My students have never let me forget an incautious remark I once made in public. I noted that, while everything Milton Friedman sees reminds him of the money supply, everything I see reminds me of sex -- only I keep it out of my writing.
It was only a joke. But it is no joke to say that now everything seems to remind everybody of inflation.
Inflation does not have a single cause and will not yield to any single remedy. Instead, it is intimately bound up with the kind of economy and economic institutions that have evolved in the U.S.
In order to control current inflation and reduce our inflation-proneness in the future, we must, I think, search out new directions for American capitalism. I do not have any pat answers. But I will have accomplished something if I can convince you that there is no magic bullet to bite, no simple mistake we only have to avoid.
There are, in fact, at least four simple stories about inflation making the rounds. They all have adherents who believe in the single-cause, single-cure hypothesis. They are all false. But I must emphasize that they are not nonsense. Each of the simple stories I will describe expains some inflationary episodes somewhere, sometime. They just do not happen to explain what has been happening in the United States during the past five years. . .
The first simple story about inflation is that its underlying cause is deficit spending by the federal government. In that case, the way to fix things up is simply to balance the federal budget. . .The story is wrong. You may favor big government or small government for other reasons, but the facts speak against the theory that the balanced budget is the key factor in ending our current inflation. To see that, you have only to look at recent history. Using the size of the federal deficit as a percentage of gross national product for comparison over the past decades, what are the facts? Back in 1972, the deficit was 1.5 percent of GNP; the economy was being stimulated into a fast recovery from the recession of 1970 in time for the election of 1972. In 1973, the deficit fell to 0.5 percent of GNP, then rose slightly to 0.8 percent in 1974. In response to the deepest recession of the whole postwar period, in 1975 the federal budget went $70 billion in the red -- a large 4.6 percent of GNP, but the figure fell in the following years to 3.1 percent in 1976, 2.4 percent in 1977, 1.3 percent in 1978 and 0.4 percent in 1979. Anyone who believes in the budget-deficit story about inflation has accelerated between 1976 and 1979, precisely while the federal deficit has been getting smaller and smaller, and how so small a tail could wag so big a dog.
Further, if we consider the logic of the argument, there is really no reason to single out the deficit of the federal government. The impact of state and municipal governments' budgets ought to be added in. A dollar of government deficit should have much of the same effect on the economy whether it is incurred in Washington or Albany or Kansas City. Indeed, during the period we are talking about, over 15 percent of federal expenditures took the form of grants-in-aid to state and local governments. It would have made no essential difference to inflationary pressure in the U.S. economy if those grants-in-aid had been a billion dollars less, and the bonds to cover a billion dollars of local spending had been issued by the State of Kansas instead of the U.S. Treasury; of course, the federal deficit would have been a billion dollars less, but the Kansas surplus would also have been a billion dollars smaller.
That reasoning suggest we should look at the consolidated budgetary deficit of all local governments in the United States. It happens that throughout the period we are examining, state and local governments taken together were in surplus. For all governments, the consolidated deficit was 0.3 percent of GNP in 1972, rose to a surplus of 0.5 percent in 1973, fell back to a deficit of 0.2 percent in 1974 and reached a deficity of 4.2 percent of GNP in the recession year of 1975. Thereafter the aggregate deficitt was cut in half, to 2.1 percent in 1976, halved again to 1 percent in 1977 and brought to almost exact balance in 1978. Finally, in 1979, the consolidated budgets at all levels of government showed a surplus of 0.6 percent of GNP. Precisely while the inflation was worsening, the aggregate budget was improving. The first simple story will not do. . .
One down and three to go.
The second simple story about inflation blames it all on the Federa Reserve System. Inflation happens because the money supply grows too fast; turn off the printing press and you turn off the inflation. Now monetarism, as this doctrine is usually called, has two faces: one face is subtle theory, and the other is a simple story. The subtle theory has a lot of truth in it, but the subtle theory is not so diffferent from mainstream economics and does not lead to any easy policy conclusions. The simple story is wrong or misleading.
Once again, the facts are sufficient to disprove the simplicities. There is some ambiguity about the "right" way to define the money supply: the current favorites are what are now called "M1-B" and "M2." M1-B includes essentially any deposit at a bank or thrift institution against which you can write a check; M2 adds such things as shares in money market mutual funds, and small-time savings deposits.
In the case of M1-B, there has clearly been an acceleration in growth since 1975 and 1976. But between December 1976 and now, the rate of growth of M1-B has been fairly steady; and indeed 1979.