Business: THE RISING RISK OF RECESSION

THERE has always been an element of risk that Washington’s efforts to control the worst inflation since the Korean War would tip the U.S. economy into a recession. The Administration’s policy of gradual slowdown has been shaped to avoid any pronounced increase in unemployment. Though a few pessimists have been issuing warnings for several months, the danger of recession has generally seemed remote. Rather suddenly, the mood has shifted. In the privacy of executive suites, top bankers and corporate leaders have begun to voice their fears that the U.S. might be sliding into an economic slump that could have important political and social consequences.

Businessmen see the signs of decline in their sluggish sales and softening profits. Investors discern the portents in falling stocks; the Dow-Jones industrial average has dropped 9% in the past five weeks to a three-year low. The Consumer Confidence Index, measured by the highly regarded University of Michigan Research Center, has plummeted from 95 in January to 79.7 now. President Nixon’s economic policymakers recognize the signs of danger. “We are now at a critical period of economic events,” says Budget Director Robert Mayo. “The economy is in a state of delicate balance.”

The majority of economists outside Government believe that U.S. business still has enough momentum to avoid what would be the first recession in nine years. They point to such sources of strength as record capital investment. Still, businessmen have a sense of foreboding. That anxiety has been intensified by the bearish warnings of one economist who was once ignored and ridiculed, but whose views have lately had an important influence on Government policy. He is Milton Friedman, the leading iconoclast of U.S. economics. “We are heading for a recession at least as sharp as that in 1960-61,” he warns. “There is more than a 90% chance of that. There is a 40% chance of a really severe recession, such as occurred in 1957-58, when unemployment reached 8%.”

Friedman, a 57-year-old economics professor at the University of Chicago, is still regarded by critics as a pixie or a pest, but he has reached the scholar’s pinnacle: leadership of a whole school of economic thought. It is called the “Chicago school,” and its growing band of followers argues that money supply is by far the most important and fastest-acting of the economic regulators at the Government’s disposal. Friedman has succeeded in persuading many leading economists to adopt his monetary theories, at least in part.

Most economists also follow the teaching of Britain’s late John Maynard Keynes, who articulated how changes in taxes and government spending can stabilize business cycles. The philosophy of Keynes, who died in 1946, has dominated the economic policies of industrial nations since World War II. Today’s prevailing belief, however, is a hybrid; most economists now consider themselves “Friedmanesque Keynesians.” Having risen from maverick to messiah, Friedman ranks with Walter Heller and John Kenneth Galbraith as one of the most influential U.S. economists of the era. Heller, who was chairman of the President’s Council of Economic Advisers under President Kennedy, has whimsically classified Friedman’s supporters: “Some are Friedmanly, some Friedmanian, some Friedmanesque, some Friedmanic and some Friedmaniacs. Friedman is just Friedman.”

Milton Friedman’s opinions have particular weight now because the Nixon Administration has placed great reliance on the policies that he prescribes to deal with the current inflation. Friedman was one of Richard Nixon’s chief economic advisers during the election campaign. He did not seek a full-time job in Washington because “I like to be an independent operator,” but his ideas are highly regarded within the Administration. “Milton Friedman has influenced my thinking,” says Paul McCracken, chairman of Nixon’s Council of Economic Advisers, who describes himself as “Friedmanesque.” The two men often talk on the telephone, chat privately at the many conventions that economists attend. McCracken has been monetarist-minded for years, and since he took office the council has begun running computer calculations about the future course of the U.S. economy based on monetary indicators. Friedman has even closer relations with Arthur Burns, Nixon’s choice to succeed William McChesney Martin next month as chairman of the Federal Reserve Board. Friedman studied under Burns at Rutgers, and they have often spent evenings in animated discussion at Ely, Vt. where both own country homes.

In Friedman’s monetarist view of economics, the chief instrument for controlling movements of the economy is the seven-man Federal Reserve Board. For months, the board has been following a tight-money policy of unusual severity. A year ago, it began to hold back the growth of the money supply; since midyear, it has permitted no growth at all. Ironically, Friedman’s principal complaint is that the Federal Reserve is overdoing the restraints in its effort to cure inflation. “If the board continues to keep the growth of money at zero for another two months, I find it hard to see how we can avoid a severe recession,” he says. “The board has made the same mistake that it has made all along. It is going too far in the right direction.”

