Economics students used to be taught a simple fable about how central bankers keep the economy on an even keel:
When the economy periodically overheats, workers become hard to find, and plant capacity grows tight. With this shift in supply and demand, workers can bargain for inflationary wage increases, and industry can jack up its prices. But just in time the Federal Reserve comes to the rescue, raising interest rates to chill the overheated economy and damp down inflation.
“Our job”, former Fed Chairman William McChesney Martin used to say, “is to take away the punch bowl just when the party gets going.”
In recent weeks, Fed Chairman Alan Greenspan has faithfully followed that austere tradition. As signals of inflation have appeared, the Fed has pushed the prime rate to 11.5%.
But there is very good evidence that the Fed’s traditional strategy no longer fits the new economic realities.
Today, unions have been weakened to the point where labor retains little bargaining power to demand wage hikes, given current unemployment rates of over 5%. Tight domestic plant capacity is far less inflationary in an open world economy, because imported substitutes discipline domestic prices.
A close look at the actual sources of today’s inflation shows just how misguided the tight-money strategy is. Wages, for example, have been falling behind the rate of inflation for two years. Wages of private-industry, non-supervisory workers slowed down during 1988. They rose 1% in each of the first two quarters of 1988, then 0.9% in the third quarter and 0.8% in the fourth quarter, for an annual increase of just 3.7%.
A broader index, measuring the weekly earnings of all full-time wage and salary workers, rose just 2.9% during 1988, while prices increased 4.3%. Whatever is responsible for the uptick in inflation, it isn’t wages.
Another measure of labor costs, one that counts fringe benefits, increased last year somewhat faster, at 4.3% or just about the rate of inflation. The main factor causing higher labor costs for industry has been out-of-control health-care charges, which show up in higher insurance premiums. This is surely a problem, but not one that can be solved by higher interest rates.
Last Wednesday, the Commerce Department released another misleading indicator, showing that “personal income” rose a robust 1.8% in January, seemingly suggesting runaway economic activity. But a closer look shows that this increase reflects mainly one-time cost-of-living adjustments to Social Security and federal pay, farm subsidies, the Fed’s own higher interest rates (which show up as higher interest income for savers), and the creation of new jobs--but not an acceleration in wages.
By misreading these various tea leaves, the Federal Reserve creates the danger that tight money will indeed chill the economy and discourage new investment, just at a time when America needs more productive machinery. The overall rate of economic growth slowed to just 2% in the last quarter of 1988--hardly a sign of an overheated economy. And the Fed fails to address the real structural causes of inflation like runaway medical costs.
The other main source of the new inflation is the cheap dollar, also the consequence of wrongheaded economics. Many economists argued that a cheaper dollar would be a painless cure for the trade deficit. But a cheap dollar raises import prices.
American producers who import their raw materials are beginning to report price increases that they pass along to customers. Imported consumer products are also becoming more expensive as a result of the fall in the dollar, which has now lost more than half of its value against the Japanese yen and the German deutsche mark.
About half the change in the relative currency values has been passed through in the form of higher import prices. Here again, chilling the economy does little to solve that problem.
There is only one macro-economic source of mild inflationary pressure today, and it is the federal budget deficit. If the economy seems overheated by an excess of purchasing power, reining in the federal deficit would do far less damage than the Fed’s traditional icy bath of tight money.
Yet the White House will not hear of a tax increase, and the continuing deficit gives the Federal Reserve a handy rationale for raising interest rates.
The National Economic Commission, one possible source of fiscal compromise, was neutered by President Bush’s intransigence. The Republicans on that panel, most of whom know better, loyally backed their President rather than doing their job.
There will be plenty of blame to go around for the next recession: a Federal Reserve Board that indulged in outmoded thinking about inflation; economists who made wishful prophesies about the cheap dollar, and an Administration that placed ideology above common sense.