THE GREAT American inflation began early in 1965, when Lyndon Johnson got into a war in Vietnam without raising taxes to pay for it. The war is now long over. But unlike the other wartime inflations, this one has continued and accelerated.
In the latest desperate effort to get it under control, the government has now driven interest rates to unprecedented heights. The impact has thrown the financial markets into turmoil and raised the prospect of steadily rising umemployment in the coming election year. But not even the optimists expect the inflation rate to respond quickly or easily.
This wave of inflation, now in its 15th year, has developed a persistence and endurance beyond anything in previous American experience.
Underneath all of the technical explanations lies a political attitude that has become widespread among Americans. When a cost rises -- when the price of oil goes up, or somebody gets an outsized wage raise -- that presents society with a choice. It can either absorb the cost by cutting somebody else's income. Or it can keep passing the unabsorbed cost around by trying to raise everyone's income to cover it. That's inflation.
Currently, most Americans consider it unacceptably cruel and unfair, as a matter of social equity, to force income cuts on anyone. That's why most of the choices over the past decades have been, consiciously or not, in favor of inflation.
An illustration: A hypothetical country is adamantly committed to an inflation rate of zero. This hypothetical country, like the United States, is in a period where labor productivity is not growing -- an important condition, for it means that there is no economic growth per capita to accommodate change.
Now suppose that the price of imported oil rises. To keep the average of all prices from rising, other prices will have to be cut.
Suppose that the wages of the auto workers, or the coal miners, go up. To hold the average at zero, other workers' wages have to fall.
Suppose that farm prices go up, raising farmers' income. To compensate, in a zero-inflation economy, consumers' incomes would have to come down.
Can you imagine an American government, or any elected government, imposing those reduction in income and prices as a matter of deliberate policy?
What happens, in the real world, is that some prices and wages go up but none come down -- in dollars or, as the economists say, in nominal terms. Instead, these increases of wealth for some people are accommodated by making everybody's dollar worth a little less. That's inflation, and it serves the purpose of spreading these costs over the whole economy automatically, without any political debate or need for political decision.
Here we come to an awkward truth: There is a serious and substantial case to be made in favor of inflation, as a way to permit rapid change of the economic structure in democratic societies.
Structural change means that some people are getting richer relative to the others. If the others refuse to accept cuts in their incomes, and insist that the government has a responsibility to protect them from it, inflation has to be the government's answer.
In the hypothetical zero-inflation country, the government would assign price and wage cuts to specific industries and workers in order to balance rises elsewhere. In the real world, the government does nothing but create a few more dollars. In the absence of economic growth per capita, creating more dollars makes every dollar worth less. The process is silent, complicated and not very visible. The effect is to spread the reduction in wealth very widely throughout the whole society. Since everybody is to blame, no body is to blame.
The case for inflation holds that this process is infinitely less divisive and inflammatory than imposing actual cus in nominal prices and pay. People feel anxious and vaguely threatened by rising prices, but it's a threat that they share with everyone else. It inflicts none of the sense of real persecution and desperation that comes with imposed income cuts -- whether through unemployment or through pay and price slashes in the manner of the early 1930s. The public reaction to a true zero-inflation policy might be dangerous to any democracy, the argument continues, but particularly dangerous in the atmosphere of mistrust and division that existed in this country after the Vietnam War. Nobody likes inflation but, you could plausibly contend, it has been preferable to any method of accommodating the enormous structural changes that have overtaken the economy of the United States, and the world, in the 1970s.
But there are fundamental flaws, unfortunately, in the inflationary argument. One is that no inflation rate remains stable. The frightening 3 per cent rate that drove President Nixon to resort to price controls was 6 per cent when President Ford left office, and is 13 per cent now. Another flaw is that inflation damages economic growth, and actually creates unemployment. As for social equity, the penalties of inflation are by no means distributed evenly throughout the economy. Inflation, for example, hurts people who save. It benefits debtors.
After 14 years' experience of high inflation, Americans are learning to adjust to it. The adjustments, unhappily, make the inflation worse.
An example: The family that buys an expensive house with a 12 percent mortgage is, in effect, gambling on the continuation of a high inflation rate. With inflation, their nominal income will rapidly rise to help them meet the mortgage payments, and the appreciation of the property's value will offset the cost of the interest. But if, by some magic stroke, inflation were to sink to zero, that 12 percent mortgage would be a crushing burden -- a burden so dangerous that in most states, in any period except the present one, it would have been illegal.
