt to control inflation, beginning in 1969, was also a complete failure due to faulty diagnosis.
On taking office, President Nixon announced that prices and wage rates would be left to the free market and inflation would be controlled by fiscal and monetary means. A large budget surplus, based on the Johnson surtax, was maintained throughout 1969, and so tight a money policy was adopted that expansion in the money stock was halted. There was no excess in demand. Yet in 1969 the wholesale price index rose 4.8 per cent, more than twice the rate of the years from mid-1965 to the end of 1968.
In his 1970 Economic Report, the President tried to explain this price rise by saying, "The inflation unleashed after mid-1965 had gathered powerful momentum by the time this administration took office a year ago." He called the growth of total spending "the driving force of the inflation" and outlined a program to "slow down the rapid expansion of demand."
The program was to take the heat out of the inflation by creating 2½ years of stagnation.
Economic growth was to be halted to mid-1970, followed by two years in which the gross national product was, by plan, to be kept some 30 billion below the economy's estimated potential. This called for putting an additional 2 million people out of work so as to increase the unemployment rate to about 6 per cent.
ADMISSION OF FAILURE
This brutal plan was successful in creating stagnation (see Chart 3). The continued budget surplus became a restraining force and the money stock, measured in constant purchasing power, was reduced. Real demand declined, industrial production started down in the summer of 1969, and unemployment increased as planned. By the end of 1970, the objective of 6 per cent unemployment had been achieved.
But stagnation did not prevent inflation.
The reason is simple. The driving force of the inflation in 1969 was not "the growth of total spending." Rather, the President had unleashed the forces of administrative inflation by rejecting the price-wage guideline principle. The inflation in the 1969-70 recession was entirely administrative inflation, the kind of inflation that Woodlief Thomas had said could not be controlled by fiscal and monetary measures.
The administrative character of this inflation-in-recession is easily shown by examining the main sources of the rise in the wholesale price index (see Chart 4). The great bulk of the price increase during the recession was contributed by the concentrated industries. In the more competitive industries, prices went up little or went down. The only exception was the fuel and power index, which rose 11 per cent, largely because of the scarcity of pollution-free fuels.
The dismal failure of this program was acknowledged by the August, 1971, price-wage freeze after it had already cost the country nearly $50 billion in lost GNP and promised more loss until reflation could restore full employment. No apology was given to the millions who suffered unnecessary unemployment or to the stockholders whose profits were reduced.
KENNEDY'S GUIDEPOSTS
Now, with the new emphasis on monetary and fiscal policy and with the weakening of price and wage controls in Phase III, it looks as if the Nixon administration is about to repeat these same errors. This is all the more disturbing because we have had importantly successful experiences in the control of administrative inflation, the Kennedy guideposts and the Nixon Phase I and II, which point the way toward an effective program.
The Kennedy guideposts directly faced the problem of administrative inflation. When the program was being drafted in 1961, unemployment was above 6 per cent and the problem was recognized as one of preventing administrative inflation while expanding demand through fiscal and monetary measures to achieve full employment.
The Kennedy program was both an outstanding success and a partial failure. Its success was in holding down administrative inflation while achieving full employment. By the fall of 1965, unemployment was down close to 4 per cent. Labor had adhered to the wage guideposts so closely that the labor cost per unit of manufacturing output was down 3 per cent. Management had not adhered as closely and industrial prices rose a little. This in itself was not serious and might have been corrected. Nearly full employment had been achieved with an annual rise in the wholesale price index of only 0.6 per cent.
But this goal had been achieved at the expense of a serious distortion in the relation between prices and wage rates because the guidepost program took no account of the reflation rise in the more competitive prices, which was appropriate to recovery. The increase in demand which reduced the unemployment rate from over 6 per cent to 4 per cent could be expected to raise the average of farm prices and other flexible market prices substantially and produce only a small increase in the most administered prices, thus bringing a moderate increase in prices and living costs. Yet the wage guidepost took no account of this appropriate rise in living costs.
NO DEMAND INFLATION
Because of the failure to include a cost-of-living factor in the wage guidepost, the program suffered a partial breakdown. By 1965, the rise in living costs had absorbed more than a third of labor's legitimate productivity gains and had significantly widened profit margins.
