Stabilization Methods - II
Since we have found that economic instability is primarily a matter of unstable market price levels due to a lack of balance between the two economic streams entering the markets-the stream of goods and the stream of money purchasing power-two possible methods of control to achieve stability immediately suggest themselves: (1) control of the goods stream, or (2) control of the purchasing power stream. As indicated in the discussion in the preceding chapter, however, control of the stream of goods is not practical, nor would it be desirable from an overall standpoint even if it were practical. This leaves the control of the purchasing power stream by compensatory reservoir transactions as the only immediately obvious answer to the problem.
It was demonstrated in Chapter 24 that government fiscal operations provide us with the kind of a money purchasing power reservoir that can be manipulated for control purposes. A countercyclical fiscal program of the kind outlined in that discussion is not without its disadvantages, however. The principal argument that has been advanced against it in the past is that so many delays will probably be experienced that the controls are unlikely;y to be applied at the right time. J. E. Meade assessed the situation in this manner:
The clarification of the nature and operation of the business cycle in the preceding pages points the way to elimination of a large part of this delay. With the benefit of this new information there should no longer be any difficulty in recognizing an inflationary or deflationary trend as soon as it appears, and with a control program that modifies the stream flowing to the markets by direct additions or withdrawals of money purchasing power, there should be no delay in getting the full effects of the control measures. But delays of an administrative or political nature will be more difficult to eliminate, and unless there is a rather widespread understanding of the theoretical aspects of the compensatory fiscal policy, it is not unlikely that some essential element of the program may be omitted, or modified by political pressure to the point where it is ineffective.
One of the major obstacles to the introduction of a fully effective economic control program based on government fiscal policy is the existence of a school of thought which holds that tax cuts are good for the economy at any time; that they stimulate business and thereby increase governmental revenues enough to offset the revenue lost by reason of the lower tax rates. Hence they “cost nothing.” Like all other schemes for getting something for nothing, this idea has great appeal to those who are unable to look behind the false front and see the fallacy on which it is based. But something for nothing is always an illusion, no matter how attractively it is packaged.
It is generally recognized that tax reductions in the face of constant, or increasing, government expenditures have the potential of causing inflation-nations all around the world are giving practical demonstrations of this fact every day-but the advocates of these reductions contend that inflation is not a necessary result, and that it can be prevented by taking direct action against any inflationary developments. For instance, both the Kennedy and the Johnson administrations reacted violently against efforts of basic industries to raise prices on occasions when inflationary trends were developing, and both administrations felt that they had won significant victories by compelling the producers to rescind the price increases (temporarily).
What the government officials and their economic advisers fail to see is that tax reductions that are not accompanied by corresponding reductions in government expenditures, or by non-inflationary borrowing, are inherently and hence inevitably inflationary.
Borrowing from the banking system is inflationary because the banks normally obtain new money from the Federal Reserve to replace the amount loaned to the government (by purchase of securities), and this new money, or a large part of it, adds to the flow in the circulating purchasing power stream. Borrowing from individuals is not inflationary, because these transactions do not change the total money purchasing power. The purchasing power of the individuals who buy the government bonds is decreased by the same amount that the purchasing power of the government is increased. Borrowing from foreign sources is also non-inflationary because it has no effect on the domestic purchasing power stream, but in this case the non-inflationary status is only temporary, as sooner or later the foreigners will want real values (that is, goods) instead of paper, and these goods have to be diverted from the stream going to the domestic markets, resulting in inflation of the price level. Redemption of the bonds sold in the domestic market does not produce a similar inflation, as in this case the government has to levy taxes to raise the money with which to redeem the bonds, and the total money purchasing power is not altered.
When spending (in real terms) remains unchanged every dollar added to disposable income by reason of lower tax rates means one dollar increase in the price of goods. Once the tax cuts have been made, the price rise cannot be avoided. As brought out in Chapter 10, direct control of the general price level is mathematically impossible. Any control of the prices of some items simply raises the prices of other items. However beneficial the actions of the Kennedy and Johnson administrations in blocking price increases in some individual items may have been politically, they were nothing but futile gestures from the economic standpoint.
