Guidepost Origins

Postwar economists agreed that when the economy passed the point of full employment, commonly assumed to mean about 4 percent unemployment, excess demand for goods would pull up prices and excess demand for labor would pull up wages.^{Footnote 10} This condition came to be known as demand-pull inflation, the classic phenomenon of too much money demand chasing too few goods. But in the 1950s, economists became troubled that prices were rising even though the economy seemingly retained much slack, a trend that came to be explained as cost-push inflation. According to contemporary theory, cost-push inflation arose when firms and unions took advantage of their market power to raise their prices and wages. This price and wage administration would reduce demand for products and labor, resulting in unemployment unless the government accommodated the higher wage-price level through inflation. The Employment Act of 1946 had committed the federal government to the pursuit of “maximum employment, production, and purchasing power,” and the Keynesian backers of this law feared that firms and unions might interpret this language as a guarantee that the government would shield them from the consequences of their price and wage decisions. As a result, private economic actors could hold the government’s macroeconomic policy hostage, as it was their decisions that determined how much inflation the government would have to tolerate in order to achieve full employment.^{Footnote 11}

This trade-off between lower unemployment and higher inflation was especially problematic as it apparently rendered the domestic priority of full employment inconsistent with the commitment to the international financial order, the Bretton Woods System. Under Bretton Woods, the dollar served as the basis for a global system of fixed exchange rates between currencies, with the dollar in turn convertible with gold. The United States provided liquidity to the rest of the world by running a deficit in its balance of payments, but the larger this gap became, the less confidence existed that the United States would be able to meet its obligations in gold. Inflation exacerbated the balance of payments deficit by making exports less competitive and eroding the value of dollars held abroad, making it more likely that foreigners would attempt to cash in dollars for gold at the risk of bringing down the entire system.^{Footnote 12}

Soon after the passage of the Employment Act, Keynesian economists began to argue that if a democratically accountable government wished to free itself from the inflationary constraints imposed by a democratically unaccountable free-market economy, it would have to cultivate a sense of private responsibility.^{Footnote 13} Already in the inaugural (1948) edition of what would be the best-selling economics textbook of the century, Paul Samuelson’s Economics, the MIT economist and future Nobel laureate concluded his chapter on “Fiscal Policy and Full Employment without Inflation” with the warning that “wages and prices may begin to soar while there is still considerable unemployment and excess capacity” [italics in original]. Samuelson noted that the Employment Act had affirmed a joint public-private responsibility for economic stabilization, but he also described how business and unions acting “perversely” in response to increased demand would drain fiscal stimulus into inflation rather than employment. Establishing a wage-price policy that would reconcile microeconomic behavior with macroeconomic objectives remained “America’s greatest problem and challenge.”^{Footnote 14}

President Dwight D. Eisenhower accepted the Keynesian diagnosis that inflation emerged as a result of private-sector decisions. As he explained at a Cabinet meeting at the end of 1956 in response to the rejection of an apparently moderate settlement in railroad negotiations, there was a contradiction when the greatest private-sector exponents of free enterprise failed to exercise the wage-price restraint necessary to sustain a free economy.^{Footnote 15} Nevertheless, Eisenhower disagreed with the suggestion that the government must intervene directly to enforce a noninflationary wage-price policy, considering this to be a solution incompatible with the free economy it was supposed to protect. Instead, he limited his direct engagement to generalized exhortations about the dangers of inflationary behavior. In his 1957 State of the Union Address, for instance, Eisenhower called on businesses to “avoid unnecessary price increases,” and for labor compensation to be “reasonably related to improvements in productivity,” warning that otherwise political pressures to reduce inflation could lead to the replacement of private decision-making with government control.^{Footnote 16} The CEA hoped that Eisenhower’s appeals for wage-price restraint might suffice to moderate labor compensation and so obviate the need for firms to mark up their prices to preserve profits. If firms and unions did not respond, however, the government would have to exercise its responsibility over fiscal and monetary policy to establish the conditions in which the private sector would have little choice but to modify its behavior, stabilizing prices at the temporary cost of moving farther away from full employment.^{Footnote 17}

