Author: Date: Thursday, May 21, 1981
Page: ?????
Section: ECONOMY

It's perfectly possible to have both sustained economic growth and low inflation. The only thing needed is a dose of good government-monetary policy on the one hand and fiscal and regulatory policy on the other.

In monetary policy, the Federal Reserve must terminate its tendency to swing widely from one extreme of monetary growth to the other. In the last year, this has caused wild swings in interest rates and dramatic downs and ups in the economy. If this erratic policy were to continue, it would be impossible to achieve steady growth with low inflation.

Controlling the growth of money is important because, ultimately, inflation is a monetary phenomenon - nothing else.

If you control growth of the money supply, you control inflation, if you do not, inflation cannot be limited. Secondly, this control is important
because money is pervasive and affects the entire economy.

The recent instability in monetary growth produced the economy's instability. The economy requires a background of a stable monetary policy so that people can make their plans.

Curing inflation is a necessary condition for making progress on our second problem. Slow and erratic growth. But two other areas also need to be attacked if we are to speed growth:

First, the government is absorbing an ever larger fraction of the economy's resources, leaving less for the private sector to grow on. There has been no period in peacetime history when government spending has been as high a fraction of national income as it is currently.

Second, government is reducing incentives for people to save, to invest, to innovate. High marginal tax rates cause people to seek out tax shelters rather than productive investments. In addition, government regulation and extensive control over the details of economic activity mean that a large fraction of the investment that is undertaken is done to meet specific regulations rather than to add to the nation's productive capacity.

For instance, a major source of slow growth has been our incredible energy legislation. First it required enterprises to burn one kind of fuel, then another. It led to scarcities, then ample supplies of natural gas. The federal government has been a bull in the china shop, rushing one way and another and making it very difficult for the shop owners to keep things in order.

To get out of this situation, the steps that must be taken are clear: They are the ones that President-elect Reagan committed himself to during the campaign.

First, the Kemp-Roth tax recommendations. These include an annual 10 percent across-the-board reduction in individual income-tax rates for the next three years, and then indexing the tax system against inflation as well as accelerated depreciation for business in order to encourage productive investment. Second, an immediate revision of the US budget, with a lower ceiling on total expenditures. Third, a reduction of the regulatory burden on industry by executive order, such as lifting the ceiling on crude oil and gasoline prices. Fourth, presidential support for a policy of stable and steady monetary growth.

On the budget, it is not essential to balance it. It's much more important that government spending be lowered as a share of national income. Total government spending - federal, state and local - now takes well over 40 percent of national income, the federal government two thirds of that. I would much rather have a $300 billion federal budget that is $200 billion in deficit than a balanced budget of $600 billion.

If all these recommendations were followed, we would achieve the goals of steady growth and low inflation in four to five years, based on the experience in other nations.

It would work something like this, assuming we start immediately: After a brief initial period, inflation would be dropping. In the first year or two, unemployment would remain relatively high, and growth would be relatively slow. In the final three years, you would have rapid growth along with declining inflation, Thus you'd move into a healthy economy in the second or third year.

In this timetable, I assume that federal spending is reduced gradually and that monetary policy produces a steady decline in the rate of growth of the money supply - not a sudden shock, but a reduction of about 1 percentage point a year for the next five years.

It wouldn't take a depression to get us back on track. Our problems are not that extreme. But individuals must realize that, in the short run, there is no policy that will do the job and have a good effect on them.

There is no perfect, painless alternative - only bad options.

There are two choices. You let inflation continue or speed up, in which case everybody gets socked. In this case, all you're doing is postponing the evil day of dealing with the situation. By then, inflation will be even worse. Alternatively, you go through a period of difficulty as a side effect of an effective cure for inflation. For individuals, this means a year or so of low economic growth, relatively high unemployment and slow growth in incomes.

As for the government's role in the economy, inflation is entirely made in Washington - and nowhere else. Events such as crop shortages and oil-price increases send the price of those goods up relative to other things, but they don't produce inflation.

There has been a persistent policy on the part of governmental officials of blowing a smoke screen. They say: "Don't blame us for inflation. It's due to bad Arab sheiks or greedy businessmen or grasping trade unionists or spendthrift consumers." They're trying to find alibis.

Real economic growth can be interfered with by the government, but it cannot be produced by the government. Washington can provide a favorable background, but real growth fundamentally is produced in the private sector by individuals saving money, investing money, taking risks, innovating.

