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That exposed a critical weakness in the neo-Keynesian economics, which relies primarily on delicate adjustments in taxes, government spending and monetary policy to keep the economy running close to capacity. The New Economics had served well when business needed a push. But Britain's Keynes presumed that policymakers would always be wise enough, given knowledge of his theories, to do the right thing at the right moment. In the U.S., however, political leaders are usually unwilling to raise taxes quickly enough in overly expansive periods. The theories of the New Economics have not been found wanting; they have simply not been applied at all the crucial times.
When Congress finally got around to enacting the surtax at midyear, much of its effect was washed away by another big factor. While taxes went up, wages went up much faster. During the year's first nine months, about 3,400,000 unionized workers won pay raises averaging 7.5% annually, the largest gain since the Labor Department started keeping track 14 years ago. For the year as a whole, wages and benefits rose about 7%, while productivity increased only 3.2%. The result was that so-called unit labor costs jumped 3.8% —and the consumer had to pay for the jump.
Psychology of Inflation
Of course, consumers had plenty of pocket money. Often during the 1960s, they have confounded economic forecasters by spending more lavishly than the experts had expected. This year, they went on something of a spree, correctly sensing that the prices of almost all goods and services were bound to rise. Such expectations become powerful economic forces, creating an inflationary psychology that is now firmly embedded in the thinking of businessmen, labor leaders and investors. Even after the tax increase, consumers rushed to buy practically everything. Their appetite for the well-styled 1969 autos was particularly keen; sales this year will reach an alltime high of about 9,600,000 cars. The U.S., with its 60 million families and 100 million cars, is fast approaching the reality of two cars in every garage.
To help finance their spending, consumers borrowed more and saved less in 1968. From the year's second quarter to the third quarter, personal savings fell from an abnormally high 7.5% of after-tax income to 6.3%. In the third quarter, installment loans rose at a record annual rate of nearly $9 billion. And for installment buyers, as well as for businessmen, the availability of credit is far more important than its interest cost.
Credit was plentiful because the Federal Reserve Board, even while raising interest rates, allowed the supply of money in circulation to grow at a rate that proved to be inflationary. The board had to feed funds into the money market so that the Treasury could borrow to finance the federal deficit of $25.4 billion in fiscal 1968. Such great deficit financing, most economists agree, is the fundamental cause of U.S. inflation.
The money supply expanded at an annual rate of 8% during the year's first half. Even after the midyear tax increase, the Fed's governors continued to ease credit because, like most other experts, they misjudged how quickly the surtax would begin to brake the economy. In the last three months, the Fed has changed course, holding the increase in the money supply to a moderately constrictive rate of 3.8% a year.