Past Speakers of the: LANDON LECTURES

Landon Lecture by Walter H. Heller,

Professor of Economics at University of Minnesota
March 19, 1974

by Walter H. Heller

I'm honored to be your Alfred M. Landon Lecturer this morning, and I am doubly honored to have Governor Landon in attendance. The election in which he ran for the presidency stands vividly in my mind since it was the first election in which I was old enough to vote. And Governor, I refuse to say for whom I voted on grounds that I might tend to incriminate myself. But let me say this, if there were a vote for a position of elder statesman, the qualifications for which are grace, wisdom, and perspective, you'd have my vote any day.

I am also honored and humbled by President McCain's introduction. One point relating to my subject today that he didn't happen to mention is that I am a member of William Simon's economic advisory panel. A good deal has been made of the fact that I serve on Bill Simon's panel. But I should note that when the panel meets, I find that it's great to be among friends, even when they're not my own. My other comment is that reports of the life or liveliness of this committee are much like those erstwhile reports of Mark Twain's death: greatly exaggerated. We had one meeting on January 11. It was a very constructive exchange and I must say both Bill Simon and John Sawhill were very impressive. It was an excellent meeting, but that was almost ten weeks ago and we haven't heard another peep. With a short-handed staff, perhaps they simply haven't had time to call other meetings. But it does make one wonder whether it is a public relations ploy or whether they really are turning over a new fig leaf. I wanted to put it in the most felicitous way, as you can see.

The economic problem and the energy crisis are certainly no laughing matter, and we ought to turn now to some of the problems that are crying for attention. Just how does the oil crunch, in particular, worsen the prospects for an inflationary recession this year? Second, what tax and budget measures should we be taking to counteract it? Third, what should we be doing to handle the problems of short supplies and run-away prices of oil and gasoline in the short run? (This morning's Topeka paper noted, by the way, that lifting the embargo would not resolve either the shortage or the price problem, that's right, as I shall note later.) How do we handle this explosive price problem, particularly in ways that will avoid price gouging of the consumer, that will curb profiteering by producers, that will cut our wasteful, our really hoggish uses of energy, and that will at the same time preserve incentives and stimulate the search for new supplies of energy? Finally, what measures should we be taking in the longer run looking to that objective?

Just a few words on a couple of underlying assumptions before going into the details. The energy shortage, even with the lifting of the Arab embargo, is for real. It was developing before the oil embargo hit and it will continue now that the embargo is lifted. I take time to underscore that point because of the enormous skepticism I have run into around the country about the reality of the energy shortage. Time and again I'm asked, "Isn't it just a conspiracy; isn't it just something contrived by the oil companies and the Nixon administration?" And you can understand why there would be that skepticism when people get much of their information from impeachable sources in the White House. But the shortage, and the price explosion it touched off, are very real and very significant factors in today's economic outlook.

Somebody asked me this morning at the press conference if I felt that the energy policy and economic policy were suffering from the Watergate affair. Well, I don't think policy management, as such, is suffering much in the narrow sense at least. George Schultz and John Dunlop and Bill Simon have been managing really quite well on economic policy. All their mistakes are intelligent mistakes I want to make that perfectly clear. In other words, the economic management is in competent hands whether you agree with the policies or philosophy or not. When it comes to making appeals to the country from a moral platform, so to speak, there may be a few problems of credibility.

Even as the Arabs turn off the spigots and end the embargo, the impact of the petroleum price explosion will continue to imperil oil importing economies throughout the world. Ending the embargo isn't quite the biggest non-event of the year but, did you notice, the stock market seemed to think so? It dropped 13 points yesterday. There is an old adage buy in anticipation of good news and sell on the realization of that news. The stock market seems to be following that advice.

By the way, I am not going to talk about the stock market because making a forecast on the stock market requires the skills, not of the economic analyst, but the psychoanalyst. But I do want to share with you Will Rogers' advice on the stock market. He said, "Don't gamble, just take all your savings and put them in some good stock and when it goes up, sell it. And if it don't go up, don't buy it." You know, there is a lot of wisdom in that.

The ending of the embargo isn't nearly as big an event as the quadrupling of the price of foreign oil from $2.50 to $10.00 a barrel in a little over a year. The price of domestic crude oil has jumped from $2.90 to $5.25 in the past 20 months and from $3.50 to $5.25 in the past 12 months. That is for "old oil," which is about 70 per cent of our domestic oil. But there's also been a jump from that $2.90 or $3.50 to $10.50 for "new oil," which is about 30 per cent of our total supply, and rising. There's the rub, and it is the consequence of that to which I want to devote most of my attention this morning.

