University of Virginia Library

Colloquium

You Can't Run A Country On Peanuts

By RICHARD SELDEN

—Ed.)

The U.S. now finds itself in a
serious economic predicament, and
the Nixon Administration likewise
faces a serious political
predicament. To understand these
problems one must look back at
least as far as 1964 when President
Johnson, newly in office,
engineered a massive tax cut
without any concurrent adjustment
in federal government spending.
This stimulative action was
followed in 1965 by a significant
step-up in our Southeast Asian
military operations. Many
economists believe that such highly
expansive fiscal policies inevitably
had to result in inflation since there
was little slack in the economy by
1965. Moreover, many laymen as
well as economists believe that wars
necessarily generate inflation, and
that once the decision was made to
accelerate hostilities there was
really no way of avoiding inflation.

Economic Disaster

I disagree, although I will
readily admit that there has been
almost a one-to-one correspondence
in the past between major inflations
and wars. I am also willing to
concede that some relatively minor
inflation was likely in 1966, given
the excessive fiscal stimulation of
1964-65. Unfortunately, however,
monetary policy decisions by the
Federal Reserve authorities (Fed.)
converted an already tricky
situation into an economic disaster.
During late 1965 and early 1966
the Fed permitted the nation's
money supply to grow at rates far
in excess of the economy's ability
to expand real output. As one
would expect, upward pressures on
prices became very strong and
widespread.

Now the men who set Federal
Reserve policies are neither evil nor
stupid, so the questions arise, "Did
they have a choice? Could they
have prevented what everyone now
recognizes was grossly excessive
monetary growth in 1965-66?" The
answers, I believe, are clearly "yes."
The Fed has adequate powers to
prevent excessive monetary growth.
The reason they failed to use these
powers seems to be that their
actions were being guided by an
incorrect theory of how monetary
policy works. Apparently they were
misled, as they have been on many
occasions both before and since
1965, by the fact that interest rates
were rising quite rapidly and had
reached what at that time seemed
dramatic levels by early 1966. The
Fed believed, in orthodox
Keynesian fashion, that it could
check the interest rate rises by
making money and credit more
plentiful. It is now clear that this
policy was self-defeating: rapid
monetary expansion was the cause
of the interest rate rise, as lenders
demanded compensation through
higher rates for the inflation that
they foresaw in the months and
years ahead.

At any rate, by early 1966 it
was obvious to everyone that the
economy had strayed seriously
from the stable growth path it had
been following in the early 1960s
The Fed responded by throwing its
money machine into reverse
between April and October 1966.
Not surprisingly the inflation soon
began to abate. However, credit
market do not easily adjust to such
rough tactics and by August 1966
the famous "credit crunch" was in
full swing. Faced with what it
believed to be the beginnings of an
old-fashioned liquidity crisis, as in
1893 or 1907, the Fed started the
money machine rolling forward
once more—again at a rate that
would certainly be untenable for
any prolonged period.

The Federal Reserve narrowly
averted a recession in 1966-67, but
only at a cost of propelling the
economy forward again at an
inflationary rate. As interest rates
skyrocketed in 1968 and 1969 the
Fed persisted in its permissive
monetary policy, fearful of
inducing another credit crunch.
When Congress finally got around
to raising income taxes(temporarily)
in June 1968, economists at the
Fed began to cry out in anguish

about "fiscal overkill". Their belief
in the potency of fiscal policy was
so strong that they expected the
tax increase to produce a recession.
So excessive monetary growth
continued and was rationalized as a
needed antidote to the "overdose"
of fiscal medicine. Meanwhile,
inflation was accelerating, reaching
six percent plus rates in late 1968.

Finally, early in 1969 the Fed
screwed up its courage and
slammed on the monetary brakes
once more. This time it slowed the
economy enough to generate a
classical business recession,
beginning in November 1969. The
recession turned out to be the
mildest ever recorded—so mild that
it was almost over before
economists could agree that there
had been one at all. The overall
unemployment rate never exceeded
6.2 percent compared with levels of
7.5 percent and 7.1 percent in the
recessions of 1957-1958 and
1960-61. Indeed, if one looks at the
more meaningful unemployments
rate for married males only, one
finds that the 1970 levels were not
much higher than those of most
prosperous years of the past.
Similarly, the decline in production
was very slight. By the end of 1970
the recession was over, and a steady
though hardly vigorous recovery
has been under way since then. It is
reasonable to suppose that the
economy will be back at "full
employment" sometime in the
next couple of years.

