Charting America's Future: The Roots of Stagflation

...They complain only of those of other people...

...With less building, and more households, the cost of housing shoots up—not only for private homes but also for rentals and condominiums What holds for housing applies to all commodities and services in short supply due to the brake put on production by high interest rates 4. PRODUCTIVITY LAG...

...ADAM SMITH Stagflation is a recently coined word It is not mentioned in Webster's Third International Unabridged Dic-tionary(1966), or in the New Columbia Encyclopedia (1975) It does turn up in the Harper Dictionary of Modern Thought (1977), where it is described as a "term introduced by Ian McLeod to mean a combination of inflation and industrial stagnation", and in the American Heritage Dictionary (1978), where it is defined as "a condition in which a high rate of price and wage inflation is coupled with stagnant consumer demand and high unemployment" By the late 1970s, it was inevitable that somebody would give a name to the illness plaguing the decade Until then no name was supplied because, according to classic economic doctrine, there could be no such thing Prosperity brought rising prices and depression falling prices, it was simply impossible to have rising prices in a falling economy But McLeod, who was more a politician than an economist, was not sufficiently steeped in traditional tomes to be blind to what he saw, so he invented an appropriate oxymoron to label the sickness of the '70s Actually, stagflation was born many decades earlier, around the turn of the century (1897-1905) when the free enterprise system began to lose some of its freedom and prices became more subject to corporate power than to market forces Prior to 1897, the price trend over 97 years was downward a decline in 56 years and a rise in 41, from 1897-1980, the price trend was upward, rising in 65 years and falling in only 18 The most intriguing contrast in price behavior before and after 1897 was dramatized by two depressions one in the 1890s, the other in the 1930s Although both were severe, the Great Depression of the 1930s was by far more precipitous Yet prices did not go down as in the 1890s Something had happened in the economy that made them act in a perverse way, they refused to fall—as the good textbooks required—in line with the drop in demand A clue to the mystery was provided at the time by Gardiner C Means Together with Adolf A. Berle, Means had written an epic on the way modern corporations are run He applied his knowledge of big business techniques to investigating the odd behavior of prices during the Great Depression and found that wheie oligopoly (concentrated ownership) existed, it was the it was the practice to set "administered prices " In other words, prices were held up at a predetermined level with minimal regard for what was happening in the market And since there had been a marked trend toward oligopoly, starting with a trustification movement in the years 1897-1905, by the Depression years enough of the American economy had come under administered pricing to upset the mechanics of a truly competitive economy Concentrated ownership allowed the handful in control to fix a price and maintain it by agreeing on limiting production to keep down the supply What Means found, however, was merely the germ of stagflation Prices did not fall according to classic reckoning, but neither did they rise, there was rigidity Eventually, the pattern—registered in successive recessions—became one of prices acting in an increasingly contrary fashion—going upward as the economy went downward Before exploring the phenomenon in detail, let's take a brief look at the syndrome itself The earliest recorded case of honest-to-goodness, fully matured stagflation in the United States occurred in the 1950s " In the five years from 1953-58," observes Means, "there was an 8 per cent increase in the wholesale price index, while at the same time unemployment of both men and machines was evcessive higher at the end than at the beginning In those years, the price level did not rise in every sector of the economy?only in the ohgopoy vones Reviewing the period, John Blair, former chief economist for the Senate Anti-Trust Committee, has noted "The general pattern was one of price increases in the concentrated, inflexible-price products and of decreases in their unconcentrat-ed, flexible-price counterparts " In the 1970s, Arthur F Burns, economic adviser to President Richard M Nixon and chairman of the Federal Reserve Board, confronted the same situation Annoyed, almost angry at the refusal of prices to come down under the Administration-induced recession, he ticked off the climbing numbers " In the concentrated industries energy, up 11 percent, transportation equipment, up 9 per cent, metals and metal products, up 8 per cent, machinery and equipment, up 7 per cent, nonmetallic minerals, up 6 per cent, and rubber and plastic products, up 5 per cent Meanwhile, in the less concentrated industries, such as processed foods, skins, leathers and hides, and textile products and apparel, price changes were below average, at about 2 per cent " What Burns was describing, of course, was what Means had discovered in 1935 amely, theduahtyof the American economy The competitive sector has its price set by the market, the noncompetitive sector sets its price for the market Once oligopoly dominated the economy, its practices put pressure on the competitive companies to raise prices to keep up with rising costs As a consequence oretold by Means?prices simply refused to recede with the recession Burns had prescribed to counter inflation Disconsolately the nation's foremost proponent of deflating prices by depressing the economy had to confess 'So the medicine that was supposed to cure inflation apparently went down smoothly for the concentrated industries But the nonconcentrated ones took their lumps without a significant payout in lowering of inflation " Over a half century (1930-80), the "administered price" that had been the abnormal became the norm as the total economy was transformed from imperfect competition to imperfect monopoly When Means did a study for the National