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J. Bradford DeLong
University of California at Berkeley and NBER
- The Misfortunes of Prosperity
- The Fall of Bretton Woods
- Oil Shock and Productivity Slowdown
- The Late 1970s
- The Volcker Disinflation
The Misfortunes of Prosperity
As time passed, and the memory of the Great Depression dimmed, governments' commitments to fight unemployment fiercely even at the cost of risking some infiation began to fiag. This became of great importance because the post-World War II economic system's ability to deliver low unemployment without high infiation began to erode as well.
Between 1954 and 1969--between the Korean War and the height of the Vietnam War-it looked as though the U.S. economy was sliding back and forth along a stable infiation--unemployment "Phillips Curve." Democratic governments tended to spend more time at the left end of the curve, with relatively high infiation and relatively low unemployment. Republican governments tended to spend more time at the right end, with low infiation and higher unemployment. But by absolute and by historical standards, both infiation and unemployment were low.
The first sign that something had changed came during Richard Nixon's first term as president. He attempted to move the economy from the left to the right side of the 195469 curve, and found that it would not go. 19701973 saw unemployment and infiation both at high levels relative to the previous post-World War II experience (although still at low levels absolutely). After some thought, a consensus was reached: tight monetary policy and attempts to fight infiation by marginally increasing unemployment no longer worked because no one believed that such efforts would be continued very far.
Auto workers, say, believed that the government would not allow widespread unemployment in the automobile industry--that the government would pump up nominal demand to give people enough liquidity to buy cars if ever the industry's sales began to drop. This left the United Auto Workers, therefore, with no incentive to moderate its wage demands-it was not risking serious unemployment on the part of its members if it did so. And this left the automobile manufacturers with no incentive to resist demands for higher wages: they could simply pass them on in higher prices. And so the economy had grown "used to" steady infiation at five percent per year.
How to deal with this dilemma? One possibility was that the government should create a truly massive recession-should make it painfully obvious that if infiation rose too high and if wages agreed on by workers and firms rose too rapidly, the government would not accomodate, would not expand nominal demand, but would instead infiict unemployment and keep unemployment high until infiation came down. No president wanted to think about this possibility. It was, in the end, the road the United States took, but largely by accident and after many stopgaps. And taking this road led to the end of the most successful economic order the industrial world had seen.
In 1960 two prominent liberal economists--both future Nobel Prize winners--Paul Samuelson and Robert Solow wrote an article in which they attempted to quantify how low the government could push unemployment:
...In order to achieve the nonperfectionist's [emphasis added] goal of high enough output to give us no more than 3 percent unemployment, the price index might have to rise by as much as 4 to 5 percent per year. That much price rise would seem to be the necessary cost of high employment and production in the years immediately ahead.
All this is shown in our... Phillips curve [diagram].... The point A, corresponding to price stability, is seen to involve about 5.5 percent unemployment; whereas the point B, corresponding to 3 percent unemployment, is seen to involve a price rise of about 4.5 percent per annum. We rather expect that the tug of war of politics will end us up in the next few years somewhere in between...
The surprising thing is that three percent unemployment--a goal outside the historical operating range of the peacetime economy, a level of unemployment that had been reached in the United States only in response to the shock of a major war--as a "non-perfectionist's goal." If a non-perfectionist would demand that the economy do better than it ever had before in peacetime, what would a perfectionist have demanded?
Now Paul Samuelson and Robert Solow were not exceptional. In 1969, the former Chair of the Council of Economic Advisers, Arthur Okun, was publicly calling for a long-term "4 percent rate of unemployment and a 2 percent rate of annual price increase" as "compatible" what he called "an optimistic-realistic view" of the structure of the American economy--and as a target worth aiming at. The post-World War II U.S. had managed to attain his target in only one single year. Yet Arthur Okun believed that proper demand management of the economy could produce results better than had been achieved before
This is hubris: overpowering pride that sets itself up for nemesis, the revenge that things take because one's reach exceeds one's grasp. One explanation for this hubris--this belief that proper demand management policy could induce the economy to do things it had never done before--is that it was part of the legacy left by John Maynard Keynes's Theory of Employment, Interest, and Money. Indeed, Chicago-school economist Jacob Viner's review of The General Theory had forecast that:
In a world organized in accordance with Keynes' specifications, there would be a constant race between the printing press and the business agents of the trade unions, with the problem of unemployment largely solved if the printing press could maintain a constant lead...
And he gloomily called the General Theory a "book which is likely to have more influence than it deserves." You could not ask for a better prediction.
