Nortwestern University economists Robert J. Gordon, like so many members of his profession, casts a skeptic's eye on the promised results of the Reagan administration economic recovery program. Most of all he doubts President Reagan can cut inflation while the economy is growing strongly because virtually no one has managed that trick anywhere in the world.
Gordon recently completed a detailed examination of what has happened in major industrial nations and some developing countries when they have tried to slow inflation. He found just four instances in which a country suffered only "minor" losses of output while experiencing a marked slowdown in inflation as a result of restrictive policies.
The only such instance in the United States occurred just after World War I when inflation was not only checked but prices actually fell sharply. The others came in France from 1963 to 1966, in Italy from 1963 to 1968, and in Japan, where a remarkable performance of holding down inflation without suffering losses of output began in 1976 and is continuing today.
Gordon, who recently presented his results here at a seminar on inflation sponsored by the National Bureau of Economic Research, specifically says that neither West Germany nor Switzerland -- two examples frequently cited as inflation success stories -- managed to avoid large losses of real output and jobs.
The Swiss, for example, "achieved something close to what we achieved in the Great Depression," he declares. Swiss real gross national product fell at an average rate of 0.3 percent annually between 1973 and 1979 and manufacturing employment fell 17 percent between 1974 and 1978.
"Switzerland is not a good example of stopping inflation costlessly. It is a good example of stopping inflation," Gordon said.
Gordon's analysis proceeds this way:
Changes in a nation's GNP are the sum of the change in the real output of goods and services plus the change in prices. For instance, from the fourth quarter of 1979 to the fourth quarter of 1980, U.S. GNP rose 9.45 percent. qDuring that period, prices went up to 9 3/4 percent, and real output fell 0.30 percent.
What Gordon wanted to test was how changes in GNP have been divided between changes in output and prices.In an ideal case, a government could use a restrictive monetary policy to slow growth of total spending, which is another way of saying GNP, and affect nothing but inflation. That is, all of the slower growth in GNP would come in the price component, leaving the real output component unaffected. Unfortunately, the world has not proved ideal.
But before proceeding, Gordon also had to take into account the fact that most economies normally are growing as the labor force and productivity increase. Calculating this so-called potential growth rate for an economy is a tricky business, but the Council of Economic Advisers recently pegged it at about 3 percent a year for the United States. aThus, the U.S. economy must expand by that much just to keep unemployment from rising and the use of factories and other productive capacity from declining.
So Gordon subtracted this trend of growth in GNP from actual changes in GNP. He then compared, over extended periods of time, changes in this adjusted GNP with changes in prices.
The charts accompanying this article, illustrating Gordon's analysis and convering the past two decades of U.S. economic performance, show how history is stacked against the projections of the Reagan administration. The changes in growth of trend-adjusted GNP are plotted on the horizontal axis while changes in inflation are shown on the vertical axis.
Start with the point farthest to the right on the first chart labeled 1959:2Q. Its location shows that, in the four quarters ending with the second quarter of 1959, trend-adjusted GNP rose about 7 1/2 percent while prices rose aobut 2 1/2 percent.
Follow the line in the direction of the small arrows as it moves to the left to the point labeled 1961:1Q. Over that nearly two-year period, the recovery from the 1958 recession was snuffed out and another sharp downturn hit the nation. The increases in trend-adjusted GNP got smaller and smaller and finally turned negative.Virtually all of the impact fell on real output even though inflation fell about a one percent annual rate. This was the recession that sent John F. Kennedy to the White House.
As the plotted line traces the changes in adjusted GNP and prices through the remainder of the decade of the 1960s, the pattern is more horizontal than anything else. In that pattern lies Gordon's essential message: The large changes in GNP growth that are traced in the horizontal lines were accompanied by only small changes in the rate of inflation. If a change in adjusted GNP produced only a change in inflation, then the track of the line would parallel the slanted dotted line.
The upward movement of inflation that began in 1965:4Q as the Vietnam buildup began was temporarily halted by a near recession in 1966. Then as the economy expanded rapidly in 1967 and 1968, inflation rose to the 5 percent level. GNP growth then slowed but prices kept on rising until a mild recession hit in 1970. But as the chart shows, the impact on prices was equally mild.