Because money is so potent, he contends that the board should allow the supply to expand at a fairly constant rate of about 5% a year, in line with the long-term growth rate of the nation’s production of goods and services. Last week the Federal Reserve issued some statistics that led even a few experts to conclude prematurely that it had begun to ease its tight-money policy. In reality, the board has done no such thing. It has merely followed its usual policy of permitting a slight seasonal rise to accommodate businessmen’s heavy pre-Christmas buying patterns.

Split in the Board

The board is split by a rare public debate over whether, when and by how much to expand the money supply. Last week Vice Chairman James L. Robertson called for “tighter and more painful controls” to eradicate the nation’s “inflation psychosis.” Such tough talk reflects a serious worry that is still shared by the majority of the board’s members. They fear that even the slightest move toward easier money or lower interest rates would be misinterpreted by businessmen as a signal to get set for another jolt of inflation. In the minority at present, Board Members Sherman

Maisel and George W. Mitchell, both economists, side with Friedman in contending that the Federal Reserve has kept money scarce for so long that it has created a severe risk of recession. Though neither embraces Friedman’s whole concept, they maintain that the board should pay less attention to fluctuations in the money market and more to fundamental trends. They also have been arguing since last August that unless the money managers act promptly, they will eventually have to release so much money to prop a slumping economy that inflation will begin again.

As Friedman sees it, the timing and severity of a recession will depend mainly upon how quickly Maisel and Mitchell can persuade their fellow board members to ease up on money. President Nixon can cajole the members, but legally he cannot control the actions of the board, which is independent of the executive branch. As a practical matter, though, the board would find it difficult to resist presidential arm-twisting.

Nixon faces a dilemma. Inflation is his No. 1 domestic problem and, though it started long before he came into office, it is rapidly being identified in the public mind as “Nixon’s inflation.” The American people are angered and frustrated by inflation, and the polls show that an overwhelming majority criticize Nixon’s handling of the persistent problem. Moreover, Nixon believes that he must stabilize the economy before the nation can effectively marshal the resources to carry through the social and environmental programs for which so many voters are clamoring.

The other side of the coin is that if Nixon pushes anti-inflationary policies too long or too hard, the result could indeed be what most economists define as a recession: at least two successive three-month periods of no real growth in the total economy, a condition that is almost sure to bring about a substantial jump in unemployment. At present, the nation might find such an experience particularly troublesome. A recession could aggravate social unrest. The jobless rates among blacks normally run twice as high as those common whites; among blacks under 25 years old, they often reach five times the overall rate.

Overkill and Brinksmanship

Though Paul McCracken is a socially sensitive man who fully recognizes the dangers involved, he argues on behalf of the Administration that “We have no alternative but to risk overstaying with policies of restraint.” Economist Gabriel Hauge, chairman of Manhattan’s Manufacturers Hanover Trust Co., agrees: “The nation has to run the risk of getting into a recession. We should not be afraid of overkill.”

The Administration’s economists admit that they are practicing brinksmanship. Anything more severe than a mild or brief recession would damage Republican chances of winning more Senate and House seats in next November’s election. It will avail Nixon little politically to blame inflation on the Johnson Administration, even though Lyndon Johnson’s failure to ask for higher taxes in 1966 to help meet Viet Nam costs is a major source of today’s problem. Some congressional Republicans believe that Nixon will arrange to relax the money squeeze well before ballot time. But at least one of the President’s most trusted advisers has counseled him to risk unpopularity in 1970 and concentrate on stopping inflation before the 1972 presidential race. Any letup now, he feels, would give Nixon a politically lethal credibility gap on the issue of inflation—a gap that could be as harmful as the public’s disenchantment with Lyndon Johnson’s Viet Nam policies.

Nixon’s difficulties are complicated by the fact that the Republican Administration and the Democratic-controlled Congress have hit an impasse on fiscal policy. The President has trimmed $7.5 billion from the federal budget that he inherited from Lyndon Johnson and ordered reductions in Government construction. Congress has consistently voted this fall to raise federal spending above the levels that the White House wants. Last week Nixon announced that he would impound appropriated funds, if necessary, to keep the Government from running an inflationary deficit in fiscal 1971.