But it is more accurate to see the views of Arthur Okun and company as a consequence of the very long shadow cast by the Great Depression. The Great Depression had broken any link that might ever have been drawn between the average level of unemployment over any time period, and the desirable, attainable, or sustainable level of unemployment. With the memory of the Great Depression still fairly fresh, it was extremely difficult to argue that the normal workings of the business cycle led to fiuctuations around any sort of equilibrium position.
There was "frictional" unemployment--workers looking for jobs and jobs looking for workers before the appropriate matches had been made--which served as a kind of "inventory" of labor for the economy. There could be "structural" unemployment-- people with low skills in isolated regions where it was not worth any firm's while to employ them at wages they would accept--which could not be tackled by demand-management tools.
Everything else was "cyclical" unemployment: a smaller case of the same disease as the unemployment of the Great Depression, which could presumably be cured by the standard expansionary policy means that economists' believed would have cured the Great Depression if they had been tried at the time.
The Great Depression had taught everyone the lesson that business cycles were shortfalls below, and not fiuctuations around, sustainable levels of production and employment. As of the start of the 1960s, there was no good theory to explain why "frictional" and "structural" unemployment should even together add up to any significant fraction of the labor force. Thus anyone-it did not have to be John Maynard Keynes-developing a macroeconomics in a context in which the Great Depression was the dominant empirical datum would find that the path of least resistance led to expansionary policy recommendations: Depression-level unemployment certainly did not serve any useful economic or social function; the bulk of observed post-World War II unemployment looked like Depression-era unemployment; therefore policy should be expansionary.
Did economists' overoptimism matter? Did it make a difference that they were talking at the beginning of the 1960s of 3 percent unemployment as a "nonperfectionist" goal, and were arguing at the end of the 1960s that 4 percent unemployment and 2 percent infiation was likely to be a sustainable posture for the American economy over the long run?
During periods of Republican political dominance, perhaps not: the 1950s saw not gap-closing but rather stabilization policies of the kind that Herbert Stein had pushed for from the CED, as Eisenhower's economic advisers balanced between Keynesians to the left and residual Hooverites to the right. But during periods of Democratic political dominance, economists' overoptimism almost certainly did matter.
The core of the Democratic political coalition saw every level of unemployment as "too high." And economists' professional opinions about what was and was not feasible, given the policy tools at the U.S. government's disposal, were in a sense the only possible brake on the natural expansionary policies that would have been pursued in any case by the post-World War II Democratic Party.
Perhaps economic advisors would have proven irrelevant in any case. If the profession had been less heavily concentrated toward the Keynesian end of the spectrum, and if Walter Heller and James Tobin had possessed views on macroeconomic policy like those of Arthur Burns and Herbert Stein, perhaps President Kennedy's economic advisors would have had other names. For every conceivable policy there is an economist who can wear a suit and pronounce the policy sound and optimal, and that to a large degree Presidents and Senators get the economic advice that they ask for. Perhaps a less optimistic group of advisors drawn from the academic economics community would have had no more effect on macroeconomic policy in the 1960s than advisors from the academic economics community had on fiscal policy at the beginning of the 1980s when they pointed out that revenue projections seemed, as former Reagan-era CEA chair Martin Feldstein very politely put it, "inconsistent with the Federal Reserve's very tight monetary policy."
Sooner or later, the turning of the political wheel would bring a left-of-center party to effective power in the United States. And when that happened everything--the memory of the Great Depression, the elements of that party's core political coalition, the theories of economists in the mainstream of the profession--would push for policies of significant expansion.
If 4 percent unemployment had turned out to be consistent with relatively stable inflation, the cry would have arisen for a reduction in unemployment to 2 percent. Sooner or later a liberal government would have pushed total demand beyond the economy's capacity to produce without accelerating inflation. And it happened that this sooner or later turned out to be the late 1960s and eary 1970s.
It is well within the bounds of possibility that the U.S. might have avoided a burst of infiation in the late 1960s and early 1970s. But then it would have been vulnerable to an analogous burst of infiation in the late 1970s, or in the early 1980s. And if infiation had been avoided through the early 1980s, analogous policy missteps might well have generated infiation in the late 1980s. The "monetary constitution" of the U.S. at the end of the 1960s made something like the 1970s, at some time, a very likely probability. And I do not see how the "monetary constitution" could have shifted to anything like its present state in the absence of an object lesson, like the experience of the 1970s.
From 1954 to 1968, the relative levels of infiation and unemployment in the United States moved back and forth along a stable curve that came to be called the "Phillips Curve." Democratic governments tended to want to position the economy at the left end of the curve, with relatively low unemployment and moderate infiation. Republican governments teneded to want to position the economy at the right end of the curve, with moderate unemployment and low infiation.
