Edward S. Shaw*

Simon Kuznets remarked in his Capital in rate. There is physical wealth, its ownership The American Economy, " ... extrapolation of represented by an homogeneous financial asset inflationary pressures over the next thirty in the form of common stock or "equity," and years raises a specter of intolerable conse­ there is wealth in the form of real money bal­ quences.... "1 Fifteen of the thirty years are ances. Accumulation of physical and monetary over, and inflation has accelerated. The central wealth derives from a constant rate of saving concern of this paper is whether Kuznets' pre­ for the community. Inflation occurs because the diction of "intolerable consequences" for capital growth rate of nominal money exceeds the markets and capital accumulation is on track or growth rate of real money demanded. patently wrong. 2 The inflation is immaculate because its pace Monetary theory distinguishes between "im­ is constant and perfectly foreseen and because maculate" inflation, "clean" inflation, and the inflation tax on real money balances is com­ "dirty" inflation. It is the last of these that pensated precisely by a deposit-rate of interest Kuznets dreaded and that we have endured. The on money. It is fully anticipated, and it does not first section below deals very briefly with dif­ impose a relative penalty on the money form of ferences between the three styles of inflation. wealth. Money-wage rates rise faster than out­ The second section is a catalogue of ways in put prices in the degree that labor productivity which dirty inflation may obstruct and distort is growing. The price of common stock rises capital flows and capital accumulation. The in precise accord with the marginal reproduc­ third section considers some ways, including tion cost of corporate capital goods, and the "indexing," to cleanse a dirty inflation and some earnings-price ratio of corporations equals the ways to prevent it. real marginal productivity of physical capital. Stocks are a perfect hedge against inflation, and Styles of inflation so is money whether the rate of inflation is posi­ Immaculate inflation can be visualized most tive or negative, high or low. It is evidently not easily for a competitive economy that is firmly immaculate inflation that bothered Kuznets. settled on a path of steady growth. Final out­ Clean inflation is also constant and perfectly puts are produced by three forms of wealth. foreseen. However, money-holders are not There is human wealth, growing at a constant compensated for the inflation tax, so that a rise in the rate of inflation makes money wealth a "'Edward S. Shaw was Visiting Scholar at the Federal Re­ less attractive alternative, in the optimum port­ serve Bank of San Francisco (1974-75). He is Emeritus Professor of Economics at Stanford University. folio, to human and physical wealth. Depend-

5 ing upon the functions attributed to money and ital growth. We pass this by, because inflation upon other considerations, the higher rate of often reduces the social rate of saving and be­ clean inflation may lower the growth rate of cause more efficient devices to increase aggre­ output, the yield to human wealth, and the earn­ gate savings are available. Another alleged ings-price ratio on equities or it may raise them. gain is that inflation demolishes a complex and For example, if money is a consumer good, an awkward structure of claims against wealth and uncompensated inflation tax can increase the permits a purified financial system to concen­ community's savings-income ratio and acceler­ trate on incremental growth of capital. This ate growth of wealth and output. On the other may be a benefit of once-and-for-all hyperinfla­ hand, if money is a producer good, a negative tion, but it is not the result of chronic infllati,ol1. yield or tax on it can reduce the productivities Still another gain is said to be that inflatilon of complementary physical and human wealth. posed as a tax to yield government re\<'ennes Then workers and stockholders suffer along impedes efficient capital formation less with money-holders, and all of them should alternative sources of revenue. This is true for dread the "specter" of inflation. They should some but not for all alternative taxes. To con­ insist that the monetary system link growth of tinue down our list, inflation of product prices nominal money precisely with growth in real is said to be an essential, though second-best, money demanded. defense for full employment against autono­ Immaculate and clean inflation are figments mous inflation of factor prices. It must be not of monetary theory. The real world is not firmly merely tolerated but validated by monetary ex­ settled on a stable growth path for output, pansion until there can be a "social contract" to human wealth, and physical wealth. Wealth is inhibit monopoly practices in factor markets. not riskless and homogeneous, its ownership We pass this by, partly on the grounds that represented by homogeneous common stock of monopoly in its various guises is characteristi­ gilt-edge quality. In particular, the growth cally laggard in adjusting its price demands to paths of price levels for output and wealth are inflation: autonomous inflation tends to be not straight lines into infinity. Inflation pro­ catch-up inflation. Finally, there is Phillips-ism ceeds, instead, at unstable rates on markets for which tells us that inflation is the right way to output, factors, and securities. Its variance de­ reduce marginal real labor costs to employers fies foresight and can be regarded as a disease and so to excite demand for labor to the full­ of capitalism's guidance mechanism, the price employment level: unstable and unanticipated system. The inflation tax is not compensated. inflation clears the labor market. This allega­ The inflations that we experience are dirty, and tion we put aside because we do not know the an increase in the inflation rate or its variance inflation-unemployment rate of exchange nor has real consequences that the simple models of how often the rate of exchange may vary, and immaculate and clean inflation do not com­ the evidence is strong that chronic unemploy­ prehend. ment responds less durably to inflation stimulus than to improvement in labor training and Capital costs of inflation mobility. We turn now to the obstacles that dirty infla- .tion puts in the way of efficient wealth or capital The safety principle accumulation. The list of obstacles below is not Every segment of economic theory about all-inclusive, and the costs they impose are not finance emphasizes benefits that accrue to indi­ measured. It is not balanced against a list of viduals and society from the existence of some social gains from inflation. One alleged gain is safe asset or assets; that is, of assets bearing that inflation shifts income from low-saving sec­ real yields of negligible unanticipated variance. tors to high-saving sectors and accelerates cap- The hypothesis here is that dirty inflation deals

6 bnltally with safe assets with financial markets. se~:mleni:ed; relative financial financial stocks are de:,tnJv(:d: cial ad,iptatHJnS inefficient. The first of monetary benefits if some asset has a fixed in terms of the nUJmeraiJre zero variance in the numeraire It is for the efficient orf;aniz3ltio1n of markets and for extension of th,;irboluil,darie:s limits

of a "C(lmlTIOn-cun'en,cy which two or more local monies an rate of zero variance.