However, when the recovery from the recession in 1971 began to edge the inflation rate higher once again, President Nixon imposed wage and price controls, which is just about the point at which the second chart picks up the story.
For a while, controls broke the normal relationship between changes in GNP and prices, with GNP rising rapidly and prices falling through 1972:3Q. Then the first of the disasters of the decade of the 1970s struck. A Soviet what crop failed and soaring world grain prices pushed up food prices. The Nixon administratioon partially abandoned controls at the beginning of 1973 just as a boom occurred simultaneously in most industrial economies around the work and OPEC discovered its ability to quintuple world oil prices.
These forces combined to produce another break in the historical pattern. For nearly three years, growth of adjusted GNP became smaller and smaller while prices continued to soar, culminating in the worst recession since the Great Depression, bottoming in 1975:1Q. Then for the next year, a swift recovery from that deep recession produced the best of all worlds, rising GNP and lower inflation, Jimmy Carter was elected president.
Under the stimulus offered by the Carter administration, GNP growth accelerated and so did prices. The economy had become more sensitive to inflation, as the steepness of the slope of the line rising to 1979:1Q testifies. Most of the acceleration in adjusted GNP growth was translated directly into prices. And when Carter and the Federal Reserve turned to more restrictive policies beginning in 1979, the impact fell mostly on output, not prices. The second OPEC oil price shock contributed significantly to this, of course.
So where does all this history leave us? A plot of the Reagan economic forecast would show faster growth in adjusted GNP and falling prices, something accomplished during the postwar period only during the recovery from the severe 1974-75 recession. And beginning in 1983, adjusted GNP growth would slowly decline with virtually all of the impact falling on inflation. As Gordon says, that hasn't happened in the United States since the bursting of the World War I economic bubble.
As a practical matter, Gordon expects the Federal Reserve to continue to reduce growth of the money supply -- as the administration keeps urging -- and that the increases in GNP to be considerably smaller than the Reagan economists forecast. If GNP rises more slowly than the administration expects, the difference, according to Gordon's analysis, will show up in terms of less real output and higher unemployment.
But why can't a way be found to emulate one of the four successful efforts to tame inflation in the past without great losses of real output? "Each of the four -- has limited relevance to the United States in 1981," Gordon says.
"Our own experience during 1916-1922 predated the advent of three-year staggered union wage contracts, which has introduced an extra delay into the responsiveness of the U.S. inflaiton process," he explains. "The success in Japan since 1976 has resulted from a union bargaining structure in which contracts last only a year and expire simultaneously, and in which unions appear to have entered into an implicit social contract with the monetary policy authorities."
Asks Gordon, "Can you imagine (Chairman) Paul Volcker coming out on the lawn of the Federal Reserve over on Constitution Avenue accompanied by the presidents of the Teamsters and the Auto Workers to announce a monetary policy and have them concur in it?"
And for other reasons, Gordon finds the experience in France and Italy in the early 1960s equally inapplicable to the United States today.
Despite his analysis, the Northwestern University professor does not regard himself as a pessimist on inflation. "Inflation can be stopped more quickly than most people expect," he says, though he obviously does not include Reagan administration officials in that group. Gordon believes that of any slowdown on the rate of GNP growth, about 25 percent to 30 percent will show up in lower inflation in the first year, about 50 percent to 60 percent in the second year and 100 percent by the fourth year.
Even such an impact on prices, which is indeed larger than most economists think the case, suggests that slowing inflation cannot be nearly as costless as the administration maintains. Pursuing that objective will mean "an unemployment rate higher than we have today and a much larger budget deficit," Gordon says.
In short, Gordon's work for the National Bureau of Economic Research makes plain one aspect of the Reagan program and its predicted results. Such a program has never produced such results in the past. Certainly the 1964 tax cut, spoken of so approvingly by administration officials, did not. It stimulated the economy, to be sure, but inflation went up after that tax cut, not down.