When this unfairness became obvious, labor refused to play ball and forced wage increases larger than the increases in productivity. Management, striving to maintain the widened profit margins, passed along the increases in labor costs. This struggle lifted the wholesale index by another 3.5 per cent from mid-1965 to mid-1967 and brought wages and profits more nearly into line with each other.
Even with the partial breakdown of the wage guidepost, full employment was maintained throughout 1966 and 1967, and the rise in the wholesale price index from mid-1961 to mid-1967 was only 6 percent – just a little more than the reflation that could have been expected in moving from more than 6 percent unemployed to the 3.8 percent reached in 1967.
In no part of this period is there evidence of demand inflation. Farm and other sensitive market prices rose rapidly until relatively full employment was reached, but they were little higher in mid-1967 than in mid-1965. Most of the rise in those two years was administrative as labor sought to recover from the unfairness of the wage guidepost.
It seems likely that, with an appropriate living-cost provision in the wage guidepost, the full reflation could have been accomplished by 1965 with negligible administrative inflation, and full employment could have been maintained without further inflation.
THE NIXON PROGRAM
The Nixon guidelines program, initiated in August, 1971, after the failure of the stagnation policy, also directly faced both the need to control administered prices and the necessity of reflation.
The guidelines introduced in Phase II were a distinct improvement over the Kennedy guideposts in three respects. The wage guideline included a factor for the cost-of-living rise that could be expected from reflation, and the price guideline focused on containing profit margins, which allowed businesses to increase profits by producing more but not by increasing prices relative to costs. Finally, Phase II was backed by authority to exercise controls.
Phases I and II were quite successful in preventing administrative inflation. In the first 15 months to November, 1972, the weighted index for the six most concentrated industrial groups of Chart IV went up only 2.2 percent, while that for the three mixed groups went up 3 percent, mostly because of the scarcity of pollution-free fuels. Both of those increases could be expected as a part of the reflation accompanying the partial recovery. The cost-of-living factor meant that the non-farm labor cost per unit of output increased, but by less than 1.5 percent.
On competitive prices, special developments led to price increases exceeding those to be expected from reflation alone. A severe drought in Texas and the destructive corn blight in 1970 broke the cattle cycles so that less meat and fewer hides were available in 1972. Then drought in other parts of the world forced up grain and feed prices and, in turn, produced abnormally high prices for hogs, poultry and eggs, and also caused a further increase in beef prices.
Next summer, as the effects of these abnormal developments pass, food prices could be expected to fall if there is no further recovery. With a complete recovery to full employment, the reflation can be expected to be completed without much further rise in food prices, particularly if farm production is allowed to expand.
A FAIR DEAL
Phases I and II have also been substantially fair to both labor and capital. In the last half of 1972, the division between capital and labor of the income generated by non-financial corporations has been almost exactly the same as that in 1969 and as that in the eight years of the Eisenhower administration. While profits per unit of output have gone up faster than the compensation to labor, interest costs per unit of output have gone up less, so that the total compensation to capital and to labor have risen together.
The success of Phases I and II in preventing administrative inflation suggests the need for retaining this type of program until reflation is complete and full employment is achieved.
But instead of perfecting the controls over administrative inflation, the Nixon administration persists in returning to the myth of a momentum from demand inflation and emphasizing fiscal and monetary restraints. Thus, the President's 1973 Economic Report, after recognizing the existence of nonclassical inflation, attributes it to momentum from the preceding demand inflation, saying: Inflationary expectations and behavior left over from the country's experience since 1966, even though reduced in 1972 from previous heights, have not been completely eliminated. The demand inflation arising from the Vietnam war was indeed real, but it did not start until mid-1967. In calendar 1966, the federal budget was in essential balance, and in the first half of 1967 there was practically no increase in the wholesale price index. But with the economy already at full employment, rapidly increasing military needs could be expected to produce an excess in demand and a demand inflation unless other demand was restricted.
THE JOHNSON SURTAX
This danger of demand inflation was well recognized by the administration, and in January, 1967, President Johnson recommended a 6 per cent surtax to be effective by mid-1967. The Congress failed to act. The President repeated his request in the summer of 1967, raising the requested rate to 10 per cent. Again, in January, 1968, the President repeated his request.
It was not until mid-1968 that the surtax finally passed, a year and a half too late. By that time, demand inflation had carried the wholesale price index up at an annual rate of 2.2 per cent from its mid-1967 level, with the increase approximately equal for competitive and administered prices.