consumer another. Inflation to demonetize an ec()n()m:y Portfolio asset or assets, the frontier Risk-averse investors of their if asset for unsafe assets an average deviation of 4.5 percent during pooled experience was that stock prices gained 1960-1966. In view of the deteriorating yield approximately one-half of one percent for each and quality of Treasury bonds in particular and percentage point of inflation. Inflation reduced of other Treasury issues in smaller degree, it is the real value of equities. James Tobin has re­ not surprising that private domestic investors ported a reduction from 1.62 to .995, during made no net purchases of Treasury issues during 1965-1973, in the ratio of aggregate market 1967-1973 and elected to hold in their port­ values for stocks and debt of American corpora­ folios only $I22 billion of Treasury debt, at tions to reproduction cost of corporate capitaL" values in 1967 prices, in 1973 as compared with Data assembled by Henry Kaufman indicate $206 billion in 1967. that the ratio of market value to stated book From the mid-1960's to the 1970's, dirty in­ value for Dow Jones industrials declined during flation has reduced the safety of money, claims 1965-1974 to its lowest level since World War on intermediaries, and government bonds. Com­ II.' Michael Keran, exploring quarterly data plementary investments with high-risky returns for the United States during 1956-1970, found have been affected as one expects. One particle a negative and highly significant relationship be­ of evidence comes from the market for venture tween Standard and Poor's 500 index and the capital, a principal source of finance for small, gross national product deflator lagged from one new enterprise. The flow of funds to this mar­ to sixteen quarters.s These and other studies ket is down to a trickle, and the terms have leave little doubt that dirty inflation is not a become more severe. The Department of Com­ happy context for bulls on stock exchanges. merce is concerned that the effect may be to Complement-shift is by no means the only inhibit technological innovation as well as com­ explanation for the perverse response of stock petition with relatively large, established enter­ prices to inflation. That it does count is sug­ prise.' We consider this "complement-shift" at gested by varying degrees of response in price greater length in the following section. indices for stocks of different grades and quali­ ties. If aversion to stocks arises from decay of Complement - shift of Portfolios and the safe assets, one would expect aversion to hit Stockmarket. Some assets that qualify as "safe" least the large, blue-chip issues, to hit hardest when inflation is negligible deteriorate along the the issues of relatively new and small firms. This risk scale when inflation is substantial and dirty. is what happens. From the end of 1972 to the Asset portfolios are adjusted to this decay of end of 1974, for example, the Dow Jones index safety in two ways. For one, there is a shift for thirty industrials declined by thirty-six per­ away from the assets with high-risky returns that cent, the NASDAQ index for over-counter are complementary with assets qualifying as safe stocks by fifty-two percent. Dirty inflation in­ when inflation is negligible. For the other, there creases the cost of capital to extraordinarily, is a shift to assets that are relatively inflation­ even infinitely high levels for industry on the proof. Disappearance of venture capital during safety fringes. It tends to close the door of this the past few years in the United States may be particular habitat to capital inflows. one bit of evidence on the former or comple­ ment-shift. The behavior of stockmarket indices Substitute-shift and The Term Structure of during inflation is another bit of evidence. Interest Rates. If inflation were immaculate or Many studies have made it clear that stocks clean, borrowers and lenders could not err in are not a secure inflation hedge during dirty in­ forecasts of nominal or real rates of interest. flation. One study has regressed annual growth Information about forward rates of interest rates in stock-price indices, during 1953-1969, would be just as precise and reliable as informa­ on growth rates of commodity prices and indus­ tion about spot rates. Differences in trading trial production for twenty-two countries." The cost aside, short-term and long-term securities

8 would be perfect substitutes and occupants of short must put a damper on capital formation in the same habitat. Issues at various terms to the private business sector. maturity are not perfect substitutes in the real world. One reason is that inflation imposed in The lag principle the past at random rates generates expectations In immaculate or clean inflation, the future of inflation at unpredictably variable rates in path of inflation can be foreseen precisely by the future. Then nominal and real forward rates participants in all markets. In dirty inflation, cannot be forecast precisely. This means, of the mean inflation rate for some long period is course, that short-term securities provide a mar­ approached by successive accelerations of in­ gin of safety for risk-averse investors over long­ flation interspersed with slow-downs of price­ term securities. The latter lose gilt-edgeness, level growth. Current and past short-run infla­ and dealings in them take place in a distinctive tion rates are not an accurate guide to expecta­ risk habitat. tions of the mean rate: historic price behavior When dirty inflation has done its mischief becomes unreliable information about prices in with such safe assets as, say, money or Treasury the future. On general principle, of course, any bonds or endowment life insurance, one can decline in the efficiency of the price mechanism count on a substitute-shift by investors. One as a device for disseminating information and obvious way to retrieve an element of safety for for coordinating economic activities is bound to portfolios is to substitute short-term claims for have its social costs in the capitalist system." longer maturities. Security markets must re­ Some of these costs must be evident on capital spond to this shift with an increase in the liquid­ markets where present prices of capital assets ity premium on the longer maturities that can be depend in complex ways upon both prices in the explained, in part, by the variance of past and, present and past and prices expected for the hence, of expected inflation. future. We turn now to three examples. Especially since 1965, the liquidity premium on longer-term securities has increased in this Relative Prices of Debt and Equity. Michael country. Modigliani and Shiller have traced Keran has developed a subtle model, with part of the increase, for the premium on AAA strong empirical verification, in which unstable corporate bonds relative to prime commercial inflation generates changes in relative rates of paper, to growth in the rate of inflation. They return to corporate debt and corporate equity.1:! have traced part of the increase to growth in the The market rate for corporate bonds of AAA standard deviation of the market rate of interest quality, a measure of both return to savers and for commercial paper." This short-term rate has of capital's supply price to corporate investors, become less stable because inflation has been is determined by expected rates of change in the dirtier, but there are other reasons including GNP deflator (with positive effect), by rates of higher variability of the money supply. Whether change in real GNP (with positive effect), and and by how much inflation's variance affects the by change in the real money stock (with nega­ liquidity premium for long-term securities has tive effect). When inflation is unstable and yet to be determined, but exploratory work by accelerating, this interest rate rises sensitively Rose McElhattan indicates that the substitute­ in response to inflationary anticipations. The shift does occur along the maturity spectrum.") supply price of capital on the stock markets re­ The maturity shift poses hazards for eco­ sponds even more sharply. Security buyers there nomic welfare. Shorter mean maturity of busi­ insist upon a rate of return that is competitive ness debt can result in difficult cash-flow prob­ with bond rate. They bid prices on the stock lems for both borrowers and lenders, especially exchanges to the low levels that will yield the including banks. Even if financial crisis does competitive rate, given anticipated corporate not result, the risks of borrowing and lending earnings. However, they are relatively myopic

