1974 Annual Report Essay
The Limping Giant:
The American Economy 1974-75
Bruce K. MacLaury
President
Federal Reserve Bank of Minneapolis
As we close out the accounts on 1974 and try to peer ahead into
1975 and beyond, the economic barometer is giving out strong signals
of unsettled conditions, with a possibility of rough seas. The
sources of our malaise are well known, yet difficult to understand,
and still more difficult to deal with.
At least four factors are contributing to our troubled situation:
-
inflation,
-
recession,
-
"the energy crisis," and
-
questions of financial stability.
Each of these problem areas in turn has several dimensions—domestic
and international; long-term and short-term—and they are all
interconnected. It's small wonder that the public is confused, and
policy makers find it difficult to devise a comprehensive, yet comprehensible
program.
Inflation
There is not much profit in debating whether inflation or recession
is America's number one economic problem. There's little doubt that
we are suffering from both, and that the virulence of price increases
in 1974 had much to do with the recession we are now experiencing.
Nor is there much doubt that "stagflation" (i.e., a combination
of stagnation and inflation) is a worldwide phenomenon. Many of
the other developed countries experienced even faster price increases
last year than did the United States, and are now in a similar downturn
in economic activity.
The causes of inflation are many, and the importance of each factor
varies over time. We could leave such complexities to economic theorists,
were it not necessary to untangle them in order to prescribe appropriate
remedies. Some observers, noting the unusual persistence of inflationary
pressures in the postwar period, point to apparently fundamental
institutional changes in society as a root cause of our inflation.
They cite, for example,
-
the strong political commitment in most developed countries
after World War II to "full employment,"
-
the downward rigidity of wages in an era of labor unions
and unemployment insurance,
-
a similar downward rigidity of prices in key industries
where a few large firms can exercise market power,
-
the phenomenon of rising expectations worldwide, promoted
by advertising, transmitted by example, and financed by credit,
-
the allocation of a part of business capital financing to
non-output-producing investments in environmental cleanup
and employee safety. (Some might add, as a fundamental change,
a growing scarcity of resources to meet these rising demands,
but this point is much more controversial.)
On top of these secular trends that, it can be argued, now impart
an inflationary bias to the world economy, one must add a number
of cyclical and special factors that in 1974 drove the price indexes
to record readings. The worldwide boom of 1972-73, partly the result
of excessive monetary expansion, carried economic activity around
the globe to unprecedented—and unsustainable—levels. In
the process, bottlenecks were created in basic industries and in
raw material supplies that caused commodity prices to skyrocket.
The exchange rate realignments of 1971, and especially the second
dollar devaluation in 1973, added price and output pressures in
the U.S. and elsewhere that echoed throughout the international
trading world. Crop failures in 1972, and disappointing grain harvests
again in 1974, against a background of rapidly rising demand for
feed grains, resulted in sharply rising food prices at home and
abroad. Compounding the food price increase was the roughly four-fold
jump in world petroleum prices levied by oil-producing countries
following last winter's embargo. And to round out the picture, in
the United States, prices in several sectors probably rose unusually
rapidly this past year following the end of Phase IV controls last
spring, and perhaps in anticipation of possible new price/wage guidelines
in the coming year.
These myriad factors all contributed to upward price movements,
and we usually lump their effects together under the catch-all term
“inflation.” Yet it's clearly inappropriate, if not impossible,
to respond to a multi-faceted problem with a single policy prescription,
especially when “inflation” is only one of our afflictions. Indeed,
to the extent that last year's price increases were exaggerated
by non-recurring events, a policy response—apart from an attempt
to lessen the extent to which such increases are institutionalized
in 1975 wage settlements—should concentrate primarily on the
sources of continuing price pressures.
Recession
Given the boom conditions that characterized 1973, one could argue
that the world was poised for a cyclical slowdown in any case. But
the timing and extent of the slowdown were virtually impossible
to predict because of the extraordinary shock to the world's economic
system caused by first the oil embargo and then the increase in
petroleum prices.
In retrospect, it appears that in this country at least, and perhaps
elsewhere, the onset of recession was delayed—and the downturn
made potentially more severe—by the shortage mentality that
gripped businessmen. Not only were there real shortages of grains,
raw materials, and outputs of key basic industries in a boom economy,
but there were artificial shortages of petroleum and petroleum products,
and continued rounds of price increases that gave the appearance
of shortages. Order backlogs grew at misleadingly rapid rates; inventory
accumulation was stimulated not only by “shortages,” but by inflation
hedging; dollar sales appeared to hold up despite declining real
incomes; and nominal profits continued to rise, largely reflecting
the effects of inflation.
