In February President Reagan told the nation "inflation results from all that deficit spending."
But his chief economic spokesman, Treasury Secretary Donald T. Regan, said recently that a bigger federal deficit need not mean higher prices, provided that the gap is not financed by creating new money and credit.
Reagan has also rejected the traditional view that there is a trade-off between inflation and unemployment, that inflation can be fought by higher unemployment and worsened by measures to cut unemployment.
But the chairman of his Council of Economic Advisers, Murray Weidenbaum, said in an interview last month that "the key restraint [on inflation] is unsold products and unemployed labor. That's what private-sector economics is all about."
It is ;not just within the administration that confusion reigns. The past decade of combined high inflation and high unemployment has foxed the experts and wrecked many theories, leaving the economices profession divided on the causes and possible cures of inflation.
There are several main schools of thought.
The more traditional postwar economists assume that excess demand, often caused by overly expansionary government policies and large budget deficits, leads to inflation;, and that there is a trade-off between inflation and unemployment.
Others say recession is an ineffective and costly method of fighting inflation, as both wages and prices respond only slowly to changes in demand. Direct intervention in wage and price fixing, such as income policies and anti-inflationary policies in other areas of government, such as setting farm-price supports, are needed to complement demand management, they say.
Monetarists, whose theories have moved center stage with this administration, hold that inflation is caused only by increases in the supply in money and credit in the economy, and that tight money is both a necessary and sufficient means of fighting inflation.
Neoclassical economists, also represented in the Reagan administration, hold that all prices, including the price of labor, are set by the market to balance supply and demand. Monopolists, such as unions, may force up prices so that there is unemployment. ybut the goverment can do no more than encourage a better working of the market, perhaps by making it less attractive to be unemployed.
While inflation has become apparently more intractable and less easily explained or controlled, people have turned increasingly to the simplest explanation of inflation: monetarism.
The chief proponents of monetarism, including Treasury Undersecretary Beryl Sprinkel and CEA member Jerry Jordan, argue that generally rising prices are simple a measure and a reuslt of excess money creatin. When the central bank, or Federal Reserve, prints money or allows banks to expand credit, it automatically decreases the value of the newly created dollars and those already in existence by raising the supply of money, the argument goes.
"Too much money chasing too few goods" then leads to a general rise in the price level: The more p lentiful and therefore less valuable dollars will purchase fewer goods and services.ythe answer to inflation, monetarists say, is simply to print less money and allow less credit to be created.
The dictionary definition of inflation displayed with this article agrees with the monetarists. ybut it leaves many questions unanswered.
Monetarists claim that over the long term there is a good correlation between changes in; the money supply and changes in prices, a nd that it is the first that causes the second.
But others argue that it depends on which measure of money is used; that the supposed lags between money movements and price movements are so variable as to make nonsense of the relationship; that experience in other countries suggests that institutional differences in wage bargaining and the financial system affect the relationship between money and prices.
In any case, some argue, the causal relatio;nship could run the other way. As prices rise, people and businesses need more money and credit to finance the same level of transactions; it takes more money to buy the same amount of goods and services as before. Increased demand could be a major reason for the increases in money supply, they say, rather than the other way around.
Monetarists can then reply that if only the Fed would not allow the extra money and credit to be created, then the inflation, or general price rises, would stop. Thus a straict monetarist would deny that oil exporting countries made U.S. inflation accelerate in the 1970s. If the Fed had not "monetized" or "validated" the higher energy prices by providing the money to pay them, then prices in general would not have gone up, an administration official has claimed.
But what is the mechanism by which the slower money growth translates into lower price increases? How can the Fed or the administration be sure that people will not pay the higher prices and just buy fewer goods and services and the same number of dollars?
Most experts agree that the total amount of demand in the economy, or the gross national product, is tied to some degree to the supply of money: There is a limit to how much dollar spending any given quantity of money will support.
But changes in GNP comprise two components: price changes and output changes. It total GNP is constrained by a tight-money policy, the effect may be to lower inflation, reduce real output or a bit of both. Those administering the tight-money policy cannot determine which element of GNP is affected.
Pure monetarists often argue that in the long run, prices alone will adjust.
The government cannot affect the level of output, or real GNP, by changing the amount of money in the economy, they say. Real wages and prices, after adjusting for inflation, are fixed by the market to balance supply and demand, they say.
Variations in the money supply affect only the inflation part of the total, nominal GNP -- which inclued both prices and output changes -- while leaving real GNP unchanged, they claim. Thus a slowdown in money growth will feed through into lower prices and will not cause a prolonged slowdown in growth, so as
But it seems clear that the only way that tighter money can feed through to wage and price decisions is by slowing the economy and raising unemployment. Firms and workers must discover that if they increase their prices and wages too rapidly, they will be unable to sell their goods and labor. Once they make this discovery, they may accept lower increases. As Weidenbaum said, "unsold products and unemployed labor" are the key restraints.
The restriction on money growth will resutl in a tightening of credit markets, higher interest rates, less easily obtained financing for business investment and consumer spending, and a consequent slowdown in economic activity.
If the monetarist cure for inflation boils down to this, then it has much in common with the more traditional postwar view, described above, that additional unemployment and slower growth will lead to lower price rises.
The Keynesian "demand management" that guided most postwar administrations' economic policies suggested that the federal government could stimulate the economy through cutting taxes or raising spending (or a combination of both), and enlarging the federal deficit (or shrinking the surplus).
This would lead directly to an increase to total, nominal demand in the economy. If factories already were working close to capacity and unemployment were low, then the additional deficit would lead to more inflation. If the economy was in recessio;n, then the extra demand would consist of more output and less inflation.