However, the direct connection between government fiscal operations and the market price level that makes inflation the normal consequence of government deficits is not only an obstacle standing in the way of the dreams of getting something for nothing. It also has a positive aspect in that it provides us with a tool that can be used for economic stabilization. In this connection, it should be recognized that it is the inflationary or deflationary aspect of these operations that affects prices. A tax cut does not, in itself, inflate prices if it is accompanied by a corresponding reduction in expenditures, as is so often recommended. The nation may be better off as a result of this combination of actions, if the reduction of expenditures is achieved by genuine economies and not be elimination of needed projects and activities. But the additional buying that the taxpayers are now in a position to do merely replaces the spending that the government has eliminated, and if the flow of money purchasing power to the markets was inadequate before the tax cut, it remains inadequate. A tax cut is of value as a business stimulator only by reason of what it accomplishes in the way of creating a government deficit.
Furthermore, it is not even sufficient just to create a deficit; it must be an inflationary deficit. As brought out in the preceding paragraphs, if the deficit is financed by non-inflationary borrowing, the total available money purchasing power remains unchanged, and the tax cut has no effect on general business conditions. It is not the tax cut that stimulates business; it is the inflation. Money inflation stimulates business because it subsidizes business profits at the expense of the consumers. If the tax cut is so handled that it does not produce inflation, than there is no increase in profits, and no stimulation. This is another illustration of the “no free lunch” principle. If the tax cut does not produce inflation, no one is paying the bill, and consequently no one gets any benefit.
From a technical standpoint, flexible tax rates constitute a very effective stabilization tool. We must recognize, however, that variable tax rates have a serious disadvantage in that the required manipulation is too conspicuous. Even at best the general public cannot be expected to understand all of the intricacies of purchasing power stabilization, so there will inevitably be public pressure tending to favor increased government borrowing beyond the actual needs when borrowing is in order, and to resist the liquidation of outstanding debt when the technical position calls for an input into the reservoirs. This is not necessarily an insurmountable obstacle. If no other adequate control measure were available, it would be entirely possible to go ahead with a variable tax program, either on the basis of overriding whatever resistance may develop, or preferably, by accompanying the program with an educational program to promote a better public understanding.
A suggestion that has been made to minimize the public opposition that is likely to develop when tax increases are required is to separate the stabilization tax or rebate from the normal taxes, so that the taxpayers will realize that the amount of this special tax or rebate is merely a temporary adjustment, and will sooner or later be offset by an equivalent adjustment in the opposite direction. In its original form this proposal contemplated an entirely separate tax, the idea being to level a tax on all retail sales when the price index exceeds a certain standard, and to make a corresponding rebate on sales when the index falls below the standard by a given percentage.208 In the light of the information developed in the preceding pages, it is apparent that this proposal, in its original form, is unsound, as any attempt to maintain a fixed price level is detrimental to the economy. It could, however, be modified to operate on the basis of the condition of the money and credit reservoirs, levying the tax when the excess of the reservoir transactions is outward, and applying the rebate when there is a net inflow.
The central idea of this plan, that of clearly identifying the stabilization component of current taxes, so that the taxpayer would realize that whatever gain or loss may thereby accrue to him is only temporary, has considerable merit. However, a wholly separate tax is not essential for this purpose. The expense and inconvenience of a separate tax system could be avoided by applying the stabilization tax or rebate as a percentage of the income tax computed on the regular basis. In this form, the proposal should be feasible, both technically and politically. It is true that there is no real difference between a increase in the tax rate and an equivalent percentage surtax applied to the normal taxes, but the obstacle to be overcome is psychological, and there is a psychological difference between the two methods of handling the situation. The general reaction to the news that taxes are to be raised is quite unfavorable, but once the public becomes accustomed to a regular adjustment which is downward as often as it is upward, the necessary changes will, in all probability, be accepted as a matter of routine.
Nevertheless, in spite of all that can be said in favor of tax adjustments as a means of economic control, and regardless of what may be done to make those adjustments more palatable to the taxpayers, it is clear that an unobtrusive primary method of control would be advantageous, if such a method is available.
In making a detailed examination of the possibilities along this line, we find that there is another alternative in addition to the two general methods of stabilization previously discussed: control of the goods stream or control of the purchasing power stream. The third alternative is to equalize the flows by interchanging goods and purchasing power and diverting enough from one stream to the other to bring about an equality.
At first glance this may seem absurd, as conversion of wheat to dollars, or anything of that nature, is obviously impossible. But even though it is not possible to convert real goods to money, it is possible to convert credit goods to credit money and vice versa. Since both of the streams entering the markets contain substantial amounts of credit instruments, it is entirely feasible to meet an inflationary threat by withdrawing credit money from the purchasing power stream, converting it to credit goods, and injecting these goods into the goods stream flowing to the markets. In order to counter deflation, all that is necessary is to reverse this action.