The same logic applies to all borrowers, from the corporations floating long-term bonds to the consumers running up big bills on their credit cards. The standard 18 percent interest rate on consumer credit sounds awfully high. But if inflation continues at 13 percent, the real interest rate is less than 5 percent -- to be precise, 1.18 divided by 1.13, or 4.42 percent -- and, since interest is tax-deductible, the cost of the loan is zero to anyone who is in a 20 percent tax bracket.
The same principle applies to public borrowers as well. Nobody talks much about it, but the past several years' inflation has provided a crucial element of the financial rescue of New York City.
As inflation has continued, year after year, more Americans have come to perceive these effects, to think in terms of inflation-adjusted rates, and to try to cash in on the profits to be made through it.
In the famous Malaise Speech last July, President Carter deplored the decline in Americans' saving as another indication of moral erosion and self-gratification. That's absurd. The decline in savings is a rational and well-informed reaction to inflation. But Carter is right in thinking that the savings rate is central to the operation of the economy, and that the low American savings rate is related to the lack of improvement in productivity.
Meanwhile, the decline of savings and the billowing of credit is, in itself, inflationary. People's attempts, individually, to protect themselves from inflation inevitably make the inflation spin faster.
It would be an exaggeration to say that there is a political constituency now in favor of inflation. But there are many and vigorous constituencies against all of the public policies that reduce inflation -- because all of them require somebody, somewhere, to absorb income reductions. If you have learned, through borrowing heavily, to stay even with inflation and maybe a little ahead, you no longer fear inflation and you begin to lose interest in the painful measures necessary to restrain it.
To get out of inflation -- assuming that anyone still wants to try it -- it's useful to recall how we slid in. The inflation of the Vietnam years was nothing new in American experience. Inflation has accompanied all wars; prices doubled during World War I. Johnson signed a war tax into law in 1968 shortly before he left office. the following year President Nixon, in collaboration with the Democratic Congress, repealed it, and inflation went on. But in the early 1970s the pattern began departing from the historic path.
Citing the inflation, in the summer of 1971 Nixon put the economy under controls and abandoned the international system of fixed exchange rates based on gold. He wanted the dollar to sink a little, and give the United States a trade advantage. It did indeed sink a little, and then -- to his astonishment and everyone else's -- it kept right on sinking. The fixed-rate system had masked the international effects of the Vietnam inflation and, once the system was abandoned, the dollar was revealed to have been weakened far more than Americans realized. The declining dollar made most imports cost more. That was the first new cause of inflation: instability of the international monetary system.
Meanwhile, at home, the Nixon administration was resorting to highly inflationary expedients to raise employment and make the economy hum during the coming election campaign. Nixon was using the wage and price controls to postpone the consequences until after the election. That's the second cause of the inflation: Nixon's reelection tactics.
Nixon told his secretary of agriculture in 1972 to sell as much grain as possible to the Russians, to cut budget costs and raise farm prices. They succeeded better than they knew. They sold nearly the whole national grain reserve to the Russians, with the result that bad harvests abroad, over the next two years, led to tremendous demand on American markets. The price of food rose spectacularly. Cause number three: rising worldwide demand for food, reflecting population growth and higher living standards abroad.
The oil crisis of 1973-74 hardly needs to be described again here, except perhaps to point out that it came in a moment of extraordinary political weakness in the White House. The Arab oil embargo fell into a period when Nixon was totally preoccupied by the Watergate scandals. By the time the embargo ended, in early 1974, Nixon had no standing to deal with the Arabs, or this country's allies, or, above all, the American people. Cause number four: a jolting increase in oil prices, compounded -- not for the last time -- by confusion in Washington.
As the controls were peeled off in 1973, after the election, prices shot up faster than ever. It now seems fairly clear that prices were higher, by the mid-1970s, than they would have been without any controls at all. Two economists, Alan S. Blinder and William J. Newton, in a study published by theNational Bureau of Economic Research, estimate that by the end of 1976, prices averaged a full 1 percent higher than they would have been in the absence of controls. Cause number five: mismanaged presidential intervention in the economy.
Although the economic analyses don't touch on it, the collapse of the Nixon presidency obviously contributed to the extraordinary lift in the inflation rate during mid-1974. A failure of public faith in government and its competence always aggravates economic malfunction. The evaporation of confidence in the Hoover administration made the Depression sharply worse in the early 1930s and, similarly, the inflation hit a peak in the summer of 1974 as Nixon was being forced painfully and dramatically toward resignation. Cause number six: a collapse of public authority.