9 about the effect of inflatIOn in raising future during periods when profits are depressed rela­ earnings: they are inflation-sensitive on the tive to interest payments. bond market, inflation-insensitive on the stock Lags and Wealth Effects. Dirty inflation market. The result is that the supply price of leaves a trail of wealth effects. For the moment, equity capital, computed from earnings that are we are concerned only with those effects that adjusted to inflation, is driven upward relative can be attribl,lted to imperfect foresight regard­ to bond rate. In due time, as the higher inflation ing inflation and to lags in anticipations regard­ rate is prolonged, the error in stock valuations ing inflation's mean and variance. More wealth is corrected and a "normal" relationship is re­ effects follow from other aspects of in~ation, stored between yields on bonds and yields on especially from governmental pricing and tax equities. Conversely, as inflation slows, market policies, and we turn to them later. returns to equities diminish temporarily relative to bond rate, then rise as deflationary anticipa­ During economic growth, the private sector tions are applied to forecasts of corporate generates a stock of debt and financial assets. profits. The public sector has become a chronic borrow­ The Keran model dramatizes the uneven im­ ing sector. Financial accumulation is the coun­ pact of inflation and inflationary expectations terpart of private capital accumulation and ex­ on different segments of the capital market. One pansion of the public domain. At low and stable suspects that this model can be augmented, to rates of inflation, only a negligible share of the explain the impact of unstable growth rates in financial accumulation is explicitly "indexed." nominal money. When monetary growth is As inflation increases and becomes more vari­ accelerated, there tends to be a "first" effect able, indexing is extended in various guises, but reducing corporate bond rate and raising stock its costs are apparently so high that it lags be­ prices. "Second" effects follow, including in­ hind inflation. It is discussed in a later section. creases in real national product that tend to Indexing is perfect, of course, in immaculate raise bond rate and increases in real corporate inflation. profits that tend to raise stock prices. Keran's Dirty inflation imposes a quadruple tax on model is concerned mainly with "third" effects, holders of the bulk of financial assets. First,the as inflation sets in, that tend to raise bond rate real value of claims that promise a given flow of and to raise the supply price of equity capital nominal returns is diminished by each increment even moreY Extended or not, the Keran model of realized but unanticipated inflation. Second, generates a clear account of fragmentation on the value of such claims is diminished by in­ capital markets during dirty inflation. Bond creases in market rates of interest that reflect markets and stock markets become more dis­ anticipated inflation. Third, many varieties of tinctive habitats as the result of changing lag claims slip down the scale of security ratings. patterns in output, prices, profits, and inflation­ Fourth, holders of equity claims are injured by aryanticipations. the lag of stock prices behind inflation of labor With increased variance in yield, equities slip and commodity prices. It may be noted in pass­ down the scale of safety relative to corporate ing that claimants in such contingency contracts bonds, and there must be a trend during dirty as insurance bear inflation taxes along with inflation toward the higher leveraging of cor­ holders of financial assets. These penalties on porate investment. In view of increases in the contingency contracts should be expected to liquidity premium against long-term debt that have effects on portfolio choice and substitution develop during inflation, the higher leveraging similar to effects of dirty lnfl.ation on "safe" must involve a rising ratio of short-term debt to assets. . equity. This trend involves obvious risks for No accurate and complete estimates of these corporate liquidity and solvency, particularly costs to holders of financial assets have been

10 made. Bach and Stephenson have published tax, may be overstated by at least $30 billion. estimates for the first taxon our listY For the He suggests, too, that use of a constant dollar quarter~century 1946-1971, real capital losses in measuring profits would reduce the reported from unanticipated inflation may have amount­ increase from 40 percent to 10 percent in 1966­ ed to $600~billion. For each one-percentage 1973.10 Terborgh reports that corporation prof­ point of inflation after 1971 in this country, the its during 1946-1970 were overstated by nearly cost to creditors may amount annually to $35 20 percent because of just one instance of billion at the 1971 level of commodity prices. money-illusion, underestimation of depreciation Of course, this tax is objectionable on all canons charges. 16 Bach and Stephenson note the re­ of taxation. For one thing, who the beneficiaries markably diverse impact upon companies of are is not clear. They must include taxpayers correcting income statements for bias in the dol­ who benefit from government's debt exposure lar as measuring rod.'7 Valuations of aggregates or, when government does not pass on to tax­ by the Department of Commerce have been no payers the benefits of its inflation windfall, users more immune to illusion~error than micro-valu­ of public goods and purveyors of various ser­ ations by accountants and tax collectors. The vices to government. They seem to include, too, American Institute of Certified Public Account­ stockholders of corporations with exceptional ants has nominated inflation-bias as the pre­ debt leverage. Recipients of low and high in­ eminent issue in reform of corporate accounting comes are taxed for the benefit of middle-in­ procedures.18 come households, and elderly people are taxed The economy travels through time with a for the benefit of the young. The distribution of slowly changing stock of "old" tangible wealth benefits and burdens is not random, but it is and "old" financial assets and debt. The stocks obscure and is not determined by explicit politi­ are substantial multiples of annual flows of in­ cal choice or by efficient market choice. The tax comes, cost, and debt service. The ages of the is biased against savings, and it is biased for stock range from the new to the well-nigh in­ relative growth of the government sector. finitely old (land). One result is that, if assets The second, third, and fourth taxes on hold­ and debt are measured in original values, re­ ers of finanCial assets have no benefiCiaries. ported net worth of individuals, firms, and the Their effect, it was argued earlier, is to distort economy can vary substantially between periods capital markets, twisting the structure of interest just because the vintage of assets and debts rates against risky and long-term assets. In more changes. Reported income can be over-stated general terms, they add to the risks and hazards or under-stated just because the current price of capital accumulation. The long-run result of level differs from the weighted mean of price augmented risk can be only to diminish eco­ levels at which old assets and debt were ac­ nomic productivity and growth. quired. All by itself, the calendar produces variance in net worth and income. Valuation Lags. Valuation of assets, liabili­ Instances of illusory valuation are familiar. ties, and net worth of both companies and indi­ There is original-cost depreciation, which is cor­ viduals is based on the principle that "a dollar rect only partially when depreciation charges is a dollar is a dollar." They are afflicted with are accelerated. There is FIFO costing of in­ money-illusion. They are rarely adjusted to the ventory and costing of debt at contract instead fact that last year's dollar and this year's are of market rates of interest. These and other quite different when price levels are unstable. distortions in accounting information are the The result is that levels of income and wealth heritage of more or less prolonged dirty in­ and change in the levels are misrepresented. flation. Fabricant estimates that corporate profits for Bach and Stephenson have made the essen­ 1973, reported as $118 billion before income tial point about the effect of these distortions on

