Uneasy Money

In my previous post I wrote about the mistakes made by Arthur Burns after Nixon appointed him Chairman of the Federal Reserve Board. Here are the critical missteps of Burns’s unfortunate tenure.

1 Upon becoming chairman in January 1970, with inflation running at over 5% despite a modest tightening by his predecessor in 1969, Burns further tightened monetary policy, causing a downturn and a recession lasting the whole of 1970. The recession was politically damaging to Nixon, leading to sizable Republican losses in the November midterm elections, and causing Nixon to panic about losing his re-election bid in 1972. In his agitation, Nixon then began badgering Burns to loosen monetary policy.

2 Yielding to Nixon’s demands for an easing of monetary policy, Burns eased monetary policy sufficiently to allow a modest recovery to get under way in 1971. But the recovery was too tepid to suit Nixon. Fearing the inflationary implications of a further monetary loosening, Burns began publicly lobbying for the adoption of an incomes policy to limit the increase of wages set by collective bargaining between labor unions and major businesses.

3 Burns’s unwillingness to provide the powerful stimulus desired by Nixon until an incomes policy was in place to hold down inflation led Nixon to abandon his earlier opposition to wage-and-price controls. On August 15, 1971 Nixon imposed a 90-day freeze on all wages and prices to be followed by comprehensive wage-and-price controls. With controls in place, Burns felt secure in accelerating the rate of monetary expansion, leaving it to those controlling wages and prices to keep inflation within acceptable bounds.

4 With controls in place, monetary expansion at first fueled rapid growth of output, but as time passed, the increase in spending was increasingly reflected in inflation rather than output growth. By Q4 1973, inflation rose to 7%, a rate only marginally affected by the Arab oil embargo on oil shipments to the United States and a general reduction in oil output, which led to a quadrupling of oil prices by early 1974.

5 The sharp oil-price increase simultaneously caused inflation to rise sharply above the 7% rate it had reached at the end of 1973 even as it caused a deep downturn and recession in the first quarter of 1974. Rather than accommodate the increase in oil prices by tolerating a temporary increase in inflation, Burns sharply tightened monetary policy reducing the rate of monetary expansion so that the rate of growth of total spending dropped precipitously. Given the increase in oil prices, the drop in total spending caused a major contraction in output and employment, resulting in the deepest recession since 1937-38.

These mistakes all stemmed from a failure by Burns to understand the rationale of an incomes policy. Burns was not alone in that failure, which was actually widespread at the time. But the rationale for such a policy and the key to its implementation had already been spelled out cogently by Ralph Hawtrey in his 1967 diagnosis of the persistent failures of British monetary policy and macroeconomic performance in the post World War II period, failures that had also been deeply tied up in the misunderstanding of the rationale for – and the implementation of — an incomes policy. Unlike Burns, Hawtrey did not view an incomes policy as a substitute for, or an alternative to, monetary policy to reduce inflation. Rather, an incomes policy was precisely the use of monetary policy to achieve a rate of growth in total spending and income that could be compatible with full employment, provided the rate of growth of wages was consistent with full employment.

In Burns’s understanding, the role of an incomes policy was to prevent wage increases from driving up production costs so high that businesses could not operate profitably at maximum capacity without a further increase in inflation by the Federal Reserve. If the wage increases negotiated by the unions exceeded the level compatible with full employment at the targeted rate of inflation, businesses would reduce output and lay off workers. Faced with that choice, the Fed or any monetary authority would be caught in the dreaded straits of Scylla and Charybdis (aka between a rock and a hard place).

What Burns evidently didn’t understand, or chose to ignore, was that adopting an incomes policy to restrain wage increases did not allow the monetary authority to implement a monetary policy that would cause nominal GDP to rise at a rate faster than was consistent with full employment at the target rate of inflation. If, for example, the growth of the labor force and the expected increase in productivity was consistent with a 4% rate of real GDP growth over time and the monetary authority was aiming for an inflation rate no greater than 3%, the monetary authority could not allow nominal GDP to grow at a rate above 7%.

This conclusion is subject to the following qualification. During a transition from high unemployment to full employment, a faster rate of nominal GDP growth than the posited 7% rate could hasten the restoration of full employment. But temporarily speeding nominal GDP growth would also require that, as a state of full employment was approached, the growth of nominal GDP be tapered off and brought down to a sustainable rate.