So far as the primary objective is concerned, it makes no difference whether the control measures are applied to one stream alone or involve diversion from one stream to the other. Either method is capable of equalizing the flows in the two streams, and that is all that is required for stability. The interchange between credit goods and credit money does, however, have some practical advantages that warrant serious consideration. One of these is that the interchange is twice as effective as a corresponding unilateral transaction. If the inflationary unbalance is a million dollars per day, for example, a million dollars per day must be withdrawn from the purchasing power stream in order to maintain an equilibrium by this kind of a transaction alone. But a half million dollars of credit money withdrawn daily from the purchasing power stream and injected into the goods stream in the form of credit goods will accomplish the same purpose.
Another major advantage is that no one gains or loses by the transaction, even temporarily, and this program therefore avoids the possible adverse public reaction that constitutes the strongest objection to control by means of government fiscal operations. Fluctuations in the disposable incomes of the individual taxpayers such as those that would result from the operation of a flexible tax system are not only objectionable in themselves but, as has been pointed out, are a constant threat to the successful handling of the control mechanism, as there will always be political pressure for more liberal tax reductions when reductions are in order, and a resistance to tax increases when increases are in order. Unless the authorities are more callous toward this political pressure than government officials can normally afford to be, there is a hazard of destroying the effectiveness of the system. The interchange between credit goods and credit money, on the other hand, is a balanced transaction from the standpoint of the individuals concerned. There will have to be a small price differential to enable the transactions to be carried out when and in the amounts needed, but aside from this, each participant simply exchanges one asset for another of equal value.
An important consequence of this fact that there will be no substantial gain or loss to anyone is that the control transactions can be carried out as routine business dealings without attracting the widespread public attention that is given to increases and decreases in taxes. This is a definite advantage, particularly in the early stages of the operation of the control system, when its effectiveness is still questioned by skeptics, as a public advertisement of the intention of the government to take steps to combat inflation is, in itself, likely to have an inflationary effect (that is, cause increased withdrawals from the money reservoirs). Of course, a fully effective control program should be able to handle any situation that may develop, but nevertheless, it is clearly desirable to keep the load on the control system as low as possible, and for this reason it is helpful to keep as much as possible of the manipulation behind the scenes.
The Federal Reserve System already has the legal power to operate a control program of the kind suggested. One of the powers granted to it by existing laws is that of buying and selling government obligations and certain other classes of securities in the open market for the purpose of carrying out the policies established by the Federal Reserve Board. Before 1922 these powers were exercised in a rather haphazard and unorganized fashion by the separate Federal Reserve Banks, but by this time the potential of these open market operations was beginning to be more clearly realized, and a new policy was adopted which put the execution of the program in the hands of a central committee.
In the period from 1922 to 1927 the open market powers were used on several occasions with uniformly favorable results, and the banking authorities became convinced that they had found a least a partial answer to their stabilization problems. The 1929 action, however, was not well timed, and accentuated an inflationary tendency already under way. As a result, the sale of securities had to be undertaken in 1928 and 1929 to stem the rising tide of speculation and inflation, but to the dismay of those who had regarded the open market operations so optimistically, this action had little apparent effect, even though it was carried to the point where the supply of securities on hand was practically exhausted. After the stock market crash in the fall of 1929, buying was begun, and large purchases were made throughout most of the decline, again with little or no visible results. As expressed by W. Randolph Burgess of the New York Federal Reserve Bank, from 1922 to 1927 the response to relatively small changes in Federal Reserve policy were extraordinary, but in 1928-29 and later the most vigorous measures had relatively little effect.209
In order to appreciate what happened, and why the operations were effective at one time and ineffective at another, it must first be understood just what the open market operations do to the economic system in general. The bankers, accustomed to looking at the situation from the standpoint of the technicalities of their own business, regard these operations as a means of credit control, and so label them in their financial discussions. As they see the picture, purchase of securities by the Federal Reserve expands the reserves of the member banks, whereas reversing the process contracts those reserves. The effect, according to this view, is to make the bankers either more or less willing to lend.
But we who are investigating the reactions of the economic mechanism as a whole are not interested, for the present, in these inter-bank relations. From the standpoint of the general economy, the entire banking system is one unit. An increase in bank reserves is an increase in the amount of money storage in the banks. But if this increase is the result of a transaction by which a corresponding decrease occurs in the amount of money in storage in the Federal Reserve Banks,, the net total change in money storage is zero, and there is no effect at all on the general economy.