Because consumers in the United States had not previously faced
double digit inflation, they were probably unprepared for the rapid
inroads that price increases of that magnitude make on real incomes.
Only gradually, as bills accumulated, did it become clear that family
spending would have to be curbed—and big ticket items like
cars and color TV sets were the first to feel the jolt.
Thus inflation in its many manifestations was a key ingredient
in the present recession. Not only was real purchasing power siphoned
off by the oil producers, but disposable income was further eroded—for
both businesses and individuals—by higher taxes on fictitious
profits and misleading increases in nominal incomes.
If one could be sure that the present sharp down-turn in business
activity would be equally sharply reversed in coming months, then
it might be possible to dismiss this cycle as an unavoidable correction.
But because at least one element in the picture—the “energy
crisis”—is unprecedented (and unpredictable), one can have
no such confidence.
“The Energy Crisis”
Like inflation and recession, the energy crisis is a worldwide
phenomenon with worldwide repercussions. Unlike inflation and recession,
it is essentially a political problem, but with profound economic
(and social) consequences.
As with inflation, it is important to be specific about the nature
of the energy crisis. Obviously, if the major foreign oil producers
decide for political reasons to cut back production sharply once
again, then the developed countries dependent on their output are
in a crisis by any definition. And given the persistent tensions
in the Middle East, that kind of crisis can by no means be ruled
out. By the same token, that kind of crisis cannot be dealt with
by economic policy responses alone.
The vulnerability of the developed countries to an oil embargo
has been increasing over time. In the United States, for example,
consumption of petroleum grew at a 4 1/2 percent annual rate since
the mid-1960s, while domestic production ceased expanding in 1970.
At the moment, therefore, we are dependent on foreign supplies for
100 percent of any increase in our petroleum consumption. Moreover,
it seems fairly clear that world demand and supply of energy in
general, and petroleum in particular, could be kept in equilibrium
in the years ahead only at rising energy prices. Were it not for
the political vulnerability of dependence on unreliable supplies,
however, it's far from clear that the prospect of gradually increasing
energy costs could be characterized as an “energy crisis,” despite
the adjustments that would have to be made. The fact is, at today's
artificially high petroleum prices, there is surplus of productive
capacity and supplies, not a shortage.
What has turned the present situation into a “crisis”—apart
from the threat of another embargo—is not an energy shortage
as such, but the income, balance of payments, and financial consequences
of the
fourfold increase in the world price of petroleum. It is estimated,
for example, that foreign oil producing countries will accumulate
some $50 billion of trade surpluses, the rest of the world will
“accumulate” equal trade deficits—imbalances that dwarf any
previous experience. Theoretically, if the surplus countries were
willing to lend or invest their surpluses in the deficit countries,
the overall accounts could be brought into balance. As a practical
matter, such automatic recycling is not in the cards. As a result,
an urgent search is under way for new institutions to assist private
financial markets in rechanneling these huge balances. Even if such
institutions can be found, there remains a real question—how
long the rest of the world can afford to go on borrowing or selling
off assets to sustain economic activity on the basis of artificially
high-priced imported oil. And in the meantime, there will be increasing
temptations among deficit countries to solve their own problems
at their neighbor's expense.
A further aspect of “the energy crisis” is the distortion, or
perhaps more accurately, distension, of financial markets and institutions
that accompanied the massive rechanneling of financial flows from
oil consumers to producers and back. Actually, the private markets
have absorbed these shocks surprisingly well. Those financial institutions
that did get into well-publicized difficulties during the past year
seem to have been the victims of poor management and/or unwarranted
foreign exchange exposure in a world of floating exchange rates,
not innocent victims of forces beyond their control.
Nevertheless, it seems inevitable that the task of transforming
billions of dollars of oil revenues into productive, repayable loans
and investments will continue to place severe strains on existing
financial institutions. Not only is the rapid growth of assets and
liabilities likely to stretch further the banks' already reduced
capital ratios, but it will also be difficult to resist the temptation
to widen further the maturity gap between deposits and investments.
As has been pointed out elsewhere, recycling, while sounding easy,
really comes down to piling debt upon debt, with the institutions
in the middle between petro-lenders and consumer-borrowers—whether
private, national, or international—taking on substantial added
credit risks.
Financial Stability
Questions of financial stability are not confined to the new pressures
associated with petro-dollars. As with the other problems we now
face, some of our present difficulties are the result of trends
in progress for many years, from a peak at the end of World War
II, the liquidity of our business and financial institutions has
been gradually eroding, and with it, their flexibility to cope with
adverse economic circumstances. While attention has more often focused
on government deficits and the corresponding increases in federal
debt, a much more rapid increase has taken place in corporate debt,
in absolute terms and in relation both to business income and invested
equity. This increased leveraging has not only reduced the capability
of firms to withstand variations in income (i.e., made them less
stable), but has used up borrowing capacity that might see them
through economic reverses.