11 capital markets. They sought but could not find The second tax effect depends on the progres­ evidence that stock markets discriminate suc­ sivity of tax schedules. Inflation drives nominal cessfully between business profits that are and real incomes along different paths. The illusory, based on the age-pattern of old assets United States is aware, from its experience of and debt, and profits that are corrected for 1973-1975, that nominal and real incomes may money illusion."! Stock markets are not efficient move in different directions, the former rising enough, in valuing profits, to draw the line and the latter declining. Progressive taxation where illusion ends and efficiency begins. They pays no heed to the path of real incomes. It cannot be as selective as we would like them to imposes higher tax rates as nominal incomes in­ be in allocating scarce savings. crease, and government seems not to be con­ cerned that, because real incomes lag, the pro­ Inflation and government gression of taxes against them is steeper still. Dirty inflation should be labeled, "Made in Real incomes, then, are subject to "double pro­ Government." Inflation is generated by exces­ gression" as the result of dirty inflation. 20 The sive growth rates of nominal money, dirty infla­ double progression is especially notable for the tion by excessive and unstable growth rates of profit share of income since it is so sensitive to nominal money, and the determination of these change in real national product. Of course, the rates is government's prerogative. In this sec­ impact of inflation cum progressive taxation on tion, we sample other government actions that, after-tax, distributed real profits and the stock by adding to the turmoil of inflation, distort cap­ markets' valuation of private capital formation ital markets. The hypothesis is proposed, in must be adverse to private investment. Since passing, that dirty inflation increases the eco­ the impact is variable, it increases the variance nomic size of government relative to private sec­ of real yield to capital, the risk of investment, tors: in particular, it increases governmental and the aversion to investment at each mean rate relative to private demands upon capital mar­ of return. Dirty inflation cum progressive taxa­ kets, governmental relative to private financial tion makes safe assets risky, risky assets riskier intermediation, and governmental manipulation still. of private financial choice. If government were We observed earlier that business income motivated to self-aggrandizement, dirty inflation varies with the vintage of business wealth when would be the instrument to use. there is variable, unanticipated inflation. It is Tax Effects of Inflation. The list of tax effects overstated by original-cost depreciation and of inflation is long, and we draw only a small FIFO accounting for inventory when prices are sample from it. The most obvious, of course, is rising, under-stated when prices are falling. that unstable inflation imposes unpredictable Business taxes are assessed on measured or rates of taxation upon private balances of gov­ "vintage" income, and so they are progressive to ernment debt and high-powered money. These inflation at rates which vary from taxpayer to private balances are depreciated during inflation taxpayer according to the vintage of capital and, since income taxation is afflicted with mon­ goods and inventory. After-tax incomes are not ey-illusion, the depreciation cannot be counted unbiased measures of firms' relative efficiencies. by the private sector as a tax-deductible loss or They are biased by the relative ages of business business expense. Government imposes the loss assets. and declines to allow relief for it in explicit The vintages of debt also count in measure­ taxes, even declines to report it as a fiscal rev­ ments of income and assessment of taxes during enue. One result, as we have seen, is to take inflation. Any firm with debts that are not in­ away from investors the haven of safe assets, dexed, by the market or by contract, receives and another is to reduce private savings, given real income from the inflation tax on its credi­ constant savings-income ratios. tors. The tax is higher as the debt is older. Of

12 course, this real income of private debtors is not inflation, of tax-exemption clauses in issues of counted as income subject to government tax, local government. Still, one notes that the mean and the inflation costs of creditors are not de­ ratio of market rates of interest on U.S. Treasury ductible from income subject to government bonds to market rates on high-grade issues of assessment. Since the corporate sector at large local government declined from 1.15 on the is a net debtor, this exemption of real income average in 1960-1963 to 1.07 in 1970-1973. from assessment is a partial offset against the During the same period, quality ratings were re­ punitive tax effect of original-cost depreciation duced for numerous issues of local governments and FIFO accounting for inventory. Musgrave in response to lags in local revenues behind takes the position that, since there is offset in local interest obligations. It may be more im­ some degree, tax assessments should not be cor­ portant, from an efficiency standpoint, that the rected for vintage of either assets or debts. 21 incidence of relative increases in cost of capital was uneven among local governments, depend­ Inter-Government Finance. Inflation affects ing in some substantial way on differences in in arbitrary and unexpected ways the relative styles of taxation and composition of tax bases. flows of real revenues and savings for different Demands for revenue-sharing by the Federal levels of government and their relative ease of government must have arisen in part because of access to capital markets. For example, only the differential impacts of inflation on different central government collects the inflation tax by levels of public administration. issue of nominal money to excess. This tax is one that state and local governments are pre­ Price Controls. Government is nourished by cluded from using. However, there are more inflation, then bites gently the hand that feeds important differences. it by imposing selective price ceilings. Whether In the main, lesser governmental units do not the ceilings are numerous, as in Phases I-III employ progressive taxation of private incomes during 1971-1973, or more selective, their effect or the rate progression is gentler than the fed­ is to differentiate the impact of inflation upon eral progression. They do not enjoy automatic various kinds of wealth and upon the markets growth of real revenues from income taxation. for wealth. In much the same way that old Again, much of local government depends only assets and old debt affect gains and losses from to a slight degree on income taxation and relies inflation, old prices stabilized by controls adjust instead on property taxation. Revenues from the relative burdens of inflation on the processes property taxes characteristically lag behind in­ of capital accumulation. flation because reassessments of property are in­ One expects two principal effects of specific frequent and because collections are annual price ceilings on capital markets. Wealth yield­ rather than quarterly or by withholding. Still ing services that are subject to effective price again, local government bears first the brunt of controls must yield declining real revenues dur­ taxpayers' resistance to automatic growth of ing inflation and, at any discount rate, must de­ total real tax burdens in inflation. In some de­ cline in real market value. Probability that con­ gree, that is to say, growth of real federal tax trols will be imposed must increase the risk of revenues turns out to be at the expense of real wealth ownership so that a higher discount rate local tax revenues. is appropriate. Market values of wealth are Lags in revenue growth for local government diminished, relative to reproduction costs, by relative to expenditure growth tend both to in­ either the fact of control or by the prospect of crease government bids for funds on capital control. markets and to lower the markets' valuation of There are numerous illustrations of the im­ the debt offerings. Of course, the markets do pact of inflation, dirtied by price controls, on take into account the increasing value, during capital values. Private residential construction