By the way, as part of the factual base, you should know that oil constitutes just short one-half of our total energy source in the United States and of that half, two-thirds comes from domestic sources and one-third from foreign sources. Of that one-third, only one-fourth or about 9 to 10 per cent of our total oil supply albeit, a rising share comes from the Arab oil countries that have been putting the whammy on us with this oil embargo. I hope we bear that in mind in looking at the problem.

Now let me look at the 1974 economic prospects as impacted by the oil shortage. First we should remind ourselves that the economy was already heading into a slowdown before the Arab oil cut-off hit us. The economic slowdown was consciously engineered in part by the tight money policies of the Federal Reserve, approved by the White House, which led to short-term interest rates in the 10 to 12 per cent range last summer. The slowdown was engineered in part by White House tight budget policies designed to cool off an overheated economy.

Now I have been critical of the way that Mr. Nixon's White House handled the agricultural crisis in 1972, particularly in terms of the Russian wheat sale; not, mind you, that any other administration would not have sold that wheat to Russia. They would have done it; but I doubt that any other administration would have paid a $300 million subsidy to keep the price to the Russians at about a quarter or a third of the level that it is today. And I have been critical of the way they have handled the energy crisis. Mr. Nixon has made a number of speeches over the years, but there has been no follow-through in trying to drive Congress to take some definitive action. So I am critical on both of those scores. I think that the White House in those areas has shown an infinite capacity to be caught by surprise.

On the other hand, the White House deserves good economic marks in the past year for its tough budget policy. Now I underscore the word economic because I happen to have a very different view of what the social judgment or ethical judgment should be of how Mr. Nixon cut back that budget. I have to divide myself into economist on one hand and sort of a value preference social observer on the other. I thought that squeezing down the social service programs for the poor the way he did and impounding funds were very bad social policy. At the same time, it took a lot of intestinal fortitude to cut that budget down and run a tight budget policy in a year of an overheated economy that was obviously running into the problem of excess demand. On the purely economic side, Mr. Nixon has to be given good marks for that.

So as I say, you always have to think on the one hand and then on the other. I can't help recalling the first chairman of the Council of Economic Advisers, Ed Nourse, the adviser to Harry Truman who is now 90 years old (since deceased). Every former chairman of the Council is still living. I don't know whether that proves that it is the fountain of youth down there, but it is true that we are all still alive. Ed Nourse thought that the appropriate way to handle that office was to tell the president, "Mr. President, on the one hand there are these factors and Mr. President on the other hand there are those factors," and then not make a recommendation. Leave it to Mr. Truman in his great economic wisdom to make the judgment. Well, you can imagine how Truman went for that. One day Ed Nourse was in the oval office and he said, "Mr. President on one hand and Mr. President on the other hand," and finally Mr. President slapped his desk and said, "For God sake, give me a one-armed economist." So I'll try to be a one-armed economist today but it isn't always easy.

Now enter the "oiligarchies" with their embargo and their huge price increases, and what has happened to the economy? Well, instead of an economic slowdown which most of us were forecasting before the oil was cut off, we really are now in what looks to be a recession or in Mr. Nixon's somewhat more delicate terms, a "downturn." But a downturn, or recession by any other name, smells just as bad. It is a fairly mild downturn but still it is an actual drop in real output for perhaps this three-month period, this quarter and the next quarter with a very sharp rise in unemployment it has already gone up from 4.6 to 5.2 and held there for a month in terms of percentage. Behind those percentages lie 650,000 people unemployed who had jobs in October and there probably will be a further rise in unemployment of about 800,000 or 900,000. That is a huge increase.

When you come to the question of the impact of the oil crisis on this picture, the surprising thing is and this is where Simon and company deserve credit that the crisis isn't the result of a shortage of energy or shortage of oil cutting back on production that isn't what has happened. People thought at first that the crisis was going to hit from the supply side. We simply wouldn't have enough energy, and here I mean energy in the economic sense; we simply wouldn't have enough oil not enough oil for energy nor enough for petrochemical feedstocks to keep the economy moving up. That is not what has happened. What we have had is a surprisingly sharp impact surprising to many people although it shouldn't be surprising when you think of the economics of it on demand. There have been two types which I call demand-diverting effects and demand-absorbing effects.

