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67 October 25, 1978 AN ANALYSIS OF THE CARTER ANTI-INFLA TION PROGRAM THE ISSUE One of the few sounds that has been heard above the rumble of rising prices is the angry cry for an inflation policy. The past redistribution of wealth and the promise of future income distortions have prompted a unanimous and relentless clamor for action. President Carter's responseto the call was presented October 24, 1978, in the form of voluntary wage and price controls and government restraint.
Even before the announcement, the program had generated con siderable criticism from both labor. and business leaders. Many are skeptical about the effectiveness of a voluntary program.
Some believe that "voluntary" is merely a necessary prelude to mandatory The Administration itself does,not hold a great deal of hope for the effectiveness of the program. Although the official tar get is a 1.5 percent cut in the inflation rate, a more realistic figure is one-half of one percent.
Inflation promises to be a most redoubtable foe. Next year's major wage contracts, in trucking, auto industries, and oil, among many others, threaten to boost the wage-price spiral into orbit.
The Federal Reserve has persistently exceeded its stated money supply targets. The decline of th e dollar, itself in part inspired by inflation, has contributed to the decline in purchasing power through higher priced imports. The dismal productivity perfor mance, pushing up unit labor costs, promises to exert even more upward pressure on prices 2 BA C KGROUND The currently voluntary wage and price controls are actually Phase I1 of the "deceleration" program announced last April. In that version, business and labor were asked to hold increases below the average of the previous two years. The Administrat ion in an attempt to lead by example, limited government white collar increases to 5.5 percent. Promises to limit budget deficits and inflationary regulations were also part of the package.
Enforcement was practiced through the gentle art of suasion or jawboning. As attested to by the current situation, the "de celeration" program was a failure THE PRESENT PROGRAM The present voluntary program, retroactive to October 1, calls for annual wage increase ceilings of 7 percent. This standard applied to executive, union, and non-union pay, also includes fringe benefits pay increases and are subject to the guidelines. Multi-year contracts must average no more than 7 percent a year. Existing contract s are excluded. Union wage contracts above 7 percent are permissible if accompanied by work rule changes which reduce costs.
Those earning less than four dollars an hour will be exempted from the stricture Cost-of-living adjustments would be considered The package also contains a "Real Wage Insurance" proposal designed to make the wage guideline more palatable. Should the inflation rate exceed 7 percent, workers who have accepted wage contracts of less than 7 percent would receive the difference between th e inflation rate and the 7 percent standard in tax re bates. I-:-T-his"proposal, however, must first obtain congressional approval Prices, while not tied to a specific figure, are to be held at least one-half percentage point below the 1976-1977 average in creases. This is very similar to the Phase I guideline. In practice, this will limit increases to a 6 to 6.5 percent range.
Those firms which benefit from substantial cutbacks in labor settlements are expected to cut prices by more than one-half per cent. Firms facing oppressive costs will be permitted to increase There is, however, a 9.5 percent ceiling, on each product, regard less of cost prices accordingly, but profit margins are to remain the same.
The Council on Wage and Price Stability will monitor develop ments on a day-to-day basis. There will also be periodic reviews 3 of large corporations. To carry out these tasks, a staff increase of 100 to 200 is required. Many of these have been drafted from existing agencies. The 400 largest corporations al so have been requested to make available to the Council on Wage and Price Stability weighted indices of all manufactured profits. This request is enforceable by subpoena.
Enforcement of the voluntary standards is in the hands of the Office of Management an d Budget. This will also necessitate a staff increase. Firms bidding on federal contracts over five million dollars, must demonstrate, in advance, that they are op erating within the guidelines. Offenders are expected to be hit by a loss of federal purcha ses and construction contracts. The OMB controls purchases of 80 billion. The White House is also expected to use the power of public censure to promote compliance.