Several factors contributed to this trend:
-
declining rates of return on equity (i.e., profits),
-
tax laws that induce firms to raise capital in the form of
debt rather than equity shares,
-
investor preoccupation with "performance" as indexed by price/earnings
multiples, and
-
a generalized emphasis on rising standards of living now
(i.e., consumption) at the expense of more output in the future
(i.e., savings and investment).
Businesses in general, and financial institutions in particular,
have gone through an especially severe wringer this past year. Monetary
restraint tightened in the face of inflation-amplified credit demands,
and nearly brought new-issue credit and equity markets to a halt
in the early fall. Thrift institutions were hit hard by rapidly
rising interest rates, and housing suffered disproportionately as
a result. Capital values in the form of equities and fixed-income
securities eroded rapidly with rising interest rates, and business
ventures built on expectations of continuing inflationary boom began
to look much less attractive, both to investors and lenders.
These financial symptoms of an economy moving from boom to recession
are not different in kind from those experienced in previous business
cycles. But the unprecedented severity of the present inflation,
the distortions in the economy resulting from the energy crisis,
the reduced flexibility of less liquid, more leveraged firms to
cope with adversity, and the untested ability of international financial
markets to handle the wrenching transfer of financial wealth, all
raise new questions as to the ability of existing institutional
arrangements to withstand these pressures.
A program for 1975
If our current problems are as many-sided, interconnected, and
as long in accumulating as the foregoing discussion indicates, then
it would be holding out false hope to suggest that there are any
easy, simple, or fast-acting remedies. At the same time, we are
already late in getting started on a program to deal with our problems,
and an integrated approach must begin now.
Perhaps the greatest temptation (and the most dangerous trap)
would be to single out inflation or recession as “the” problem,
and then apply the standard treatment. There is a particular risk,
given the biases of our political system, that we will concentrate
on short-run “cures” for recession, to the detriment of our ability
to correct more fundamental weaknesses in our economy.
If the present recession were simply one more cyclical downturn
along an essentially stable economic growth path, then it might
be appropriate to try another dose of the medicine we've used in
the past—an expansion of federal spending and further easing
of monetary policy. But our problems today are intractable partly
because:
-
we have tried to raise living standards faster than investments
in productive facilities could keep pace;
-
investments, particularly those financed by equity capital,
have lagged as a result of inadequate rates of return on capital;
and
-
we have substituted credit expansion for savings as the means
to finance the growth of consumer and business spending. Another
dose of the old medicine would only worsen the disease, in
the longer run if not immediately.
Instead, if this analysis is correct, we are going to have to
accept as fact that we cannot continue to expand consumption (i.e.,
living standards) as rapidly in the next few years as we have during
the past decade. It is important to understand that this conclusion
rests basically on the argument that credit-financed expansion,
beyond a certain point, leads to instability rather than further
expansion. The conclusion does not rest on the dubious premise that
the world is running out of resources. It is strongly reinforced,
however, by the current drag on potential rates of growth in consumption
among developed countries imposed by the transfer of wealth from
oil consumers to oil producers.
In the past, widespread increases in standards of living in developed
countries eased social tensions that otherwise might have been associated
with disparities of income and wealth, both within and between countries.
If long-nourished expectations of “a better life” (i.e., more goods,
services, leisure, etc.) are now going to be frustrated, or at least
postponed, as seems inevitable, then there is going to have to be
an equitable sharing of the burden of this adjustment. This is particularly
true in the short run, given the disparate effects of past price
increases and the anticipated rise in unemployment.
The thrust of a program for 1975, then, should be:
-
to ease the harsher impacts of the current recession without
worsening inflation;
-
to do so in ways that are at least consistent with, and hopefully,
make a positive contribution to, a shift in the use of resources
from current consumption toward future consumption, i.e.,
investment; and
-
to mitigate the financial effects of the energy crisis, and
possibly turn them to advantage as a means of financing needed
investment.
This is no small order. Too often, however, we despair of finding
policies that can usefully attack inflation and recession simultaneously.
If there's a lesson in the above approach, it's that we can indeed
structure a program that takes advantage of the current recession
to get a start on our longer-run problem of inflation.*
The federal budget is a key element in any economic program. Like
other budgets, it has two sides, revenues and expenditures, that
can be adjusted to a considerable extent independently. Both tax
and expenditure changes, however, should be targeted toward achieving
each of the above objectives. To help ease the harsher impacts of
the current recession, for example, it makes sense that unemployment
benefits be expanded and that the public service employment program
be enlarged. This has already been done, and the adequacy of the
program will need to be reassessed in the months ahead. For the
same reason, the largest part of any cut in personal income taxes
should be targeted toward low and middle income groups whose incomes
have been eroded particularly rapidly by food and fuel price increases.