The President’s struggle with Congress has been greatly intensified by the fight over the tax-reform bill (see THE NATION). It started out with some sensible and overdue reforms, but many were gutted by irresponsible actions in the Senate. The 1969 bill that the Senate passed last week is loaded with so many tax reductions—as well as a costly 15% increase in social security benefits—that the President has threatened to veto it. “I intend to use all the powers of the presidency to stop the rise in the cost of living,” said Nixon at a press conference shortly before the Senate acted. “If I sign the kind of bill which the Senate is about to pass, I would be reducing taxes for some of the American people and raising prices for all the American people. I will not do that.”

How Monetary Policy Works

In dealing with the reality of inflation and the possibility of recession, Nixon so far has shown a deep reluctance to intervene in the private economy. He has rejected price guidelines, personal pressures on business and labor leaders, and outright controls. His policy coincides with Friedman’s fundamental ideology—a strong aversion to Government interference—and places great emphasis on lower federal spending, as well as the monetary measures that Friedman has illuminated and popularized. Manipulation of the money supply operates indirectly on the economy, but its impact is ultimately massive and touches the lives and fortunes of nearly everyone.

The intricacies of monetary theory generally seem as mystifying as the Mock Turtle’s description in Alice in Wonderland of “the different branches of arithmetic—Ambition, Distraction, Uglification and Derision.” Money supply can be measured in four ways, but Friedman prefers to use the total of currency in circulation plus checking accounts and time deposits in banks. The Federal Reserve controls the rate at which money supply grows or shrinks chiefly by buying or selling Government bonds. When the board buys bonds, it automatically raises the quantity of reserves available to banks; this increases the amount of credit that banks can extend to borrowers. When the board sells bonds, the process operates in reverse and borrowing tends to become difficult.

The Federal Reserve tinkers constantly with the money stock, much to the distaste of Friedman, who advocates a policy of moderate, steady expansion. For example, the board expands the supply during periods of peak demand, as it did to an extreme degree to help the Treasury finance its huge deficit in fiscal 1968. Through the same kind of maneuvering, the board tries to smooth the ups and downs of the business cycle. Friedman argues that the board’s fallible members frequently misjudge how much to expand or shrink the money supply, and that their actions often exaggerate the swings of an economy that they are supposed to stabilize.

By Friedman’s reckoning, history supports his argument. As he notes in his definitive work, A Monetary History of the United States 1867-1960, a decline in the nation’s money supply has preceded every recession except one (1869-70) in the last hundred years. After World War I, for example, the Government cut its spending by an amount equal to 16% of the U.S. gross national product. On top of that, the Federal Reserve contracted the money supply by 5.2%. Says Paul McCracken: “The remarkable thing is not that there was a 1921 recession but that our economic system survived under this massive fiscal and monetary whipsaw.”

Friedman blames unknowing monetary policy in large measure for the magnitude of the Depression of the 1930s. Partly because so many banks failed between 1929 and 1933, the U.S. supply of money shrank by 33%—and that compounded a worldwide economic collapse. The Federal Reserve, which took a narrow view of its responsibilities, felt itself almost powerless to reverse the tide of events. Not really understanding what should be done, it did practically nothing to offset the contraction of the money supply.

One consequence, in Friedman’s view, was that John Maynard Keynes concluded that monetary policy had only a limited impact on economic trends. That led him to underrate the money supply as an economic regulator. Friedman maintains that Keynesian economists made the same error for decades afterward—and indeed, that many still do today. In reality, Friedman argues, the Federal Reserve in the 1930s had ample power to prevent the monetary contraction. “Had the facts been as Keynes assumed them to be,” Friedman has written, “I could not hold the views I do about the role of money. Had Keynes recognized that the facts were what they were, he would have had to modify his views.”

Today’s stubborn inflation, according to Friedman and his adherents, has been greatly magnified by Federal Reserve Board mistakes. From April 1965 to April 1966, the money supply expanded at an abnormally high 9½%-per-year rate, even though inflation was on the rise. Too late, says Friedman, the board reversed itself too emphatically, and caused the “credit crunch” of August 1966. In 1968, the board, fearful that the tax surcharge would overburden the private economy, increased the money supply at an average annual rate of 10%—almost twice the rate that the economy could absorb without inflation. Then, a year ago, the board switched to its restrictive money policies. Six to nine months after these gyrations occur—and sometimes much later—they significantly affect the performance of the whole U.S. economy.