The demand-diverting effects are obvious all around you because of the shortage of gasoline and the rising price of gasoline. People have cut down on their purchase of cars. They are down 32 percent on the last period and, much more importantly, the standard car purchases are down over 50 percent. The dollar weight on the cutback in the automobile industry is horrendous. People aren't buying campers and boats and tourist services. A lot of that demand is diverted, where does it go? Well part of it goes to other purchases but some of it simply goes into savings, it is taken off the consumer market. When you don't buy a car, you don't go right out and buy something else instead you simply don't take out as much installment debt, and that is algebraically an increase in savings. Now in spite of inflation we have had a considerable increase in savings and that is no mean trick. In that connection, I should share with you a sign I saw outside the Holy Nativity Lutheran Church in Minneapolis. It read as follows: "Jesus saves and, in these days of inflation, that's a miracle." I thought you would appreciate that little religious note. It isn't so much the shortage as the petroleum price explosion that is "killing us softly."

Now the more interesting effect, and the one that is less understood, is the demand-absorbing effect. The zooming petroleum prices are absorbing $15 to $20 billion that we might otherwise be spending on other things. I wonder how many are aware that for 20 years petroleum prices at the refinery went up only one percent a year from 1953 to 1973 and then jumped 125 percent in one year, 1973. Those are spot prices, you know, the auction prices in the market place. If you knock off, as I do, a conservative 25 percent, it still makes a pretty brisk comparison. One per cent a year for twenty years and 100 per cent the past year.

As that works its way through into consumer prices, it will absorb $15 to $20 billion of your purchasing power and mine which simply will not reappear in the economy. Why not? First, a large chunk of it goes to the overseas oil potentates, and they are not going to increase their imports from us by more than a very small amount in the short run and not all that much in the long run. Secondly, it goes to the oil companies where it will not reappear quickly in the economy because (a) they are probably skittish about increasing dividends given the political risk and (b) their plant and equipment investment programs for this year are already largely set, and they will simply rely more on internal cash flow and less on borrowing from the markets. Out of that $15 to $20 billion you can't expect more than $2 to $4 billion to reappear in the economy in the current year. So it is just as if you levied a tax for that amount on the American consumers and squirreled it away in the United States Treasury.

That effect will not be relieved by the ending of the embargo. As a matter of fact, the effect will be increased. The oil company presidents have been pointing out the past couple of days that as the larger amount of high priced foreign oil enters our mix that $10.50 oil as against the $5.25 old domestic oil, the prices of gasoline and other products will rise. It is important, then, to recognize that while the end of the Arab oil embargo will increase gross national happiness, it will not increase gross national product. It will have a further demand-absorbing effect on it, even though the demand-diverting effect will be diminished.

Now let me turn back just very quickly to the net effect of last year's tight money and tight budget and this year's tight and expensive energy on the economy. The economy is sliding into a recession right now. Whether it will finally be labeled a recession is not all that important. Will there be an upturn in the second half of the year as Mr. Nixon has forecast? People look at his forecasts with, shall we say, skepticism because some of his past economic forecasts and his economic advisers' forecasts have been pretty wide of the mark, not that the rest of us haven't made our mistakes too. We really did not foresee the severity of inflation in the past year, no matter how close to the mark our forecast of real growth might have been.

I can go through that routine only because this time I agree with the President. I think there will be an upturn in the economy in the second half of the year. First, after sliding so far, though you can't call the turn exactly, automobiles will rebound. The automobile manufacturers say they are going to manufacture 4.8 million little cars in 1975 model year. Second, housing, which has taken an awful beating down from 2.4 million starts to 1.4, will start to rebound. Lots of money is going back into the savings and loans and mortgage rates will taper a little bit. I expect that to pick up in the second half of the year. Third, business has never abated its spending on plant machinery and equipment. That got started late in the last expansion, somewhat retarded, and now as more materials become available with the reduction of output of cars and housing, etc., I think we will have a real bounce in the building of machinery and plant equipment during the second half of the year. That will tend to pull the economy back up.

I don't think it will be quite in time for graduation. I'm sorry for you seniors, but later in the year, if you are still unemployed, you'll get jobs. Oh, I suppose everybody at K-State gets jobs, so I shouldn't worry about that. The agricultural economy is doing swimmingly. By the way, I notice that there isn't the kind of resentment of the farm price explosion in terms of the farmers that one finds in the petroleum area. Nobody talks about a conspiratorial action on the part of the farmers, nor should they. Last year, at long last, farmers had a big jump in their income. They moved their median family income from 83 per cent of the national average to 93 per cent. The country doesn't think of that as profiteering and shouldn't.

Now let me go on to say that profits in general will not do too well this year. But even if they go down, leaving aside the oil companies, about 10 percent, remember that profits have zoomed 80 per cent in the past three years for the economy as a whole. So even if they go down only 10 per cent this year, they will still be on a very high plateau. Somehow or other, in spite of all the difficulties, companies seem to be doing quite well on profit.

