should continue, with the amount varying with the excess of the unemployment rate over 41⁄2 percent, until such time as unemployment has again fallen below 4% percent for a quarter. The distribution of this total payment among States should be based on population, on the severity of unemployment within the State, and on the degree of dependence of each State on progressive taxes such as the personal income tax. This latter factor is important because progressive taxes are most sensitive to changes in the rate of personal income growth. Consequently those States with the most progressive tax systems are the most severely affected when unemployment rises. The counter cyclical payment we are proposing would remove one major cause of current State and local budgetary problems. It would not by itself provide the complete solution to State and local financial problems. Another major problem is the poor distribution of income, and of tax resources, among and within States. This inequality of income distribution is not a cyclical problem, but a longer-term structural problem. It needs to be attacked by a major Federal effort to change the distribution of Federal aid programs so as to bring this distribution more in line with the distribution of need. The cyclical problem and the longer-term structural problem are different both in their cause and in their cure. We believe they must be attacked by two separate programs rather than by a single "cure all" such as the Administration's revenue sharing program. Unless the separate causes of State and local budget problems are understood, the cures will not be appropriate. A Monetary Policy To Support Recovery During the first half of 1971 the money supply increased at the unusually rapid rate of 10% percent per year. Yet, since April interest rates have been rising. This combination is puzzling. More importantly, the rise in interest rates is disturbing, because it could choke off activity in the only two sectors of the economy that presently seem at all strong, residential construction and State and local government. Several factors may help explain the rise in interest rates in the face of such monetary growth, although they are not complete explanations. First, business demands for credit have been heavy, as business has been striving to correct the very tight liquidity positions into which they were drawn during the tight money period of 1969 and early 1970. Second, inflation is a factor in interest rates. As long as there are expectations of inflation, interest rates will be higher than they would otherwise be. Third, several of our witnesses pointed to the difficult seasonal adjustment problem in the money supply estimates. It may well be that when the data are revised we will learn that the money supply has been growing somewhat less rapidly than the preliminary figures indicated. The Joint Economic Committee has previously suggested that in normal times a rate of monetary growth somewhere between 2 and 6 percent per year is desirable, and we have requested that the Federal Reserve supply this Committee with an explanation whenever the rate of growth of the money supply departs from this range during any quarter. Past statements of the Committee's view have made it quite clear that we recognized there would at times be exceptionally difficult periods when it would be desirable for monetary growth to be outside our suggested range. The present situation is certainly exceptionally difficult. In order to restore full employment the rate of growth of real output must for a time exceed the "potential" rate of growth of the economy. That is, real output must grow in excess of 41⁄2 percent per year until full employment has been restored. The growth of the money supply must be adequate to accommodate this growth plus some increase in the price level. What the exact rate should be cannot be determined in advance, but it might well continue to exceed the range recommended by the Committee for normal times. In any event, it is essential that Federal Reserve policy be based on present needs and not on any effort to balance the very rapid monetary growth of the first half by very slow growth in the second. An important objective of policy must be to arrest the present rising trend of interest rates, and, if possible, to reduce longer-term rates at least to the levels of the first quarter of this year. Some witnesses at our recent hearings expressed a concern that large increases in the money supply would lead to further inflation and therefore to higher rather than lower interest rates. We do not feel this has to be the case. As discussed in chapter II of this Report, many observers expect that given present policies, inflation will continue serious. But if the incomes policy recommendations we make in chapter II are adopted, we believe that a significant reduction in the rate of inflation can be achieved. Most importantly, expectations of future inflation-an important factor in interest rate determination-can be sharply dampened by an effective incomes policy. If this is done, fears of inflation need not deter the monetary authorities from adopting policies designed to produce lower interest rates. Certainly these policies should include adequate growth of the money supply. During the remainder of this year monetary policy should 65-810-71 -3 II. AN EFFECTIVE POLICY TO CONTROL INFLATION Persistent Lack of Progress Against Inflation The inflationary problem that has persisted during the past 3 years has proved much more stubborn than had generally been anticipated. When the present Administration took office the unemployment rate was 3.4 percent, and the inflation rate measured by the GNP deflator was 4.5 percent. At the time it was believed that excess demand could be eliminated and inflation checked without causing unemployment to rise much above 4 percent. Experience has demonstrated that this estimate was far too optimistic. Unemployment has exceeded 4 percent for the past 18 months, and it has averaged about 6 percent for the past 8 months, yet the rate of inflation is not noticeably less today than it was in the first quarter of 1969. After 21⁄2 years of a conscious effort to fight inflation by holding economic activity below the full employment level, the Chairman of the Council of Economic Advisers made the following progress