Part VI, Chapter 1
The Long-Run Economic Outlook
The most probable course of events in the American economy in the next ten to fifteen years is the following: (1) continuing, in fact, accelerating inflation; (2) no major depression, but occasional periods of reduced real output (and hence employment); (3) off-and-on price and wage controls; (4) a rising pattern of interest rates; (5) an increasing direction of private economic activity by public agencies; and (6) an increasingly hampered economy, with an associated decline in its efficiency and its capacity to produce economic growth. The most probable final outcome of all this is that the American economy will come to look very much like the English economy of today, an economy that one English observer has described as “sinking slowly under the sea, giggling as she goes down.”The reasons for this probable course of events are many and complex. However, many of those reasons relate to what I believe to be serious misconceptions about what inflation is, what causes it, and what it can and cannot produce.
Misconceptions about Inflation
(1) The primordial sin in treating of inflation is that of assuming that interest rates can be kept at some desired level (usually “low”) by increasing the money supply, i.e., by an easy money policy. It is typically argued that high interest rates reduce investment, curtail output, reduce home building, penalize the debtor-poor to the advantage of the creditor-rich, etc., and that low interest rates are clearly to be preferred to high. This argument is filled with dubious connections, but the
real trouble flows from the attempt to implement its thesis by means of continuous inflation.The fact of the matter is that the level of interest rates is a market phenomenon, and not only is it undesirable for government to seek to control it but it is largely impossible for it to do so as well. It is true that by adding to or subtracting from the rate of change in the money stock,
temporary changes, particularly in short-term rates, can be achieved—and this illusion of effectiveness is the precise source of the problem. Suppose for example that the monetary authority (i.e., the Federal Reserve System) were to bring about a significant injection of new money into the economic stream over a short period of time. The point of impact of the injection would normally be the short-term money market, and the rather immediate consequence would be a fall in the short-term rate of interest. However, over the course of the next few months, as this new money churned through the economy, there would be a tendency for spending of all kinds to increase, with consequent upward pressure on prices. This in turn would lead both businesses and individuals to wish to spend more now, to build up inventories or undertake expansion of plant, or buy durables and homes
now before prices go even higher. This increased propensity to spend would be translated into a sharply increased demand for loanable funds. This in turn would mean that the original increase in the quantity of money would be offset by the increased demand for loanable funds, and interest rates would start to climb. Moreover, as potential lenders would see prices rising, they would insist on an inflation premium in the interest rate; in other words, the supply curve of loanable funds would shift up and to the left, indicating that it would now take a higher rate to bring forth a given volume of loanable funds than was true before.But why can’t this countering effect be matched or more than matched by continuing injections of new money? Because this would mean continuing inflation and this in turn would mean a demand by lenders for an even higher inflation premium on interest rates.To try to cure the problem of high interest rates by increasing the quantity of money, i.e., by inflation, is like trying to cure a hangover by some “hair of the dog” the next morning. The temporary feeling of wellbeing is closely followed by a renewed attack of the problem; the alleged remedy is in fact not a cure to the problem but its precise cause. It is inflation that causes high interest rates, not the reverse, the Honorable Wright Patman to the contrary. There is one way and only one way to bring the market rate of interest back to the levels we tend to think of as normal, and that is to take the inflation premium out of interest rates by taking the inflation out of the economy—and there is only one way to do that, and that is by keeping the quantity of money from going up faster than the output of goods and services.(2) A related misconception is that it is possible to trade off any given degree of inflation for corresponding levels of unemployment, i.e., that we can purchase whatever level of unemployment we think bearable or desirable by paying the cost in the form of some predictable level of inflation. (This is the famous Phillips Curve hypothesis of recent fame.)It can be demonstrated that this is true
only if the specified level of inflation is
unanticipated by the economic units in the society. Thus an unanticipated rate of inflation of 5 percent may be consistent in a given economy with a 3 percent level of unemployment. But of course a continued rate of inflation of 5 percent soon comes to be anticipated by wage earners, lenders, and others in the economy; this in turn will lead them to demand an inflation premium in their wage rates, interest rates, etc., and the changing cost structure, given