The open market operations are effective as inflationary or deflationary measures only to the extent that these transactions do not affect the bank reserves; that is, to the extent that the securities are bought from or sold to non-bank investors, directly or indirectly. The principle here is the same as that involved in government borrowing. Sale of bonds to non-bank purchasers “soaks up” excess money purchasing power; sale to the banks does not. In the non-bank transactions additional credit goods (government bonds) are introduced into the goods stream, while the money purchasing power stream remains unchanged. Market prices then fall, or are prevented from rising in response to inflationary forces.
These operations in the open market, excluding purely inter-bank transactions, are a means of accomplishing the same kind of a result (or the reverse) by a transfer between credit goods and credit money. Credit goods (government securities) are withdrawn from storage and exchanged in the market for credit money, which in turn is put into storage (retired from circulation). In the reverse transaction credit money is withdrawn from storage (new currency is issued) and it is exchanged in the market for credit goods. The latter than go back into storage. By this means the current stream of money purchasing power is increased or decreased relative to the stream of goods, without altering any other economic relation except the form of a portion of the national debt outstanding.
Here is a very simple and effective tool for controlling the economy. If stabilization is undertaken as a continuous process, the net excess of transactions to be counterbalanced by the open market operations will never be very large, as each small deviation in one direction or the other can be nipped in the bud by the appropriate action. The key to successful control is a clear understanding of just what is to be done, and a close watch on the relevant data to make certain that action is taken promptly when needed. Heretofore the Federal Reserve authorities have neither recognized the true effect of the operations on the business cycle, nor possessed an adequate guide as to when action should be taken, or as to the magnitude of the operations required. As a result there has been no action at all until the unbalance has become large enough to be plainly visible, and when action finally has been taken, the operations have conformed to a set pattern rather than being adapted to the quantitative requirements of the existing situation.
This explains the seeming discrepancy between the 1922-1927 results and the subsequent experience. When the open market operations were first placed on a definite policy basis, the magnitude of the individual operations was arbitrarily set at a figure of from 200 to 500 million dollars, for lack of any accurate method of determining the actual requirements. In the 1922-1927 period no strong trend in either direction developed in the money and credit reservoirs, and open market operations of this size were therefore adequate not only to neutralize the net transactions into or out of the reservoirs, but were also sufficient to give the general economy a momentum in the opposite direction. In 1928 and 1929 the picture was entirely different. Now the nation was in the midst of a speculative boom, with money purchasing power flowing out of the consumer money and credit reservoirs in a veritable flood. The transactions that were ample to counterbalance the small streams that issued from the reservoirs in the previous years were of no avail against this tremendous volume. It was just another case of sending a boy to do a man’s work. The same comments apply to the situation after the 1929 collapse, with additional emphasis.
The failure of this program to stem the money inflation of 1928-29 and the subsequent deflation was not due to any defect in the method itself; it was merely a matter of too little and too late, the employment of mild and gentle measures where only action of truly epic proportions would suffice. It is very common for the advocates of an unsuccessful economic program to try to explain away the failure by the assertion that the program was not applied on a large enough scale, and there may possibly be some suspicion that the foregoing explanation is the same kind of an excuse. By referring to the discussion of business cycles in Chapter 14, however, it can be seen that the reservoir theory therein explained definitely requires the corrective operations to be equal in magnitude to the net excess of consumer transactions in order to have the desired effect. The quantitative aspect of the action-not too much and not too little-is the essence of the program. From the statistical records of the movement of money and credit it is apparent that the 1922-27 open market operations were adequate to meet this requirement, whereas the operations in 1929 and the following years were far below the necessary level, not because they were smaller, but because the reservoir unbalance was vastly greater.
This is not the kind of a situation where a partial action does some good. The decline can be slowed by measures of less than the magnitude required for neutralization of the reservoir transactions, but it cannot be halted unless the storage of money and the contraction of credit are fully balanced by the control operations. Slowing the rate of decline is of no particular value. It probably does more harm by prolonging the depression than it does good in any other respect. Anything short of the full amount needed to restore equilibrium is useless. Obviously the Federal Reserve operations during the 1928-29 boom and the following depression, large as they seem when judged by normal standards, were trivial in comparison with the coincident huge unbalanced transactions in and out of the consumer money and credit reservoirs.