But what if an incomes policy does keep the rate of increase in wages below the rate consistent with 3% inflation? Could the monetary authority then safely conduct a monetary policy that increased the rate of nominal GDP growth in order to accelerate real economic growth without breaching the 3% inflation target? Once again, the answer is that real GDP growth can be accelerated only as long as sufficient slack remains in an economy with less than full employment so that accelerating spending growth does not result in shortages of labor or intermediate products. Once shortages emerge, wages or prices of products in short supply must be raised to allocate resources efficiently and to prevent shortages from causing production breakdowns.

Burns might have pulled off a remarkable feat by ensuring Nixon’s re-election in 1972 with a massive monetary stimulus causing the fastest increase in nominal real GDP since the Korean War in Q4 of 1972, while wage-and-price controls ensured that the monetary stimulus would be channeled into increased output rather than accelerating inflation. But that strategy was viable only while sufficient slack remained to allow additional spending to call forth further increases in output rather than cause either price increases, or, if wages and prices are subject to binding controls, shortages of supply. Early in 1973, as inflation began to increase and real GDP growth began to diminish, the time to slow down monetary expansion had arrived. But Burns was insensible to the obvious change in conditions.

Here is where we need to focus the discussion directly on Hawtrey’s book Incomes and Money. By the time Hawtrey wrote this book – his last — at the age of 87, he had long been eclipsed not only in the public eye, but in the economics profession, by his slightly younger contemporary and fellow Cambridge graduate, J. M. Keynes. For a while in the 1920s, Hawtrey might have been the more influential of the two, but after The General Theory was published, Hawtrey was increasingly marginalized as new students no longer studied Hawtrey’s writing, while older economists, who still remembered Hawtrey and were familiar with his work, gradually left the scene. Moreover, as a civil servant for most of his career, Hawtrey never collected around himself a group disciples who, because they themselves had a personal stake in the ideas of their mentor, would carry on and propagate those ideas. By the end of World War II, Hawtrey was largely unknown to younger economists.

As a graduate student in the early 1970s, Hawtrey’s name came only occasionally to my attention, mostly in the context of his having been a notable pre-Keynesian monetary theorist whose ideas were of interest mainly to historians of thought. My most notable recollection relating to Hawtrey was that in a conversation with Hayek, whose specific context I no longer recall, Hayek mentioned Hawtrey to me as an economist whose work had been unduly neglected and whose importance was insufficiently recognized, even while acknowledging that he himself had written critically about what he regarded as Hawtrey’s overemphasis on changes in the value of money as the chief cause of business-cycle fluctuations.

It was probably because I remembered that recommendation that when I was in Manhattan years later and happened upon a brand new copy of Incomes and Money on sale in a Barnes and Noble bookstore, I picked it up and bought it. But buying it on the strength of Hayek’s recommendation didn’t lead me to actually read it. I actually can’t remember when I finally did read the book, but it was likely not until after I discovered that Hawtrey had anticipated the gold-appreciation theory of the Great Depression that I had first heard, as a graduate student, from Earl Thompson.

In Incomes and Money, Hawtrey focused not on the Great Depression, which he notably had discussed in earlier books like The Gold Standard and The Art of Central Banking, but on the experience of Great Britain after World War II. That experience was conditioned on the transition from the wartime controls under which Britain had operated in World War II to the partial peacetime decontrol under the Labour government that assumed power at the close of World War II. One feature of wartime controls was that, owing to the shortages and rationing caused by price controls, substantial unwanted holdings of cash were accumulating in the hands of individuals unable to use their cash to purchase desired goods and services.

The US dollar and the British pound were then the two primary currencies used in international trade, but as long as products were in short supply because of price controls, neither currency could serve as an effective medium of exchange for international transactions, which were largely conducted via managed exchange or barter between governments. After the war, the US moved quickly to decontrol prices, allowing prices to rise sufficiently to eliminate excess cash, thereby enabling the dollar to again function as an international medium of exchange and creating a ready demand to hold dollar balances outside the US. The Labour government being ideologically unwilling to scrap price controls, excess holdings of pounds within Britain could only be disposed of insofar as they could be exchanged for dollars with which products could be procured from abroad.