Federal Reserve Chairman William Martin recognized the costs of restrictive macroeconomic policies, but he believed that once expectations of inflation had become ingrained, it would require resolute action to prevent inflation from spiraling out of control and the balance of payments from collapsing. As he explained to CEA Chairman Raymond Saulnier during a meeting in April 1957, “[Credit ease] would convey to the business community the impression that the Board’s policy is to validate price levels inflated by a cost push and that this would induce an inflation-minded psychology and have very damaging long-run consequences.”^{Footnote 18} Eisenhower agreed with Martin that inflation rather than unemployment was the greater of two evils, and so he was willing to accept the recessionary costs of monetary restraint. Eisenhower declined to increase spending on public works to alleviate unemployment, and he ruled out a tax cut on the grounds that the short-run need for countercyclical fiscal expansion did not outweigh the long-run need to balance the budget. Instead, he aimed to wring out inflationary expectations through budget surpluses, achieved in 1956, 1957, and 1960.^{Footnote 19}

Eisenhower and Martin’s efforts, although crude in comparison to the economic theory of the later twentieth century, successfully combated inflation.^{Footnote 20} While unemployment rose from under 4 percent in 1957 to over 7 percent in 1958 and again in early 1961, contemporary conservative economists applauded the use of macroeconomic policy to establish the incentives for wage and price restraint without microeconomic controls. As Milton Friedman of the University of Chicago had argued to Saulnier in 1957, exhorting the private sector to prioritize the national interest against inflation only distracted the government from putting its own monetary house in order: “[Exhortation] seems to me not only to be analytically wrong, but politically dangerous. Heaven preserve us from a world of business men and labor leaders conducting their affairs in terms of ‘social responsibility.’” Former Eisenhower CEA member Neil Jacoby of UCLA likewise wrote Saulnier that it was the government’s responsibility to “establish an environment within which vigorous competition, among private individuals and groups each actively seeking his own self-interest, will result in general prosperity and a stable price level.”^{Footnote 21}

To contemporary Keynesian economists, however, this use of fiscal and monetary restraint to combat cost-push inflation indirectly proved socially indefensible because it imposed a burden of unemployment on society as a whole rather than targeting those who abused their market power. In his 1958 bestseller, The Affluent Society, Harvard economist John Kenneth Galbraith decried the use of macroeconomic demand management techniques to target inflation as antisocial, belittling monetary policy specifically as “ineffectual, discriminatory, and, possibly, dangerous.” Galbraith argued that the only way to pursue maximum employment without encountering inflation would be for the government to insert itself into the private economy as a countervailing force on behalf of the public at large.^{Footnote 22} Similarly, Samuelson and his MIT colleague Robert Solow would estimate in 1960 that the government could use fiscal and monetary policies to move the economy between different trade-offs, including price stability at the cost of about 5.5 percent unemployment and full employment with 4.5 percent inflation. Samuelson and Solow distinguished between the ability to select a trade-off along this “Phillips Curve” from policies that would move the curve itself. Shifts could occur due to “the institutional changes on which cost-push theories rest,” such as union market power or postwar expectations of full employment. These two leading Keynesian macroeconomists concluded that the government could engineer a more favorable set of trade-offs through “feasible institutional reforms . . . designed to move the American Phillips’ curves downward and to the left.”^{Footnote 23} Incomes policy, although not cited in the paper directly, was one such method. As Samuelson would elaborate several years after the publication of this paper, incomes policy shifted the entire curve by causing a less-than-competitive economy to better approximate the set of trade-offs that would exist in a more competitive and less sticky economy.^{Footnote 24}

Theory into Practice

Samuelson, Solow, and Galbraith would do more than provide theoretical justifications for incomes policy in the wake of Eisenhower and Martin’s macroeconomic battle against inflation. When the Democratic Party took the White House in 1960, due in no small part to dissatisfaction over the state of the economy, these Keynesians themselves played instrumental roles in enacting their preferred policies. Samuelson served as Kennedy’s economic adviser during the presidential campaign, and he urged the president-elect to embrace an incomes policy that would permit fiscal and monetary policy to pursue expansion without fear of premature inflation. Samuelson warned Kennedy that a democratic government could not forsake its responsibilities to the American people by running deliberate slack to minimize inflation as had Eisenhower. In an echo of his work with Solow, Samuelson instead recommended “government influence”: “Just as we pioneered in the 1920’s in creating potent monetary mechanisms and in the 1930’s in forging the tools of effective fiscal policy, so may it be necessary in the 1960’s to meet head on the problem of a price creep.”^{Footnote 25} In meeting with Samuelson and other members of his economic team, Kennedy referred to the work of Galbraith and other economists in declaring how his administration would be “inclined to make hard requests of both business and labor” in order to avoid inflation without having to abandon a strong posture on defense spending.^{Footnote 26}