The surtax brought the federal budget into essential balance by the last quarter of 1968 and insured a substantial surplus in 1969. It seems probable that, if the surtax had been passed in early 1967 and the guidepost policy stressed, full employment could have been maintained without either demand inflation or serious administrative inflation. As it was, the prime source of the 1967-68 demand inflation had been removed by the end of 1968.
Actually, there was no excess demand when President Nixon took office and little momentum from the preceding year and a half of mild demand inflation. And today one cannot take seriously the claim that a year and a half of demand inflation in 1967-68 at the rate of 2.2 per cent a year could engender such a momentum that, with no excess in demand in 1969, wholesale prices would rise 4.8 per cent and that four years later, with a recession in between, momentum from the earlier inflation is still the problem.
THE DANGERS AHEAD
Because of this faulty diagnosis and the President's willingness to use unemployed workers as an instrument of policy, there are serious dangers in the Phase III program he announced last month.
The first danger is that fiscal and monetary policy will again be used in an effort to prevent an administrative inflation that it cannot control. This would create more unemployment without reducing the pressures producing administrative inflation. The appropriate level of demand in the economy will not have been reached until full employment is attained and maintained. A restrictive fiscal and monetary program can prevent demand inflation, but it cannot prevent the arbitrary lifting of prices and wage rates in the less competitive industries or achieve price reductions where costs have gone down.
The Phase III guidance program may turn out to be so weak that it will allow substantial administrative inflation, regardless of Mr. Nixon's "big stick" in the closet. The profit margin provisions have already been weakened to the point that there would be room for considerable administrative inflation even if the guidelines were consistently adhered to. And the administrative inflation is likely to be greater still because the pressures for adherence have been greatly relaxed.
The last danger is that the employment goal will be too niggardly. Even apart from human considerations, each extra 500,000 persons employed can produce an extra $6 billion or $7 billion of production, while the resulting wages, profits and taxes can provide a corresponding market.
In the light of all this, it is vital that Congress refuse to simply renew the Economic Stabilization Act expiring April 30. A mere renewal, leaving it entirely up to Mr. Nixon to use this crucial authority as he wishes, would be an abdication by the Congress of its responsibility for basic policy and another transferral of vast power to the White House.
A NECESSARY NUISANCE
Rather, Congress should make mandatory the price guidelines of Phase II for all corporations controlling assets, or having yearly sales, of more than $500 million. To enforce this policy, Congress should create an interim wage-price guidance board equivalent to the President's Cost of Living Council, thus making that unit accountable to the Congress as well as to the White House. Businesses with assets or sales below the $500 million cutoff should operate under voluntary guidelines unless the wage-price board finds that mandatory controls are necessary.
The wage guidelines should parallel those for prices: mandatory for workers in corporations with assets or yearly sales of more than $500 million, voluntary for others unless the wage-price board decides otherwise.
Nor should Congress stop there. The legislation should make Congress' intent specific and clear on several other fronts:
It should adopt 4 per cent unemployment as the interim goal for the end of 1973 and 3.8 per cent for the end of 1974.
It should recognize that some reflation is to be expected in moving from the present level of employment to the interim goals.
It should approve the principle of a full employment budget – a budget that would balance at the interim employment goal but operate with a deficit when unemployment is more than the interim goal and a surplus when unemployment is less than the interim goal.
It should direct the Federal Reserve Board to adopt a "full employment monetary policy" under which it would expand the monetary stock to that level estimated as necessary to support the interim job goal but not to an extent that would result in excess demand and demand inflation.
In passing such legislation, Congress must be aware that while controls are a nuisance to both management and labor, that nuisance would be small compared to the "nuisance" the President was willing to impose on individuals by putting 2 million people out of work in his earlier attempt to control inflation.
The Congress should also recognize that some distortions can be expected in the economy as a result of prolonged price-wage guidance (though the President's 1973 Economic Report was not able to report any significant distortions to date or any other significant costs of the guideline program). But such distortions as may develop in the next two years are likely to be insignificant compared to the distortions that would arise with administrative inflation. And the costs are likely to be insignificant compared with the advantages of a quick return to full employment.
Such an interim program should allay the fear in foreign quarters of runaway inflation in the United States and give ample time to develop a more permanent program to maintain full employment without administrative inflation.