Resources Committee in 1939, only one out of five manufacturing industries met his standards of "concentrated ownership " But a generation later (1975) he would write "When actual transactions in the modern world are examined, it is found that prices are seldom highly flexible and that supply and demand in the traditional sense are seldom equated by price For most goods, the price has been set, usually by the seller, and kept constant for a period of time and for a series of transactions " Despite the fact that the Means analysis advanced in 1935 has been repeatedly confirmed by our experience, it has been almost completely ignored in the making of public policy Indeed, throughout the long "liberal era" no President and no Congress tried to restructure the economy to curb the power of concentrated ownership over prices So the strength of this economic elite has grown virtually without interruption, and the influence of administered prices has been felt both in good times and bad It has been most harmful, though, in recessions or depressions For contrary to all that common sense suggests, it is in a weak market that corporations are under greatest duress to raise prices, driven less by greed than by need One reason for this is the top-heavy structure of the oligopohzed sector, the disproportionately great sums sunk into land, factories, machinery, design, supervision, local taxes, etc These costs are fixed, as differentiated from the variable costs that go for materials and labor, and regardless of whether a facility is running at full or at half speed the fixed costs must be met Consider the simple case of a company that puts $1 billion into buying a new piece of equipment It plans to pay off this cost in 10 years, which comes to $100 million a year At full capacity it turns out 100 million widgets annually, and by adding one dollar to the price of each one gets the income to amortize the investment Then along comes a recession, reducing production to one half of capacity To pay for the expensive equipment, the company must now add two dollars to the price of each widget The situation is not imaginary, as consumers of electricity and heating oil have discovered in recent years When they patriotically followed the advice of the President of the United States to lower their thermostats and put on sweaters, instead of seeing their bills go down they saw them go up The utilities were granted rate increases because?as they argued successfully before public rate commissions with demand reduced they could not stay alive unless the unit charge was increased Falling demand necessitated rising prices Not all kinds of businesses are under equal compulsion to raise prices in response to declining demand A small labor-intensive business responds to a weak market by reducing its price, and by cutting back on production to use less labor and raw material It cannot take the course of the oligopohzed sector, for small labor-intensive firms are highly competitive, always fearful of being undersold Since their prices cannot be administered and total production cannot be curbed in a controlled manner, companies in the competitive sector have to suffer their way through recessions (assuming they survive at all) Big business, on the other hand, can and must raise its prices It can do so because it has little fear of competitors There are few of them, if any, in the capital-intensive areas, where great gobs of money are required to enter the fray At the same time, big business must raise prices to pay for the costly and now idle--overhead that fostered the concentration of ownership in the first place If oligopolies can and must raise their prices during recessions and depressions, it follows that their spread means the spread of this pernicious practice Ultimately, we reach the point (as in the 1970s) where what was once thought impossible, simultaneous stagnation and inflation (stagflation), becomes a commonplace recurrence There was no stagflation when President Nixon came into office Neither unemployment nor inflation was running high he jobless rate in 1968 was 3 5 per cent and the inflation rate was under 5 per cent But to the new Republican President, as to his predecessor, Dwight D. Eisenhower, inflation was the malady and recession was the remedy Unlike Eisenhower, Nixon was not going to sit back and just let the recession happen, he was going to make it happen He announced that he would "cool the economy," a euphemism for stunting economic growth and creating unemployment He was very specific about his plans In his 1970 Economic Report, he saw the growth of total spending (purchasing power) as "the driving force of inflation " To halt the drive, he proposed to "slow down the rapid expansion of demand firmly and persistently " He offered a timetable plus a formula two and a half years of synthetic stagnation He even submitted a visual aid to show exactly by how much he would depress the economy each year In his Chart 8 (on page 85 of his Economic Report), he showed the "potential" level of growth, which he found too high, and his "projections," or proposed level of growth, which was well below the potential In describing his plans for the years ahead, Nixon said "Projected available real output lies below potential output from 1970 to 1972 because some gap between actual and potential output is necessary to slow down inflation " In plain words, he would depress the economy in order to "deflate" prices Chart 8, reproduced below, ought to be placed in the Smithsonian as a historic treasure It marks the moment when a President of the United States, for the first time in the life of the nation, publicly proposed to throw several million Americans out of work and presented a pictorial rendition of his plan of attack The proposal, moreover, was not some passing tancy, it became the cornerstone of our economic policy for at least one full decade As might be expected, the move to promote unemployment especially commended itself to all who believed the cause of inflation was excessively high wages with their cost-push and demand-pull impact on prices The theoretical underpinning tor the policy was a highly popular economic theory called the Phillips...

