govtwork     /   How To Understand Inflation   Mail this page     
United States of America
Congressional Record
Proceedings and Debates of the 96th Congress, Second Session
Vol. 126 WASHINGTON, MONDAY, NOVEMBER 17, 1980 No. 160



* Mr. RIBICOFF. Mr. President, on Sunday. November 16, 1980, funeral services were held in West Hartford, Conn. for Sarai Ribicoff, beloved daughter of my brother, Irving Ribicoff, and his wife, Belle, and sister of Dara. Casey and I, together with my children and grandchildren, mourn Sarai's death deeply and extend all our love and sympathy to Belle, Irv, and Dara. Sarai was an exceptional person of great spirit, personality and intellectual attainments.

Everyone who knew her remembers her lovingly for her warmth, her great humor and life-giving quality. In her short 23 years her achievements throughout school, college and in the newspaper field were significant and constructive. Her passing will leave a deep void not only for her family and friends but for the future betterment of the world. Rabbi Howard Singer of the Emanual Synagogue conducted the service with great sensitivity that reflected the essence of Sarai. I include his sermon in the RECORD together with inserts from the service:


I must begin with the kind of simple and honest statement she would have appreciated: I didn't know Sarai Ribicoff.

Last night, I went to the Ribicoff home to talk to her parents, whom I know very well indeed. There were a great many people there. People who had worked with her on the newspaper. Young people who had gone to Yale with her. Young people who were with her in high school. I talked to them. I looked through some correspondence that the Ribicoffs had received about her. I was handed some things that Sarai, herself had written. I went home and read it all. And when I was finished I had enough to do what the Ribicoffs wanted done: They don't want me to offer religious explanations, which do not explain, or even to express grief and rage which are obvious and conventional reactions. What they wanted was for me to evoke their daughter's personality today. I respect and admire that. What emerged from my reading and listcning was a sharp awareness of three of Sarai's qualities, each somehow supplementing and supporting the others. The most striking, of course, was that she was very, very bright. Let me lovingly cite the evidence:

A letter written in October of this year by the Associate Editor of the Los Angeles Herald Examiner, to the Committee in charge of granting Rhodes Scholarships for study abroad.

October 30, 1980
Frank D. Tatum, Esq.,
Cooley, Goodward. Castro, Huddleston & Tatum
One Maritime Plaza, San Francisco, Calif.

DEAR SIR: This is a letter in support of the application of Sarai K. Ribicoff, who is applylng for a two-year Rhodes Scholarship for study in philosophy, poltics and economics in England.

Let me start by saying how much I hope the Committee is able to grant Sarai the scholarship. There is almost nothing she needs more at this utterly early stage of her life than the broadening and deepening that would surely occur from two years study at Oxford or Cambridge.

Sarai at the moment may be the most intelligent 23-year-old person I've met. She is more than a quick study; she is a thorough study. She is more than brilliant; she is keenly perceptive.

About 9 months ago I was able to move her off the City Desk and onto the editorial page. She instantly developed from a promising talent to a star. Her series of editorials on inflation in the U.S. caught the attention of the Federal Reserve Board of San Francisco, was distributed by the Hearst Corp. to the L.A. school district, and probably will win some national awards. It was so good I wish I had written it myself. I never could have written it at 23. I console myself by applaudlng that I had the good luck to assign her to it.

Out of the series, Sarai developed an intense and scholarly interest in economics and in the art of explaining the complex issues of economic policy and theory to the general reader. Alas, Sarai has developed now about as far as she can - and about as far as I can help her. The next quantum-leap in intellectual development must come from a sustained, well-laid out plan of graduate studies.

In this letter, I am in essence hoping to help create an opportunity for Sarai that will compel her to leave the Herald Examiner, where she is clearly the most outstanding young talent at the newspaper. I do so a bit reluctantly, but necessarily, for if American journalism is to improve the state of its art, it must support the further education and development of a rare talent like Sarai's.

A final word: One will not meet a more thoughtful, compassionate and serious-minded young citizen than Sarai. She has tremendous personal qualities, and a steely integrity that will help her chart a sane course through life. What she does not have - despite a cosmopolitan family background, Yale, and experience at a major metropolitan newspaper - is precisely the sort of philosophical broadening and unsettling that a PP&E program would provide. I want to see her assumptions challenged, tested and even strained. I want her to have the experience of battering her well-thought-out ideas against differing pbilosophical points of view that may be even better thought out. I'd like to see Sarai lose a few arguments - not by close decisions (the best I've been able to do) but by knockouts. Then I'd like her to come back to the U.S., work here, or at Time magazine, or the Washington Post, or CBS News - wherever - and demonstrate, as I am willing to bet she will, that she is the finest economics journalist in the United States.

With your help, that goal is very readily achievable. Sarai is a tremendous talent.

Associate Editor,
Los Angeles Herald Examiner.

When I finished the correspondence, I read Sarai's series on, "How to Understand Inflation." It is splendidly written. It glows with intelligence. Good writing is only clear thinking. I sat up half the night reading and rereading Sarai's piece. I compared her piece with two college texts on Economics, Samuelson and Gerstembers; I looked up the same topics in them. She made the dismal science not only comprehensible but lively. I fully understand her editor's enthusiasm.

The second quality: She was solid, mature. practical, far beyond her years. This impression on solidity came to me from her classmates. In every class there is usually one student around whom opinions are likely to coalesce: One student who seems to know, earlier than others, what he or she wants to do with life; one who stimulates classmates to think about their own directions. Apparently she was that student. I quote: 'She was always hard on you. She would never let you get away with sloppy thinking. And she was always learning. Always.'

The third quality, much harder to establish, is a kind of playfulness. That did not come naturally. Apparently she had to give herself permission to relax, to stop trying to take everything too serIously. But in recent years she had begun giving herself that permission more often. I'll cite only one minor and gentle example. It concerns the Rhodes Scholarship application. Among the documents she needed was a copy of her birth certificate. She wrote for it but the Clerk at the Bureau made a typing error, put down male, instead of female. She had to send them back, and her father eventually sent out the corrected copies. Whereupon she wrote a postcard, which reads as follows:

DEAR DADDY: Thanks for the birth certificates. I am glad to find out I am not, after all, a male. I would have to buy all new clothes and everything.

Much love,

Much love, she loved music, and she loved Robert Frost's poems. She enjoyed playing the flute. It is no disrespect to say that she wasn't very good at it. She enjoyed It, but she was far from expert. There was, I understand, one particular note in her favorite piece that she could never hit just right. But she loved the flute, perhaps because it lends itself to the light and the playful.

I conclude by reading Robert Frost's poem entitled: 'Away.' He wrote in contemplation of his own death, and he manages to do it playfully. After I've finished you will hear one of her favorite flute pieces. It is the best way we know to evoke her spirit.

I leave behind
Good friends in town,
Let them get well-wined
And go lie down.

Don't think I leave
For the outer dark
Like Adam and Eve
Put out of the Park.

Forget the myth.
There is no one I
Am put out with
Or put out by.

Unless I'm wrong
I but obey
The urge of a song:
I'm - bound - away!

And I may return
If dissatisfied
With what I learn
From having died.

Mr. President. Sarai's gifts as a journalist were truly unique. During the course of her work on the Herald Examiner she wrote a series of articles, "How to Understand Inflation." For clarity, simplicity and understanding, they are beyond compare. These articles were reprinted widely and used as a text in the schools of Los Angeles as well as for the Federal Reserve Bank of San Francisco.

Her supervisor, Associate Editor Thomas Plate, said of her:

She was the brightest 23-year old writer I've ever met. She would have become a great newspaper editor or magazine editor or anything she wanted. To understate it, she was easily one of the brightest people on any paper in the country, and certainly at the Herald Examiner.

He said Ms. Ribicoff had recently written a series of editorials on inflation that won praise as a significant work on the economy from the Federal Reserve Bank of San Francisco, which recommended the series to member banks around the country. Mr. Plate also said she was "sincerely committed to social justice, caring - really an extraordinary individual and talent." I ask that these articles be printed in the Record:

The articles follow:

[ From the Los Angeles Herald Examiner, Sarai Ribicoff ]


This is an editorial you probably won't understand, but don't blame yourself. The inflation crisis is filled with more esoteric terminology than the SALT II issue. Here are the terms you probably don't understand all that clearly - read on, and then we'll tell you why:

Soaring inflation is with us now as a result of our historical (1) monetary and fiscal policies. For one thing, growth in (2) the money supply has too much money chasing too few goods. For another, a rising (3) federal deficit continues to fuel demand even though (4) the Consumer Price Index is rising and (5) productivity has begun to fall. These factors worsen our position on (6) the Phillips Curve (also known as the Index of Economic Discomfort) as we move into our second decade of (7) stagflation.