13 has been damped in New York City since World criterion for market value of utilities' net worth War II, as in Paris and London and elsewhere, while the free capital market, adapting to infla­ because of the lethal combination of rent ceil­ tionary experience and expectations, depends ings and general inflation. Cattle herds in Ar­ on reproduction cost. Here is another case in gentina are destroyed as their effective rate of which an old price distorts capital markets dur­ return relative to free market rates of interest ing inflation. is reduced by over-valuation of the peso on the Keran's results demonstrate that, during in­ foreign exchanges and by controls on export flation, the market values of utilities' equity prices for beef and mutton. Cocoa plantings in issues take the same path as the market prices Ghana recede when price ceilings discriminate of old bonds. Book value of net worth is com­ against cocoa production during inflation and parable with· the initial price of a bond, and then expand when ceilings are raised or infla­ "fair return" is comparable with the bond's con­ tion reduced. 22 tractual interest yield. When unanticipated in­ Keran has demonstrated the impact of con­ flation sets in, the market prices of utility issues ventional "fair-return" pricing of services of and old bonds must decline, and the effective public utilities, during inflation, by regulatory nominal rates of return to investors must rise so commissions. 23 The commissions have been that the real rates of return do not decline. Reg­ charged with responsibility for thwarting the ulatory commissions do not recognize the dis­ disposition of utility companies to price their tinction between nominal "fair return," which services monopolistically and so to extract ex­ seems to them the appropriate criterion of com­ cessive returns for their stockholders as well as petitiveness, and real competitive return. The to supply smaller and poorer flows of services consequences of their money-illusion are an in­ than might be expected in a competitive context. crease in the cost of new capital to utilities and Of course, there is no perfectly competitive mar­ retardation of growth in the utilities' productive ket for utility services that might generate capacity. It would be interesting to compare standards of price and output quality for the the relative effects, on growth of power produc­ non-competitive markets that commissions reg­ tion, of OPEC's pricing policies for petroleum ulate. The regulators must look to competitive and the commissions' "fair return" rule. capital markets for their criteria. The common regulatory rule is that a utility Disintermediation. Unanticipated inflation qualifies as competitive if the aggregate market deals roughly with financial intermediation, value of its equity issues is in line with book shrinking its real and even its nominal volume value of net worth. Presumably then stockhold­ of characteristic indirect debt. Variance of in­ ers can realize, from the anticipated earnings of flation necessarily increases the supply price of their company, the rate of return that accrues equity capital to intermediaries. Whether the to stockholders of competitive and unregulated sources of funds are indirect debt or equity is­ industry. The rule guarantees that inflation will sues, their stocks and flows tend to be reduced reduce the market price of the utilities' stock in volume, destabilized, and made more expen­ issues relative to prices for equities of unregu­ sive. The impact upon savings and loan associa­ lated firms. The reason is, of course, that the tions is familiar but not unique among classes of equity market anticipates inflation in some de­ intermediary; for example, the real value of life gree-imperfectly in the short run, more ade­ insurance reserves declined during 1967-1974 quately in the long run-and arrives at a rate of as· well as in the earlier inflationary periods of return for unregulated industry that tends to 1946-1948 and 1950-1951. equate market value of equities with the repro­ Some intermediaries are victimized along duction cost, not the book value, of net worth. with taxpayers, public utilities, and others by Regulation depends on book value as the right the familiar burdens of old assets, old debt, and

14 governmental price-fixing. Their problems are aries. Inflation's effect on intermediation, like not unique. Their portfolios are dominated by its effect on taxation, expands the public sector long-term bonds and mortgages, acquired at low at the expense of the private. Even if ratios of contractual rates of interest, and by equities, savings «(ad investment to income in the aggre­ acquired before inflation has had its first effect gate do not fall, the pattern of investment must ofdepreciating equity prices. Unanticipated in­ change, with emphasis 011 the production of flation generates capital losses for them, and it merit goods and public goods. Inflation and raises operating expenses other than interest government constraints, such as Regulation Q, costs relative to revenues of interest and divi­ tend to shrink private intermediation, and gov­ dends. Rates of interest on their debt are fixed, ernment intermediaries are slipped into the fi­ by contract in some cases, by ceiling in the style nancialgap, with at least qualitative effects upon of Regulation Q in other cases. When free-mar­ capital accumulation. e" ket rates of interest are driven up by inflation, Decline in the real growth rate of their re­ creditors of intermediaries demand liquidation sources induces private intermediaries to inno­ of their claims in some substantial amounts at vate. Pension funds develop variable annuities; prices fixed by contract or regulation. Unless mutual funds proliferate in variety; savings and someone rides to the intermediaries' rescue, loan associations introduce long-term deposits their plight can be serious indeed, caught as they and payments services. Then there is pursuit of are between constant revenues and rising ex­ these innovations by new government regula­ penses, depreciating assets and liquidation of tions. One may suggest the principle that gov­ debts. ernment, imposing inflation, induces private fi­ The public eye has been caught by episodes nancial innovation and pursues it with a net of of disintermediation. They disturb capital for­ new regulations. Dirty inflation is a stimulus mation, at least in terms of its composition, but both to growth of government finance and to the trend of disintermediation during prolonged government regulation of private finance. dirty inflation may be a source of more funda­ mental change. It reverses the secular increase Palliatives and remedies for dirty inflation over a century in intermediation relative to di­ Three ways of dealing with dirty inflation rect finance of investment and of government come to mind: live with it, cleanse it, stop it. deficits.2+ For given aggregate ratios of savings This disease of the price system might simply be to income, secular disintermediation implies endured or tolerated except for the probability, that alternative modes of finance will develop. discussed first below, that it gets worse when They may include greater reliance on private treated with benign neglect. Alternatively, soci­ self-finance of investment from retained earn­ ety might try to cleanse it and transform it to ings, but that seems improbable while the trend immaculate or clean inflation. We consider in after-tax real corporate profits continues some cleansing techniques, such as indexing in downward. They may include increasing sub­ the second section below. Then the discussion stitution by consumers of durable goods for turns to methods and costs of stopping inflation. financial assets, but that will be damped by the Convalescence can be expensive. rising price of energy. Of course, secular decay Dynamics of Inflation. Inflation in the United of traditional intermediation may stimulate in­ States is not damped, tending to wear itself out, novation of modes of indirect finance: the Euro­ nor does it tend toward a steady state. It is a dollar market is a case in point. The certainty rhythmic process, and the rhythm tends to be­ is that the government sector will substitute for come more violent. The driving force is fiscal­ private intermediation either by taxation and by ized monetary policy. Fiscal deficits run in issue of direct government debt to savers or by cycles of increasing amplitude, and the Federal proliferation of government financial intermedi- Reserve, together with other central banks, fi-