...In 19S9 he published a pa-pei entitled 'The Relations Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1951-1957 " His famous document never established a parallel movement of wages and consumer prices, with the former stimulating the latter It only demonstrated that when employment was high (a tight labor market) wages went up—in the same way the price for anything goes up when demand exceeds supply But a wage hike need not mean a price hike for many reasons productivity (output per worker per hour) is increased, idle overhead is fully used, raw materials are cheaper, profit margins are cut, etc Nothing in Phillips warrants the conclusion that there is a built-in trade-off between unemployment and inflation Ironically, the Phillips study ends with the 1950s, precisely the decade when stagflation began to make its presence known With each passing recession, it had become increasingly evident that prices were rising, rather than falling, in poor times But sweeping the facts aside, the policy makers seized upon an irrelevant theory and twisted it to their own propaganda purposes, thus providing a lofty and learned rationale for throwing several million Americans out of work The prime lthough not the sole?instrument for cooling the economy was high interest rates There has been much talk about the various market forces that pushed up interest rates, yet the simple fact is that the Federal Reserve Board raised them by fiat It did this not in response to market pressures but to tighten credit, to limit the money supply To put it plainly, Nixon called for lowering output below the potential and the Federal Reserve Board made available the instrument for accomplishing this That is not to say interest rates don't respond to general inflation and to market pressures It is to point out that the first push to raise interest rates was not the work of Adam Smith's "invisi-ble hand," it was Arthur F Burns'very visible handiwork in his role as chairman of the Fed Had the interest rates gone up on their own, there would have been no need for Burns and his successors to use the power of the Fed to raise the rediscount rate, to set high levels of interest on funds borrowed by one bank from another, to set limiting ratios between reserves and loans, and to do dozens of other things to make it hard and costly to borrow The factual evidence that the recessions brought on by high interest rates did not hold down prices is amply strewn all over the 1970s economic landscape in annual or quarterly or even monthly reports Over and over, as the economy sagged, prices rose, as the economy lifted, the rate of inflation subsided After a half dozen years of such experience, Burns concluded that the suppositions on which he had been working were wrong and it was time to take another look at the way our modern economy is structured In a 1976 speech in Akron, Ohio, he said "If an unemployment rate of 8 or 9 per cent is insufficient to bring inflation to a halt, then our economic system is no longer working as we once supposed In the future, governmental efforts to achieve economic progress will need to encompass structural reforms as well as responsible monetary and fiscal policies " I have added the italics because the word "structural" is the key concepts Gardiner Means had affirmed in the 1930s Burns also made clear what our structural problem was "We must face up to the hard truth," he said, "that competition has become less intense in many of our private markets " Monopoly was making a mockery of deflation by depression High interest rates-con-cocted cooling bviously could not (as it did not) check inflation But it did (as it had to) add still another factor to the inflationary push—in at least eight different ways 1. THE COST OF MONEY...

...They are silent with regard to the pernicious effects of their own gains...