no change in the rate of increase in the money supply available for spending, would produce reduced outputs and rising unemployment. When this happens, the 5 percent rate of inflation comes to be associated with a much higher rate of unemployment, say 6 percent. To bring the rate of unemployment back to 3 percent would now require an additional and unanticipated inflation factor of (say) another 5 percent, for a total rate of inflation of 10 percent. In other words, as for the drug addict, ever increasing dosages come to be necessary to achieve any given level of “high” or feeling of well-being. Any attempt to maintain unemployment at some given, desired level by the means of a continuously easy money policy must mean not just continuous but accelerating inflation.(3) Another related misconception can be handled very quickly. It is the belief that the liquidity problems of individuals, businesses, government, and whole nations can be cured by increasing the supply of money within nations and worldwide. An economic unit can be said to face a liquidity problem wherever it can make necessary borrowings only at interest rates that are inconsistent with other parameters in its system, e.g., the family’s income available for payments on interest and principal, or the prices the business firm can charge for its product, or the level of taxation a political unit feels it can impose on its citizens, or the interest payment outflow that a nation’s balance-of-payments position would seem to tolerate. The fact is of course that it is inflation itself which tends to produce this seemingly universal illiquidity. Borrowers are tempted to borrow for the very good reason of buying now before prices go even higher; lenders are tempted to lend by the ready insistence of borrowers and the rising charges they can impose on loans. One special feature of this process deserves mention here. In those periods of time when an easy money policy has brought about a temporary lowering of the short-term rate relative to the long-term, those institutions which tend to borrow short and lend intermediate and long tend to expand both their borrowings and their lendings. When the inevitable rise in the short-term rate comes, they then find themselves with a most embarrassing problem of liquidity. At this point they never cease to cry aloud for a new injection of money to save them from a liquidity crunch or crisis. Again the proposed remedy for the ailment turns out to be that which brought the ailment in the beginning and also that which is certain to produce a recurrence of the ailment at a later date.A liquidity problem, whether it be for Joe Doaks and family, the Widget Manufacturing Company, the First National Bank of Everywhere, the U.S. Government, or the countries of India, England, Italy, and Japan, can never be solved by inflation, by creating more dollars or more pounds or more yen or more SDRs. The temporary relief so gained is purchased at the price of a certain recurrence of the disease, and in a more virulent form.(4) Another misconception is that inflation is caused by something other than the money relationship and that it can be stopped by doing things other than that of bringing about a proper relationship between the stock of money and the output of goods and services.One form that this misconception takes is the Keynesian one, the belief that changes in total spending in the economy are not as closely related to changes in the stock of money as to other variables, such as business and consumer propensities and the fiscal actions of governments. For example, in the mid-sixties, the Keynesians who were advising the Johnson administration assumed that in urging a more restrictive fiscal posture on the government, they had taken the important step in fighting the developing inflation and that they could then feel free to recommend a somewhat easier money policy. Although their advice was not followed in all details, the course of action was roughly what they called for—but the consequences were what Friedman and the monetarists were predicting, i.e., rising inflationary pressures under the influence of excessive monetary ease.Another and more disquieting form that this misconception takes is what might be called the Galbraithian one. It is the belief that inflation is
really produced through the domino effect of price and wage increases triggered by powerful business, labor, and farm groups in the economy. This point of view is supported neither by common sense nor theory nor the facts. Professor Paul McCracken once said of this idea that “it is still common among uneducated people. Galbraith’s view is unusual only in being held by the president of the American Economic Association and in being described by him as new.”
It is indicative of the nature of the problem we are facing that this self-same McCracken was to publicly defend a system of wage-price controls instituted by his president just three weeks after he, McCracken, wrote the above statement.Strong groups within the economy may be able to
divert spending in various antisocial ways but they cannot bring about an
increase in total spending, which is what inflation is all about. Trying to stop inflation by wage and price controls is like trying to cure a fever by breaking the thermometer. The observed wage and price increases are but symptoms of the disease. The real problem is the heat in the body economic and this can be reduced only by reducing the rate of increase in the quantity of money.(5) A final misconception about inflation is that it should be and is possible to stop an inflationary process without cost to anyone in society (except perhaps the very rich, who deserve their comeuppance in any case).The fact is that once inflation lasts for any length of time, it will come to be anticipated in the decisions of a greater part of the society. If inflation is stopped, those anticipations prove to have been in error and the decisions based on those anticipations now have painful consequences: unemployment for the workers who had demanded the higher wages, losses for the firms who had contracted to pay the higher costs, financial loss to all who had purchased assets, directly or indirectly, in anticipation of rising prices, financial distress to all who had borrowed long-term money at high interest rates, etc.The fact is that we can find not one single case of a society that has been able to stop an inflationary addiction without serious withdrawal pangs, in the form of higher rates of unemployment, lower real output, declining profits, etc. Moreover, the experience indicates that the longer and more rapid the inflationary surge, the more painful the withdrawal process.