The government cannot fine-tune the economy to eliminate every up and down. Its attempts to do so have made the ups and downs worse, not better.

There are severe limits to the good that the government can do for the economy, but there are almost no limits to the harm it can do.

Despite the inevitable difficult period at first, I'm quite optimistic these recommendations for stable, low-inflation growth will be carried out. The results of the election said that the people of America are fed up with the inflation we've experienced, the uncertainties we've experienced, the burdens we've experienced. The election produced a clear mandate for change.

On the other hand, if we were simply to continue along the path of the previous 20 years, we would get more of the same, but in a more extreme way. We're now on a roller coaster of inflation, with each peak higher than the previous one. So we could have inflation in the 15 percent to 20 percent range.

We would have worse stagflation, higher unemployment. But sooner or later, public opinion would be sufficiently strong that the kinds of policies I've described would be put into effect. I'm quite hopeful there will be a change.

Lawrence R. KleinFRfi*

Awarded the Nobel Prize in 1980 for his development of computer models to analyze the economy, Klein, 60, is a professor at the University of Pennsylvania.

Intellectually and logically, there is no reason why we can't get out of the mess of low growth and high inflation that we're in now. Other countries, including West Germany, Switzerland and Japan, have managed to do it - at least for a while.

But there is no quick cure. If you accept the view that our problem was fairly long in building up - usually we take the starting point as 1965, during the Vietnam War escalation - then it's reasonable to believe it will take a long period to wind it down.

What is required is greater capital formation, a larger proportion of expenditures for research and development, more-generous support of basic research and further industry deregulation. These are all elements of a developing consensus on US industrial policy.

Our efforts should be oriented toward business tax cuts rather than personal. Productivity needs to be improved. Capital formation has been lagging. More-efficient use of energy has been lagging. These are not the kinds of things that individuals can effect directly, so one would naturally think that the business sector is where the first gains are to be made.

We can do this by tilting the tax system to encourage more capital formation. For instance, the attitude in tax legislation in recent years has been to give 60 percent or 70 percent of the benefits to individuals and the remaining 30 percent or 40 percent to business. We should tilt the tax system to reverse those proportions.

I strongly believe, too, that if we are to deal satisfactorily with our present problems, economic policy must become more structural. That is, it must be oriented more toward supply-side conditions and must be aimed specifically at various industries and activities.

A tax cut in 1981 is advisable if it is tilted as I've described.

I don't like the Kemp-Roth proposal, because it cuts tax rates across the board and is not tailored to deal with our specific problems. Furthermore, we don't need to stimulate individuals' demands. We're coming out of the recession without special stimulus. I'd prefer to see tax cuts in the form of savings incentives for individuals.

We're in a situation now where we need to encourage demand on a selective basis, for particular kinds of things. For example, it would be good to encourage people to buy fuel-efficient cars rather than low-mileage ones.

Overall, we need to emphasize shifts that will help us get out of the bind we're in now. If you tailor tax cuts to shift people's energy use or to promote capital formulation and higher productivity, then you get more out of the tax system than simple reductions.

Forcing the federal government to have a balanced budget is good discipline. It's a way to enforce efficiency in the operation of the bureaucracy, so we should aim for it as a goal. But a balanced budget is not particularly useful as a symbol of the fight against inflation or as a guide for whether we're operating the macroeconomy appropriately.

I'm in favor of an incomes policy, using the tax system to restrain increases in wages and prices. When you know it's going to take a long time to lower inflation and build growth, then an incomes policy can be of great help in accelerating the process.

With good luck and wise policies, we could be in much better shape by 1985, with an annual growth rate of 3 percent and an annual inflation rate of 7 percent. If we make extra efforts and are very skillful and have really good luck, then we ought to get down to 5 percent inflation and up to 3 percent real growth by then. We should begin to see improvements by 1983 if we follow this course.

For a long-term approach to work, top government officials have to have a definite view in mind of what they intend to do, and they have to be very gutsy about it. They have to be very steady and persistent. What we've had is people reacting to every problem of the day, to every six-month problem. They've seemed unable to take a long view and to plan accordingly. It's hard for politicians to take a long view because they all are running for reelection from day one.