To counter the inflationary component of our economic ills, the Carter administration has created a serious (8) recession. The administration is resisting pressure to adopt (9) wage and price controls, and many are recommending the adoption of (10) incomes policies instead.

In the short-term, (11) the bond market will certainly respond to inflation-fighting steps, as will (12) the Dow Jones Industiral Average.

Still unclear is whether these policies will have a good effect on (13) the savings rate and (14) capital formation, both necessary for economic improvement in the long term.

Meanwhile, (15) exchange rates add uncertainty by fluctuating and (16) the balance of payments remains hostage to the energy crisis. In the interests of stability. some have even begun to urge a return to (17) the gold standard.

The way we choose to remedy these problems will depend on whether (18) the supply-siders or (19) the post-Keynesians are in charge of economic policy. But some say there can be no real remedy until we face up to (20) the inflationary bias of the American economy.

Got all that?

If you have, then you won't need to read this series of editorials. Titled "Mystery Inflation Terms," it should help you chart a clear path through the terminological jungle of the inflation crisis. We hope you find the series helpful. And drop us a line it there are any questions we haven't answered.


Monetary and fiscal policy, although always mentioned in the same breath as a sort of matched pair of economic bookends, are actually not much alike, although their relationship was established early on. Monetary policy controls the supply of money, and therefore its cost (interest rates) to those who want to borrow it. When demand is high, restricting the money supply limits economic expansion.

In its modern form, monetary policy is a government instrument, controlled by the Federal Reserve Bank, but at its inception - in England in the 18th century - it was an outgrowth of the private central bank. The Bank of England, among other historic innovations, was the first institution to consolidate control over a national currency as we know it, in the form of bank notes. This meant that the men who ran the bank could control the amount of money in circulation and thus, in theory, stop inflationary expansions.

Fiscal policy, at this time, was in a far more rudimentary form, bearing little resemblance to the elaborate array of programs, grants, contracts and taxes that government now oversees. Instead, it was limited to the government's methods of raising revenue - chiefly through taxes and tariffs - in order to support its own functions, the most expensive of which was fighting wars. Yet even in this form, the government of England was able, at the time, to challenge the Bank's monetary policy. In order to wage war against the colonies and, later, Napoleon, the British government demanded loans from the Bank in escalating amounts. Despite the Bank's theoretical control, it acceded; inflation took hold and persisted until the wars (and the demand for loans) ended, 40 years later. Theory aside, monetary authorities have nearly always exercised highly imperfect control and generally have to give way to government policy objectives even when that means sacrificing economic stability. In today's struggle against inflation - depending on the outcome - we may be witnessing an historic reversal.

In America, fiscal policy began to take its modern shape during the '30s, when the ideas of the British economist John Maynard Keynes began to be applied to remedy the Depression. Keynes argued that merely expanding the money supply was not enough to counteract a deflationary slump. (Some economists liken increasing the supply of money when there is no demand for it to "pushing on a string"; i. e., it doesn't work.) What was needed, he said, was for the government itself to spend, in order to create the demand that would stimulate economic growth. Keynes's ideas, never fully implemented during the '30s, were validated when financing U.S. participation in World War II provided the necessary fiscal stimulus to recover from the Depression.

The sustained growth trend that the economy took off on after World War II elimiated the need for massive government spending to control unemployment, which has not since reached Depression levels. Instead, beginning with the establishment of the Council of Economic Advisers to the President in 1946, economists assigned monetary and fiscal policies the task of stabilizing the economy, keeping it on a path of steady growth and avoiding a pattern of inflationary peaks and high-unemployment troughs. Unfortunately, fiscal policy instruments are better at stimulating growth to fight unemployment than at fighing inflation, and, as in the 18th century, the monetary policies that do work against inflation come with socially unacceptable costs. And so the goal of a stable economy has proved elusive.


Since 1913, when Congress established the Federal Reserve Bank of the United States, the Fed (as it has come to be known) has overseen U.S. money supply. This, as we shall see, is not the same thing as controllIng the money supply; the fine-tuning that monetary theory describes is, in practice, really a blunt instrument.

Money supply is simply the country's total stock of money: less simple is deciding what to include in that measurement, a problem over which economists are increasingly divided.

The major definitions of money supply in use are M1, which is the total of all coin and paper currency (outside banks) and checking accounts in banks; and M2, which includes Ml and adds time and savings deposits.

In order to measure the flow of money over time, economists multiply the figure for the total stock by the rate at which it is spent, known as income velocity.

When inflation, and therefore interest rates, are high, velocity is also high, because investors do not want to hold onto non-interest-bearing cash any longer than necessary. Modern innovations like bank computers, which greatly speed up the rate of transactions, increase the amount of money that can be spent in a given period even if actual supply is steady, further complicating measurement and, therefore, control.

The majority of private commercial banks and, as of this year, thrift institutions like S&Ls, belong to the Fed. Membership in the Fed requires them to keep reserves - a set percentage of their deposits, ranging from 7 percent to l6 1/4 percent for commercial banks, depending on the size of their assets - on deposit.

The reserves are known as high-powered money because they create other deposits in the system. The way this works is that when a bank with a 10 percent reserve requirement gets $1,000, for example, only $100 is held as reserves, while $900 of the amount goes into circulation.

The $900 thus goes to another bank, which keeps $90 of it as reserves and puts $810 into circulation, which goes to another bank, and so on, until the original $1,000 has multiplied many times. In this way, growth in reserves increases the money supply.

The Fed adds to or subtracts from reserves through the use of three policy instruments:

1. Open-market operations. To reduce the money supply, the Fed sells government bonds on the financial market. Buyers' checks are made out to the Fed, which takes the money from the buyer's bank's reserves. (To expand the money supply, the Fed buys up government bonds, depositing the purchase prices in member banks' reserves.) Decisions on whether and how much to buy and sell are made by the Fed's 12-member Federal Open Market Committee, consisting of the seven Federal Reserve Board members and representatives from 5 of the Fed's 12 regional branch banks.

2. Discount-rate policy. The discount rate is what the Fed charges member banks for funds they borrow to increase their reserves. (The prime rate is what banks charge their most creditworthy customers for short-term loans. The prime rate and market-interest rates fluctuate with the discount rate.) The Fed raises the rate at the "discount window" when it wants to discourage borrowing, generally some time after it has begun contractionary open-market operations.

3. Changing reserve requirements. This is a powerful weapon that can take huge amounts of money out of circulation. It is therefore seldom used.

When the Fed allows money supply to grow according to demand - rather than letting interest rates rise high enough to reduce demand for money - it is said to he following an accommodative policy. This is, in fact, its usual policy, for which it has been roundly condemned by monetarist economists, who maintain that if money supply growth were kept steady, prices could not rise at a faster rate. In an oversimplified form, monetarist theory rests on the premise that prices will be held down if there isn't enough money in the system to meet them. Conversely, some anti-monetarist economists hold that increases in the money supply merely follow price increases, because, they say, monetary policy doesn't control the economy but only supports it.

Mainstream economists, however, say the problem with tight money policies is only that they work too well. Severe restrictions make credit ruinously expensive to obtain or even unobtainable. The economy does slow down as a result. But rather than forcing prices down, this merely cuts into growth and investment, showing up soonest in credit-dependent sectors like the housing industry and next as rising unemployment.

A purely monetary disinflation - that is, continued restriction on money supply growth until inflation is cut back - might subject us to 10 percent unemployment for 15 years, with correspondingly serious social and economic costs. One of the consequences of such a policy, which we'll be discussing again later in the series, would be further concentration of corporate market power and resistance to competitive pressure as smaller firms were forced out of business by the hard times.


Technically, the federal deficit is the difference between what the government earns (in tax revenues) and what it spends. Philosophically, the existence of a deficit is not the root of all economic evil, nor is it necessarily the sign of a profligate administration that is spending beyond the country's means. This is because fiscal policies have two functions. One is the achievement of social policy goals like providing schools, defense and (a goal that has evolved gradually since the '30s) subsistence levels of food, clothing and shelter to those who need them. Critics who point to the size of the deficit ($40 billion in 1980) as an indication that we are spending too much to achieve those goals overlook the second function of fiscal policy, which is to stabilize the economy.

When the economy is weak, the deficit is meant to rise automatically; higher unemployment, for example, means both fewer income tax receipts and higher payouts in unemployment benefits. In more prosperous times, automatically rising tax revenues and lower spending are meant to wipe out the deficit. This is know as "leaning against the wind"; the principle is to use the implicit energy of fiscal spending - which affects output, employment and overall economic health - to cap economic peaks and cushion downturns.