We turn now to my not-so-Delphic forecast of things to come. We have before us most of the ingredients on which I base my specific predictions.(1) We will have continuing, in fact accelerating inflation in the years ahead. Reasons: (a) It would be too painful to stop it. Not only would it be painful to many of the citizenry; because it would be painful to the citizenry, it would be political suicide for any administration that really attempted to do it. I am saying that I doubt if any administration could stay in power long enough (or continue to have power enough) to carry through to conclusion a really successful struggle to end inflation. (b) For the same reason, the administrations in power, of whatever political party, will find it necessary to move to a higher rate of inflation from time to time to avoid the letdown that continuing a fully anticipated rate of inflation inevitably brings.(2) We will
not have a major depression in the next two decades. No administration could tolerate it, and the alternative (a step-up in the rate of inflation) is much less dangerous, politically, than a major depression. However, because of the imperfect nature of
all attempts at control and because of the necessity from time to time of taking half-hearted steps to slow down inflation, there will be occasional periods of recession. These will be marked by reduced rates of real growth, perhaps even negative real growth, higher unemployment, etc.,
but not by lowered levels of prices and wages. (The descriptive word is “stagflation”—stagnation with inflation.)(3) We will have off-and-on wage and price controls. Too many people believe the Galbraith myth, and the pressure on administrations to do something (or to seem to be doing something) about inflation will bring recurring trials with direct controls. Each new return of controls will be greeted with huzzahs and cheers (even from the business community), only to fall victim to the inevitable frustrations and conflicts of the economic anarchy produced by those controls. Each repeal, though, will leave a larger part of the economy under some form and degree of direct controls.(4) The combination of continuing (accelerating) inflation and on-again off-again controls will make it increasingly difficult for economic calculation to take place with any degree of efficiency. The subsequent inefficiencies, shortages, frustrations, and inequities will lead to increasing demands for even more detailed control of the private sector. In banking, this may well take the form of governmentally assigned quotas of lending to identified groups and for identified purposes at levels of interest rates well below market. This in turn will mean that the government will itself become an ever more important guarantor of loans and fund source of last resort.(5) The increasing control of economic life by government can have but one effect on the vitality and strength of the economic process—and that is to sap the vitality and diminish the strength of the most productive economic system in the history of man. With the size of the pie growing but slowly or diminishing, the conflicts over its division will increase in intensity. As the English experience so clearly demonstrates, these conflicts (particularly in the form of labor disputes) can make the efficient functioning of an integrated economy virtually impossible.All of this in turn will reduce the capacity of this country to compete in world markets. Our fate, as England’s, will then be chronic balance-of-payments problems, continuing loss of faith in the currency in the world money markets, and periodic crises of increasing dimension. If this analysis be at all accurate, then we can say, with Archie the Cockroach, that there is indeed more reason to be optimistic about the past than about the future.
Washington Post, July 28, 1971.
Industrial Concentration and Inflation (Washington, D.C.: American Enterprise Institute, 1975), p. 1.
Here again Brozen is a useful source; see his “Concentration and Profits: Does Concentration Matter?” in Brozen,
The Competitive Economy (1975).
Government Mandated Price Increases: A Neglected Aspect of Inflation (Washington, D.C.: American Enterprise Institute, 1975), p. 3.
Joseph A. Schumpeter,
Capitalism, Socialism, and Democracy, 3rd ed. (New York: Harper & Row, 1962), p. 99.
The Wealth of Nations
(New York: Modern Library, 1937), p. 651.