People will have to accept that this slow, gradual course may mean some years of very slow improvement in their living standards. But it does not necessarily mean that our levels of living have to go downhill. Individuals also have to be more patient in waiting for economic results. Along with that, they need to be given better explanations of what's going on so that they'll know what they're being patient about.

The Federal Reserve should focus on keeping interest rates and foreign- exchange rates steady. I'm not a fan of its present techniques to control the money supply, with interest rates flopping all over the place.

The trouble is, I think, the Fed has overreacted and lost control. The monetary aggregates haven't followed the course that the authorities want. The factor that is easiest to control but has only an indirect link to the money supply - bank reserves - has translated rather poorly into achieving the Fed's targets for growth in the money supply. So present policy is not working satisfactorily.

KENNETH J. ARROW

Arrow, 59, is a professor of economics at Stanford University. He shared the Nobel award in 1972 for pioneering work in the field of equilibrium theory, dealing with balances among economic forces.

The historical record suggests that it is possible to have sustained growth without high inflation. On the other hand, we seem to have built in a set of inflationary expectations, together with a combination of circumstances we don't fully understand, that have created a self-perpetuating core of inflation. So it is very difficult to see any set of policies that would enable us to have both high employment and full growth.

Looking out over the next six to seven years, it doesn't appear possible to sustain really good employment and avoid inflation.

Still, we can improve the present situation. There are considerable possibilities for working toward a higher sustained level of employment while keeping inflation within moderate levels.

The most important thing is a steadiness of policy. A great effort should be made to stabilize the operation of both the money supply and the government fiscal system. Admittedly, this is not an easy prescription to follow.

The volatility of the money supply in the last year has been quite
alarming. I am worried that the Federal Reserve may be unable to control the growth of money. It's possible we're in a new situation where our money supply is so affected by foreign-curren cy flows that new restrictions may be necessary on the movements of foreign capital. That would be an unpleasant and undesirable policy. The alternative is coordination of policy among the leading nations - and that has failed.

By the same token, the role of government expenditures in the economy should be more stable. It's not so much a question of a high level or a low level, but a stable level. We shouldn't have a big increase in spending one year and deep cuts the next.

The problem is that government spending is, in part, dictated by considerations other than the economy. For example, it probably is more important to defend the country than to worry too much about the stability of the economy. But ultimately, of course, an unstable economy may be the greatest blow to defense.

A tax cut should be one of the first items of business in 1981. The 10 percent cut being declared sounds about right. Beyond that, the idea of cutting taxes 10 percent a year for three years sounds absurd. It will produce deficits of the type that even one who views deficits with as much equanimity as I do finds horrifying in terms of reducing private investment and the like.

One thing that fuels inflation is the expectation of future inflation. To the extent that you can be convincing about holding it to the present level, you're probably helping to produce the rate of inflation in the future.

Still, I'm not optimistic about quickly or dramatically reducing inflation from the present level of 10 percent or so. I hope in two years we may nudge it down to 8 percent. That would be a great accomplishment.

If we could reduce it about 1 percent per year for the next 10 years, that is a lot better than we did over the last decade.

There is no good theory showing that budget deficits are a problem as far as inflation is concerned - and certainly not deficits of the size we have now. They really are very modest in the overall economy.

The problem is a different one: How is the deficit financed? If it is paid for by printing more money, then the deficit is likely to be inflationary. But if the economy gets to reasonably full employment, you have another danger. If the government finances the deficit by borrowing rather than printing more money, it may crowd out private investments. That hurts the economy because growth ultimately depends in great measure on private investment.

The deficit should be measured in relation to the stage of the business cycle. I don't see much evidence that a deficit due to slack in the economy is inflationary. In fact, by most standards it is a positive influence in stabilizing the economy. Similarly, in a time of high employment it makes sense to aim for a balanced budget.

The long-run loss of output due to unemployment is basically a more serious issue for the economy than inflation is. I'd like to see moderate fiscal and monetary policies so that we can work on both problems simultaneously. But we cannot afford to let the employment situation worsen - even if it means giving up on other goals.

I disagree with those who suggest we use shock methods or a very severe economic slump to eliminate inflation. It could have permanently bad consequences. People don't get over a depression easily.

It would create very, very pessimistic expectations that would greatly inhibit new investment, research and business expansion.

Furthermore, there could be a permanent, bad reaction on wage demands. People who have been unemployed are apt to be very, very concerned about getting as much as they can during a period of prosperity.