Other adjustments to the budget should be designed to stimulate
investment. Specifically, liabilities for corporate taxes should
be adjusted to compensate for the effects of inflation on nominal
profits and depreciation schedules. In addition, the investment
tax credit should be enlarged to, say, 10 percent. In the same vein,
dividends on new equity capital issues should be deductible as a
business expense (as interest payments on borrowings now are) to
reduce the bias favoring debt financing over equity. And capital
gains taxes should be prorated with length of holding period.
On the expenditure side, increases, except to ease hardship or
stimulate selected investments, should be severely restricted. So
far as investment priorities are concerned, a systematic process
for identifying high priority areas is needed. In the meantime,
energy research and development and mass transit (financed from
the highway trust fund, and designed to ease transition problems
in the auto industry) seem two reasonable candidates. Housing, though
technically an investment, would qualify for assistance primarily
to ease the severe slump in that industry.
To reduce the flow of dollars to oil producing countries, an effective
energy conservation program is needed. Voluntarism is not enough.
A sizable tax on imported and domestically produced petroleum is
essential, even though the effect will be to further raise consumer
prices. The substantial revenues generated by such a tax (together
with such “tax reform” measures as capital gains liability at death,
elimination of depletion allowances, and higher tax rates on preference
income) could be used to finance investment incentives and other
tax reductions in order to reduce the size of budget deficits.
There will be substantial budget deficits in the next couple of
years, however, and given the expected sluggishness of the economy,
deficits are appropriate. In the short run, with the economy expected
to operate so far below potential, reasonable deficits should not
add significantly to inflationary pressures. But in the longer run,
as the economy moves back toward its potential, deficits should
be eliminated since they represent, in themselves, dis-saving rather
than needed savings. Even in the short run, it is important that
the deficits be financed to as great an extent as possible from
savings rather than credit creation.
In this connection, there is an opportunity to tap the forced
“savings” extracted from this economy and from other developed countries
in the form of unspent revenues of oil-producing countries. Indeed,
it is essential that these huge “savings” be placed back into income
streams quickly if a world recession is not to feed on itself. Again,
in the short run, it is appropriate that such funds finance government
deficits. In the longer run, they must be channeled into productive
investments (rather than used to finance unsustainable levels of
consumption in the developed countries) if the credits and equity
holdings acquired by the oil producers in this process are to be
serviced.
Whether recycling of petrodollars in this fashion can be accomplished
is an open question. Indeed, if there is an Achilles' heel in the
prospect for recovery from the current recession, it will probably
stem from an inability of the world's economic and financial institutions
to adapt quickly enough to the financial consequences of the oil
price increase.
For this reason, among others, it is important to see that our
own financial institutions are in as strong a condition as possible.
Among the measures needed to reinforce confidence in those institutions
are the following:
-
supervisory insistence on gradually strengthened equity
bases, and an asset/liability mix less sensitive to interest
rate changes;
-
improved examination procedures, and reserve requirements,
for banks' Eurocurrency and foreign exchange positions;
-
standby authority for a government institution analogous
to the Reconstruction Finance Corporation;
-
consolidation of bank supervisory authority;
-
passage of the Financial Institutions bill, which, among
other things, would gradually remove interest ceilings on
consumer time deposits; and
-
curbs on further relaxation of consumer credit terms, and
eventually, some tightening of these terms.
On the price/wage front, the key risk now is that previous price
increases will become institutionalized through large wage settlements
in 1975. For this reason, among others, the Council on Price and
Wage Stability should be given subpoena powers, as well as the power
to delay wage settlements and price increases for up to ninety days
in key industries. The Council, if given sufficient prominence,
is also the logical body to publicize the direct link between restrictive
practices, productivity, and incomes. Wage restraint should also
be emphasized as a quid pro quo in connection with the tax reductions
mentioned earlier.
There are undoubtedly other measures that could help see us through
the difficult months that lie ahead. In fact, none of the policy
actions suggested above are novel, though some are controversial.
Too often, however, proposals are put forward that deal with only
one facet of our current problems, overlooking the consequences
for our problems taken as a whole. If there is a need at the moment,
it is to try to understand our present difficulties in their broadest
context, and to devise remedies that contribute not only to short-run
solutions, but longer-run solutions as well.
Footnotes
*This same point was made by Robert V. Roosa, in a talk prepared
for the Atlantic Institute for International Affairs, Munich, Nov.