Few economists, politicians, or bureaucrats in the middle 1960's disagreed with Johnson economic advisor Walter Heller, who said that opinion now took it "for granted that the government must step in to provide the essential stability [of the economy] at high levels of employment and growth that the market mechanism, left alone, cannot deliver."
By the beginning of 1969, the U.S. had already finished its experiment: was it possible to have unemployment rates of four percent or below without accelerating infiation? The answer was reasonably clear: no. Average nonfarm nominal wage growth, which had fiuctuated around or below four percent per year between the end of the Korean War and the mid-1960s, was more than six percent during calendar 1968.
By the early 1970s the low-infiation low-unemployment Keynesian order had definitely broken down. As economist Robert Gordon wrote, looking back, "[t]his framework collapsed with amazing speed after 1967. My graduate school classmates and I were acutely aware of the timing of this turn of the tide, as we began our first teaching jobsand almost immediately found our graduate school education incapable of explaining the evolution of the economy." Kennedy and Johnson economic advisors had argued that a substantial reduction in unemployment could be achieved with only a moderate increase in infiation. But as Vietnam War spending overheated the economy from 19661969, unemployment did not drop much and infiation accelerated far beyond the expectations of Keynesian analysts.
The newly-elected Republican administration of Richard Nixon sought to move the economy back to the right end of the Phillips curve, and hoped to attain a cooling off of infiation at the cost of only a small increase in unemployment. But their policies only half worked: unemployment did indeed rise from 3 1/2 to almost 6 percent from 1969 to 1971, but infiation did not decline. The failure of infiation to fall led the Nixon administration to abandon its non-interventionist principles, and to impose stringent price controls for 90 days and then further "phases" of price and wage controls thereafter.
The period of price controls did see a small deceleration of infiation. It was, however, accompanied by a surge of demand pushed by an expansionary monetary policy: to some degree, the Federal Reserve misread how expansionary its policies were, and to some degree the Federal Reserve was anxious to please Nixon, who did not want to enter the 1972 election campaign season with a rising unemployment rate. Nixon recalled how in 1960 he and Arthur Burns--in 1972 Federal Reserve chairman--had gone to President Eisenhower, begged Eisenhower not to let unemployment rise during the 1960 year, and how Eisenhower had then turned him down.
Nixon had then lost the 1960 election to John F. Kennedy.
Thus President Nixon was extremely unwilling to back any moves toward placing reducing inflation ahead of reducing unemployment. Democrats in Congress agreed that Nixon's policies were too "deflationary". And Federal Reserve Chair Arthur Burns did not think that it was politically and economically possible in the early 1970s to fight inflation by inducing a recession.
Could such a reduction in inflation have been accomplished at the end of the 1960s? At a technical level, of course it could have. Consider infiation in the five largest industrial economies, the G-5. Before the breakdown of the Bretton Woods fixed exchange-rate system, the price levels in these five countries are loosely linked together. But the Bretton Woods system breaks down at the beginning of the 1970s, and thereafter domestic political economy predominates as infiation rates and price levels fan out both above and below their pre-1970 track.
West Germany was the first economy to undertake a "disinfiation." The peak of German infiation in the 1970s came in 1971: thereafter the Bundesbank pursued policies that accomodated little of supply shocks or other upward pressures on infiation. The mid-1970s cyclical peak in infiation was lower than the 1970-71 peak; the early-1980s cyclical peak in West German infiation is invisible. Japan began its disinfiation in the mid-1970s, in spite of the enormous impact of the 1973 oil price rise on the balance-of-payments and the domestic economy of that oil import-dependent country.
The other three of the G-5--Britain, France, and the United States--waited until later to begin their disinfiations. France's last year of double-digit infiation was 1980. Britain's last year of double-digit infiation was 1981. Certainly there were no "technical" obstacles to making the burst of moderate infiation the U.S. experienced in the late 1960s a quickly-reversed anomaly.
But Arthur Burns had no confidence that he could reduce inflation at a price in terms of higher unemployment that the economy was willing to pay. In 1959 Arthur Burns had given his presidential address to the American Economic Association. His presidential address was called, "Progress toward Economic Stability." Burns spent the bulk of his time detailing how automatic stabilizers and monetary policy based on a better sense of the workings of the banking system had made episodes like the Great Depression of the past extremely unlikely.