The lessons to be learned from this experience are first, that speculative excesses should not be permitted to get a start, and second, that the stabilization program should be automatic and continuous, so that no inflationary boom or deflationary recession will have a chance to get beyond the point where it can be handled effectively by ordinary means. If the wild swings due to speculation are curbed, bank credit is carefully watched, and foreign trade is subjected to some intelligent control, there is no doubt but that the minor ups and downs that will still occur can be ironed out by a small but continuous program of open market operations. All that is necessary is that the Federal Reserve keeps fully informed as to the current status of the purchasing power reservoirs and balances any net inflow or outflow promptly by open market operations of the opposite character and exactly the same amounts.
The result of such a program will be to maintain the price balance between production and the markets, and to insure a flow of money purchasing power to the markets that will be just sufficient to buy the full volume of goods produced at the full production price. It will not mean a constant market price level; on the contrary, any changes at the production end of the economic mechanism, either because of altered tax or wage rates or because of technological improvements, will be promptly reflected in the market price level, but such variations have no adverse effect on the general economy. The stabilization of the flow of money purchasing power will eliminate the destructive price fluctuations, those due to an unbalance between production volume and active money purchasing power.
As indicated in the preceding chapter, it sill be advisable to authorize and set up a tax adjustment program to be held in reserve for use when and if there is a heavy surge in the system which the open market operations might have difficulty handling. Probably this program will never be needed, except perhaps in getting the stabilization program started, but there are some limitations on what can be done by the interchange of credit goods and credit money, and as long as a tool that is essentially unlimited in available, it is good insurance to have this tool ready for prompt use in case of an emergency. Actually, the fact that it is available will go a long way toward eliminating the possibility that it may be needed.
The stabilization program that is here being recommended leaves business and government free to operate in almost all respects just as they would in the absence of such economic controls. Nevertheless, it is impossible to set up a program of this kind without affecting something. If the open market operations are to be used as the primary means of economic control, then they cannot be used for other purposes. The particular significance of this point lies in the fact that these operations are currently being used for other purposes. One action that has frequently been taken is to buy government securities at appropriate times as a means of supporting the price of those securities; that is, keeping the interest rate artificially low to hold down the cost of government financing. In order to make the open market operations available for control purposes these support purchases will have to be discontinued.
Since this will increase the amount of interest that has to be paid on the national debt, there will undoubtedly be some opposition to discontinuing this price support, particularly from the Treasury Department, which is quite legitimately concerned with keeping the interest cost as low as possible. If we assume, for the moment, that holding the interest rate down is a worth-while objective, and that the cost of government financing will be substantially increased if the price support actions are no longer taken, the question becomes: Is stabilization of the economy at a permanent high level worth enough to justify this increase in interest costs? There cannot be any doubt as to the answer to this question. The added interest costs are only a drop in the bucket compared to the losses that are now being incurred by reason of the economic fluctuations of the business cycle.
But, in reality, holding down the interest rates on the government debt is not as desirable an objective as it appears to be on superficial examination. When we examine the situation more closely, it becomes evident that the “low interest” policy does not actually reduce the cost to those who pay the bills: the taxpayers. The artificially low interest rate is made possible only by creating new money for the Federal Reserve banks to use in buying government securities to support their prices. Injection of this new money into the purchasing power stream automatically raises the market price level, and the taxpayer pays out in higher prices all that the lower interest rate saves on his taxes. Behind all of the machinery by which it is carried out, this “management” of the interest rate is simply another attempt to get something for nothing, and it shares the fate of all other schemes of this nature.
In recent years, the most significant use of the monetary tools of the Federal Reserve System, including the open market operations, has been to manipulate the interest rate as a means of combatting inflation. As pointed out earlier, this is a prime example of economic mismanagement. We create cost inflation by adopting a labor policy that imposes no significant restraints on wage increases, and then deal with the cost inflation due to these wage increases by choking business with high interest rates to create the unemployment that will bring the wage rates back down. One of the prerequisites for constructing a workable program to stabilize business is to recognize that such a program should be directed against money inflation only. Cost inflation has no major effect on the general economic situation. It does create inequities among different classes of workers, and therefore deserves some attention, but this is a totally different problem, which should not be permitted to confuse the stabilization issue.
Thus the fact that we will have to discontinue using the open market operations for these other purposes in order to make them available as the principal tool of the stabilization program is not an argument against the program. These other uses should be discontinued in any event, as they do not benefit the economy. Where they have any effect at all, it is harmful.