11, 1974, entitled "Controlling Inflation During Recession." As
we close out the accounts on 1974 and try to peer ahead into 1975
and beyond, the economic barometer is giving out strong signals
of unsettled conditions, with a possibility of rough seas. The sources
of our malaise are well known, yet difficult to understand, and
still more difficult to deal with.
At least four factors are contributing to our troubled situation:
-
inflation,
-
recession,
-
"the energy crisis," and
-
questions of financial stability.
Each of these problem areas in turn has several dimensions—domestic
and international; long-term and short-term—and they are all
interconnected. It's small wonder that the public is confused, and
policy makers find it difficult to devise a comprehensive, yet comprehensible
program.
Inflation
There is not much profit in debating whether inflation or recession
is America's number one economic problem. There's little doubt that
we are suffering from both, and that the virulence of price increases
in 1974 had much to do with the recession we are now experiencing.
Nor is there much doubt that “stagflation” (i.e., a combination
of stagnation and inflation) is a worldwide phenomenon. Many of
the other developed countries experienced even faster price increases
last year than did the United States, and are now in a similar downturn
in economic activity.
The causes of inflation are many, and the importance of each factor
varies over time. We could leave such complexities to economic theorists,
were it not necessary to untangle them in order to prescribe appropriate
remedies. Some observers, noting the unusual persistence of inflationary
pressures in the postwar period, point to apparently fundamental
institutional changes in society as a root cause of our inflation.
They cite, for example,
-
the strong political commitment in most developed countries
after World War II to “full employment,”
-
the downward rigidity of wages in an era of labor unions
and unemployment insurance,
-
a similar downward rigidity of prices in key industries
where a few large firms can exercise market power,
-
the phenomenon of rising expectations worldwide, promoted
by advertising, transmitted by example, and financed by credit,
-
the allocation of a part of business capital financing to
non-output-producing investments in environmental cleanup
and employee safety. (Some might add, as a fundamental change,
a growing scarcity of resources to meet these rising demands,
but this point is much more controversial.)
On top of these secular trends that, it can be argued, now impart
an inflationary bias to the world economy, one must add a number
of cyclical and special factors that in 1974 drove the price indexes
to record readings. The worldwide boom of 1972-73, partly the result
of excessive monetary expansion, carried economic activity around
the globe to unprecedented—and unsustainable—levels. In
the process, bottlenecks were created in basic industries and in
raw material supplies that caused commodity prices to skyrocket.
The exchange rate realignments of 1971, and especially the second
dollar devaluation in 1973, added price and output pressures in
the U.S. and elsewhere that echoed throughout the international
trading world. Crop failures in 1972, and disappointing grain harvests
again in 1974, against a background of rapidly rising demand for
feed grains, resulted in sharply rising food prices at home and
abroad. Compounding the food price increase was the roughly fourfold
jump in world petroleum prices levied by oil-producing countries
following last winter's embargo. And to round out the picture, in
the United States, prices in several sectors probably rose unusually
rapidly this past year following the end of Phase IV controls last
spring, and perhaps in anticipation of possible new price/wage guidelines
in the coming year.
These myriad factors all contributed to upward price movements,
and we usually lump their effects together under the catchall term
“inflation.” Yet it's clearly inappropriate, if not impossible,
to respond to a multifaceted problem with a single policy prescription,
especially when “inflation” is only one of our afflictions. Indeed,
to the extent that last year's price increases were exaggerated
by non-recurring events, a policy response—apart from an attempt
to lessen the extent to which such increases are institutionalized
in 1975 wage settlements—should concentrate primarily on the
sources of continuing price pressures.
Recession
Given the boom conditions that characterized 1973, one could argue
that the world was poised for a cyclical slowdown in any case. But
the timing and extent of the slowdown were virtually impossible
to predict because of the extraordinary shock to the world's economic
system caused by first the oil embargo and then the increase in
petroleum prices.
In retrospect, it appears that in this country at least, and perhaps
elsewhere, the onset of recession was delayed—and the downturn
made potentially more severe—by the shortage mentality that
gripped businessmen. Not only were there real shortages of grains,
raw materials, and outputs of key basic industries in a boom economy,
but there were artificial shortages of petroleum and petroleum products,
and continued rounds of price increases that gave the appearance
of shortages. Order backlogs grew at misleadingly rapid rates; inventory
accumulation was stimulated not only by “shortages,” but by inflation
hedging; dollar sales appeared to hold up despite declining real
incomes; and nominal profits continued to rise, largely reflecting
the effects of inflation.
Because consumers in the United States had not previously faced
double digit inflation, they were probably unprepared for the rapid
inroads that price increases of that magnitude make on real incomes.