Toward the end of his speech, Burns spoke of an unresolved problem created by the progress toward economic stability that he saw: "a future of secular infiation":
During the postwar recessions the average level of prices in wholesale and consumer markets has declined little or not at all. The advances in prices that customarily occur during periods of business expansion have therefore become cumulative. It is true that in the last few years the federal government has made some progress in dealing with infiation. Nevertheless, wages and prices rose appreciably even during the recent recession, the general public has been speculating on a larger scale in common stocks, long-term interest rates have risen very sharply since mid-1958, and the yield on stocks relative to bonds has become abnormally low. All these appear to be symptoms of a continuation of infiationary expectations or pressures...
Before World War II such infiationary expectations and pressures would have been erased by a severe recession, and by the pressure put on workers' wages and manufacturers' prices by falling aggregate demand. But Burns could see no way in which such pressures could be generated in an environment in which workers and firms rationally expected demand to remain high and recessions to be short.
Burns's skepticism about the value of monetary policy as a means of controlling infiation in the post-World War II era was reinforced by the pressure for avoiding any significant rise in unemployment coming from his long-time ally, patron, and friend, President Nixon, and from the Democratic leaders of congress.
Arthur Burns played a key role in the Nixon administration's eventual adoption of a wage-price freeze in late 1971. The context was one of a Council of Economic Advisers averse to all forms of incomes policy, from guideposts on up, as "wicked in themselves and steps on the slippery slope... to controls"; of a President who "did not like 'incomes policies' and knew they did not fit with his basic ideological position"; and of an opposition party that had a "great interest in pointing out that there was another, less painful, route to price stability [than gradualism and recession], which Mr. Nixon was too ideological to follow." And Burns's intervention on the pro-controls side so that "every editorial writer who wanted to recommend some kind of incomes policy could say that 'even' Arthur Burns was in favor of it" led Stein to liken:
the administration...[to] a Russian family fieeing over the snow in a horse-drawn troika pursued by wolves. Every once in a while they threw a baby out to slow down the wolves, hoping thereby to gain enough time for most of the family to reach safety. Every once in a while the administration would make another step in the direction of incomes policies, hoping to appease the critics while the [gradualist] demand management policy would work. In the end, of course, the strategy failed and the administration made the final concession on August 15, 1971, when price and wage controls were adopted...
Rockoff (1984) finds nothing good in the 1971-1974 experience with controls. The controls did not calm infiationary expectations. Instead, they appear to have created them-with a general expectation that prices would rebound once the controls were lifted. The controls imposed the standard microeconomic, compliance, and administrative costs on the American economy. Perhaps most serious, the fact that wage and price controls were still in effect in the fall of 1973, when the price of oil jumped, created a substantial divergence between the cost of energy to U.S. users and the world price of energy, which slowed down the process of adjustment. Energy price controls remained, until eliminated as one of the good deeds of the Reagan administration in the early 1980s.
And perhaps the controls led to overoptimism, and hence to looser monetary and fiscal policy than would have otherwise been put in place, because of their apparent initial success.
If the apparent initial success of the Nixon controls program did lead to overoptimism about how much more monetary and fiscal restraint was necessary to contain infiation, the Nixon administration suffered less from such overoptimism than did its critics.Walter Heller, one o fhte most prominent Democratic economists of the early 1970s, testified before Joint Economic Committee on July 27, 1972 on how Nixon administration policy was too contractionary: "As I say, now that we are again on the [economic] move the voice of overcautious conservatism is raised again at the other [White House] end of Pennsylvania Avenue. Reach for the [monetary] brakes, slash the [fiscal] budget, seek an end to wage-price restraints."
And private-sector forecasters agreed. One of the striking features of the infiation of the 1970s was that increases in infiation were almost always unanticipated. The figure below plots the average forecast for the forthcoming calendar year, made as late in the year as possible, from the survey of professional forecasters alongside actual December-to-December GDP defiator infiation. In every single year in the 1970s, the consensus forecast made late in the previous year understated the actual value of infiation.
Even if the Johnson-era infiation had not already done so, the first Nixon administration destroyed investors', firms', and workers' confidence in the nominal anchors of the economy. Before the mid 1960's, infiation in the United States (outside of wartime) was something that academic economists worried, but was outside the realm of considerations important enough to enter the calculations of other people. As a result, the economy moved back and forth along the Phillips Curve-moving up and to the left with higher infiation and lower unemployment when total demand was high and wages rose, moving down and to the right with lower infiation and higher unemployment when total demand was low-which was set in its position because by and large investors, firms, and workers did not think that shifts in the rate of infiation were enough to worry about.