There are, however, at least two-and-one-half reasons why fiscal policy works better as a cushion than a cap. 1.) Because a large proportion of fiscal spending has social-policy rather than stabilization goals, a lot of money is pumped into the economy even when demand is high, a particularly sore problem when rapid inflation accompanies high unemployment. 2) While stimulative fiscal moves like tax cuts are politically popular, restrictive moves like tax increases never are. Thus, it took Lyndon Johnson two years to propose and then to obtain from Congress the 1968 income tax surcharge that was supposed to offset rising military spending for Vietnam. The surcharge came too late to halt the inflationary surge underway by then; that was halted later, by the 1970-71 recession.

This brings us to a related problem with the deficit, only half attributable to fiscal policy. 2 1/2) When the task of curbing inflation is handed over, by default, to the Fed. the anti-inflationary economic contractions induced by tight money raise unemployment and lower national output, thereby increasing the deficit as well. The 1980 recession, for example, is turning the balanced budget promised by President Carter for 1981 into a budget with a $60 billion deficit.

To counteract these structural flaws, some economists recommend establishing a fiscal authority equivalent to the Fed and putting at its disposal a sharpened set of fiscal tools to be used for anti-inflationary stabilization. These include: (1) temporary tax increases that would be subject to Congressional veto but not to the long budgetary approval process that now effectively removes tax increases from the fiscal policy arsenal; (2) temporary excise taxes on consumer durables (cars, washing machines), that could be imposed to discourage consumer spending for short periods; (3) increased corporate investment tax credits that could be temporarily suspended to discourage business spending for short periods (in a fairer and less drastic way than tight money policies now shoot for that goal).

The intent of all these measures is to allow the government to target taxing and spending. Otherwise, we'll have to choose between cosmetic budget cuts like Carter's, or spitting-into-the-wind policies like the 30-percent tax cut that Ronald Reagan endorses. Neither approach harnesses the considerable fiscal energy that exists to fight inflation.

Finally, a note about the national (or public) debt. Each yearly deficit is added to it, and we pay the interest on it in each year's federal budget. Additions to the debt are merely the government's decision that there is more to be gained in future economic health (and future taxable capacity) by spending now than there is to be lost by higher interest payments on the debt in the future. By financing rising output, the government's deficit-spending defies the analogy to a household with fixed resources living on borrowed money. And, in fact, the expense of interest charges on the national debt as a percentage of GNP is almost exactly the same now as it was in 1945.


When economists begin to discuss inflation, they often end up arguing about how to measure it before they even get to questions of how to control it. The most commonly used measurement of inflation - the Consumer Price Index - is what starts a lot of the arguments.

The Consumer Price Index is a comparative index that slates today's prices against prices In 1967. And when the Consumer Price Index rises, a staggering amount of public and private spending rises along with it, pulling inflation up all the more.

Union members with COLA (cost-of-living adjustment) clauses in their contracts, for example, get pay increases that vary with the index. The index also triggers increases in a raft of federal expenditures - federal employees' pension benefits, Social Security benefits, food stamps (which are tied to the food component of the index) and more. Government expenditures rise by about $1.5 billion for every one-point jump in the Consumer Price Index. Proponents of reducing the government's reliance on the index point out, for example, that just by tying Social Security increases to 85 percent rather than 100 percent of the Consumer Price Index the federal government would save $39.6 billion by fiscal 1985.

Technically, the index compares the overall price of a "market basket" of goods and services with the 1967 prices of roughly the same items. With base-year 1967 given a rating of 100, we are told, the Consumer Price Index rose to 242.5 In April, 1980. Most economists agree, however, that the index exaggerates the actual rate of inflation. Their main objections are these:

The exact selection of the different goods and services In the Consumer Price Index (how much meat and how many movies and what percentage spent on clothing) are based on a consumer expenditures survey taken in 1972, which does not very accurately reflect what we buy now. For example, gasoline prices were said to have led the way in the huge monthly increases we saw at the beginning of 1980. But we're not buying nearly as much gasoline as we did in 1972. The Consumer Price Index does compare the changing price of a constant standard of living. But the actual cost of living because of the adjustments we all make as prices change - isn't necessarily rising as fast.

Shelter services were said to be the co-leader of the 1980 increases, particularly the curge that brought the yearly inflation rate over 20 percent in the Los Angeles area during the first quarter of 1980. But some economists say that the weight given to housing costs in the total is too heavy, creating distortions when interest rates are rising. Thus, say some observers, it was the prime rate's spectacular rise to 18 percent that triggered the Consumer Price Index's similarly high rate of increase - because of escalating mortage costs - earlier this year. Now that high interest rates have brought down the demand for money and themselves begun to fall in response, the Consumer Price Index's yearly rate of increase has also dropped back - to about 12 percent - with little of the change in either direction having much to do with the real inflation rate.

It's obvious, then, that overstating the inflation rate is more than an arithmetical problem. First, to the extent that our economy is indexed to cope with inflation (COLA clauses are a prime example of indexing, but so are interest rates, which tend to float a few points above the inflation rate), we are indexed to a single indicator, the Consumer Price Index. Thus, its distortions are translated into real increases, which are exaggerated in the next month's announced increase, and so on.

In addition, behavior that is based on expectations of further inflation is a major contributor to what is called cost-push inflation, as businesses try to protect themselves from expected rises. It also contributes to plain old demand-pull inflation, as consumers demonstrated late in 1979 when they continued to spend, borrow, and spend more despite the Carter administration's efforts to slow down the economy. The reason? Based on expectations, buying seemed smarter than holding onto increasingly devalued money. The result? High demand combined with high interest rates brought the announced yearly inflation rate to 16.8 percent from January to March, before it began to taper off in April. The "core," or underlying rate, economists think, is about 10 percent. And that's more than high enough to worry about.


Productivity Is one of the simplest terms in our series; fortunately, it's also very important. Technically, productivity is a figure obtained by dividing the country's total output (Gross National Product, adjusted for inflation) by the total labor input (number of worker hours), which yields a rough measure of how efficiently we produce goods and services. Since 1945, U.S. productivity has increased at an average annual rate of 2.5 to 3 percent. Last year - for only the second time in 35 years - it declined, by 2.2 percent.

A decline in productivity raises the cost of goods and services (and therefore, prices) by increasing the number of paid hours that are needed to put out a given number of, say, widgets. But it doesn't necessarily mean that workers are goldbricklng.

Low productivity may mean, for example, that manufacturers are not using their plant capability fully but have not yet begun to lay off workers, which is why a productivity slowdown is taken as an indication of a coming recession. Our poor recent productivity record also reflects the reduced industrial efficiency that follows 15 years of rising inflation and low business investment.

Productivity is thus a key in the four easy steps from inflation to economic stagnation, as follows: 1) High interest rates discourage long-term investment. 2) Neglect of capital improvements shows up, after a time lag of several years, in decreased capacity and higher labor costs because of outmoded equipment and technology. 3) Industry can't meet demand without raising prices - because of both low production capacity and higher coats. 4) Inflation speeds up, worsening the bad investment climate and promising more inflation in the future because of further diminished capacity.

That's why much of the current discussion of inflation-fighting policies focuses on ways of increasing productivity. The aim is for supply to meet demand at lower cost. The Joint Economic Committee of Congress, in its 1980 report, identified increasing productivity as a fundamental economic goal and recommended these strategies, among others:

Developing a national energy policy to protect industry from the full effects of OPEC price increases.

Encouraging - through tax credits for research and development and capital investment, plus accelerated depreciation allowances for new plant and equipment - the construction of high-production industrial technologies.

Providing better transportation networks and public utilities for major industrial centers.

Preparing to shift out of - rather than protect - industries that cannot successfully meet foreign competition (a suggestion pointedly aimed at American steel and car manufacturers, the leaders in lobbying for protective legislation).

But the productivity-inflation relationship remains very much a chicken-and-egg question. While higher industrial efficiency might slow inflation over the long term, inflation must come down before productivity can be increased enough to affect prices. If inflation is high, businesses will continue to shy away from the high cost and uncertain outcome of long-term investment. Further, cost-push inflation (price shocks from OPEC and other raw-materials producers, higher wage demands and prices based on expectations of inflation, etc.) can easily wipe out the effects of a much larger increase in productivity than even the most energetic research and instant development could possibly bring about. Tax cuts that fuel demand-pull inflation (as would even corporate tax cuts, unless property directed) would do the same.


The Phillips Curve is a graphic illustration of the economic trade-off between inflation and unemployment. Discovered during the '50s by the late British economist A. W. Phillips, the curve doesn't explain anything; it merely illustrates the historical fact that forcing the economy below a certain rate of unemployment generally produces inflation. And that reducing inflation without raising unemployment is difficult.