Remember, our union movement increased enormously during the last depression. You could end up unleashing an even worse inflation during the subsequent prosperity.

Paul A. Samuelson

Samuelson, 65, a professor at the Massachusetts Institute of Technology, received a Nobel in 1970 for his widely-read works that have improved economic analysis.

Changing our present inflation-growth path quickly will take severe measures-which I'm not for. It's snake oil to believe that there is a simple, costless way of doing it. The simple truth is that in a modern economy like ours, you have to compromise among evils.

The only way we can improve the inflation situation in the short run is along a path that involves a considerable cost: Higher unemployment, stagnant production, and weak profits and capital formation.

In the long run, it's possible to achieve sustained growth with low inflation. But in economies such as ours, it is difficult because the system is biased toward upward price creep when business is grpwing vigorously.

The cardinal error that many people make is to think that inflation is like smallpox-if we can stamp out that last case of smallpox in Ethiopia, then it's gone for good. Instead, inflation is more like being slightly overweight. Anybody can go to a diet class and take off 20 pounds. The problem is keeping it off. Inflation is always there waiting, ready to reappear.

We are not locked into long-term inflation if we are willing to pay the price. The debate today is: What is the cost-benefit ratio of different measures designed to dent the rate of inflation? The prize of lower inflation will have to be bought dearly over a long period of time.

Other nations-including Switzerland, West Germany and Japan-have shown us that their achievements in slowing inflation were accomplished by less-than- average recoveries. The price of such progress will be even higher for the United States because of differences in our labor markets and other factors.

For an idea of the price we might have to pay, look at the last time we made significant progress on inflation-the eight Eisenhower years in the 1950s. People look back on that period with a golden glow. But the fact is we had three recessions in a two-term presidency. Even by prewar standards, that was a lot.

The average rate of real growth in output in the United States during the "miracle" years of the 1950s and early 1960s was 2 percent, at a time when growth in the rest of the world was soaring. The people who came in with John Kennedy verified that the actual growth potential for the American economy at the time was more like 4 percent. So the difference between 2 percent and 4 percent real growth might be a measure of the cost that was paid to dampen the inflation caused by the Korean War.

Today, assume the potential growth for the economy might be 2 percent per year over the next eight years. To get our core rate of inflation down to between 3 percent and 5 percent from its present level of around 10 percent, you would have to sacrifice, on the average, growth of 1 percent a year or so over the full eight years. Such a period would go down in American history as one of the longest anemic peacetime recoveries.

There may be many people in America willing to pay that price. But many other groups have not thought of our economic problems in terms of these tradeoffs. It could be quite tough, for instance, on the progress that black workers have made. My personal judgment is that this is too severe a price for less advantaged people to pay. I would favor slower progress on inflation so that economic growth would be somewhat higher.

Tax cuts alone won't bring us lower inflation and steadier growth. There is a great deal of supply-side moonshine for which there is no scientific basis.

The talk of repeated tax cuts, such as the Kemp-Roth proposal, along with new tax giveaways to stimulate good causes, means a more expansionary fiscal policy and bigger deficits unless there are cuts in nonmilitary spending. Interest rates will be rising.

So what you do to stimulate capital formation on the one hand, the Federal Reserve is going to have to undo on the other hand by rationing credit and making it costlier. This suggests to me that the new administration will have to do some very unpopular cutting in programs. Improving efficiency won't lower spending enough.

There are some who think the Fed should set its targets for monetary growth and ignore what the rest of government does, I disagree.

For good policy, the Federal Reserve will have to take into account what is happening elsewhere in government. If, for instance, the budget is severely balanced, the Fed should be on a pro-capital-formation, low-interest-rate track. But if all the tax reductions take place, expenditure cuts don't stick and military spending is increased, leading to a budget out of control and demand-pull inflation, then the Fed should be tight with the money supply. That's not fine-tuning the economy. It's coarse, common sense.

When it comes to the US, budget, the issue of whether the budget is one pfennig out of balance or two pfennigs in balance is an ideological and symbolic one. It has no economic significance. The difference between small surplus or small deficit in a $2.5 trillion economy is symbolic as an indication of society's spending discipline or its humaneness to individuals.

I do not favor wage and price controls. They work very well in the short run. But we have a long-run inflation problem, so save devices like controls for an emergency.

Reprinted from US News & World Report.

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