Only gradually, as bills accumulated, did it become clear that family
spending would have to be curbed—and big ticket items like
cars and color TV sets were the first to feel the jolt.
Thus inflation in its many manifestations was a key ingredient
in the present recession. Not only was real purchasing power siphoned
off by the oil producers, but disposable income was further eroded—for
both businesses and individuals—by higher taxes on fictitious
profits and misleading increases in nominal incomes.
If one could be sure that the present sharp downturn in business
activity would be equally sharply reversed in coming months, then
it might be possible to dismiss this cycle as an unavoidable correction.
But because at least one element in the picture—the “energy
crisis”—is unprecedented (and unpredictable), one can have
no such confidence.
“The Energy Crisis”
Like inflation and recession, the energy crisis is a worldwide
phenomenon with worldwide repercussions. Unlike inflation and recession,
it is essentially a political problem, but with profound economic
(and social) consequences.
As with inflation, it is important to be specific about the nature
of the energy crisis. Obviously, if the major foreign oil producers
decide for political reasons to cut back production sharply once
again, then the developed countries dependent on their output are
in a crisis by any definition. And given the persistent tensions
in the Middle East, that kind of crisis can by no means be ruled
out. By the same token, that kind of crisis cannot be dealt with
by economic policy responses alone.
The vulnerability of the developed countries to an oil embargo
has been increasing over time. In the United States, for example,
consumption of petroleum grew at a 4 1/2 percent annual rate since
the mid-1960s, while domestic production ceased expanding in 1970.
At the moment, therefore, we are dependent on foreign supplies for
100 percent of any increase in our petroleum consumption. Moreover,
it seems fairly clear that world demand and supply of energy in
general, and petroleum in particular, could be kept in equilibrium
in the years ahead only at rising energy prices. Were it not for
the political vulnerability of dependence on unreliable supplies,
however, it's far from clear that the prospect of gradually increasing
energy costs could be characterized as an "energy crisis," despite
the adjustments that would have to be made. The fact is, at today's
artificially high petroleum prices, there is surplus of productive
capacity and supplies, not a shortage.
What has turned the present situation into a "crisis"—apart
from the threat of another embargo—is not an energy shortage
as such, but the income, balance of payments, and financial consequences
of the
fourfold increase in the world price of petroleum. It is estimated,
for example, that foreign oil producing countries will accumulate
some $50 billion of trade surpluses, the rest of the world will
"accumulate" equal trade deficits—imbalances that dwarf any
previous experience. Theoretically, if the surplus countries were
willing to lend or invest their surpluses in the deficit countries,
the overall accounts could be brought into balance. As a practical
matter, such automatic recycling is not in the cards. As a result,
an urgent search is under way for new institutions to assist private
financial markets in rechanneling these huge balances. Even if such
institutions can be found, there remains a real question—how
long the rest of the world can afford to go on borrowing or selling
off assets to sustain economic activity on the basis of artificially
high-priced imported oil. And in the meantime, there will be increasing
temptations among deficit countries to solve their own problems
at their neighbor's expense.
A further aspect of "the energy crisis" is the distortion, or
perhaps more accurately, distension, of financial markets and institutions
that accompanied the massive rechanneling of financial flows from
oil consumers to producers and back. Actually, the private markets
have absorbed these shocks surprisingly well. Those financial institutions
that did get into well-publicized difficulties during the past year
seem to have been the victims of poor management and/or unwarranted
foreign exchange exposure in a world of floating exchange rates,
not innocent victims of forces beyond their control.
Nevertheless, it seems inevitable that the task of transforming
billions of dollars of oil revenues into productive, repayable loans
and investments will continue to place severe strains on existing
financial institutions. Not only is the rapid growth of assets and
liabilities likely to stretch further the banks' already reduced
capital ratios, but it will also be difficult to resist the temptation
to widen further the maturity gap between deposits and investments.
As has been pointed out elsewhere, recycling, while sounding easy,
really comes down to piling debt upon debt, with the institutions
in the middle between petro-lenders and consumer-borrowers—whether
private, national, or international—taking on substantial added
credit risks.
Financial Stability
Questions of financial stability are not confined to the new pressures
associated with petrodollars As with the other problems we now face,
some of our present difficulties are the result of trends in progress
for many years, from a peak at the end of World War II, the liquidity
of our business and financial institutions has been gradually eroding,
and with it, their flexibility to cope with adverse economic circumstances.
While attention has more often focused on government deficits and
the corresponding increases in federal debt, a much more rapid increase
has taken place in corporate debt, in absolute terms and in relation
both to business income and invested equity. This increased leveraging
has not only reduced the capability of firms to withstand variations
in income (i.e., made them less stable), but has used up borrowing
capacity that might see them through economic reverses.