Friedman’s fact-laden criticisms of the Federal Reserve have considerably undermined its once sacrosanct standing as the arbiter of U.S. monetary affairs. Mindful of his formulations, the Congressional Joint Economic Committee has been pressuring the board to expand money supply at a rate of between 2% and 6% a year. The board has refused to go that far. but it has begun providing the committee with quarterly reports explaining its money-supply maneuvers.

Dazzling Variety of Ideas

Friedman’s controversial opinions range far beyond his evaluation of the Federal Reserve. He propagates them tirelessly in books, in classrooms, in testimony before congressional committees, in private chats with policymakers, and in a triweekly column for Newsweek. Last week he left his Vermont mountaintop retreat, where he customarily spends about half his time studying and writing, for a rapid round of evangelistic appearances. He flew to Washington to meet with a Nixon commission that is studying plans for a U.S. shift to an all-volunteer Army. Later he made a speech in Manhattan, then went to Boston. Dressed in a baggy brown suit and well-worn shoes, Friedman met for lunch with 20 impeccably tailored mutual-fund advisers and entertained them with unexpected quips and sallies. Later he spent two hours answering questions from some 50 Harvard and Radcliffe students who, unhappy with the schools’ accent on Keynesian precepts, have recently formed the Association for the Study of Friedman Economic Doctrines, or “the Milton Friedman Fan Club.”

A truly original thinker, Friedman is the author of a dazzling variety of ideas about how nations should cope with myriad matters of public policy. On the question of the international monetary system, Friedman for nearly two decades has been urging the adoption of freely moving exchange rates instead of fixed rates. Now, after a series of monetary crises and devaluations, central bankers in the U.S. and abroad are giving serious study to a modified form of the idea. As early as 1942, Friedman began advocating a negative income tax as a substitute for the nation’s demeaning and generally ineffective welfare system. The Nixon Administration this year asked Congress to provide a minimum income for every American, though not quite in the way that he advocates. Friedman would abolish most other types of aid to the poor and substitute the income guarantee. It would provide direct cash grants that poverty-level families could spend any way they pleased. He argues that most current programs to help the poor either wind up aiding the better-off instead or place humiliating restrictions on what the poor can do with the money they get.

Friedman has a big recipe for economic reform, and he calls for an end to many politically sacred Government programs. A sampling of his ideas: FOOD STAMPS. “There is nothing you can do with stamps that you cannot do better by giving people money. The real drive behind food stamps is not to help the poor; it’s to dispose of farm surpluses.” Friedman calls the farm-subsidy program, which piles up huge surpluses in grain elevators, “a free-lunch program for mice and rats.” PUBLIC HOUSING. “It was instituted in the 1930s to improve the housing of the poor, give the poor a sense of pride, and reduce juvenile delinquency. The effect, in each case, has been exactly the opposite. Public housing is a total failure. The major beneficiaries are the people who sell their property for housing projects. Some of the poor benefit, but at the expense of other poor people, who are forced to vacate bad housing and occupy worse.” SOCIAL SECURITY. “It is a means of taxing the poor for the benefit of the rich. If you are poor, you start to work earlier in life, yet your life expectancy is shorter, and if you work after 65, you get less benefits. High-income people come off better. If you have property, you get the benefit of this, plus social security. The system redistributes income from the young (rich or poor) to the old (rich or poor). I think we ought to help the poor indiscriminately.” GOVERNMENT PRIVILEGES. “All over the world, the predominant source of great increases in private fortunes over the past several decades has been Government privileges.” For example, the issuance of radio-TV licenses is “an enormous giveaway of valuable capital sums to individuals who are not low-income people.” Friedman also holds that the Federal Communications Commission should auction TV channels to the highest bidder and thereafter stay out of the picture.

INFLATION. Friedman challenges the popular theory that full employment and price stability are incompatible. “The belief, like most of those propositions that get widely accepted, is a half-truth,” he argues. The two goals conflict over brief periods when an economy is shifting from one rate of inflation to another, he concedes. But over any period of five, ten or 20 years, says Friedman, fast economic growth and full employment can be meshed with stable prices.