By the early 1970s this had changed: everyone knew that a raise or an interest rate of 6 percent over a year was no interest rate at all, because infiation ate away the whole increase. As a result, when demand was tight and workers could press for higher wage settlements, they would press for enough to cover expected infiation, plus a real wage increase-plus enough to cover the extra infiation that would come about in the economy as a whole because demand was tight. This meant that throughout the 1970's, any move to reduce unemployment would provoke an immediate upward jump in infiation and interest rates. President Carter thus went into--and lost--the 1980 election with 7 percent unemployment and 9 percent infiation. He was followed by a Republican administration that in many respects saw not only the 1970's but also the 1960's-and, indeed, the entire post-World War II Keynesian order-as a series of mistakes.
The End of Bretton Woods
There were two other major events in the early 1970's that in prospect were seen as sideshows, but that in retrospect played as large or larger a role in the end of the great post-World War II Keynesian boom as the erosion of the Phillips Curve. The first was the casual destruction of the Bretton Woods arrangements, which had preserved almost all of the benefits of fixed exchange rates while granting the fiexibility to change exchange rates to adjust to major economic shifts that the gold standard had lacked. The system posed an obstacle to Nixon's and Treasury Secretary John Connally's plans to use price controls to reduce infiation while reducing unemployment to increase the chances of reelection: the resulting large trade deficit would either require higher interest rates to finance the balancing infiow of capital--which would tend to raise unemployment--or devaluation. Under the Bretton Woods system the United States could not devalue without the agreement of other countries because all other countries defined their currencies as given fractions or multiples of the dollar, and this agreement was not readily forthcoming. So it was abandoned and the U.S. forced the move to the current system of freely-fioating exchange rates, which has not served the world economy well.
Thus there is a very real sense in which monetary policy did not contain infiation in the early 1970s because it was not tried. And it was not tried because the Chairman of the Federal Reserve did not believe that it would work at an acceptable cost. Even the threatening breakdown of the fixed exchange rate system, which Burns "feared... with a passion," would not induce Burns to tighten sufficiently to risk a more-than-moderate recession. Paul Volcker reports an "interesting discussion with Arthur Burns" over lunch at the American embassy in Paris, at which "the Chairman of the Federal Reserve Board made one last appeal" to retain a system of fixed exchange rates (see Volcker and Gyohten (1992)). Volcker reports that:
To me, it simply seemed too late, and with some exasperation I said to him "Arthur, if you want a par value system, you better go home right away and tighten money." With a great sigh, he replied, "I would even do that..."
The Oil Shock
The second event was the tripling of world oil prices in the fall of 1973. This sent the world economy into a major recession accompanied by rapid infiation, and pushed the world economy toward a much more energy-conserving pattern of production. Somewhat paradoxically, the rational-expectations school of economics that would have given advance warning of the breakdown of the Phillips Curve, and had as a result become dominant, believed that the tripling of world oil prices was macroeconomically irrelevant: the oil price would rise, other prices would fall, and the overall price level would be unaffected because the general price level was determined by the money supply and not by decisions of producers of individual commodities to raise prices. The tripling of oil prices sent the world economy into one of the deepest recessions of the post-World War II period, and left the economy with the legacy of high infiation that would in its turn lead to the 198082 recession, the deepest of the post-World War II era.
It is possible that the tripling of world oil prices was an intended result of U.S. foreign policy. Nixon's chief foreign policy advisor, Henry Kissinger, wanted to strengthen the shah of Iran as a possible counterweight to Soviet infiuence in the middle east. With the oil price tripled, the shah was indeed immensely strengthened-at the price of enormous economic damage to the industrial west and to the rest of the developing world, which saw its oil bill multiplied manyfold. It is certain that the economic repercussions of the oil price rise came as a surprise to the Nixon administration-Kissinger always thought economic matters were boring and unimportant in spite of the fact that the military and diplomatic strength of the United States depended on and should have been used to safeguard the liberty and prosperity of the United States.
It is most likely that the oil price rise struck the administration as not worth its concern, and certainly as not worth trying to roll back--it did, after all, strengthen the shah, few had any conception of the economic damage it might do, and those few were not listened to by the U.S. government.
Alan Blinder, Vice Chair of the CEA and of the Federal Reserve in the 1990s, argued that double-digit infiation in the 1970s had a single cause: supply shocks that sharply increased the nominal prices of a few categories of goods, principally energy and secondarily food, mortgage rates, and the "bounce-back" of prices upon elimination of the Nixon controls program. Such shocks were arithmetically responsible for, in Blinder's words, "the dramatic acceleration of infiation between 1972 and 1974....The equally dramatic deceleration of infiation between 1974 and 1976....[And] while the rate of infiation.... rose about eight percentage points between 1977 and early 1980, the 'baseline'... rate may have risen by as litle as three."