Several factors contributed to this trend:
-
declining rates of return on equity (i.e., profits),
-
tax laws that induce firms to raise capital in the form of
debt rather than equity shares,
-
investor preoccupation with "performance" as indexed by price/earnings
multiples, and
-
a generalized emphasis on rising standards of living now
(i.e., consumption) at the expense of more output in the future
(i.e., savings and investment).
Businesses in general, and financial institutions in particular,
have gone through an especially severe wringer this past year. Monetary
restraint tightened in the face of inflation-amplified credit demands,
and nearly brought new-issue credit and equity markets to a halt
in the early fall. Thrift institutions were hit hard by rapidly
rising interest rates, and housing suffered disproportionately as
a result. Capital values in the form of equities and fixed-income
securities eroded rapidly with rising interest rates, and business
ventures built on expectations of continuing inflationary boom began
to look much less attractive, both to investors and lenders.
These financial symptoms of an economy moving from boom to recession
are not different in kind from those experienced in previous business
cycles. But the unprecedented severity of the present inflation,
the distortions in the economy resulting from the energy crisis,
the reduced flexibility of less liquid, more leveraged firms to
cope with adversity, and the untested ability of international financial
markets to handle the wrenching transfer of financial wealth, all
raise new questions as to the ability of existing institutional
arrangements to withstand these pressures.
A program for 1975
If our current problems are as many-sided, interconnected, and
as long in accumulating as the foregoing discussion indicates, then
it would be holding out false hope to suggest that there are any
easy, simple, or fast-acting remedies. At the same time, we are
already late in getting started on a program to deal with our problems,
and an integrated approach must begin now.
Perhaps the greatest temptation (and the most dangerous trap)
would be to single out inflation or recession as "the" problem,
and then apply the standard treatment. There is a particular risk,
given the biases of our political system, that we will concentrate
on short-run "cures" for recession, to the detriment of our ability
to correct more fundamental weaknesses in our economy.
If the present recession were simply one more cyclical downturn
along an essentially stable economic growth path, then it might
be appropriate to try another dose of the medicine we've used in
the past—an expansion of federal spending and further easing
of monetary policy. But our problems today are intractable partly
because:
-
we have tried to raise living standards faster than investments
in productive facilities could keep pace;
-
investments, particularly those financed by equity capital,
have lagged as a result of inadequate rates of return on capital;
and
-
we have substituted credit expansion for savings as the means
to finance the growth of consumer and business spending. Another
dose of the old medicine would only worsen the disease, in
the longer run if not immediately.
Instead, if this analysis is correct, we are going to have to
accept as fact that we cannot continue to expand consumption (i.e.,
living standards) as rapidly in the next few years as we have during
the past decade. It is important to understand that this conclusion
rests basically on the argument that credit-financed expansion,
beyond a certain point, leads to instability rather than further
expansion. The conclusion does not rest on the dubious premise that
the world is running out of resources. It is strongly reinforced,
however, by the current drag on potential rates of growth in consumption
among developed countries imposed by the transfer of wealth from
oil consumers to oil producers.
In the past, widespread increases in standards of living in developed
countries eased social tensions that otherwise might have been associated
with disparities of income and wealth, both within and between countries.
If long-nourished expectations of "a better life" (i.e., more goods,
services, leisure, etc.) are now going to be frustrated, or at least
postponed, as seems inevitable, then there is going to have to be
an equitable sharing of the burden of this adjustment. This is particularly
true in the short run, given the disparate effects of past price
increases and the anticipated rise in unemployment.
The thrust of a program for 1975, then, should be:
-
to ease the harsher impacts of the current recession without
worsening inflation;
-
to do so in ways that are at least consistent with, and hopefully,
make a positive contribution to, a shift in the use of resources
from current consumption toward future consumption, i.e.,
investment; and
-
to mitigate the financial effects of the energy crisis, and
possibly turn them to advantage as a means of financing needed
investment.
This is no small order. Too often, however, we despair of finding
policies that can usefully attack inflation and recession simultaneously.
If there's a lesson in the above approach, it's that we can indeed
structure a program that takes advantage of the current recession
to get a start on our longer-run problem of inflation. *
The federal budget is a key element in any economic program. Like
other budgets, it has two sides, revenues and expenditures, that
can be adjusted to a considerable extent independently. Both tax
and expenditure changes, however, should be targeted toward achieving
each of the above objectives. To help ease the harsher impacts of
the current recession, for example, it makes sense that unemployment
benefits be expanded and that the public service employment program
be enlarged. This has already been done, and the adequacy of the
program will need to be reassessed in the months ahead. For the
same reason, the largest part of any cut in personal income taxes
should be targeted toward low and middle income groups whose incomes
have been eroded particularly rapidly by food and fuel price increases.