That reassuring thesis may be difficult for some inflation fighters to accept, because 1969 has been such a frustrating year. Repeatedly, Administration leaders have announced that, as Nixon said on Oct. 17, “we are on the road to recovery from runaway prices.” Paul McCracken’s original year-end deadline for arresting the price trend faded quietly into oblivion. “We underestimated the inflationary expectations,” says Under Secretary of the Treasury Charls Walker. “They were deeply ingrained. We didn’t expect that it would be so tough.”

Evading the Squeeze

Tight money might have reduced inflation faster if big banks had not discovered ingenious methods of avoiding the Federal Reserve’s pincers. To help meet corporations’ vast appetites for loans in the face of the credit shortage, U.S. banks borrowed $13.3 billion in Eurodollars—U.S. dollars in private hands abroad—and brought them home. The board finally closed that loophole by imposing a 10% reserve requirement on borrowed Eurodollars. Thereafter, the banks circumvented restraint by issuing vast quantities of commercial paper —unsecured promissory notes. Belatedly, the Reserve Board plugged that loophole by placing an interest-rate ceiling on commercial paper. Now, big Manhattan banks have found still another gap in the Federal Reserve’s regulations. To raise funds for domestic loans, they have begun selling large-denomination certificates of deposit to foreign central banks, which have plenty of U.S. dollars.

Some of the loopholes were deliberately allowed to stay open, authorities admit. Federal Reserve officials feared that if they had closed every gap in the regulations, some banks might have failed. In a banking system based on confidence, that might have touched off a financial panic, something that the Federal Reserve is sworn to prevent. Still, Board Chairman Bill Martin admitted to Congress that the “safety valve” had become “an escape hatch through which restraints are being avoided.” The banks also flooded the country with new credit cards, which stimulated consumer spending and certainly did not reduce inflationary pressures.

Where the Economy Stands

Businessmen are still borrowing expansively and betting on continued inflation. They figure that demand will remain high, and so they had better build plants and buy equipment now instead of waiting until prices go up still further. Despite dwindling profits, scarce credit and excess capacity, the Government’s latest survey shows that businessmen plan an 11% increase to $71 billion in their investment for plant and equipment next year. Capital spending has been an important force behind inflation in recent months, and such an increase would add greatly to price pressures.

Still, economists generally agree that the economy now shows plenty of signs of losing momentum. As interest rates climbed to the highest peak in more than a century, housing starts fell sharply and the bond markets approached collapse. Banks, the principal buyers of municipal bonds, were short of funds and shying away from 20-year and 30-year securities with a fixed rate of return. Industrial production has slipped, and personal income is now rising at a rate of only 1.3% a year.

Yet prices, which often continue rising long after general business turns soft, have continued to climb. They are rising faster than wages—and wages are rising faster than workers’ productivity. When productivity slackens, real labor costs go up, and companies often make up the difference by increasing the prices of their products. The cost of living rose 5.9% this year and has gone up by 20% since 1964. The dollar of that year is worth only 84¢ today.

The stock market, a leading indicator that often foretells the economy’s performance in months to come, shuddered through a disastrous year. The Dow-Jones industrial average dropped 19%, from a May high of 969 to a December low under 784. The conglomerates took a beating; LTV and Gulf and Western dropped more than 50% from their year’s highs. Among the blue chips, strike-troubled General Electric has sunk to 79 from a historic high of 120 in 1965, California Standard to 49 from a high of 86 in 1966, Allied Chemical to 24 from 66 in 1961, Du Pont to 105 from 260 in 1965, and U.S. Steel to 34 from 108 in 1959.

An Inflationary Recession

Investors were depressed by the fading of the unrealistic Viet Nam peace hopes that they had held in the spring, and more recently by warnings of a forthcoming economic decline. The worst depressant in the market undoubtedly has been tight money. The market frequently falls before recessions and rises when they occur; thus a 1970 recession would not necessarily make stock prices fall further. But it will be hard for stocks to rally briskly until credit is eased. Economists generally expect that interest rates will taper off slightly—perhaps by 1% or a bit more—as production and demand slacken in the year ahead, but that they will stay fairly close to their historic highs for as far ahead as anyone can see.