An example of the type of pressure that will occur was reported in the Wall Street Journal (October'20 1978 To ensure sufficient resistance to the upcoming 'Teamsters contract negotiations, the ICC, at the Administration's behest, has warned trucking firms that cost increases may not necessarily be passed on in higher rates On the labor side, t he Washington Post (October 24, 1978) reported that the Administration is studyinq alternative methods of computing wages paid to privately-employed labor working on federal projects.
A less controversial aspect of the program is President Carter's proposal for government restraint.
The Administration has pledged to minimize the inflationary effects of government regulation. To accomplish this, a "Regula tory Council composed of inflation specialists and representa tives of selected independent agencies,.s uch as OSHA and the EPA has been established.
The program also includes a plan to limit the 1980 budget deficit to 30 billion. The proposed 1979 deficit is an estimated 40 billion. An additional element is a partial freeze on hiring No new positions are t o be created and only 25 percent of existing vacancies are to be filled ANALYSIS The Administration's plan to limit the role of government promises to have a.positive impact on inflation. Barry Bosworth director of the Council on Wage and Price Stability, estimates that regulation accounts for three quarters of one percent of the current inflation. An evaluation of the inflationary aspects of future regulations is a step in the right direction.
The promise to cut the budget deficit, while still only a prom ise, bodes well for the future. It implies less government spending and will permit the Federal Reserve to pursue a more 4 restrictive monetary policy. However, the proposed "Real Wage Insurance" might, if enacted, have a significant effect on the size of the deficit. Rebates if the inflation rate exceeds 7 percent, could be substantial, particularly since federal workers, now limited to wage increases of 5.5 percent, are to be included.
The outlook for the wage and price controls is not so Wage and price controls function, primarily, by squeezing optimistic profit margins. Increased cos.ts are not passed on in higher prices, but rather absorbed through a decrease in profits objection to the voluntary, or any future mandatory wage and price controls is tha t by squeezing profits, controls endanger the future of the economy Price increases are not eliminated under this policy, merely postponed unfairly and inaccurately cast business and labor in the role of the originators of inflation The Wage and price cont r ols also PROF ITS Profits perform a critical and vitalizing function in our economy. When retained, profits finance expansion and research When distributed, profits offer inducement for investment and consequently, growth. The prospect of diminishing prof its threatens not only the return to corporate shareholders, but also the degree to which our economy can expand.
The imposition of wage and price controls is, particularly at this time, a dangerous policy. Profits are, and have been for several years, bel ow their historical post-war levels. Further more, the current reports dramatically exaggerate the true level of profits. Finally, due to the nature of the inflation process prices lag behind cost increases HISTORICAL LEVELS There are a variety of conflic t ing theories to explain the recent decline in secular prices. There is, however, no dispute that profits have indeed fallen. Profits, as a percentage of national income, exceeded, sometimes .substamtially the 10 percent level in every year from 1946 throu gh 1969.
Since that time profits have never surpassed 10 percent. In fact, the percentage sank as low as 7.5 and 7.6 in 1974 and 1975 respectively See chart on page 5 both government-compiled statistics and corporate earnings state ments. Standard accounti ng practices fail to adequately compen sate for the effects of inflation on capital equipment replacement and the cost of inventories The seriousness of the situation is actually understated in 5 OWORATE PROFITS 'AS PERCENT OF NATIONAL INCOME Year 1945 19 4 6 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 4 i Yearly Average 0 9.2 11.4 13.3 12.7 14.2 14.0 12.4 11.8 11.6 13.6 12.4 11.6 10.2 12.2 11.4 11.0 12. 0 12.3 12.9 13.6 13.3 12.1 12.0 10.6 8.5 9.0 9.6 9.3 7.5 7.6 0 Source: Business' Conditions' Digest September 1976 6 George Terborgh, in a study for the Machinery and-Alliedl Products Institute, has found that the reported $77 billion in profits for 1977 w a s, in real terms, only $43 billion. To arrive at this figure, Terborgh adjusted the rate of depreciation to more closely reflect the cost of replacement ventory consumption charges from historical to current costs the value of retained earnings. Based on 1972 dollars, retained earnings declined from $28 billion in 1966 to $7.9 billion in 1976.