15 nances the deficits by issue of high-powered both financial and non-financial sectors. It money including currency and reserves of com­ would seem that rejuvenation of these relics mercial banks. There is another, complemen­ from the past could reduce inflation's costs sub­ tary force at work; namely, lags in the rate of stantially. In fact, there have been numerous inflation behind changes in unemployment rates experiments with rejuvenation since at leastthe and in real national product. early eighteenth century, and now it appears When growth in real national product is near that their use is spreading. 2G its cyclical low point and unemployment is at Rejuvenation of an old price simply by its high, automatic fiscal processes increase fed­ moving floors under it and ceilings over it is the eral deficits, and the Congress authorizes dis­ simplest of "corrections." Foreign-exchange cretionary increases in spending and decreases rates can be floated; usury and rental ceilings in rates of taxation. The discretionary measures can be lifted and Regulation Q discarded; take effect, in the main, after recovery of output utility rates might be allowed to find their own and employment has begun. The Federal Re­ levels, and union contracts might be renegoti­ serve applies downward pressure upon interest ated oftener. Some of these corrections do rates, as seems necessary for economic recovery, occur, at some times and places, but always in by taking Treasury issues into its own portfolio, the face of strong resistance. and the volume of purchases increases well into Objections to turning prices loose, for mar­ the recovery. Low interest rates in this country kets to determine, are familiar. One is that and rising aggregate demand for goods and ser­ there are social costs. So frequent adjustments vices including internationally traded items gen­ of labor contracts would waste resources on bar­ erate deficits in the official settlements account gaining and negotiation. Release of utility rates of the balance of payments. Then a share of from the control of regulatory commissions fiscal deficits here is financed by central banks would permit producers to exercise monopoly abroad. power. Floating the dollar cleanly would dis­ Cyclical recovery, with its rising output and qualify it as a payments medium internationally rising rate of inflation, eventually reduces fiscal and raise costs of trading. Another familiar ob­ deficits. As deficits decline and as the rate of jection is that increases in liberated prices would inflation rises relative to growth of output, aggravate inflation of other prices. They would monetary policy becomes restrictive. It is most add cost-push to demand-pull as a source of restrictive after the peak of the business cycle inflation. A third objection is recurrent, that and, in pursuit of accelerating inflation, de­ there would be unfortunate results in terms of presses output and employment. When inflation equity: the poor would pay rents, interest rates, has been reduced and when unemployment has and utility rates that they can ill afford. Still reached unacceptable levels, the cycle of fiscal­ another objection is that, without Regulation Q, ized monetary policy is over, and a new one is financial institutions would compete themselves ready to begin. Successive troughs of output into insolvency and crisis. Good and bad, these and employment occur at higher price levels and objections and others have such strong appeal rates of inflation, and the monetized deficits are that this cleansing technique, turning old prices larger for each percentage point of unemploy­ loose, is not used effectively. ment. Fiscalized monetary policy generates un­ When markets are not trusted to correct old stable inflation along with a rising trend of in­ prices, corrections are sometimes imposed by flation. The remedy is not benign neglect. public authority. Rules are adopted for the linkage of controlled individual prices with mar­ Cleansing Techniques. Old assets, debts, ket-basket indexes of free prices. The rules contracts, prices, and tax schedules are the vary. For example, they may link single prices source of numerous inflationary distortions in with cost-of-living indexes, indexes of wholesale

16 prices, or foreign-exchange rates. They may it, and to shrink the market for such issues, not link single prices with experienced or antici­ broaden it. pated change in general indexes. The linkage is Current yields on bonds and mortgages have sometimes complete, sometimes partial or frac­ been adjusted to such indicators as market rates tional. Price adjustments may be frequent or of interest on short-term securities, including infrequent, at regular or irregular intervals. Treasury bills. This variety of correction is There is opportunity for administrative discre­ clearly defective. Change in the current or im­ tion, and it is commonly used for a variety of minent rate of inflation is not the only com­ purposes including production and export in­ ponent of change in bill rates. They can rise centives for sellers at managed prices, income because the central bank is constraining growth redistribution, and fiscal effects. It can be and of the money supply. They can rise, too, be­ usually is a technique of official intervention in cause the real national product is rising or be­ real aspects of economic behavior. 27 Then, of cause bill rates abroad are going up. Indexing course, it is not a cleansing technique. to bill rates does not cleanse yields on bonds Rejuvenation of old debts by indexing is and mortgages and put them at levels which familiar where inflation has been unstable along would prevail during immaculate or clean in­ a rising trend. It is a way, perhaps, of reducing flation. the liquidity premium on securities of longer Argentina, Brazil, Canada, Denmark, the terms and of pre~erving markets for them. It Netherlands and other countries have developed might be a way of limiting or preventing disin­ various styles of correction for nominal assess­ termediation when market rates of interest rise. ment values in property taxation as well as for It might give some protection to creditors nominal exemptions, deductions, and income against redistribution of income and wealth to brackets in income taxation. 28 It is not uncom­ debtors. The technique is to adjust each con­ mon, in business taxation, to permit indexing of tractual payment on an old debt, for interest and depreciation charges, inventory valuations, and principal, to change in some index, partly or capital gains. Corrections are imposed or per­ completely, often or infrequently. There has mitted for a variety of purposes; to protect the been no consensus about the appropriate index: real value of tax collections, to manipulate the a short-term rate of interest, a foreign-exchange value of collections, to protect the poor against rate, an index of commodity prices, and other erosion of tax concessions, to prevent double indexes have been tried. progression, to encourage business capital for­ Presumably the ideal correction for bonds mation. Choice of correction indexes has varied, would protect the proportion of the creditors' from cost-of-living indexes to minimum wage claims to the market value of wealth that they rates and foreign-exchange rates. There can be have helped to finance. Itwould adjust the mar­ no pretense that the corrections purge tax sys­ ket value of claims in the same degree as infla­ tems of distortion by inflation. The corrections tion changes the market value of underlying change the impact of unstable inflation. wealth. Any adjustment larger or smaller than All prices, taxes, and contracts are indexed in this would redistribute wealth between creditors a model of immaculate inflation. However, un­ and equity-owners. However, there is no index stable inflation cannot be made immaculate by of inflation's and only inflation's effect on mar­ indexing. One reason is that unstable inflation ket values of wealth. Furthermore, since dirty involves different rates of response among in­ inflation tends to reduce market values of some dividual prices to aggregate effective demand. large aggregates of wealth, such as corporations, Then there is no neutral index of change in the ideal correction could be punitive for credi­ money's purchasing power. Another reason is tors. The effect would be to increase the liquid­ that initial costs of indexing are not small: some ity premium on long-term issues, not to reduce substantial investment is required in bargaining

