We have no real choice now but to move down the path of disinflation while, at the same time, avoiding the high cost of deflation that could trigger a worldwide depression. But there is no parallel in history to guide us in this difficult task. No tested theory exists of crossing over from a prolonged high peacetime inflation to disinflation.

While the improvement in inflation is welcome and, indeed, is a necessary antecedent for an eventual return to sustainable economic growth, let us recognize the challenges still confronting us. One legacy of inflation is that marginal debtors now abound. The ability to service debt has been sharply reduced, and the economic and financial survival for many businesses hinges on a meaningful business recovery. In a longer view, let us also recognize that the cutting of inflation was done at a cost of a postwar record high unemployment rate and a massive idling of plant capacity. Moreover, the strength of the dollar was important in checking inflation and economic activity here.

However, high unemployment and a strong dollar are not permanent solutions. If they prevail too long, the risk is that they will undermine the economic and financial system. The need, therefore, is for the development of policies that will ensure a noninflationary environment as we move, hopefully, to a higher utilization of resources. In this context, I continue to favor the removal of all public and private inflation-indexing contracts; a governmental role, either through legislation or moral suasion, in ensuring competitively arrived at price and wage decisions; and the abandonment of multi-year labor contracts.

Our approach in defining and constructing a noncyclical anti-inflation policy will be a particularly important influence on financial behavior over the next year, mainly because of the impact on market expectations. A revival in economic activity will heighten concerns about the revival of inflation, higher credit demands and, in turn, loftier interest rates. While I have never believed in a close link between inflation and interest rates, inflation, nevertheless, enlarges credit demands, distorts economic decisions and creates unmanageable balance sheets. One of the major financial objectives next year should be to continue refurbishing financial positions. One of the essential prerequisites will be in holding inflationary expectations in check.

If we are to minimize anxieties about renewed inflation, and if we are to make further progress in improving corporate balance sheets, then a monetary approach, beyond the temporary suspension of adherence to M1 targeting, will have to emerge. To return to the monetarism of targeting and managing the narrowly defined money supply would hold down inflationary expectations, but this would limit severely the funding of liabilities.

Under monetarism, the only real discipline is the movement of interest rates that swing widely. Hence, the markets and the economy do not benefit from the funding of short-term liabilities over long periods of positively sloped yield curves, which was the case in earlier recessions. Because monetarism creates interest rate volatility, it also contributes to unduly high real interest rates.

Hopefully, the pitfalls associated with monetarism during the past few years will induce the Federal Reserve to turn elsewhere. Monetarism is subverted by the very processes it encourages: deregulation and financial innovation. The result is frequent redefinitions of the money concept, not in anticipation of change, but after new instruments and credit practices distort the prevailing definition of money.

If not a return to monetarism, what then? Interest rate or credit targeting can at best be interim solutions. This approach worked reasonably well in the 1950s and 1960s, when the financial markets were relatively stable and a number of devices were in place, including interest rate ceilings, to limit the credit creation process. Currently, market participants are continuing to monitor the monetary signs very closely indeed. Close attention is now being paid to the federal funds and the discount rates. At the same time, money supply developments, while not the center of attention, are not being ignored. This is because monetarism may return, and money supply data may provide clues to the economy's future.

Tactically speaking, the federal budget deficit is straitjacketed in an upward trendline for the immediate period ahead. Efforts, if any, to curb defense expenditures and entitlement programs will affect the fiscal budget in 1984 or in later years. Legislation to raise revenues or prune expenditures cannot really be passed until nearly half of this fiscal year is over. Moreover, it is difficult to devise strategies for effective fiscal measures that will benefit the current state of the economy when an already large deficit is in place.

At the heart of the matter is a difficult question. Would a smaller deficit and a more accommodating monetary policy be better for the economy? I think it would. A smaller portion of private savings would be preempted by the government, permitting a quicker and more substantial financial rehabilitation of business and financial institutions. Working such a timely trade-off between fiscal and monetary policies is difficult, especially in a quasi-monetarist world. Others argue that a reduction in fiscal stimulus immediately decreases economic demands that may not be resuscitated quickly by an enhancement of liquidity in the private sector. The best that can be said about the current dilemma is that much of the fiscal stimulus will soon be spent, but unfortunately large deficits will still be with us when much lower deficits would be the correct stabilization posture.

In the final analysis, financial behavior reflects the strength and weaknesses of us all: households, business and the government. Good behavior requires the adherence to contracts, fiduciary responsibilities, and the recognition of the benefits and costs of actions by the private and the public sector. For a long while, we have failed in these responsibilities.

One result has been the undermining of our economic and financial system. The savings and loan institutions, in particular, have experienced extraordinary strains. Now, these institutions are beginning to mend. Much, however, needs to be done elsewhere if thrift institutions are to operate in a viable environment. The major obstacles to significant economic recovery here and especially abroad continue to exist. These include a huge debt overhang both here and particularly abroad; an interest rate structure that is still too high to alleviate interest rate burdens or to encourage decisions in favor of real assets; a monetary policy that is shifting toward a direction not yet clearly defined; and a structural federal budget deficit that still requires solutions.

These obstacles hardly reflect a typical cyclical challenge. To overcome them will require that we first recognize the unusual and complex dimensions of the situation and respond with a sense of urgency and realism.