Twenty years after Phillips, the late American economist Arthur Okum renamed the same set of tradeoff data the Index of Economic Discomfort. The 1980 statistics - 14 percent inflation and nearly 8 percent unemployment - puts us at 22 on the index, up considerably from the lowstakes game of the early '60s, for example, when 5 percent unemployment was accompanied by nearly no inflation. Why should we be moving ever upward from the ideal lower left corner of the long-term Phillips Curve graph (no inflation, low unemployment) into the higher and more discomforting tradeoff regions?

A careful look at the graph on the front page gives us some information about past economic cycles and the effects of the policies chosen to counter them. During the '50s, the Eisenhower administration ran a slack economy with relatively high unemployment. In response, Kennedy's Council of Economic Advisers set a goal of reducing unemployment to 4 percent, spurring the economy with the 1964 tax cut. But at the very low unemployment rates reached from 1966 to 1969, the economy began to overheat, and Johnson initially failed to offset rising welfare and defense expenditures with the tax increase his advisers recommended.

Nixon's price controls, imposed in mid-1971, checked the late '60s inflation surge with a recession. But Nixon didn't cool down the economy with complementary fiscal and monetary policies, and prices surged ahead as soon as the controls were removed in early 1973. The 1974-75 recession - the sharpest economic downturn since the Depression - also checked inflation temporarily, as the graph shows. What it doesn't show is the extent of the current downturn, which may well be even sharper than the last. If it isn't - and this is the sad fact - it won't bring inflation down much below 10 percent.

The slow upward spiral of the long-term Phillips Curve illustrates what we explained in the last two parts of this series. Based on expectations and declining industrial capacity, inflation becomes, to a large extent, self-perpetuating. Meanwhile, the tight money policies periodically instituted to fight inflation can only do so by slowing down the whole economy, further diminishing our productive capacity. And the recessions created by tight money are so painful that, as the chart shows, the downturns are usually reversed before inflation is under control. With economic stimulation, prices leap up, faster than people go back to work, and higher than before.

The Phillips Curve illustrates the symptoms of our low-growth, high-consumption economy. What it tells us is that fiscal and monetary policy cannot cope with the underlying problems. Anti-inflation policies treat symptoms but not the disease of economic ill health, and they have painful unintended side effects. They provide only inadequate and temporary solutions that must be replaced by major changes in our national behavior.


Our current problems of high unemployment and accelerating inflation were named 'stagflation' by economists several years before there was any consensus about how to get rid of them.

Economists were stymied because neo-classical economic theory - picturing an imperfect market system that could be controlled by careful fiscal and monetary planning - did not account for simultaneous symptoms of boom and bust. Sure, fiscal policy was good at stimulating demand to fight unemployment. And monetary policy was good at restraining demand if it was pushing prices up. But when the 1974-75 recession raised unemployment to 8.5 percent and still left us with 6 percent inflation, economists went back to the drawing board.

They emerged in two main groups. The larger group - dubbed supply-side economists - believes that we have stagflation because the economy isn't growing fast enough. After decades of low business investment, industry is unable to meet consumer demand without bottlenecks, shortages, and production inefficiencies that result in higher prices.

Some members of this group, the so-called radical supply-siders, blame nearly all our current problems on the restraints on economic activity that hold down supply. But mainstream economists, while admitting that growth is important, say that we can't possibly increase supply fast enough to solve our problems in the short-term, for any number of reasons. Martin Feldstein, a leading conservative economist who is considered a supply-sider, recently concluded, for example, that given the conditions of stagflation any effort to stimulate economic growth wholesale - as with the massive tax cuts advocated in the Republican platform - would be highly inflationary.

Other mainstream economists blame our growth problems not chiefly on fiscal policy - a too-heavy tax burden and restrictive government regulations - but, interestingly enough, on the periodic bouts of tight money policy that most supply-siders recommend as the right way to fight inflation. Pointing to the unemployment side of stagflation. these economists say that trying to hold down demand with high interest rates has reduced business investment and caused the underlying unemployment rate to drift slowly upward.

Despite these differences of emphasis, a wide consensus is developing in favor of at least some steps: strategically aimed corporate tax cuts and investment incentives to increase growth. Some economists also say, however, that growth will continue to be held back until we develop & national energy policy to protect industry from "supply shocks" like the 1973 oil embargo and the 1979 oil-price hikes.

The other, smaller group of economists to come away from the drawing board says the chief villain in stagflation is the structure of the supply-side itself. This group complains that industrial markets have evolved into an "oligopolistic core" - the Fortune-500-type companies - who set their prices by the mark-up that will achieve a level of profits high enough to finance future investment. To be sure, the laws of supply and demand still influence prices in agriculture and some smaller markets but not, these economists say, in the industrial sector that determines the overall direction of the economy.

There is considerable evidence to support this theory. Economists are increasingly aware, for example, that price mark-ups pass through to consumers not only the high cost of credit and expectations of future inflation, but also the cost of government regulations that impose environmental standards, require training programs, limit profits or enforce other social goals. So, most attempts to offset concentrated corporate power come out in a higher inflation rate. Imperfections in the labor market - large unions whose members' wage increases bear little relation to the overall level of unemployment - also reflect the rapid disappearance of what could be called, even loosely, a competitive market economy.

Economists who have given up on markets to control inflation say we should turn to wage and price controls. But controls are, understandably, a politically unpopular proposal, and there is little agreement even among economists about how they could be made to work.


Last October, Federal Reserve Board head Paul Volcker announced a new anti-inflation policy. With the approval of the business community, the Fed announced that it would severely restrain growth of the money supply, letting interest rates rise as they might in competition for the limited funds. This produced - somewhat belatedly - an accepted remedy for inflation. It's known as a recession.

When interest rates (the price of borrowing money) go up, the demand for money drops, as do spending and investment. the whole economy slows down and, after two consecutive quarters of negative real growth of GNP, a recession is considered to be underway.

The cost of bringing prices down this way is high. Okun's Law - a rule formulated by the late Arthur Okun - holds that for every 1 percent increase in unemployment, the country suffers a 3 percent loss of yearly GNP. To illustrate: new car orders for June 1980 were at a more than 20-year low. The car companies responded by shutting down several of their older, marginally profitable plants. Steel and rubber manufacturers did the same with plants that had depended on a high volume of auto production. (So did manufacturers of consumer durables - stoves, washing machines - who expect the slump to be too long to weather.) Even when the economy gets moving again. these older plants are likely to stay closed, reducing the nation's overall productive capacity.

This recession is particularly severe because drastic measures had to be taken to induce it. First, despite the Fed's fall money-tightening, loan demand remained strong and pushed interest rates higher than anyone expected. Then came the February credit crunch - the Carter administration imposed new reserve requirements, borrowing charges, and restrictions on consumer credit. So by the time the prime reached 20 percent, business and consumer demand for credit had dropped out of sight, and from its height in early April the prime dropped nearly 10 points by July.

As the recession widens, spreading to more than the auto and housing industries, loan demand is so low that banks are taking desperate measures. For a while, some banks even altered long-term loans at below the prime rate, creating a new class of super-creditworthy customers whom they were willing to help make it through the bad times. This was a positive sign in one way: it showed that bankers thought the recession would bring inflation under control and that interest rates would drop enough for them to recoup their early losses on long-term loans made at sacrifice prices.

But below-prime loans also mean that the burden of the recession is shared very unequally. The only companies that will come out ahead (relative to everyone else) at the end of this anti-inflation campaign are the already powerful corporate giants whose pockets the bankers feel comfortable in. In addition, this sort of maneuvering reduces the business pressure on the Fed that usually keeps recessions short. If those with the loudest voices keep their mouths shut, we may be in for a long spell of tight credit.

A long recession might bring inflation somewhat below 10 percent, but many people wonder if the cure isn't worse than the disease. In fact, the use of restrictive monetary policy puts us between a rock and a hard place. If we hang on through the protracted recession that monetarists recommend, will we damage our industrial capacity so much that stimulation of the economy will only bring back inflation later and at higher levels of unemployment? We pulled out of the 1974-75 recession at 6 percent inflation, which is what started us on our current path. (Bear in mind that slowing the inflation rate - all a recession can accomplish - is like blowing up a balloon more slowly: it's very different from letting air out of a balloon.)

But if, as some observers suggest, election-year or business pressures force the Carter adminstration to abandon the recession policy - by easing up on the money supply or cutting taxes - will we have suffered a recession only to start on a new inflationary spiral at 12 percent?

These questions, alas, realistically present our monetary policy alternatives. As a result, some economists have begun advising that we try to live with inflation. We may have to, whether we like it or not.


Wage and price controls need no introduction. Unlike most of the terms in our series, the question about controls is not, "what are they?" but "would they, work?" And, if yes to that, "are they necessary?"