Now what action should we be taking at the national level to cushion the recession and speed the recovery? It seems to me that first of all, the Federal Reserve System should be easing up on money. At the moment they are having to cinch it up a little, but I think we are on the saw tooth downward in terms of interest rates and a saw-tooth upward in terms of the availability of money. I think they are playing their role in this easing process. Although I'm apprehensive; I hope they don't stop too soon. What strikes me as more interesting and what I am going to be discussing with two congressional committees tomorrow morning, the Senate Finance and Appropriations Committees, is what we ought to be doing to take up slack in the economy and at the same time in effect pay reparations to the groups in the economy that have been taking such a beating from inflation in the past year.

Now my favorite proposal for doing this is to increase the federal personal income tax exemption from $750 to $850 this year, maybe $900 next year (or, preferably a comparable amount in the form of a credit against tax). That would do no more than restore the purchasing power it had at the time it was set at $750, in other words make up for inflation. It would cost about $5 billion (out of the $129 billion amount yield of the personal income tax), and it would inject that much into the economy.

Socially I think the case for it is absolutely compelling because remember that in the past year inflation has been bitterly tough on the poor, the near poor, and moderate incomes. Normally inflation isn't all that tough on the poor. Why? Because the very same things that cause the rise in prices also cause a hiring of the people at the bottom of the barrel their job opportunities increase, their incomes increase, their hours increase and those benefits, a University of Wisconsin study has shown, exceed their losses from inflation. But not this past year. The food and fuel price explosion has hit them in the solar plexus.

The people in this audience might on the average spend about 15 to 20 percent of their net disposable income for food. A study that the Agriculture Department sponsored, published just two days ago, shows that a family of four, a couple with two teenage boys with an annual income of $3,000, spends 83 percent of its budget on food. Even at $6,000, it spends 42 percent of its budget on food. Now imagine if you had a family income 40 per cent of which was going for food, just to take again the more conservative number and food went up 25 percent as it did in the past 15 months. That is the same thing as if someone had come along with an axe and chopped off 10 per cent of your real income. We should be doing something to restore that.

The first question I will be asked by the senators is, Mr. Heller isn't that fiscally irresponsible? Doesn't the budget already provide lots of stimulus for 1974-75? Isn't it going to be a worsening of inflation? The answer to those questions is NO—NO-NO. The budget, by the studies of both liberal and conservative observers, is just about a hold-the-line budget. Mr. Nixon himself says it has about the same restraint for 1975 that was exercised in 1974. And I would offset the revenue loss with compensating tax reforms for the longer run protection of the tax base.

And as far as the inflation part is concerned, inflation this year has a life of its own. It's the petroleum price upsurge; it's the food price upsurge. Neither of these has much to do with the overall management of demand by fiscal and monetary policy in this country. It's also the commodity price explosion apart from food and fuel. Every economy in the world boomed in 1973, and everybody needed all kinds of commodities: textiles, copper, aluminum, zinc, you name it. All of them went up to record prices. All the economies of the world are now trying to cool it. They are trying to cool down their economies, so the pressure on com¬modities will be eased. Further, we will have a one-shot, or pop-up, effect on prices from taking off controls. That will work itself off by year-end. As the year wears on, the most serious inflation pressure will come from cost push, from rising unit labor costs via accelerating wages and declining productivity.

None of those have much to do with the injection of a minor amount of purchasing power into the economy. I think we can take this action, which is socially so imperative, without more than minuscule effect on the inflation picture. We can really help the lower income groups and particularly the blue collar worker whose average weekly earnings in January were worth in purchasing power 4 per cent less than a year earlier. That was the biggest drop in real income of workers in the ten years that this statistic has been kept. Again dividing it into social and economic categories, socially it would redress a glaring grievance arising out of inflation, while economically it would help cushion the recession and help us move ahead in recovery.

Now in that process I gave you my essential assessment of what I think is going to happen in inflation. Unlike the Savonarolas of the economic profession I do not expect inflation to worsen during 1974. It will be very bad this quarter and still next quarter, but a lot of it will burn itself out later this year. Later this year as the oil prices continue to work their way through the system, the explosion will be reflected in rising prices through next summer and then it will taper off. Prices will hang high, and they will still hurt. But remember, inflation, as generally understood, means rising prices—and they will rise less rapidly by the end of the year. In January, consumer prices rose 12 per cent. Just to get bold and make a specific forecast, by next January they would be rising at a 6 or 7 per cent annual rate. Now that is not as low as we would like them, but I just don't think in your careers you are going to find yourself living with less than 4 per cent average inflation per year. That's not very good, but it's a lot better than double digit inflation at 12 or 14 per cent.