17 about precise forms of insurance against the of its market rates of interest. There would be contingency of inflation. Again, unless all con­ indexing, too, of bases for federal taxation in­ tracts are on short term, indexing can increase cluding especially brackets for progressive in­ downward rigidity of prices and increase the come taxation. The preferred index would in­ cost, in terms of unemployment, of shifting clude only prices for a basket of government from higher to lower inflation rates."" Finally, purchases. Furthermore, the federal budget it appears that government simply cannot resist would include estimates of revenues from the the temptation to manipulate indexing for social inflation tax. Finally, on the fiscal side, the objectives. Indexing becomes another instru­ Federal Reserve would be required to pay inter­ ment for aggrandizement of the public sec­ est, at a rate indexed to Treasury bill rate, on tor. 30,31 members' reserve balances. The purpose of these measures is to impose new constraints on Damping. It one prefers cures to palliatives government expenditure in later phases of for unstable inflation, three severe treatments cyclical recovery and to provide new incentives may be considered. They are damping, to sta­ for shifting the expenditure to recession and bilize the price level's growth path; financial early recovery. If the central bank were ad­ deepening, to r.educe the slope of the path; and dicted to even-keeling, protecting interest rates formalized linkage of monetary with fiscal pol­ against disturbance from government financing, icy, to fix the locus of responsibility for inflation. its interventions would perhaps be cyclically These treatments work best in combination. In stabilizing, accelerating monetary growth in re­ the following paragraphs, we describe the first cession and early recovery, decelerating mone­ two treatments in some detail, leaving discus­ tary growth in later phases of recovery. Even­ sion of the third treatment for another forum. keeling, to stabilize market rates of interest, may The rhythm of the American economy in the stabilize more important things, such as output past decade has consisted of an up-beat, driven and employment, if it happens at the right time. by fiscal and monetary ease, to correct unem­ However, the second element of the damping ployment at the cost of some inflation, and a program would preclude even-keeling in the down-beat, driven by fiscal and especially mone­ money markets. It would impose, by legislative tary tightness, to correct inflation at the cost of prescription, a rule for steady growth of the some unemployment. The rhythm appears to monetary base in the range of 6 to 8 percent be anti-damped so that successive rounds of quarterly. Evidently, it sounds the melan­ fiscal-monetary measures generate more infla­ choly notes of "taps" over six decades of experi­ tion, in the process of reducing unemployment, mentation in the United States with flexible, dis­ and more unemployment in the process of re­ cretionary monetary policy. It takes the case ducing inflation. One damping technique is as proved by experience with monetary policy sheer sadism. It maintains monetary restraint, in, for example, 1920,1931,1937,1957,1966, at high levels of resource unemployment, long 1969, and 1972-1974 that contrived discontin­ enough to erase memories and expectations of uity of monetary growth is destabilizing. The inflation. Experiments with this technique in case for steady growth does not deny that con­ countries where anti-damped cycles have con­ trol theory can design some superior rule of tinued for a decade and more have been painful money management in an hypothesized econ­ indeed. The technique is applied at high risk of omy. It denies simply that monetary manage­ social discord. ment will find and apply a superior rule before A preferable damping program would have public patience is exhausted. two elements, one fiscal and one monetary. On The 6-8 rule, in combination with any rea­ the fiscal side, longer-term government debt sonable trend of high-powered money's income would be indexed, its yields linked to an index velocity, is compatible with an attainable growth

18 rate of real national output and growth rate of wage laws and labor oligopoly. Still again, the the price level that does not offend public taste outlook is not bright with regard to terms of and tolerance. Its purpose is to take advantage trade for imported raw materials. There ap­ of the long-run neutrality of money that seems pears, moreover, to be retardation in technologi­ to characterize the American economy, permit­ cal change that economizes factor inputs. Costs ting the growth path of real output to cling more of intermediated inputs by government do not closely than in the past to the path of resource decline. While all of these determinants of (T) supplies and technology. Any inflation that re­ and some others are worrisome, only the cost of sults would at least be clean. capital and, marginally, the efficiency of capital Deepening. When variance of fiscal deficits allocation concern us here. and monetary growth rates, price levels and Growth of capital relative to labor, or capital output levels, interest rates and foreign-ex­ deepening, obviously is inhibited by the cost of change rates has been increasing for a decade, capital. There are some things to do about deep­ damping can hardly be expected to reduce it ening. Of course, damping inflation is one of quickly. Even before damping has been effec­ them. It would reduce the risk component of tive in straightening the paths of inflation and the supply price of capital, invigorate financial output, deepening can be put to work in reduc­ intermediation, and draw capital away from uses ing the mean growth rate of inflation and raising that dirty inflation makes attractive. Another the mean growth rate of output. First straighten deepening technique is a shift in the balance of the paths and then tilt them. government budgets from the deficit to the sur­ It is difficult not to be pessimistic about pros­ plus side, in the manner of Germany, Japan, and pective relative changes in the price component other countries. A third technique is equilib­ (P) and the output component (T) of growth rium pricing of the dollar in foreign-exchange in nominal national income. The probability is markets, avoiding the over-valuation that in­ not small that, without effective "real" policies, duces capital flight. The American economy, growth in nominal expenditure at the rate per­ one knows, resists pressures to increase the na­ mitted by the 6-8 rule (M) and by the trend in tional ratio of savings to income, but incentives velocity of high-powered money (V) will raise to reduce the ratio can be eliminated. Since the (P) relative to (T) as the years go by. Each United States has used inflation to force savings determinant of (T) is cause for worry. For one, from holders of dollars here and abroad, one the cost of capital, which was falling from World knows there is excess demand for savings at full War II to the nineteen-seventies, seems to be employment of resources and at a modest rate rising. 32 Again, the cost of labor inputs is under of growth in output. Deepening is an essential upward pressure by, for example, minimum substitute for the inflation tax.