Friedman and some other forecasters believe that the U.S. next year will go through an “inflationary recession.” There is almost no way that the U.S. can avoid simultaneous increases in both prices and unemployment; the question is just how bad those rises will be. “Never has a U.S. inflation of the present intensity—5% to 6% a year—been controlled without a recession,” says Economist Beryl Sprinkel, senior vice president of Chicago’s Harris Trust and Savings Bank. Henry Kaufman, partner in the Manhattan investment firm of Salomon Bros, and Hutzler, expects “a mild but sustained recession.” He foresees a 15% to 20% drop in corporate profits.

The rising fears of recession show that the Administration is at last making headway in its difficult fight against inflationary psychology. All year, Nixon’s economic lieutenants have been trying to create a degree of uncertainty in the minds of businessmen, labor and consumers about the prospect for continued prosperity. Many experts find the present outlook no cause for alarm. Arthur Okun, the former head of the Council of Economic Advisers, calls the chance of either a recession or a continued boom “a long shot.” By his handicapping, the Government stands a 50% chance of bringing the inflation rate down to about 4% without causing a politically unacceptable rise in unemployment. Still, Okun insists—as do the other members of TIME’s Board of Economists—that it is high time the Federal Reserve eased its monetary brakes.

Economists tend to agree on the business profile for 1970: a rise in jobless ranks to 4¼% or 4½% of the labor force; 4% price inflation, probably tapering off toward year’s end; sluggish 2% real growth in the over-all economy, which will expand from $933 billion to $985 billion or $990 billion. A few sectors of business anticipate substantial difficulties. Auto manufacturers (except Ford) have already curtailed production a bit, and some retail merchants figure that they will have to hustle to maintain their sales volume. “The consumer is beginning to stiffen up,” says Ralph Lazarus, chairman of front-ranking Federated Department Stores. “We expect that after Christmas he will become a tough buyer, more value-conscious than in a long time.”

In the decade that opens next month, thoughtful business leaders realize they face responsibilities that go beyond the traditional definition of business, and they seem ready to do more than merely pay lip service to them. Next to inflation, recession and the need to end the Viet Nam War, the most talked-about subject among high executives is what role the corporation can play in reversing the decline of cities, building housing for the poor, finding and training blacks for jobs. Walter A. Haas Jr., president of San Francisco’s Levi Strauss & Co., believes that industry’s first big task is to put an end to polluting the environment. “We are debauching the country,” he says. Meeting such new goals will plainly require some extraordinary changes of attitudes among both businessmen and politicians. At the extreme, business may have to renounce its allegiance to all-out economic growth in order to halt the chemical and bacterial poisoning of air, land and waters. During the 1970s, the nation may also face a chronic shortage of capital to finance its seemingly boundless appetite for roads, airports, schools and many other projects. Continued inflation would disrupt the delicate mechanism through which most of the capital must be generated. Recession would force the U.S. to reallocate its resources to alleviate personal hardships.

Recipes for Reform

If the nation’s resources are to cover its future needs, Government, business and labor will have to abandon many of their inflationary programs and practices. The Nixon Administration this year began a joint Government-business-labor effort to avoid work stoppages, end restrictive practices and reduce price increases in construction, the nation’s most flagrantly inflation-ridden industry. The highly inflated costs of medical care could be brought down if a powerful union—the American Medical Association—would permit less highly trained “paramedical” workers to perform simple functions like applying bandages and giving injections. Federal purchases could be more adroitly timed to take advantage of favorable prices. Government regulatory agencies might abolish minimum rates for freight shipments and other transportation, and permit competition to take over again. Oil-import quotas, which cost gasoline consumers at least $4 billion a year, could be revised or scrapped. Fair-trade laws, which place floors under the prices of some goods, might also be repealed. These are the sort of moves that economists as far apart as Walter Heller and Milton Friedman agree should be made.

Friedman deprecates the role of his rhetoric in winning acceptance for his ideas. “People are persuaded by the evidence of experience,” he says. As for his own role, he adds: “all one can hope to do is move things in the direction they ought to go. I try to be specific about the ideal and not worry too much about what at the moment is realistic.” By following that precept, Milton Friedman has done much to revive faith in the competitive market and to change the theories by which nations guide their commercial destinies.