I hope, by the way, that the government simply doesn't throw away its wage and price controls completely. It is high time to get rid of mandatory controls. You just can't tolerate that smothering blanket, that straitjacket of controls, for any sustained period of time. But it would be too bad not to have the kind of thing that Arthur Burns has called for—a wage-price review board with guidelines and power of surveillance over big unions, big businesses, and basic materials. Such a board should have power to suspend or actually roll back a price or wage increase that is particularly flagrant. That kind of power we ought to retain.

Last year, when we made that miserable mistake of junking successful Phase 2 and went to the fiasco of Phase 3, the White House kept talking about the big club in the closet. But they never took it out (perhaps for fear of other things that would fall out). Yet, one has to have a club that is occasionally used. It can be a potent one. Side by side with the powerful tools of fiscal policy and monetary policy, since April 15, 1971, when Mr. Nixon slapped on the wage-price freeze, we have had a bipartisan wage-price policy. Government intervention in wages and prices— either in fact or in threat—will live with big business and big labor from here on out. And that added a potentially powerful tool.

In speaking here this morning, I was going to follow the terseness of Chief Justice Murdock of the U.S. Tax Court some years ago in handling a particularly flagrant tax evader who threw himself on the mercy of the court and said, "As God is my judge, I do not owe this tax." Murdock fixed him with an icy stare and said, "He's not, I am, you do." That's the way I'd like to see my students write exams, but they don't quite do it that way, nor have I quite held to that standard this morning.

Let me spend just a couple of minutes on the policies for managing oil that protect consumers, preserve incentives, and prevent profiteering. Now we do have to be very circumspect in this. One tends to fall prey to H.L. Mencken's old rule, "For every problem there is a solution, simple, neat and wrong." And that is worth remembering, too, when you write your exams. It is so easy to jump to the conclusion there are going to be windfall profits so we should slap on a windfall profit tax or an excess profit tax.

The administration has a windfall profit tax that would raise about $3 billion a year out of the $10 billion additional profits that will fall in the laps of various segments of the oil industry this year. That's not much more than sprinkling a little holy water on those excess profits. It won't do the job. A regular excess profit tax is really an exercise in futility. It is a great concept, but try to find those excess profits. It's like Gertrude Stein said when she went back to Oakland, her home town: "When I got there, there was no there there." That is the way it is with excess profits tax on oil profits. In the Korean War, by the time all of the special exceptions and deductions had been taken into account, the excess profits tax on oil companies yielded peanuts.

My approach, which is anything but popular in the White House, would be to roll back the prices; not so much on "new oil" where you need to preserve incentive but on "old oil." "Old oil" has jumped from $2.90 to $5.25. Roll it back a dollar. Costs haven't risen nearly commensurately with those increases in prices. We produce 3 to 3-1/2 billion barrels of domestic "old oil" each year. If you rolled it back a dollar you could pick up $3-1/2 billion of potential excess profits right there. I mean actual excess profits. You'd stop them at the source without all the difficulty of the excess profits tax. Then, perhaps roll back new oil to about $8 from its present $10 or $11 level. Oil company economists tell me that that would preserve plenty of incentive for both drilling more oil and developing substitutes. In short, that kind of a program would save consumers about $4 or $5 billion of excessive profits. It would, at the same time, by saving consumers those dollars, reduce that absorption effect of $15 to $20 billion by $5 billion. That would in turn help support the economy, yet, by maintaining a high price for "new oil," it would preserve the incentives which we, of course, desperately need — the incentive of the price mechanism. So that is the balanced way I would follow in on short run.

Now I would, at the same time, end those costly tax loopholes in the oil industry. As long as they are getting good prices, as Thornton Bradshaw, head of Atlantic Richfield recognized, the oil producers don't need those extra tax incentives like percentage depletion. I would retain the expensing of intangible drilling and development costs on dry holes—and I say that advisedly here in Kansas. It is important for exploration incentives, especially for small and independent drillers, to let those be deducted —but not on the wells where oil or gas is hit. That kind of a program would combine incentives to the producer with fairness to the consumer.

For the longer run, we have to do an awful lot of new domestic drilling. We have to recognize that our imported oil, and particularly Arab oil, is an interruptible source of energy. We have to develop reserves. I would just as soon have the defense department or a TVA-like corporation develop our off-shore lands. They all belong to -the people you know; they all belong to the government. We could develop maybe 3 million barrels a day of oil capacity and just cap them. It would cost a lot, but it would be worth it.

The transcription of this Landon Lecture was accomplished through the cooperation of the Kansas State University Libraries and the Office of Mediated Education.

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