The trick of this "demand management" was to balance the required or desired level of employment against the acceptable level of inflation. Conservatives would argue for less of each, and liberals for living with more of each. When prices started to rise too fast for comfort, the conservatives would get their way, and the brakes would be put on fiscal and monetary policy.
But recent recessions have been less and less effective in controlling inflation. And the cost in terms of lost output and employment of holding inflation at previously acceptable levels seems to have risen higher and higher.
It is now apparently so high that some economists question whether it is worth paying, or whether it would be better either to learn to live with continuing high inflation, if that is possible, or to look for other ways of fighting it.
Economist Joel Popkin believes that "there is a cure," but "the dynamics are such that it takes you through a path [of recession] that most people don't want." The question is "whether people are really willing to go through the swamp to get to the other side," he says.
Marvin Kosters of the American Enterprise Institute sounded the same theme in an interview when he said inflation will only change "after a period of some duress." Herbert Stein, also of AEL, connected last month that "maybe 7 percent unemployment is full employment," suggesting any attempt to bring the jobless rate below this would be doomed and inflationary.
These economists apparently believe, in Koster's words, that "there is no substitute for broad aggregate restraint of fiscal and monetary policy" for fighting inflation, and no way of avoiding the pain if price rises are to be slowed.
Some are more optimistic.
These analysts believe that expectations of future inflation are themselves a key determinant of inflation. Among them, a few go further to claim that these powerful expectations -- which help determine interest rates, the value of the dollar against other currencies, and wage and price decisions throughout the economy -- can be influenced by the mere announcement of new policies.
The pain of restraint is thus bypassed as firms and workers price themselves and their products in anticipation of restraint, and so escape being unemployed or overstocked with unsold products.
Unfortunately the real world does not seem to work like that.
It may be that people don't believe governments and central banks when they announce restrictive policies. Or it could be, as British economist Paul Ormerod wrote recently, that "expectations are being formed in a perfectly rational way in both countries [United States and United Kingdom], using the knowledge that the inflationary process is much richer and more complex than either administration woiuld have us believe."
If it is, then how can policy makers deal with it?
Most economists agree that microeconomic policy in the United States can be an ally or an opponent in the anti-inflation fight.
The conservative Kosters commented that President Carter "had the anti-inflation rhetoric, but shot himself in the foot on micro decisions." Former Carter official and Brookings Institution economist Barry Bosworth has written, "government did contribute to the [1970s] inflation in a direct way through its regulatory activities, direct administrative actions, and a shift in the tax structure toward a greater emphasis on taxes that were reflected in higher prices." He went on to list inflationary actions from higher agricultural price supports to rises in the minimum wage and sharply boosted Social Security taxes.
Recent dismal productivity performance has also contributed to inflation, as wage bargainers go on trying to win the real wage rises that used to come with steady productivity growth of 2 percent to 3 percent a year. Firms grant these increases and pass the cost through to prices.
Bosworth believes that U.S. inflation today "is not being driven primarily by pressures of excess aggregate demand," and that there is a "self-perpetuating underlying rate of inflation in the industrial sector as all individuals view themselves as responding defensively to the inflationary excesses of others."
He and others suggest that the underlying, or core, rate of inflation set by labor costs is fairly steady, but can be pushed up more easily than down. Inflationary shocks from outside, such as a quadrupling in energy prices, or a sharp rise in food prices had worldwide harvests, can have a ripple effect as people "accelerate their own wage and price increases in an effort to catch up. The result is an upward ratcheting of the underlying inflation rate in the industrial sector and a carry-over of inflation into future periods."
Fighting this through recession is "costly and inefficient," economist Arthur Okun has suggested. In a book completed shortly before his death last year, Okun pointed out that in the recession of 1974-75, "prices [of labor and finished products] kept rising at a barely diminished pace, while output and employment fell back sharply."
He didn't think governments had to rely on such a policy. He argued that demand restraint should be combined with measures to strike at the heart of wage and price rises to reduce costs.
As Bosworth and Popkin both point out, U.S. prices are not generally fixed in competitive markets to balance supply and demand, but are heavily tied to the cost of inputs. Wages for much of the economy are fixed for several years at a time, are influenced by past inflation and expectations of future inflation as well as by the general level of unemployment, and in many cases reflect the cost of training and hiring as well as the short-term cost and value of labor.
Hence, the severe consequences of using recession alone to slow the increases in wages and prices.Okun, in his last book, recommends using "cost-reducing tools" to complement demand restraint and "shift the balance in the reduction of growth of nominal GNP from output loss to inflation slowdown."
He suggests cuts in indirect taxes to offset a further sudden rise in external costs, such as oil; tax-based income policies to encourage lower wage settlements; firm opposition to import restrictions and encouragement of a stronger dollar; and measures, such as a subsidy for stocks of commodities, to cushion sharp price movements in these markets.
The present administration is clearly not interested in these measures, although it may try some more traditional market-oriented ways of reducing costs, such as repeal of the Davis-Bacon Act, along with tight money.
Reagan also promises faster growth and better productivity. Many doubt that this can be combined with tight money and lower inflation, and say that inflation will have to be "squeezed" out of the system.
British economist Andrew Tylecote, who has studied inflation in several Western countries, believes such an effort would itself be counterproductive. He argues that "the effect of deflation, in the short term, is to reduce inflation, but in the long term is to raise it."
Prolonged unemployment leads to a less skilled labor force, slow-growing living standards, reduced job opportunities, and increased labor militancy and union organization. Depressed markets and excess factory capacity stifle investment, slow growth hits risk-taking, innovative firms more than cautious ones; and all these factors tend to worsen inflation in the long term, he argues.
The supply-siders in the Reagan administration also condemn deflation and recession, although from a very different viewpoint. But many experts doubt their belief, outlined in a Wall Street Journal editorial, that " . . . tax cuts can provide incentives for growth even as monetary policy fights inflation."