Arithmetic decompositions of the rise in infiation into upward jumps in the prices of special commodities were never convincing to those working in the monetarist tradition. As Milton Friedman asked:
The special conditions that drove up the price of oil and food required purchasers to spend more on them, leaving them less to spend on other items. Did that not force other prices to go down, or to rise less rapidly than otherwise? Why should the average [emphasis in original] level of prices be affected significantly by changes in the price of some things relative to others? (Friedman (1975), cited in Ball and Mankiw (1995))
But the missing link in Blinder's argument can be provided by noting that the oil price increase entailed large increases in the prices of goods in a few concentrated sectors. They reduce nominal demand for products in each unaffected sector by a little bit. Small administrative or information processing costs might plausibly prevent full adjustment in many of the unaffected sectors, leaving an upward bias in the overall price level. Concentrated shocks that are (a) significantly larger than the average variance of shocks but (b) not so large as to require relative price movements that overwhelm administrative and information processing costs in all sectors appear to have the best chance of generating large upward boosts in infiation.
The Productivity Slowdown
- Possible causes
- The oil shock
- Environmental spending
- The exhaustion of the Great Depression's backlog of inventions
- A low pressure economy
- Politics turns nasty
- The crisis of the social welfare state
The Late 1970s
Each surge in infiation was quickly followed by--or in the case of the mid-1970s oil shock infiation cycle roughly coincident with--an increase in unemployment. Once again, each cycle in the late 1960s and 1970s was larger than the one before: unemployment peaked at around 6 percent in 1971, at about 8.5 percent in 1975, and at nearly 10 percent in 1982-83.
The recession of 1974-1975 made it politically dangerous to be an advocate of restrictive monetary policy to reduce infiation. Near the trough of the recession, Hubert Humphrey and Augustus Hawkins sought to require that the government reduce unemployment to 3 percent within four years after passage, that it offer employment to all who wished at the same "prevailing wage" that Davis-Bacon mandated be paid on government construction projects, and (in its House version) that individuals have the right to sue in federal court for their Humphrey-Hawkins jobs if the federal government had not provided them. In early 1976 the National Journal assessed its chances of passage as quite good-though principally as veto bait to create an issue for Democrats to campaign against Gerald Ford, rather than as a desirable policy.
Arthur Burns tried to avoid getting sucked into what he saw as a no-win situation:
Humphrey-Hawkins... continues the old game of setting a target for the unemployment rate. You set one figure. I set another figure. If your figure is low, you are a friend of mankind; if mine is high, I am a servant of Wall Street.... I think that is not a profitable game... (Wells (1994))
Humphrey-Hawkins eventually generated significant opposition from within the Democratic coalition. Labor would not support the bill unless Humphrey-Hawkins jobs paid the prevailing wage (fearing the consequences for unionized public employment if the "prevailing wage" clause was dropped); legislators who feared criticism from economists'--even Democratic economists'--judgment that Humphrey-Hawkins was likely to be very infiationary would not support the bill unless the "prevailing wage" clause was removed.
The bill that finally passed and was signed in 1977:
- Set a target of reducing unemployment to 4 percent by 1983.
- Elevated price stability to a goal equal in importance to full employment.
- Set a goal of zero infiation by 1988.
- Called for the reduction of federal spending to the lowest level consistent with national needs.
- Required the Federal Reserve Chairman to testify twice a year.
In other words, the bill that was signed did nothing.
Economists' instincts are that uncertainty about current prices, future prices, and the real meaning of nominal trade-offs between the present and the future; distortions introduced by the failure of government finance to be infiation-neutral; windfall redistributions and the focusing of attention not on preferences, factors of production, and technologies but on predicting the future evolution of nominal magnitudes must degrade the functioning of the price system and reduce the effectiveness of the market economy at providing consumer utility. The cumulative jump in the price level as a result of the infiation of the 1970s may have been very expensive to the United States in terms of the associated reduction in human welfare.
By the end of the 1970s average nominal wage growth was some eight percent per year rather than six percent per year, and the wedge between nominal wage and nominal price growth had vanished as a result of the productivity slowdown. Thus Paul Volcker and his Open Market Committee at the end of the 1970s faced the problem of how to slow the rate of nominal wage growth, and thus the rate of core infiation, by some five percentage points per year or so. Arthur Burns and his Open Market Committee at the beginning of the 1970s faced the problem of how to slow the rate of nominal wage growth, and thus the rate of core infiation, by two percentage points per year or so.