Other adjustments to the budget should be designed to stimulate
investment. Specifically, liabilities for corporate taxes should
be adjusted to compensate for the effects of inflation on nominal
profits and depreciation schedules. In addition, the investment
tax credit should be enlarged to, say, 10 percent. In the same vein,
dividends on new equity capital issues should be deductible as a
business expense (as interest payments on borrowings now are) to
reduce the bias favoring debt financing over equity. And capital
gains taxes should be prorated with length of holding period.
On the expenditure side, increases, except to ease hardship or
stimulate selected investments, should be severely restricted. So
far as investment priorities are concerned, a systematic process
for identifying high priority areas is needed. In the meantime,
energy research and development and mass transit (financed from
the highway trust fund, and designed to ease transition problems
in the auto industry) seem two reasonable candidates. Housing, though
technically an investment, would qualify for assistance primarily
to ease the severe slump in that industry.
To reduce the flow of dollars to oil producing countries, an effective
energy conservation program is needed. Voluntarism is not enough.
A sizable tax on imported and domestically produced petroleum is
essential, even though the effect will be to further raise consumer
prices. The substantial revenues generated by such a tax (together
with such "tax reform" measures as capital gains liability at death,
elimination of depletion allowances, and higher tax rates on preference
income) could be used to finance investment incentives and other
tax reductions in order to reduce the size of budget deficits.
There will be substantial budget deficits in the next couple of
years, however, and given the expected sluggishness of the economy,
deficits are appropriate. In the short run, with the economy expected
to operate so far below potential, reasonable deficits should not
add significantly to inflationary pressures. But in the longer run,
as the economy moves back toward its potential, deficits should
be eliminated since they represent, in themselves, dis-saving rather
than needed savings. Even in the short run, it is important that
the deficits be financed to as great an extent as possible from
savings rather than credit creation.
In this connection, there is an opportunity to tap the forced
"savings" extracted from this economy and from other developed countries
in the form of unspent revenues of oil-producing countries. Indeed,
it is essential that these huge "savings" be placed back into income
streams quickly if a world recession is not to feed on itself. Again,
in the short run, it is appropriate that such funds finance government
deficits. In the longer run, they must be channeled into productive
investments (rather than used to finance unsustainable levels of
consumption in the developed countries) if the credits and equity
holdings acquired by the oil producers in this process are to be
serviced.
Whether recycling of petrodollars in this fashion can be accomplished
is an open question. Indeed, if there is an Achilles' heel in the
prospect for recovery from the current recession, it will probably
stem from an inability of the world's economic and financial institutions
to adapt quickly enough to the financial consequences of the oil
price increase.
For this reason, among others, it is important to see that our
own financial institutions are in as strong a condition as possible.
Among the measures needed to reinforce confidence in those institutions
are the following:
-
supervisory insistence on gradually strengthened equity
bases, and an asset/liability mix less sensitive to interest
rate changes;
-
improved examination procedures, and reserve requirements,
for banks' Eurocurrency and foreign exchange positions;
-
standby authority for a government institution analogous
to the Reconstruction Finance Corporation;
-
consolidation of bank supervisory authority;
-
passage of the Financial Institutions bill, which, among
other things, would gradually remove interest ceilings on
consumer time deposits; and
-
curbs on further relaxation of consumer credit terms, and
eventually, some tightening of these terms.
On the price/wage front, the key risk now is that previous price
increases will become institutionalized through large wage settlements
in 1975. For this reason, among others, the Council on Price and
Wage Stability should be given subpoena powers, as well as the power
to delay wage settlements and price increases for up to ninety days
in key industries. The Council, if given sufficient prominence,
is also the logical body to publicize the direct link between restrictive
practices, productivity, and incomes. Wage restraint should also
be emphasized as a quid pro quo in connection with the tax reductions
mentioned earlier.
There are undoubtedly other measures that could help see us through
the difficult months that lie ahead. In fact, none of the policy
actions suggested above are novel, though some are controversial.
Too often, however, proposals are put forward that deal with only
one facet of our current problems, overlooking the consequences
for our problems taken as a whole. If there is a need at the moment,
it is to try to understand our present difficulties in their broadest
context, and to devise remedies that contribute not only to short-run
solutions, but longer-run solutions as well.
Footnote
*This same point was made by Robert V. Roosa, in a talk prepared
for the Atlantic Institute for International Affairs, Munich, Nov.
11, 1974, entitled “Controlling Inflation During Recession.”
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Annual Report