At the same time, real GNP in 1972 dollars increased from 981 billion to $1.27 trillion He also increased in Perhaps even more distressing is Terborgh's calculation of The profit distortion is further exacerbated by the federal tax system. The effective r ate on real profits, as determined by the Terborgh study, has increased from 42 percent in 1966 to 56 percent in 19
76. The result is even less real profits for reten tion and distribution.
Another factor constricting profits is the inflation process itse lf. Demand pull inflation is transmitted initially through the cost of raw materials, then labor, and finally prices. Firms up the cost of raw materials and labor reflected in prices and the wage-price spiral is under way which respond to excess demand by first increasinq output, drive These costs are then later Higher prices prompt cost-of-living increases The essential element is that most firms do not anticipate rising costs but rather react to them with a lag price freeze will leave many firms with cos t increases already incurred but not yet reflected in prices A wage and The immediate future brings with it even more-pressure on profits. The exclusion of already existing contracts from con trols, when coupled with the expectations of future inflation, p r omises to promote substantial cost-of-living increases. Wage contracts at large companies, settled in the first six months of 1978, were at a 10 percent annual rate. These contracts, in turn serve as models for 1979 negotiations. In addition, many wage co n tracts overestimate the rate of productivity, thus pushing unit labor costs higher than expected. President Carter has rejected suggestions that the January increments in the social security taxes and minimum wages be postponed. These developments cloud t h e dis mal profit picture even further that a purpose of the Administration's tax proposal was:,to increase after-tax profits and spur investment to the President contains several provisions to assist business and boost capital spending been a constant the m e among businessmen, politicians, and the press Ironically, the Economic Report of the President for 1978 states The recent tax bill sent The need for more capital spending had I 7 in the past few years. Yet with the wage and price controls the Carter Adm inistration abandons this target and instead, fol lows a completely contrary course.
The Administration's about-face is..both unnecessary and ill advised tion. The oft-repeated dictum that "wage and price controls treat the symptoms, not the disease" is tr ue Wage and price controls will at best only delay infla A study by Robert L. Schuettinger andEamonn F. Butler Forty Centuries of Waqe and Price Controls, to be published by The Heritage Foundation in November 1978, chronicles the history of wage and pric e controls from ancient China to the present.
Some common characteristics seem to be shortages, black markets and occasional political upheavals CONCLUSION Inflationis, above all else, a monetary.phenomenon. Contin ually rising prices are caused by excessi ve increases in the money supply, whether inspired by expansive or accommodative Federal Reserve policy. The cure, therefore, lies in following a restric tive monetary policy.
Adherents of the cost push school of inflation claim that monopolies and labor unions are the source of inflation plies a certain degree of power olies possess such power, why haven't they exercised it earlier?
It would be a most irrational decision to postpone achieving the optimal price or wage That im The question is, if these mo nop Furthermore, there is no evidence to indicate that business or labor unions have recently gained, or are now gaining monopoly power.
This makes it doubly difficult to ascribe inflation, defined as con tinuously rising prices, to monopolies constantly pushing up costs popular belief that business and labor are the perpetrators of in flation this misconception, but also diverts attention from the true source of inflation, the government An unfortunate by-product of this theory has been the widespread Th e use of wage and price controls not only encourages President Carter's wage and price control program is based upon a cost push theory of inflation inflation with cost push tools is similar to performing surgery with a hammer rather than a scalpel be a bl u dgeoned patient The Carter Administration is hoping f0r.a one-half percent decline in'inflation. This can be achieved, at least on a temporary To attempt to cure a demand pull The most probable result will I 8 basis, but only at an enormous cost. To jeopa rdize the future of the economy for a slight, fleeting, recision of the inflation rate is a dangerous and desperate policy.
Eugene J. McAllister Walker Fellow in Economics