Recession is Recession

The mildness of the 1969-1970
recession should be no cause for
jubilation among our policy
makers. A recession is a recession,
and even a mild one adds up to
many hardships. It is fair to ask,
therefore, whether these hardships
were necessary and whether they
served any useful purpose. This
brings us back to the economy's
predicament. The Federal Reserve
initiated its restrictive
recession-producing policies in
1969 in an attempt to stop the
inflation. Some critics are inclined
to believe that this was a misguided
objective— that it would be better
to "relax and enjoy" the inflation
rather than risk a recession by
fighting it. On this issue I side with
the Fed, and with the Nixon
Administration. Failure to fight the
inflation would have had at least
three adverse consequences. First,
an unchecked inflation results in
deterioration in our competitive
position on world markets.
This would be no cause for concern
in a world of flexible exchange
rates. In the real world, however,
balance of payments problems are
apt to lead to all sorts of inefficient
government interventions into
international trade. A basic cause of
the dollar's weakness recently is
that U.S. prices have been rising so
rapidly. Second, an unchecked
inflation produces arbitrary wealth
and income transfers withing the
economy, with much social
discontent on the part of those who
get the short end of the stick.
Third, an unchecked inflation tends
either to accelerate or to result in
unemployments, as employees seek
ever-larger wage adjustments to
protect themselves from anticipated
inflation in coming periods.

Nixon's Mistake

But even if it is agreed that
inflation must be controlled, it still
may be objected that there must be
some way of doing the job without
plunging the economy into a
recession. Perhaps so. The simple
fact, however, is that there is not
one instance throughout our long
history in which an inflation was
brought under control without a
recession. This, of course, does not
mean that it is silly for policy
makers to spend time trying to
figure out a way of ending inflation
without a recession. Nevertheless, it
would be grossly unfair to blame
the Fed and the Nixon game plan
for failing to achieve what nobody
else has ever succeeded in achieving.

Two things are disappointing
about the performance of economic
policy over the last couple of years.
One is that Mr. Nixon led the
public to believe that he would be
able to check inflation painlessly,
whereas, as we have seen, no
painless remedy is yet known.
When the recession came along in
the wake of the Fed's anti-inflation
policies, there was considerable
disillusionment with the Nixon
game plan, even though it could
reasonably be argued that the game
plan was the best we could do. With
the benefit of hindsight it now
appears that Mr. Nixon should have
stated forthrightly in January 1969
that he intended to stop the
inflation and that this would
involve some short-run sacrifices in
order to achieve longer-term gains.

The second more serious
disappointing aspect of the
Nixon-Federal Reserve policies is
that so little progress has been
made in controlling inflation. Prices
continues to move upward right
through the recession (However,
this has often happened in the
past), and even the rate of price
rise has remained unacceptably
high. Some observers take this as
evidence that the economy is
suffering from hardening of the
arteries—that big labor and big
business have introduced so many
market imperfections into the
system that traditional monetary
and fiscal policies no longer work
and must be supplemented by
direct wage-price controls of some
sort. This is the kind of thinking
that lies behind the 90-day freeze
of Mr. Nixon's New Economic
Policy (NEP).

My own view is that this
thinking is wrong. One need not
invoke market imperfections to
account for the intractability of
inflation since 1969. The inflation
has lasted longer and proceeded
faster than any inflationary episode
in recent times. Moreover, it
followed a menacing accelerating
course until 1970. It is reasonable
to suppose that the degree of
difficulty in controlling an inflation
will depend on its duration and
severity. Instead of prolonged and
powerful restraints, however, the
Fed tightened its policies
moderately for a period of only six
or seven months. In retrospect it
seems obvious that this degree of
restraint could not possibly have
achieved dramatic results in slowing
inflation.

But this is water over the dam.
The old game plan has been
scrapped, and the public is now
being reassured that inflation can
be stopped by a variety of
palliatives that are euphemistically
referred to as "incomes policies."
The outlook for price stability is
bleak. What the NEP does
(assuming that Congress ratifies it)
is to throw more fuel on the fires of
inflation, not less— all in the name
of restoring full employment. There
is a real chance that a resurgence of
inflation will be evident by election
time next year; or alternatively,
that the inflationary forces will be
repressed by an increasingly rigid
and irksome set of wage-price
controls. Neither alternative is likely
to provide an attractive setting for
Mr. Nixon's re-election prospects.

Job Unfinished

Whether or not Mr. Nixon's
NEP will prove sufficient to earn
him another term in the White
House is anyone's guess. But
whatever else the NEP may
accomplish, it seems fairly certain,
that it will leave unfinished the job
that Mr. Nixon set out to do when
he assumed the Presidency—Bring
the inflation to an end. One thing is
indisputably clear. Inflation is a
more serious social problem than
many people have believed
heretofore. If we ever succeed in
getting back on the stable growth
path, our policy makers must take
particular pains to avoid the sort of
go-stop-go monetary fiscal policies
that led to the present predicament.