If you've read this far in the series, it should come as no surprise that economists are divided over the question of whether government-imposed wage and price controls can be an effective weapon against inflation. Most are united, however, in dismissing the failure of the 1971 wage-price freeze and subsequent "Phase II" controls instituted by Nixon as a fair test of the policy. Those controls were imposed to cap an inflation rate that peaked at 6 percent in 1970, and, yes, inflation did tall back to 3.3 percent in 1972. In 1973, however, the year the last of the controls were removed, the inflation rate climbed back to 6 percent, and it reached 11 percent in 1974.

Nixon's controls failed, economists now say, because of a combination of bad policy moves and bad luck. First, while the lid was held on wages and prices, government spending was increased and monetary policy was relaxed, readying the economy to burst forth with an inflationary surge of demand as soon as the lid was taken off. Which it did. Added to those avoidable problems were two large and unavoidable problems: 1) a worldwide food shortage caused by back-to-back disastrous crop years led to rapid agricultural-price inflation in 1972-73; and 2) the OPEC oil embargo, in mid- to late-1973, brought the first and most shocking of the '70s oil-price hikes.

Under less volatile circumstances, the wage and price controls imposed by Truman during the Korean War worked fairly well, and most economists are not prepared to dismiss controls out of hand, at least as a short-term remedy. Their most useful function would be breaking widespread expectations that inflation must continue in an unstoppable upward spiral. But to avoid a post-controls resurgence of inflation, they would have to be accompanied by other anti-inflationary policies - fiscal and monetary restraint, tax incentives for investment, and increased energy conservation.

And still the second question remains: are controls necessary? Or would the other measures mentioned do the job of lowering inflation just as well without them? Economists simply disagree on this question. Those opposed to controls say they introduce monstrous inefficiencies into the operation of the economic system and unfairly freeze the distribution of income at its pre-controls level. Those in favor argue that the long recession necessary to bring inflation down without controls is even more inefficient and unfair. Unfair because it puts the short-term inflation-fighting burden almost entirely on the backs of those it throws out of work. Inefficient because it places the long term burden on the economy as a whole: continued high interest rates and high unemployment lower growth and investment. And by forcing smaller companies out of business or into mergers they decrease the competition that helps hold prices down.

Many economists who favor wage and price controls, however, acknowledge that imposing them temporarily won't remove the fundamental cause of inflation - the fact that labor and industry are, for the most part, no longer responsive to market pressures in negotiating wage increases and setting prices.


Incomes policy is a catch-all term for policies that would control inflation by controlling wages and prices - either directly or through the tax system. Opponents would prefer to let market forces - competition for jobs and sales - determine wages and prices. Those in favor of such policies say market forces no longer control wage and price increases.

Advocates of the incomes-policy approach point to the following inflation-causing factors: Oligopolistic concentration in most industries has all but eliminated price-cutting as a response to failing demand. Union bargaining power and minimum-wage legislation ensure against wage reductions even when unemployment climbs. Government anti-poverty programs have placed floors under the incomes of even the majority of the poor and unemployed. Advocates of the incomes-policy approach argue that, as a result, conventional fiscal and monetary policies are worse than useless against inflation because all they can do is restrain demand. That slows inflation somewhat, but it serves mainly to weaken the economy overall.

The most extreme incomes policy anyone proposes is an absolute wage and price freeze, which, as we discussed in Part Nine, has gained approval in some quarters as a short-term remedy against inflation. Over the long run, however, controls are inefficient, making no allowances for actual shifts in demand or earned increases in wages. And if the government decided to allow exceptions to the controls, an all too easily imagined political and bureaucratic nightmare would undoubtedly result as powerful lobbies and special-interest groups rushed forward to press their claims.

So what do the advocates of an incomes-policy approach propose? Barry Bosworth, former director of the Council on Wage and Price Stability and now at the Brookings Institution, calls for a "carrot and stick" approach that would work automatically with the tax system. The carrot would be tax incentives for low wage settlements and moderate price increases. The stick would be a high marginal tax rate for wage and price gains. Robert Heilbroner, economics writer and a leading incomes-policy advocate, proposes a 95 percent tax rate on all incomes above that earned the previous year. Exceptions for promotions, productivity gains and the like could be made, but on the same basis as tax deductions - with proof and after the fact.

That such a policy would have drawbacks is unquestionable. But as Bosworth points out, the only alternative offered so far is a recession that may do more harm than good. "It's not like you have a choice between one wonderful program and another," Bosworth says.

Still, most economists get uncomfortable at the suggestion that the government should assume responsibility for allocating resources, which is more or less what it would be doing under any form of incomes policy. Many economists believe that all the government's interference in the market system - income floors, mortgage subsidies, costly regulation - is what causes inflation in the first place. Recognizing this, Heilbroner and other incomes-policy advocates predict that the market-based solutions proposed by the present economic policymaking majority - monetary and fiscal restraint, growth-oriented tax policies - will be tried first and will fail. By that time, they say, the costs of inflation will have escalated to the point that a majority will favor imposing controls - whatever the problems they bring - as the only solution left. Like all economic forecasts, this prediction will be proven true or false by time alone.


The bond market is where businesses and the government raise funds for investment over the long term. A healthy bond market is thus essential for financing growth - now considered a major policy objective in fighting inflation. But the bond market is also one of the areas hardest hit by the anti-inflation policy of tight credit and high interest rates.

A bond is essentially a contract issued to the bondholder by a corporation or the U.S. government. Take a 10 percent bond with a face value of $1,000 and a 10-year maturity. The buyer agrees to lend the bond-issuer $1,000 for 10 years, during which he (or anyone to whom he sells the bond) will receive $100 a year in interest. When the bond matures, the bondholder gets back the principal - in this case, $1,000.

High interest rates do two things to the bond market. Anyone who bought a bond at low interest rates and wants to sell it before it matures has to settle for less than the bond's face value. A $1,000 bond might sell for $750 if its yield is well below the inflation rate, which means the bondholder must either hang on or take a loss.

More importantly, companies (or again, the government) that want to raise funds by issuing new bonds must either offer extremely high interest rates or simply withhold their issues until interest rates fall.

Prosperous companies that can afford to pay high interest rates can still issue bonds, especially if they're in a position to pass along the high cost of credit in their prices. But most companies respond to inflation by issuing short-term notes - called commercial paper - or simply by borrowing funds for the short term. Short-term debt, needless to say, does not encourage long-term investment. And, as some business-watchers point out, the financial community's nearly exclusive reliance on short-term debt raises the risk of major bank failures and subsequent business collapses if even a few large debtors come up short. There were, consequently, more than a few shivers recently when a German bank that had been asked to make a routine transfer of $8 million by the Chrysler Corp. instead seized the sum and announced that it would hold it as security against Chrysler's debt. With $4.4 billion in worldwide debt, Chrysler is just the kind of borrower no one would want to see default these days.

As the current recession deepens, and loan demand stays low, interest rates will continue to fall. The bond market and long-term debt creation are already beginning to revive somewhat, a sign that the recession has at least reduced the expectations of continued high inflation that had so distorted business pricing and investment policies (as well as consumer spending habits).

But because the lower interest rates accompany a steadily weakening economy, there is now little incentive to invest in new facilities and expand productive capacity. And if the Fed follows its stated policy of holding down money-supply growth, interest rates will start to climb again as soon as the economy - and therefore the competition for funds - heats up. Thus, say monetary-policy moderates, treating tight money as the only available weapon against inflation is a guarantee of economic stagnation and more inflation to come.


Americas "stock market" is actually several markets in which corporate shares are traded, the largest of which is the New York Stock Exchange. The most frequently cited stock market average is the Dow Jones industrial average, which uses a point system based on the per-share prices of 30 industrial giants listed on the NYSE. It is not the most indicative of overall stock prices - that honor should go to the New York Stock Exchange composite average, which covers the shares of all the companies listed on the NYSE and weights them according to the number of shares outstanding for each company. But traditions prevail, and the Dow remains the most quoted average.

The long-term trend of stock prices - as national output and price levels rise - is upward, although the market has been stagnating, after a surge in the '60s. for more than a decade. In fact, the stock market in general hasn't stirred up much excitement lately. When people buy stock, they are gambling - either on the hope of finding a rapid-growth company whose stock will shoot up, or on the short-term and unpredictable price movements caused by fluctuations in trading - and, with a few exceptions, the market hasn't been a good gamble recently. (A bond, by contrast, brings a set rate of return.)

From the mid-'50s until about 1968, the stock market was "bullish" and a good bet. With steady growth and rising volume, the Dow shot up from the 200s to nearly 1,000 in a little over a decade. Word got out that people were making fortunes on "glamor" stocks like Xerox, IBM, and Kentucky Fried Chicken, and soon everyone~ was either buying into those companies or looking for an as-yet undiscovered gold mine. As a result, the stocks of even the glamor companies became overpriced, and the market began to stagnate.

