A CEA Memorandum on Stagflation, June 1971
June 1971. A memorandum reaches the chairman of the Council of Economic Advisers. Consumer prices are rising at about 5.4 percent a year and wholesale prices at 6.9 percent. Unemployment is 5.9 percent and drifting up. New union contracts are settling at 8 to 9 percent a year over three years. Foreign central banks are converting dollars for gold fast enough that, at the current pace, the convertible gold stock would be seriously depleted within a year. A Democratic Congress will not cut spending in an election year; the president has publicly ruled out controls and privately asked for options. The Fed's discount rate is 4.75 percent.
1. Rank the three available options - tighter money, fiscal restraint, incomes policy - and justify the ranking using only the constraints described.
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Tighter money is the textbook answer and the worst-ranked in practice. With inflation already embedded in three-year wage contracts, restricting demand lowers output and employment before it lowers wages, and the exchange-rate constraint means higher domestic rates attract further dollar conversions rather than defending the parity. It is also the slowest to bite in an election year.
Fiscal restraint is economically coherent but politically unavailable as stated: the Congress will not cut in an election year, and the president cannot compel it. An option that requires an actor who has already refused is not an option.
Incomes policy ranks first on feasibility, not on economics. It acts on the one variable the actors can reach directly - the wage-price expectations written into contracts - and it can be announced without legislation. Its costs are real: it suppresses relative price signals, requires an enforcement bureaucracy, and, once removed, permits a catch-up surge. A rational adviser therefore recommends it as a short, announced, temporary freeze paired with a signal of future monetary discipline, precisely because a permanent program would be captured by the interests it regulates.
The ranking shows the difference between choosing the best policy and choosing the best available policy.
2. Why does the standard Phillips-curve tradeoff fail to describe this data, and what would a policymaker who believed in it do wrong?
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The Phillips curve implies an inverse, stable relationship: 5.9 percent unemployment should be purchasing falling inflation. Here unemployment and inflation are rising together, and wage settlements exceed productivity growth by a wide margin. The relationship is not merely shifted; it is broken by expectations.
A believer in the tradeoff would read 5.9 percent unemployment as slack and conclude that inflation must soon fall on its own, therefore recommending that the government expand to reduce unemployment. That expansion would validate the 8-to-9 percent wage settlements, embedding them in the next round of contracts, and require an even larger contraction later to dislodge them.
The correct reading is that the relevant constraint is credibility, not slack. Once workers and firms expect prices to keep rising, the short-run curve's position is set by expectations, so demand policy can choose a point on the curve only temporarily and at the cost of moving the curve itself. The honest advice is that the menu is narrower than it looks: the choice is between a sharp, announced disinflation with high transitional unemployment, and an incomes policy that buys time while credibility is rebuilt.