In late 1974 the recession suddenly accelerated and, by the following spring, the unemployment rate was up to 9 percent. Inflation abated. Nothing spectacular happened for the next couple of years, and people began to hope that inflation was under control at last. The new Carter administration was talking with some confidence about a reversed trend that was pointed downward. There was a quick attack of inflation in early 1977, mostly in food prices and much of it the result of a freeze in Brazil's coffee plantations. But those prices were quickly absorbed.
The rise that began at the end of 1977 was another matter. At first, it was mainly attributed to two acts of Congress -- the increase in Social Security taxes and the higher minimum wage -- both of which lifted wage costs. Congress knew that both were inflationary, and worried about that, but knew no other way to pursue social goals to which it considered itself committed. Cause seven; expanding social benefits at a time when the economy was not growing enough to pay for them.
But it soon became clear that the tax and wage increases were only a part of the mounting trouble in 1978, and a small part. The main cause of rising inflation was overheating throughout the economy. That is to say, federal policy was trying to force the economy to grow faster, to create more jobs and lower the unemployment rate. As production in key sectors neared full capacity, the result, instead of growth, was inflation. It has to be said that locating the point of full capacity is a highly c omplex matter of judgment, in which things become clear only in retrospect. But Carter, having talked much about the necessity of balancing the budget, was rolling along with a rising deficit that, as 1978 began, was up over $60 billion a year. He had set aside his own fiscal inclinations and was deferring to the traditional priority that the Democratic Party gives to low unemployment. The unemployment rate was still over 6 percent, very high in terms of past experience. But despite all the warnings, the Carter administration was very hesitant to take its foot off the accelerator. It went into 1979 with the budget deficit still over nearly $40 billion. By spring, the inflation rate was over 13 percent a year. Eighth cause of inflation: excessive stimulation of the economy, in pursuit of unrealistic employment goals. Or perhaps you might say that we are simply back at 1965 and the pressure of large and repeated budget deficits.
A year ago the dollar fell heavily again. The country got another round of inflation caused by international monetary instability -- as in 1972-73. Over the past spring and summer there have again been large increases in world prices of food and oil -- as in 1973-74. The process seems to have become cyclical and repetitive. So far, American policy has no answer to it.
Now the inflation, hovering around 13 per cent a year, is attacking the very principles of social equity that it earlier seemed to protect. The examples of unfairness are getting sharper. The disparities between the federal government's indexed pensions and private employers' unindexed ones are wider. The anomalies in tax treatment are clearer. The distorted relationships between borrowers and lenders are more important. Perhaps there was a period earlier in this decade when the tacit decision to choose inflation really did avoid division and conflict among the winners and the losers in a changing American economy. But that period has ended.
If the country does not act to reduce the inflation rate, inflation will continue to rise by itself as people try to protect themselves individually. At some point, impossible to predict, the inflation rate will trigger a classic panic and economic collaspe -- a flight from the dollar. You can see the premonitory stirrings in the hoarding of gold.
But only the darkest pessimism can suppose that the United States would let itself slide into a disaster as obvious, and as clearly marked by past experience, as that one.
Ideally, the solution to inflation is a strong incomes policy -- fortfied wage guidelines, for example -- that could hold incomes from rising as fast as prices. That would gradually work down the inflation rate and spread the burden over the whole society. But that strategy has been tried several times without much effect. Demonstrably, it requires a degree of public support that doesn't exist.
The likeliest outcome seems to be continuation of a pattern that has become visible in the past several months. Because of a recession, personal income is now rising less rapidly than prices. In response to tightening federal budgets and high interest rates, the economy is shifting down into second gear. It will run for a time with a good deal of slack -- expressed, for most people, in rising risks of unemployment, fewer wage raises, falling purchasing power and less opportunity for advancement. How effectively this will reduce inflation is still an open question.
For the past generation, Americans have regarded recessions as enemies and have fought them by rapidly raising public spending. This time, the country may react differently. There are hints of it in the very restrained attitudes in Congress, and its refusal so far to consider tax cuts. Perhaps the future, not for a few months but for years, will be a flickering semi-recession in which short periods of modest growth alternate with retreat and retrenchment.
That's not a very happy prospect.
But it's far better than steadily rising inflation followed by panic and crash. It's also more realistic than the prospect for strong and effective guidelines in which all Americans join in abstaining from the attempt to catch up with inflation.
Protracted semi-recession isn't anyone's first choice. But it will be national policy if, as I suspect, it turns out to be everyone's second choice. n