During the '70s, the Dow stopped climbing, although it did finally top 1,000 before plunging into the 500s during the 1974-75 recession. The word in the financial press turned around: no one was making any money in the market, stocks selected by a blindfolded dart-thrower performed about the same as those selected by supposedly savvy investment brokers. And, in fact, that was about right. The shifting economic and social climate of the '70s ensured that the market would go down as much as up, because the only guarantee of steadily rising stocks - continued, wholesale investor optimism - was gone.

These days, no one is advising a dip into the stock market as the path to a quick fortune, or even a profit. But just because economic uncertainty has brought stock prices down, some say it's now a good time to buy. (Others say that the market won't bottom out until sometime after the trough of the current recession, which most analysts feel won't arrive until the end of 1980 or the beginning of 1981.) And the danger of a stock market resurgence, say economists, is that it might drain funds from more productive physical investments and hinder recovery from the recession. Investors who put their money into stock, after all, are only buying pieces or paper.


The savings rate is the percentage of national income which is not spent on consumption. This economist's definition of saving essentially matches the common-sense understanding of the term: putting some income aside - whether in a bank account, a pension fund, or a bond - instead of spending all of it. The difference in definitions is that to an economist, personal saving - even if it is buying a bond - does not count as investment.

But your purchase of a bond does finance investment. The corporation whose bond you buy may use the revenue raised by its bond issue to build a new plant, and that constitutes investment because it adds to the country's total capital stock.

The total of personal saving is what finances business investment, which is why it is significant that personal saving in the United States is now at an all-time low. Our personal savings, nationally, declined by more than $10 billion in nominal terms between 1975 and 1979 - from $83.6 billion to $72 billion. In real terms, figuring in inflation, the drop is much larger.

Of course, it's no mystery why the U.S. savings rate has declined. When the inflation rate climbed to 11 percent in 1974, it became clear to even the thriftiest people that earning 5 1/2 percent interest in the savings bank was losing money. Income tax law, which taxes interest received, aggravates the problem. Tax law, in fact, encourages buying a house as the best form of personal investment; interest payments, even if they are at a far lower rate than inflation, are deductible. And so, despite 15 years of accelerating inflation, the government continues to penalize savers and reward those who simply hold onto an appreciating asset, which does nothing whatsoever to increase the funds available for investment.

The current recession - much delayed by the buy-now, it'll-cost-more-later mentality - has increased the savings rate somewhat (although at the cost of such a drop in economic activity that firms are hardly being encouraged to make capital investments). People are more willing to buy bonds at interest rates that companies can afford to offer now that the inflation rate has slowed. Economic uncertainty and credit restrictions have also motivated people to put money in the bank. But economists insist that reform is necessary if we want to keep the savings rate up in the future. Their recommendations:

The tax system should recognize only real, not nominal, interest rates. In other words, savers should only be taxed for the rate of interest earned over and above the inflation rate, and possibly only on interest above a certain level, such as $10,000.

Disposable personal income should be increased by indexing the tax codes, so that people are not forced into higher tax brackets merely because of inflation. This would work by multiplying tax brackets by the inflation rate, a system already in use in Canada.

Some economists add that a tax on consumption - especially purchases of cars and other consumer durables - should accompany any government attempts to decrease the tax burden on savings. Otherwise, they say, there is no guarantee that higher income would go into savings, especially if the inflation rate remains high.

Governments (and corporations, for that matter) should offer purchasing-power bonds, which would pay not a set interest rate, but a rate that fluctuates one or two points above inflation. Not only would this encourage saving regardless of the inflation rate, it would serve as evidence that government (and industry), had a vested interest in substantially reducing inflation.


Increasing Americas rate of capital formation - that is, money invested in new plant and equipment - is the central aim of the anti-inflation fiscal policies recommended by a growing number of economists. There is reason to be concerned about our rate of capital formation; by every measure - machinery-worker ratio, age of equipment. etc. - we have fallen behind Japan and most of Europe. To reverse the trend, economists say they would:

Increase investment tax credits. Businesses would then be able to write off more than they now can of the cost of capital improvements and investments for research and development.

Allow accelerated depreciation of assets. Businesses pay lower taxes on plant and equipment as it ages. If the IRS assigned assets shorter lives, their taxable value would decrease more each year, and so would businesses' tax cost on new equloment.

Reduce government regulation. Some economists blame the decline in capital improvements mostly on the increasing amounts of money that businesses must spend for "defensive" R&D like pollution control equipment. Other economists argue that pollution control and the like add to the quality of life, representing improvements that, while not measurable as capital stock, are priceless. Nor is there much agreement on either side about just which government regulations are "unnecessary."

Some economists add that the fiscal-policy solutions detailed above won't stimulate growth if restrictive monetary policies keep interest rates high. Tight credit makes long-term investment too costly for many, and tax credits do no good to businessmen who can't afford to borrow at all. As for large companies that can borrow, high interest rates make short-term, non-productive uses of cash more profitable than building new factories particularly if periodic recessions introduced to fight inflation ensure that demand will be unreliable.

The recessions of the last decade (1960-70, 1974-75, and 1980) have proven the point by progressively lowering industrial capacity use, which is the rate of production at which manufacturers operate most efficiently, given production costs (labor, energy, materials) and other factors. At the lowest point of the last recession, capacity use plunged to 70 percent, and there are indications that it will go lower this time. This, say economic analysts, strongly discourages investment in new plant.

Finally, argue some economists, we can't devote a higher proportion of national income to saving and investment unless we decrease consumption. In real terms, that means lowering our standard of living in the interests of future national wealth, because if we decrease consumption the result will be not only fewer goods for American consumers but also lower returns for American firms. Cutting government spending enough to finance growth - the alternative recommended by many economists - would be as great a setback for our national expectations as lowering consumption, but with the losses and gains distributed differently. The most difficult aspect of inflation, ultimately, is confronting these choices.


Exchange rates are what make international trade possible by setting the amounts at which different currencies can be traded for each other. There are different ways exchange rates can work, among them:

They can be fixed. The relative values of different currencies then depend on the amount of same agreed-on material (historically, gold or silver) that each coin contains or that each note is backed by.

They can be free-floating. The relative values of currencies are then set by the supply of and demand for each in international goods and capital markets.

They can be managed or "pegged." In various forms, this system has governed international monetary dealings since 1944, and in its present form is known as "dirty" floating. It allows rates to fluctuate, but only within fairly narrow boundaries set by national governments. If speculation or trade conditions threaten to alter a country's currency value drastically, the government can intervene to offset the trend - buying up or selling its own currency on world markets until the exchange value returns to its pegged rate.

Many factors determine the demand for a given currency. If there is a great worldwide demand for, say, German cars, people will want to exchange their currencies for marks in order to pay German auto manufacturers, so the mark's value will go up relative to other currencies. If German industrial productivity in general is high, non-German investors will "export capital" by buying into German companies, or even building plants there. And if Bonn follows a tight monetary policy that keeps inflation low and maintains high real interest rates (that's the after-inflation interest rate), foreign investors will want to profit from the high rate of return they can get by buying German securities.

All those factors have been at work in countries like Germany and Japan during the last 20 years, which is why their currencies have been so strong and their products expensive for us to buy.

If a high exchange rate is maintained artificially, a currency can become "over-valued." That's what has happened to dollars over the last 20 years. The high exchange rate of the dollar was undermined by capital exports (Americans' investing and lending overseas), inflation, and declining productivity relative to other industrial nations. Dollars and American goods were no longer in great demand because they were over-priced. Under our old fixed exchange-rate system, this led to a "devaluation" of the currency - raising the dollar price of gold and thereby making each dollar worth less. Under the current floating system, the dollar can be "depreciated." The government simply allows its exchange rate to fall relative to other currencies rather than buying up dollars in order to keep the rate high.

When the dollar falls in value, the price of imports relative to domestic goods rises. Initially, our demand for imports declines, while the demand for our exports rises. The idea is to revive the demand for dollars and strengthen the currency at the new rate. Over the long term, however, U.S. demand has tended to adjust to the higher prices of imports, which fuels inflation and raises the price of our own products. So while inflation has essentially reduced the value of the dollar, we have continued to finance our standard of living with trade deficits.

As U.S. interest rates fall because of the recession, the exchange value of the dollar has also been falling. But European financiers say the trend is healthy for the dollar because it is caused by the Fed's tight money policies, which they regard as wise. The end result, they say, will be a stronger dollar. In the meantime, our appetite for imports will probably fall as the recession deepens.