Such a permanent deceleration in nominal wage growth might have been accomplished by shifting infiationary expectations downward directly (so that a lower rate of nominal wage increase would have been associated with the same rate of increase in real wages), or by triggering a recession sufficiently deep and sufficiently long that fear of future excess supply in the labor market would restrain demand for rapid wage increases.
Nevertheless the existence of Humphrey-Hawkins, and the consequent commitment of first the Carter administration and then Carter's selection as Arthur Burns's successor, G. William Miller, to returning the economy to full employment had unpleasant consequences. To a small degree it was a matter of bad luck: senior Carter economic officials have talked of the year "when our forecasts of real GNP growth were dead on-only the productivity slowdown meant that the end-of-year unemployment rate was a full percentage point below where we had forecast." To a larger degree it was the result of the lack of interest and focus in the Carter White House on infiation, in spite of efforts by economists like Charles Schultze to warn that infiation was likely to suddenly become a severe surprise problem in 1979 and 1980 unless a strategy for dealing with it was evolved earlier.
Infiation did become a surprise severe political problem in 1979. And this generated the only episode in history in which a Council of Economic Advisers Chairman (Charles Schultze) and a Treasury Secretary (Michael Blumenthal) waged a campaign of leak and innuendo to try to get the Federal Reserve Chairman (G. William Miller) to tighten monetary policy (Kettl (1986)).
No one is willing to say a good word about G. William Miller's tenure as Chairman of the Federal Reserve. He lasted sixteen months, and then replaced Michael Blumenthal as Secretary of the Treasury.
G. William Miller's successor as Chairman of the Federal Reserve Board was Paul Volcker.
The Volcker Disinflation
Could the Volcker disinfiation have been undertaken earlier? Had Gerald Ford won reelection in 1976 and reappointed Arthur Burns, would we now speak of the Burns disinfiation? Or would the same political pressures that had driven Nixon into wage and price controls have driven a second Ford administration into an overestimation of the available room for economic expansion? Herbert Stein, at least, is skeptical: "We do not know whether a Ford administration...kept in office... would have persisted" in a course that would have kept infiation declining, "...but we do know that the basis for the persistence of such a course had not been laid." And he attributes the failures of the Carter administration and the Carter-era Federal Reserve at infiation control "not... chiefiy a refiection of the personalities involved... [but] a response to the prevailing attitude in the country about the goals of monetary policy." In Stein's opinion the Federal Reserve did not as of the mid-1970s have a mandate to do whatever turned out to be necessary to curb infiation.
Examine the price level in the United States over the past century. Wars see prices rise, by more than fifteen percent per year at the peaks of wartime and decontrol infiation. The National Industrial Recovery Act and the abandonment of the gold standard at the nadir of the Great Depression generate nearly ten percent infiation. But aside from wars and Great Depressions, at other times infiation is almost always less than five and usually two to three percent per year-save for the 1970s.
The 1970s were the world's only peacetime outburst of infiation in this century. The 1970s was the only era in which business enterprise and financing transactions were also "speculation[s] on the future of monetary policy" (Simons (1947)) and concern about infiation was an important factors in nearly all business decisions.
The truest cause of the 1970s infiation was the shadow of the Great Depression. The memory left by the Depression predisposed the left and center to think that any unemployment was too much, and eliminated any mandate the Federal Reserve might have had for controlling infiation by risking unemployment.
The Federal Reserve gained, or regained, its mandate to control infiation at the risk of unemployment during the 1970s as discontent built over that decade's infiation. It is hard to see how the Federal Reserve could have acquired such a mandate without an unpleasant lesson like the infiation of the 1970s.
Thus the memory of the Great Depression meant that the U.S. was highly likely to suffer an infiation like the 1970s in the post-World War II period-maybe not as long, and maybe not in that particular decade, but nevertheless an infiation of recognizably the same genus.
At the surface level, the United States had a burst of infiation in the 1970s because no one--until Paul Volcker took office as Chairman of the Federal Reserve--in a position to make anti-infiation policy placed a sufficiently high priority on stopping infiation. Other goals took precedence: people wanted to solve the energy crisis, or maintain a high-pressure economy, or make certain that the current recession did not get any worse. As a result, policy makers throughout the 1970s were willing to run some risk of non-declining or increasing infiation in order to achieve other goals. After the fact, most such policy makers believed that they had misjudged the risks: that they would have achieved more of their goals if they had spent more of their political capital and institutional capability trying to control infiation earlier.