19 FOOTNOTES

1. Page 460. 20. The impact of double progression on capital values of 2. Nordhaus, for one, seems to say that Kuznets was wrong: income-producing assets is analyzed in Eric Schiff, op. cit. "There is, however, no evidence that the allocational effects 21. Richard A. Musgrave and Peggy B. Musgrave, Public of the mild inflations observed in advanced countries are Finance in Theory and Practice, pp. 288-289. significant." William D. Nordhaus, "The Effects of Infla­ 22. According to Friedman, "The great German economic tion on the Distribution of Economic Welfare," Journal of miracle of 1948 was produced simply by the elimination of Money, Credit and Banking, 1973, p. 465. price controls. Ludwig Erhard, then the economics minister, 3. John Hicks, Critical Essays in Monetary Theory, p. 28. removed all the price controls one Sunday afternoon. He 4. The Wall Street Journal, December 4, 1974, pp. I, 24. did it on Sunday, because the offices of the American, Brit­ ish, and French occupation authorities were closed on Sun­ 5. Ben Branch, "Common Stock Performance and Infla­ day, and he was sure that they would have countermanded tion: An International Comparison," The Journal of Busi­ his order if they had been open." Milton Friedman, "Mone­ ness, January 1974, pp. 48-52. tary Policy in Developing Countries," Nations and House­ 6. James Tobin, "Monetary Policy in 1974 and Beyond," holds in Economic Growth (Essays in Honor of Moses Brookings Papers on Economic Activity, I, 1974, pp. 223­ Abramovitz: David and Reder, eds.) p. 274. 227. 23. Michael W. Keran, "Inflation, Regulation and Utility 7. Henry Kaufman, "Financial Roadblocks to a New Eco­ Stock Prices," Bell Journal of Economics, (forthcoming, nomic Recovery," Hearings, Subcommittee on International Spring 1976). Finance, Committee on Banking and Currency, House of 24. Simon Kuznets, op. cit., pp. 421-423. Representatives, December 3, 1974, pp. 26-37. 25. Joint Economic Committee, Achieving Price Stability 8. Michael Keran, "Expectations, Money, and The Stock Through Economic Growth, December 1974, pp. 56-74. Market," Review, Federal Reserve Bank of St. Louis, Janu­ 26. For discussions and for references to a large literature, ary 1971, p. 25. see: Robert P. Collier, Purchasing Power Bonds and Other 9. Franco Modigliani and Robert J. Shiller, "Inflation, Ra­ Escalated Contracts, Utah University Press, 1969; Albert tional Expectations and the Term Structure of Interest Fishlow, "Indexing Brazilian Style: Inflation without Rates," Economica. February 1973, pp. 12-43. Tears?" Brookings Papers on Economic Activity, I, 1974, 10. See Rose McElhattan's article in this issue. pp. 261-282; Edward Foster, "Costs and Benefits of Infla­ 11. Harry G. Johnson, Inflation and The Monetarist Con­ tion." Studies in Monetary Economics, Federal Reserve troversy, pp. 26-35. Bank of Minneapolis, 1972; Milton Friedman, "Using Esca­ lators to Help Fight Inflation," Fortune, July 1974, pp. 94­ 12. Michael W. Keran, "Forecasting Stock Prices," October 97, 174-176; Herbert Giersch et al., Essays on Inflation and 1974. Indexation, American Enterprise Institute, 1974; Jai-Hoon 13. For conclusions compatible with Keran's, see Bruno A. Yang, "The Case for and Against Indexation," Review, Oudet, "The Variation of the Return on Stocks in Periods Federal Reserve Bank of St. Louis, October 1975, pp. 2-11. of Inflation," JOl/rnal of Financial and Quantitative Anal­ 27. Albert Fishlow, op. cit., p. 268. ysis. March 1973, pp. 247-258. 28. Amalio Humberto Petrei, "Inflation and Personal In­ 14. G. L. Bach and James B. Stephenson, "Inflation and come Tax," Finance and Development, September 1974, the Redistribution of Wealth," The Review of Economics pp.38-41. and Statistics, February 1974, pp. 1-13. 29. William Fellner, "The Controversial Issue of Compre­ 15. Solomon Fabricant, "Inflation Accounting: Issues for hensive Indexation," in Herbert Giersch et. al., op. cit., pp. Research," National Bureau of Economic Research, 54th 64-68. Annual Report, pp. 10-15. 30. Albert Goltz and Desmond Lachman, "Monetary Cor­ 16. George Terbough, Essays in Inflation, pp. 53-54. rection and Colombia's Savings and Loan System," Finance and Development, September 1974, pp. 24-26. 17. G. L. Bach and James B. Stephenson, op. cit., pp. 11-12. 31. This paragraph comes very close (inadvertently!) to 18. Frank T. Weston, "Adjust Your Accounting for Infla­ plagiarism of Ludwig von Mises, in his The Theory of tion," Harvard Business Review, January-February 1975, Money and Credit, English edition, 1935, pp. 406-407. The pp.22-29. criticism of indexing had appeared in the German edition 19. G. L. Bach and James B. Stephenson, op. cit., pp. 12-13. of 1924. See also Eric Schiff, Inflation and the Eaming Power of 32. William D. Nordhaus, "The Falling Share of Profits," Depreciable Assets, American Enterprise Institute for Pub­ Brookings Papers on Economic Activity, 1974, I, pp. 200, lic Policy Research, 1974, p. 28. 212,215.

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