The international system of exchange rates, when we discussed in Part Fifteen, exists because international trade makes it necessary. International trade exists because, as the 19th century English economics pioneer David Ricardo explained more than 150 years ago, the world economy enjoys a "comparative advantage" when individual countries produce as much as possible of the goods that each produces most efficiently, trading their surpluses for needed goods rather than trying to be nationally self-sufficient. By maximizing productivity worldwide, trade thus makes possible a higher standard of living everywhere.

The theory of comparative advantage was at work for thousands of years before Ricardo formulated it, although the evolution of a totally interdependent world economy was an accompaniment of industrialization, which had only just begun during Ricardo's lifetime.

The international economy, while it has raised standards of living in most of the world, has brought international problems as well. Right now, our biggest problem is that we can't satisfy our appetite for imports without trade deficits. On our national balance sheet - an accounting made by the Department of Commerce - anything that brings foreign money into the country (selling Levi's to Frenchmen, attracting French investors to buy Levi's stock) counts as a credit on our balance of payments. Anything that sends currency out (buying Peugeots, building motors or American cars in Peugeot plants), counts as a debit. For years, we've been buying more from and investing more in foreign countries than we can really afford.

The OPEC oil-price hikes are the central problem in our current trade deficit, and they illustrate the difficulties of internationalism. Price shocks in such a central production factor from outside the domestic economy have been depressive, to the extent that they force production cutbacks. To an even greater extent, they've been inflationary, as higher costs are incorporated in higher prices.

A high inflation rate devalues the dollars that our nations receive for the products we buy, so they raise their prices to make up for the lost revenue. In some cases, our demand for imports falls in response. When we can't or don't significantly reduce demand - as we can't, beyond a certain point, with oil - the further price increases just speed up the inflationary cycle.

In theory, what could finance our appetite for imports and our copious government and private investment overseas is soaring productivity, a high rate of GNP growth, and an attractive investment climate for foreign investors. In fact, productivity in other industrialized countries has been zooming, relative to ours, since World War II, encouraging U.S. businessmen to invest overseas, adding to our trade deficit and further weakening the dollar.

While a "bad" balance of trade can be a good thing - in that we send out increasingly worthless paper and get Toyotas and televisions in return - there is some question about how long the Japanese and other countries that export their goods to us will put up with the situation. The overvaluation of the dollar was what undermined the strictly "pegged" exchange-rate system we maintained until 1971, and led to the more freely floating system we now use. Many feel that this, too, is only temporary. Economists can only speculate about what would happen if international pressure forced a switch to a completely free-floating exchange-rate system. The only certainty is that it wouldn't make things any easier for us.

With cutbacks in imports and self-sufficiency in energy production as the recommended remedies for the ills of the international economic system, we've come a long way from Ricardo's theory of comparative advantage. Continued rapid gains in standards of living that once seemed possible - or even promised - have been snatched away. Why? Because, some economists believe, the industrialized world no longer has the monopoly on productive resources that is needed to finance such gains. Seen this way, as a world problem, the economic conflicts that cause inflation seem more intractable than ever.


As we explained earlier in this series, there is one group of economic observers that blames inflation entirely on money supply growth. Some ignore the political pressures that create money-backed inflation - the ideal of the American "economic democracy" that produces government-backed mortgages, Medicaid, and expectations of an ever-rising standard of living.

Others do recognize these pressures. For that very reason, they want to take monetary control away from pressure-sensitive politicians and make stable money-supply growth automatic by tying it to the growth of a physical commodity in limited supply. In other words, they want us back on the gold standard.

What this means is that the U.S. government would settle on the amount of gold each dollar contained and then limit monetary expansion according to our gold reserves. If an unfavorable balance of trade drained reserves, the amount of money in circulation would be decreased, and prices would have to come down until we attracted customers for our goods. We would, in other words, have to suffer through prolonged periods of high unemployment and economic contraction.

The gold standard was formally adopted by the major European nations In 1867 (with the United States following suit in 1873). But the policy has not survived into the modern age because of a fatal flaw: it is inflexible in the face of demands for overall economic expansion. If demand rises faster than the supply of gold, unemployment must rise until prices stabilize.

As a result, the gold standard encountered considerable opposition right from the start. William Jennings Bryan campaigned in the presidential election of 1896 on a populist platform essentially demanding inflation - the coinage of "free silver" to supplement the gold supply and relieve the price slump that was hurting American farmers (and workers). "You shall not press down upon the brow of labor this crown of thorns," Bryan thundered to the Democratic convention that year. "You shall not crucify mankind upon a cross of gold."

Bryan lost the election, but those who favored the gold standard lost the war. During World War I, the safe haven of the U.S. economy and our much-needed wheat attracted a tremendous flow of gold reserves in investments and payments from Europe to America, more than enough to finance a healthy, gold-backed inflation. Then came the Depression and World War II, which further bankrupted Europe and culminated - economically at any rate - in the Bretton Woods agreement of 1944. In that agreement, the leading non-Communist industrial nations agreed to abandon the gold standard in foreign exchange, substituting a system of managed exchange rates. The aim was to protect the war-torn countries from the economic hardship that would have accompanied the loss of their gold reserves through trade and hindered their recovery by preventing expansion.

Ironically, the post-World War II recovery of Europe and Japan - added to and aided by our immense overseas aid programs - caused chronic U.S. trade deficits from the mid-'50s on and a consequent gold drain from here to Europe. In 1971, we stopped offering to convert dollars into gold. Thus went the last vestige of the standard; we had left behind the gold standard's strict limits on monetary expansion decades before.

Theoretically, say most economists, there's no reason why we couldn't go back onto the gold standard. And only this year, a group favoring just such a policy sent a full-time lobbyist to Washington. But, many wonder, do we want to bring the gold standard back? Just because our monetary policy has created some problems, do we want to do away entirely with the option of using it? If we have to pay more for oil imports, do we want to do it with jobs instead of dollars? De we want to tie our money supply to the supply of a scarce natural resource produced in greatest quantities by South Africa and the Soviet Union? No, most economists answer, probably not.


For more than a decade now, economists have been coming up with little but inaccurate predictions and bad news. Lately, at least one group in the profession has changed its tune - and begun promoting an optimistic program for controlling inflation. The group has been enthusiastically welcomed by the press and labeled the supply-siders, because they believe that inflation is the result of demand outstripping supply, and that, therefore, the best way to beat it is to increase supply enough to meet demand.

We have already discussed most of the proposed supply-side solution: increasing tax incentives to businesses for R&D and capital investment, limiting government spending, and encouraging saving. There is actually, little disagreement about these ideas, either among policymakers or economists. Most say they are the obvious moves to make in the face of declining U.S. productivity.

So why all the exlctement about supply-side economics? The attention-getting ideas come from the so-called radical supply-siders, who believe the government's taxing and spending level is the sole engine of inflation because it chokes private sector growth. Their proposals? Balance the Federal budget (by constitutional mandate, if necessary), lower income taxes, and drastically reduce government regulation.

The radical supply-siders' emblem is the controversial "Laffer curve," popularized by USC economist Arthur Laffer. The curve shows that as tax rates rise above a certain level they undermine the work incentive, causing output and actual tax receipts to fall. Eventually, according to the curve, tax receipts fall to zero as the overtaxed economy grinds to a complete halt.

Accordingly, Laffer followers support the 30 percent tax cut (over three years) proposed by Rep. Jack Kemp (R-N.Y.) and Sen. William Roth (R-Del.) and endorsed in the Republican party platform. They say that the resultant increase in personal income would stimulate so much economic activity that growth would skyrocket, supply would increase to meet demand, and inflation would be wiped out without higher unemployment. Controversy over this use of the Laffer curve arises, however, because economists can argue endlessly and inconclusively about where on the curve our actual tax rates put us. Most say a large tax reduction now would stimulate mostly consumption (and higher demand), not more production.

The media's interest in the radicals' ideas has, in fact, distressed mainstream supply-siders. Martin Feldstein - identified in a recent Newsweek article as the "high priest" of supply-siders, and, as the 40-year-old president of the National Bureau of Economic Research, one of the country's most respected younger economists - recently wrote a somber article for The Wall Street Journal disavowing the contention that inflation can be eliminated without higher unemployment - either by investment incentives alone or by large tax cuts.

"With demand rising at 10 percent a year, there is no way that supply can be induced to keep up," Feldstein wrote. Even more glumly, he then pointed to studies showing that, for example, the investment stimulus proposed by the Joint Economic Committee would produce only a 1.3 percent reduction in inflation by 1990.

Feldstein also noted that "the misuse of the Lafter curve" might keep inflation at '70s levels all the way through the next decade. His conclusion? While encouraging savings and investment is wise, supply-side policies "should not be given responsibility for the job of eliminating inflation."