At a somewhat deeper level, the United States had a burst of infiation in the 1970s because economic policy makers during the 1960s dealt their successors a very bad hand. Lyndon Johnson, Arthur Okun, and William McChesney Martin left Richard Nixon, Paul McCracken, and Arthur Burns nothing but painful dilemmas with no attractive choices. And bad luck coupled with bad cards made the lack of success at infiation control in the 1970s worse than anyone had imagined ex ante.
At a still deeper level, the United States had a burst of infiation in the 1970s that was not ended until the early 1980s because no one had a mandate to do what was necessary in the 1970s to push infiation below four percent, and keep it there. Had 1970s Federal Reserve Chairman Arthur Burns tried, he might well have ended the Federal Reserve Board as an institution, or transformed it out of all recognition. It took the entire decade for the Federal Reserve as an institution to gain the power and freedom of action necessary to control infiation.
And at the deepest level, the truest cause of the infiation of the 1970s was the shadow cast by the Great Depression. The Great Depression had made it impossible for almost anyone to believe that the business cycle was a fiuctuation around rather than a shortfall below some sustainable level of production and employment. An economy would have to have some "frictional" unemployment, perhaps one percent of the labor force or so, to serve the "inventory" function of providing a stock of workers looking for jobs to match the stock of vacant jobs looking for workers. An economy might have some "structural" unemployment. But there was no good theory suggesting that either of these would necessarily be a significant fraction of the labor force. Everything else was "cyclical" unemployment: presumably curable by the expansionary policies that economists would now prescribe in retrospect for the Great Depression.
Sooner or later in post-World War II America random variation would have led the economy to fall off of the tightrope of full employment and low infiation on the over-expansionary side. Although there was nothing foreordained or inevitable about the particular way in which America found itself with strong excess aggregate demand at the end of the 1960s, it was foreordained and inevitable that eventually some combination of shocks would produce a macroeconomy with strong excess demand. And once that happened--given the shadow cast by the Great Depression--there was no institution with enough authority, power, and will to quickly bring infiation back down again.
It took the decade of the 1970s to persuade economists, and policy makers, that "frictional" and "structural" unemployment were far more than one to two percent of the labor force (although we still lack fully satisfactory explanations for why this should be the case). It took the decade of the 1970s to convince economists and policy makers that the political costs of even high single-digit infiation were very high. Once these two lessons of the 1970s had been learned, the center of American political opinion was willing to grant the Federal Reserve the mandate to do whatever was necessary to contain infiation. But until these lessons had been learned, it is hard to see how the U.S. government could have pursued an alternative, earlier, policy of sustained disinfiation in response to whatever shocks had happened to create chronic excess demand.
A mandate to fight infiation by inducing a significant recession was in place by 1979, as a result of a combination of perceptions and fears about the cost of infiation, worry about what the "transformation of every business venture into a speculation on monetary policy" was doing to the underlying prosperity of the American economy, and fear that the structure of expectations was about to become unanchored and that permanent double-digit infiation was about to become a possibility.
But the process by which the Federal Reserve obtained its informal mandate to fight infiation by inducing significant recession was a slow and informal one. Part of its terms of existence require that it never be made explicit. It is difficult to imagine it coming into being-and thus the Federal Reserve's "independence" being transformed from a quirk of bureaucratic organization into a real and powerful feature of America's political economy-without some lesson like that taught by the history of the 1970s.
Today many observers would say that the costs of the Volcker disinfiation of the early 1980s were certainly worth paying, comparing the U.S. economy today with relatively stable prices and relatively moderate unemployment with what they estimate to have been the likely consequence of business as usual: infiation slowly creeping upward from near ten toward twenty percent per year over the 1980s, and higher unemployment as well as infiation deranged the functioning of the price mechanism. In the U.S. today infiation is low, and the reduction of infiation to low single-digit levels has been accomplished without the seemingly permanent transformation of "cyclical" into "structural" unemployment seen in so many countries of Europe.
Nevertheless, other observers believe that their ought to have been a better way: Perhaps infiation could have been brought under control more cheaply by a successful incomes policy made up of a government-business-labor compact to restrain nominal wage growth (which certainly would have been in the AFL-CIO's interest, as it is harder to think of anything worse for that organization's long-term strength than the 1980s as they actually happened). Perhaps infiation could have been brought under control more cheaply by a Federal Reserve that did a better job of communicating its expectations and targets; but note that the dispute over whether "gradualism" (in the sense of the British Tory Party's Medium-Term Financial Strategy; see Taylor ()) or "cold-turkey" (see Sargent (1982)) was the most cost-effective way of reducing infiation has not been resolved; it is hard to fault those who made economic policy decisions when even those economists with ample hindsight do not speak with one voice.
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