report to this Committee at our midyear hearings: First, at a minimum the rate of price increase, which had been rising, has stopped rising. Second, some important measures indicate that there has been a significant decrease in the rate of inflation. Third, although the evidence is less clear on this, the rate of wage increase has probably also stopped rising. We agree that during the first half of this year the rate of inflation was somewhat less than the peak rate reached in early 1970. We hope this improvement will continue. Unfortunately, examination of the major price indexes does not offer any evidence of a continued slowing of the rate of inflation. Table 2 shows, for each of the latest 8 months available, the percent increase in three principal price indexes compared to the same month one year earlier. It can be seen that the Consumer Price Index improved through April, but the sharp increases in May and June have reversed this trend: The Wholesale Price Index worsened steadily through June, then improved in July due to a sharp drop in farm prices. The important industrial component of the Wholesale Price Index showed no change in its rate of increase through June but accelerated sharply in July. From February through July wholesale industrial prices showed the sharpest 6-month rise since 1957. It is clear that the Council of Economic Advisers still regards inflation as a serious danger, for the Chairman also stated in his testimony: The Administration's rejection of a policy of further economic stimulation reflects the belief that we cannot temporize with the inflation problem * * *** The Chairman of the Federal Reserve Board was even more pessimistic about the price outlook. He summarized the situation this way: I wish I could report that we are making substantial progress in dampening the inflationary spiral. I cannot do so. Neither the behavior of prices nor the pattern of wage increases as yet provides evidence of any significant moderation in the advance of costs and prices. Many of the private witnesses who testified at our recent hearings expected that the rate of inflation would still be between 4 and 5 percent in mid-1972. Thus, despite the enormous costs we have paid in terms of output and employment, the rate of inflation is just about where it was 21⁄2 years ago, and only modest improvement, at best, is anticipated during the next year. The Need for a New Approach Since a policy of reducing inflation by increasing unemployment has now been attempted for more than 2%1⁄2 years at such enormous cost and with such meager results--we are puzzled that the Administration continues to advocate more of the same. The Administration recommends no further action to increase employment because to take such action would, in the Administration's view, interfere with progress against inflation. The Joint Economic Committee emphatically rejects this "do nothing" approach. Other policies to control inflation are available. They should be tried. The effort of the past 21⁄2 years to control inflation by in- An Incomes Policy Is Essential The Administration has candidly admitted their concern over the danger of continued inflation. Both official and private witnesses have especially stressed the role of inflationary expectations in driving up interest rates, discouraging business investment, and weakening consumer confidence. Yet the Administration continues adamant in its refusal to adopt the one policy approach which, in our judgement, would dampen inflationary expectations and create an atmosphere in which full employment could be restored without creating new inflationary pressures. In a modern full employment economy reasonable price stability can be consistently maintained only if the Government assumes responsibility for specifying the rates of price and wage increase that are in the public interest and for insuring that these rates are not exceeded. We do not believe that compliance with such a policy will necessarily require legal compulsion. That is, we do not believe compulsory wage and price controls are necessary. If price and income guideposts are applied fairly and on a comprehensive basis, labor and management will cooperate. An informed public opinion will exert a powerful influence to help achieve compliance. In addition, the Government, through its important role in the economy as a regulator and as a purchaser of goods and services, has a great deal of existing power to encourage compliance. We do not mean to imply that there will be no difficulties in establishing a comprehensive incomes policy or that results will always be perfect. Of course there will be mistakes and setbacks. It may be many years before we fully succeed in combining price stability and full employment. But the Nation will be much better off with an incomes policy than without one. Such a policy can make an immediate, significant contribution. We are fully aware that one can easily find historical cases where incomes policy has not worked. The historical record in this country and abroad is valuable. We should study it carefully and attempt to learn from past mistakes. We stress that one can find successes as well as failures. Guideposts served this country well in the early 1960's. They should not have been abandoned in 1967. The country has paid dearly for their abandonment and for the failure of two successive administrations to reinstate them. In short, we reject the Administration's contention that incomes policies "won't work." It is the policies presently being followed which are a failure. Monetary and fiscal policy, unaided by incomes policy, cannot come to grips with inflation. Effective incomes policies can and must be established. The alternative is to abandon our goal of combining full employment with reasonable price stability. Obviously that alternative is not acceptable. As we have repeatedly recommended, specific quantitative 1 Senator Humphrey states: "An independent anti-inflationary price and wage board should be created to set guideposts. We should call this board exactly what it is: The Anti-Inflation Board. This board should not only publicize price, wage, and profit increases that are inflationary, but should, when necessary, recommend to the President the imposition of selective freezes on profits and wages in particular industries or sectors." |