Liberal economist James Tobin put the matter succinctly in a paper he presented at a recent Brooklngs Institution conference. Quoting an economics aphorism, Tobin quipped: "The Lord gave us two eyes to watch both demand and supply."

Removing the claims of the radical supply-siders, we are left with a proposal for moderate reductions in business taxes accompanied by conservative fiscal and monetary policies. This brings the arguments back to traditional disagreements. Some economists, like Tobin, object that those demand-restraining policies will get in the way of supply-side recovery by strangling economic growth, thereby discouraging the very investment that the tax reductions aim to stimulate. They want to preserve a fairly high level of government spending, using consumption taxes rather than unemployment to limit demands.


Post-Keynesian economics is not an organized school of economic thought so much as a protest movement. Its proponents are united by their objections to the model used in mainstream economics - a competitive more market system in which wages and prices, set by supply and demand, adjust automatically to allocate resources in the most efficient way. It is because mainstream economists depend on this unrealistic model, the post-Keynesians say, that they can't figure out how to get rid of inflation.

The group names itself after the British economist John Maynard Keynes because it was Keynes who first rattled the bars of classical economics during the '30s by showing how the wage-price system could produce unemployment instead of a perfect allocation of labor. Mainstream economists eventually took to heart Keynes' prescriptions for fiscal policy to intervene in the system by spending to reduce unemployment (producing the so-called neoclassical synthesis that governs economics today). But the post-Keynesians argue that Keynes' basic point - that wages and prices are determined by factors other than the market forces of supply and demand - was overlooked.

According to the post-Keynesian heretics, pricing decisions in manufacturing, for example, are not even greatly affected by demand. At least in the "oligopolistic core" of the economy - the leading industrial companies which determine the overall direction of the economy - prices depend on the funds needed to finance future growth.

Inflationary pressure arises because companies raise funds now for growth that may or may not take place later. Working against growth is the fact that higher corporate earnings are as likely to come from increased market shares as from market expansion. Then, when earlier investment and higher mark-ups are not offset by current-period growth, friction begins. Wage rates rise in response to higher prices, aided by union bargaining power and minimum-wage laws. Firms try to maintain their profit margins by increasing mark-ups. Wage rates rise again. And so on.

In short, the post-Keynesians say, inflation is caused by competition for larger slices of the national output-and-income pie, which is not growing fast enough for every group to have what it wants. The economy's way of handling these claims is to raise prices, thereby deflating higher nominal incomes and bringing purchasing power into line with the real availability of resources.

To be sure, a recession can be induced to ease income competition (and lower the inflation rate) by throwing people out of work. But, the post-Keynesians say, this also lowers output and, in the long run, serves to limit the size of the pie more than it limits demand for pieces of it.

Most economic theorists now agree that inflation is caused by conflicting claims over national income. Certainly, post-Keynesians and supply-siders concur that increasing output and productivity would be helpful. But conservative mainstream economists say the real goal is to let the private sector's market system determine income distribution instead of having the government do it through taxes and income supports.

Post-Keynesians disagree. They object to mainstream economists' assumption that the private sector would get rid of inflation by lowering wages and prices through competition. Instead, they say, the industrial economy would reduce competition by following its natural path toward greater concentration. Inflation might be lowered, but only because fewer people would be involved in decisions about income distribution. The result would be worse economic inequities than inflation has produced, and, quite possibly. inflation down the road.

Rather than letting the private sector make these decisions, post-Keynesians favor an incomes policy that would allow the government to weigh conflicting claims on income openly and allocate it accordingly. They admit that such a policy would be difficult - perhaps even impossible - to carry out in a democratic society. But, they say, we have only that and continued inflation to choose between.


The real problem with our attempts to fight inflation over the last decade is that they have ignored the inflationary bias in our economic and political structure. We've been unable to reduce the inflation rate because even when we attack fundamental problems like government spending and money supply growth, we forget to ask why we created those problems and why, therefore, we may not be very eager to get rid of them.

Government spending. It is true that the size of the federal budget contributes to inflation. But what we often overlook is that government spending involves not only welfare payments but a budget's worth of services intended to make life - for the middle class as well as the poor - better, safer, and more secure. As the economist Robert Heilbroner put it in a recent essay, "A century ago there was no 'fiscal policy,' no local, state, or federal payments for old-age penury or unemployment, no 'disaster relief,' no parity payments to farmers, no Small Business Administration, no federal financing of mortgages or insurance of bank deposits. It was each firm and each household for itself. Dog ate dog."

The placement of floors under most aspects of modern economic life has taken the inflation-correcting mechanism of depression out of the economy. When people are thrown out of work today, they receive benefits that allow them to maintain at least a proportion of their earlier level of consumption. To be sure, it is likely that inflation would be lower if we allowed the unemployed to starve. But it is unlikely that society could survive the socio-economic onslaught.

The fact is that income guarantees to the poor and unemployed also help business, which has come to rely on a relatively consistent level of demand. This is very different from the roller coaster cycle of booms and depressions we experienced until the development of modern monetary and fiscal policy in the '30s. Where, after all, would Chrysler be without federal loan guarantees?

The private sector. Increasing concentration has been the long-term trend of the industrial economy - fewer and larger firms and labor organizations determine the economy's direction with increasing independence from market forces. Large corporations make pricing decisions not primarily in response to short-term shifts in demand but according to the level of return they need to finance planned long-term investments. In expectation of higher returns, they borrow; the Fed tends to expand the money supply to cover the demand.

The inflationary pressure that builds up this way might be offset if investments paid off with increased growth and productivity. Unfortunately, individual firms are as likely to profit from increased market shares as from overall market expansion. Smaller companies are squeezed out, and the larger ones become more insulated from competition.

Labor unions, meanwhile, consolidate their own power. They use their leverage to get wage settlements that enable their members to keep up with inflation, and the higher cost of their wages is reflected in the next round of price increases.

In the end, the relationship of big business and big labor can be mutually destructive. When wages and prices resist downward pressure from falling demand, all the market can do is force resources to other industries, which can be a nasty shock when the shift occurs across national boundaries. That's how the U.S. steel and auto industries, for example, have steadily lost ground to foreign competitors without budging on prices, thereby contributing to inflation and unemployment at the same time.

How we got here. If we suffer from a structural inflationary bias, why didn't we have inflation before? To be blunt, because we were lucky. The '50s began with Korean War price controls and frequent recessions that kept unemployment relatively high. The '60s saw a productive boom - spurred by the unemployment-reducing economic policies of the Kennedy and Johnson adminstrations - that financed a new level of national prosperity. In addition, agricultural and energy prices declined somewhat during the period, and overvaluation of the dollar brought cheap imports in from Europe and Japan.

But the '60s boom was hollow. Low-priced imports undermined domestic industries and encouraged a shift in the composition of our GNP from manufacturing to the less productive service industries. At the same time, the economic and social goals epitomized by the "War on Poverty" put massive new demands on national income. And by the end of the '60s, we had added expensive and expanding, anti-pollution priorities to our economic agenda.

Looking back, inflation should come as no surprise. With claims on national income and expectations of further gains at their historic heights during the '70s, we suffered nothing but reversals of our earlier advantages - dollar devalution, agricultural and energy inflation, and declining relative productivity as our long neglect of capital investment finally made itself felt. We simply can't pay for what we have come to expect.

Where we're going. So far, the lines in the battle against inflation have not been honestly drawn. Budget-balancing advocates claim they have the answer; what they don't often admit is that limiting social programs would control inflation mostly by disenfranchising the poor. What they don't often realize is how temporary such an answer would be. Continued control of inflation through spending limitations would mean pushing ever more people off the lower end of the scale and into the category of the economically powerless.

With an election every four years, we are not actually likely to see any serious efforts to control inflation - despite everything that Carter and Reagan say. Republicans and Democrats are pretty much in agreement on anti-inflation policies these days; favoring relatively tight monetary policies and strategic tax cuts.

If these policies prove inadequate, as some fear they will, we may see the inflation rate continue to creep upward during the coming decade - perhaps going as high as 30 or 50 percent - interrupted by periodic recessions to slow it down. And at the moment, that almost seems the most equitable way of dealing with the problem. As Heilbroner points out, inflation has so far left distribution of income "on the steps of the national escalator about the same, although the escalator itself has been moving faster." After a prolonged and serious anti-inflation fight, unless it were assisted by controls, income distribution would most certainly be changed: less on the bottom, more on the top.

Of course, there is always the chance that large segments of the population will accept the necessity of self-sacrifice, that unions will forego income gains in exchange for price moderation on management's part, that conservation will relieve us of the burden of energy dependence, that government and industry cooperation will phase out protectionism and produce a plan for national productivity improvement, and that tax policy will be used for purposes other than re-election. There is no reason to think these things will happen. There is every reason to hope they do.

« eof »