...Money is not merely a medium of exchange, it is a commodity as well The interest rate determines the cost of money, the charge to the borrower for the use of the money on loan When the Fed raises the interest rate, the cost of money goes up in exactly the same way as a price hike by opec sends up the cost of oil More costly money, of course, hasafarmore pervasive inflationary effect than more costly oil, since money is a universal ingredient in a money economy 2. CONCENTRATION OF OWNERSHIP Small and medium-sized businesses find it difficult, often impossible, to survive in an atmosphere of high interest rates With their typically shallow cash flow, these lesser firms must borrow regularly When times are bad, as in recessions that are induced by high interest rates, the little companies are under double compulsion to borrow But, at precisely such times, they are unable to do so because of the prohibitively high interest rates So they go bankrupt and their piece of the market is picked up by the survivors, the large companies, who have easier access to funds because they are internally financed, or because they have moneyed institutions represented on their board, or because they can borrow below the prime rate while their small competitors must pay above the prime The resultant concentration in ownership encourages inflationary administered pricing 3. RESTRICTED SUPPLIES...

...The recessions induced by high interest rates have kept the American plant running below capacity The idle overhead, as we noted earlier, raises unit costs, especially in heavily capitalized enterprises in the noncompetitive sectors of the economy 6. GOVERNMENT DEBT Governments borrow in the same way that producers and consumers do When interest rates go up, the cost of government goes up, whether Federal or local Within one quarter of 1981, the Federal deficit rose by $7 5 billion because the interest rates on Treasury notes rose by 3 percentage points This meant the government had to compete with the private sector for funds, putting added pressure on interest rates The greater costs to government and the greater pressure on interest rates did not serve any public need—not an extra job, not one more school lunch, not one more bazooka?but merely added to the income of those holding Treasury notes In short, inflation without any expansion in goods or services the mark ot stagflation 7 INFLUX OF MONEY Allhough the object of high interest rates is to curb the money supplv, thev set a curious countertorcc in motion that expands the money supply High interest rates in America attract capital from other countries where return on money is not so enticing The flow of money from abroad into our markets, quite ironically, offsets the efforts to reduce the money supply in the United States 8. INFLATIONARY EXPECTATION The very consistency of the Federal Reserve Board, its proclaiming that it will continue to raise interest rates as long as prices are going up, is in itself a stimulus for inflation The would-be borrower reads these repeated declarations of stern purpose to mean that the prudent thing to do is to borrow now, no matter how high the rate, because tomorrow the rate will be even higher The borrower, the consumer, the investor—the whole nation—thinks inflationary, an attitude that sends inflation spiraling on its way IB or all these assorted reasons?because it raises the cost of money, speeds the spread of monopoly, curbs supply, slows down productity idles overhead, adds to government costs, invites money trom overseas, and promotes inflationary expectations—the policy of high interest rates is inherently inflationary It is the iatrogenic drug that multiplies the maladies ot stagflation One aspect of this negative process the slowdown in the progress ot pro-ductivty requites special attention It affects prices at lionie and America's ability to compete abroad In oui next installment ol thissuies we will lddiess lhis subieu...

...Curve According to the savants in the White House and the pun-dits in the press who regularly reiterated this "law' of economics, unemployment and inflation were at opposite ends of a seesaw When unemployment went down, prices went up, when unemployment went up, prices went down So the way to bring prices down was to push unemploy ment up That reading of the Phillips theory was from the outset a corruption and vulgarizatiion of the original lindingsot W Phillips of Australian National University...

...The recession that high interest rates successfully create reduces the supply of goods, thereby pushing up prices Take housing High interest rates slow down construction because the contractor has to pay more for a builder's mortgage and the buyer has to pay more for his mortgage, the double increase moves new housing beyond the reach of the average family...

...They say nothing concerning the bad effects of high profits...

...Productivity (output per worker per hour) depends, in the long run, on the mix of employees and machines, with the American economy operating as the most productive in the world because of steady advances in the past in methods ol production Such advances depend on lesearch, development and innovation—processes usuallv conducted by small and medium-sized companies that are dependent on easy credit High interest rates make it impossible for these industrial explorers to do what they would like to do m the world of discovery and application The consequent lag in productivity progress contnbutes to greater unit costs and, hence, to inflation High interest rates put a drag on productivity in still another way, too, for output per worker falls in recessions and rises in recoveries Incredibly, this fact has been ignored in all the vast discussion about productivity 5. IDLE OVERHEAD...

...Our merchants and master manufacturers complain much of the bad effects of high wages in raising the price, and thereby lessening the sale of their goods both here and abroad...