There was therefore intense British demand for dollars but little or no American demand for pounds, an imbalance reflected in a mounting balance-of-payments deficit. The balance-of-payments deficit was misunderstood and misinterpreted as an indication that British products were uncompetitive, British production costs (owing to excessive British wages) supposedly being too high to allow the British products to be competitive in international markets. If British production costs were excessive, then the appropriate remedy was either to cut British wages or to devalue the pound to reduce the real wages paid to British workers. But Hawtrey maintained that the balance-of-payments deficit was a purely monetary phenomenon — an excess supply of pounds and an excess demand for dollars — that could properly be remedied either by withdrawing excess pounds from the holdings of the British public or by decontrolling prices so that excess pounds could be used to buy desired goods and services at market-clearing prices.

Thus, almost two decades before the Monetary Approach to the Balance of Payments was developed by Harry Johnson, Robert Mundell and associates, Hawtrey had already in the 1940s anticipated its principal conclusion that a chronic balance-of-payments disequilibrium results from a monetary policy that creates either more or less cash than the public wishes to hold rather than a disequilibrium in its exchange rate. If so, the remedy for the disequilibrium is not a change in the exchange rate, but a change in monetary policy.

In his preface to Incomes and Money, Hawtrey set forth the main outlines of his argument.

This book is primarily a criticism of British monetary policy since 1945, along with an application of the criticism to questions of future policy.

The aims of policy were indicated to the Radcliffe Committee in 1957 in a paper on Monetary Policy and the Control of Economic Conditions: “The primary object of policy has been to combine a high and stable level of employment with a satisfactory state of the balance of payments”. When Sir Robert Hall was giving oral evidence on behalf of the Treasury, Lord Radcliffe asked, ”Where does sound money as an objective stand?” The reply was that “there may well be a conflict between the objective of high employment and the objective of sound money”, a dilemma which Treasury did not claim to have solved.

Sound money here meant price stability, and Sir Robert Hall admitted that “there has been a practically continuous rise in the price level. The rise in prices of manufactures since 1949 had in fact been 40 percent. The wage level had risen 70 percent.

Government pronouncements ever since 1944 had repeatedly insisted that wages ought not to rise more than in proportion to productivity. This formula meaning in effect price level of home production, embodies the incomes policy which is now professed by all parties. But it has never been enforced through monetary policy. It has only been enjoined by exhortation and persuasion. (p. ix)

The lack of commitment to a policy of stabilizing the price level was the key point for Hawtrey. If policy makers desired to control the rise in the price level by controlling the increase in incomes, they could, in Hawtrey’s view, only do so by way of a monetary policy whose goal was to keep total spending (and hence total income) at a level – or on a path – that was consistent with the price-level objective that policy-makers were aiming for. If there was also a goal of full employment, then the full-employment goal could be achieved only insofar as the wage rates arrived at in bargaining between labor and management were consistent with the targeted level of spending and income.

Incomes policy and monetary policy cannot be separated. Monetary policy includes all those measures by which the flow of money can be accelerated or retarded, and it is by them that the money value of a given structure of incomes is determined. If monetary policy is directed by some other criterion than the desired incomes policy, the income policy gives way to the other criterion. In particular, if monetary policy is directed to maintaining the money unit at a prescribed exchange rate parity, the level of incomes will adapt itself to this parity and not to the desired policy.

When the exchange parity of sterling was fixed in 1949 at $2.80, the pound had already been undervalued at the previous rate of $4.03. The British wage level was tied by the rate of exchange to the American. The level of incomes was predetermined, and there was no way for an incomes policy to depart from it. Economic forces came into operation to correct the undervaluation by an increase in the wage level. . . .

It was a paradox that the devaluation, which had been intended as a remedy for an adverse balance of payments, induced an inflation which was liable itself to cause an adverse balance. The undervaluation did indeed swell the demand for British exports, but when production passed the limit of capacity, and output could not be further increased, the monetary expansion continued by its own momentum. Demand expanded beyond output and attracted an excess of imports. There was no dilemma, because the employment situation and the balance of payments situation both required the same treatment, a monetary contraction. The contraction would not cause unemployment, provided it went no further than to eliminate over-employment.

The White Paper of 1956 on the Economic Implications of Full Employment, while confirming the Incomes Policy of price stabilization, placed definitely on the Government the responsibility for regulating the pressure of demand through “fiscal, monetary and social policies”. The Radcliffe Committee obtained from the Treasury the admission that this was not being done. No measures other than persuasion and exhortation were being taken to give effect to the incomes policy. Reluctant as the authorities were to resort to deflation, they nevertheless imposed a Bank rate of 7 per cent and other contractive measures to cope with a balance of payments crisis at the very moment when the Treasury representative were appearing before the Committee. But that did not mean that they were prepared to pursue a contractive policy in support of the incomes policy. The crises of 1957 and 1961 were no more than episodes, temporarily interfering with the policy of easy credit and expansion. The crisis of 1964-6 has been more than an episode, only because the deflationary measures were long delayed, and when taken, were half-hearted.

It would be unfair to impute the entire responsibility for these faults of policy to Ministers. They are guided by their advisers, and they can plead in their defence that their misconceptions have been shared by the vast majority of economists. . . .

The fault of traditional monetary theory has been that it is static, and that is still true of Keynes’s theory. But a peculiarity of monetary policy is that, whenever practical measures have to be taken, the situation is always one of transition, when the conditions of static equilibrium have been departed from. The task of policy is to decide the best way to get back to equilibrium, and very likely to choose which of several alternative equilibrium positions to aim at. . . .

An incomes policy, or a wages policy, is the indispensable means of stabilizing the money unit when an independent metallic standard has failed us. Such a policy can only be given effect by a regulation of credit. The world has had long experience of the regulation of credit for the maintenance of a metallic standard. Maintenance of a wages standard requires the same instruments but will be more exacting because it will be guided by many symptoms instead of exclusively by movements of gold, and because it will require unremitting vigilance instead of occasional interference. (pp. ix-xii)

The confusion identified by Hawtrey between an incomes policy aiming at achieving a level of income consistent with full employment at a given level of wages by the appropriate conduct of monetary policy and an incomes policy aiming at the direct control of wages was precisely the confusion that led to the consistent failure of British monetary policy after World War II and to the failure of Arthur Burns. The essence of an incomes policy was to control total spending by way of monetary policy while gaining the cooperation of labor unions and business to prevent wage increases that would be inconsistent with full employment at the targeted level of income. Only monetary policy could determine the level of income, and the only role of exhortation and persuasion or direct controls was to prevent excessive wage increases that would prevent full employment from being achieved at the targeted income level.

After the 1949 devaluation, the Labour government appealed to the labour unions, its chief constituency, not to demand wage increases larger than productivity increases, so that British exporters could maintain the competitive advantage provided them by devaluation. Understanding the protectionist motive for devaluation was to undervalue the pound with a view to promoting exports and discouraging imports, Hawtrey also explained why the protectionist goal had been subverted by the low interest-rate, expansionary monetary policy of the Labour government to keep unemployment well below 2 percent.

British wages rose therefore not only because the pound was undervalued, but because monetary expansion increased aggregate demand faster than the British productive capacity was increasing, adding further upward pressure on British wages and labor costs. Excess aggregate demand in Britain also meant that domestic output that might have been exported was instead sold to domestic customers, while drawing imports to satisfy the unmet demands of domestic consumers, so that the British trade balance showed little improvement notwithstanding a 40% devaluation.

In this analysis, Hawtrey anticipated Max Corden’s theory of exchange-rate protection in identifying the essential mechanism by which to manipulate a nominal exchange rate so as to subsidize the tradable-goods sector (domestic export industries and domestic import-competing industries) as a tight-money policy that creates an excess demand for cash, thereby forcing the public to reduce spending as they try to accumulate the desired increases in cash holdings. The reduced demand for home production as spending is reduced results in a shift of productive resources from the non-tradable- to the tradable-goods sector.

To sum up, what Burns might have learned from Hawtrey was that even if some form of control of wages was essential for maintaining full employment in an economic environment in which strong labor unions could bargain effectively with employers, that control over wages did not — and could not — free the central bank from its responsibility to control aggregate demand and the growth of total spending and income.