The Keynesian economists who filled out the Kennedy CEA fully agreed with Samuelson’s model of the inflation-unemployment trade-off. Kennedy appointed Walter Heller of the University of Minnesota as his CEA chairman, with James Tobin of Yale University and Kermit Gordon of Williams College as the other members. Like Samuelson, these three economists all supported using active fiscal policies to keep the economy at its full potential, and they also looked forward to experimenting with wage-price policy in order to improve the trade-offs achieved through fiscal expansion.^{Footnote 27} For added support, Heller also turned to the CEA’s new chief staff economist, Robert Solow. Given Solow’s work with Samuelson the previous year, it was only natural that Heller’s first memo to his chief staffer included a request for an early meeting on the wage-price issue. ^{Footnote 28}

Heller’s ultimate goal as CEA chairman was to secure a permanent tax reduction in order to remove the “fiscal drag” that the tax system placed on private demand, allowing the economy to move back to full employment. As Kennedy and his fiscally conservative Treasury Secretary C. Douglas Dillon were initially too committed to balanced budgets to consider this approach, the CEA had to pin its initial hopes for growth on expansionary monetary policy. Martin indicated in his meetings with Kennedy that he would be more willing to take an aggressive stance on monetary policy if the wage-price and balance of payments situations were resolved. Fortunately for Heller, Kennedy agreed with his CEA chairman on wage-price policy more than he did on fiscal policy. At the conclusion of a meeting with the CEA and Martin on June 12, 1961, Kennedy ordered the CEA to establish this agreement with the Federal Reserve: “We have to try hard to bring the wage-price problem under control.”^{Footnote 29}

Economic developments in the summer of 1961 forced the White House to improvise in implementing federal wage-price policy. Additional defense spending in the wake of the Berlin Crisis provided a fiscal shot in the arm, but it also moved the economy closer toward the danger-zone where firms and unions were expected to become bolder in experimenting with cost-push inflation. To the CEA, the most immediate threat to the three-year record of price stability appeared to come from the steel industry, which was contracted to raise wages on October 1, 1961. The steel industry had taken a 116-day strike in 1959 in order to cut by more than half its two-decades-long annualized trend of about 8 percent growth in employment costs. In return, the industry pledged to cease raising prices annually as it had for most of the 1950s. But the steel industry’s profitability had weakened since signing the contract, and the CEA anticipated that the industry might return to its previous pricing strategy to reverse this trend.^{Footnote 30} Rising steel prices were especially dangerous in light of the balance of payments. Heller would attribute a quarter of the $3 billion increase in the payments deficit between 1957 and 1961 to decreased net exports of iron and steel, and Tobin’s European contacts informed him that “well-informed Europeans look upon the steel wage settlements as the most critical economic event in the United States in 1962. They think that if we can hold the line on steel, the dollar has a good chance of withstanding the trials ahead.”^{Footnote 31}

Kennedy himself feared that a steel price increase could set off cost-push inflation. Kennedy discussed with Secretary of Labor Arthur Goldberg, previously the counsel to the United Steelworkers (USW), a strategy of asking the union to forgo its wage increase voluntarily in return for steady prices, but Goldberg replied that this request would do more harm than good.^{Footnote 32} Instead, Kennedy and Heller worked out a plan of action in which Democratic senators launched a preemptive assault on the industry’s claims to a price increase through a series of speeches written by the CEA.^{Footnote 33} Kennedy then wrote to the industry to emphasize that the industry’s statesmanship in absorbing wage increases would place the burden on the union to restrain wages when the contract expired in 1962.^{Footnote 34} Roger Blough, chairman and CEO of U.S. Steel, acknowledged Kennedy’s between-the-lines offer to pressure the USW, and on September 21, 1961, Blough informed Kennedy that there would be no price increase that year.^{Footnote 35}

The encounter with the steel industry demonstrated to Heller that the private sector could not be counted upon to hold to wage-price policy voluntarily, but the White House’s success in preventing a steel price increase also suggested an effective strategy to combat cost-push pressures. In several speeches that October, Heller introduced a new component to the familiar exhortations to base wages and prices around productivity, an innovation that he described to the president as “[not] very sexy, but it may still be seminal.” The federal government’s role in wage-price policy was no longer simply to prevent excess demand from emerging but to persuade and to induce management and labor to negotiate in the public interest. Where the Eisenhower administration had refused to intervene in individual circumstances, Heller argued that a “reasoned and persuasive appeal for specific actions” such as had been made in steel was a constructive tool to ensure adherence to wage-price policy.^{Footnote 36}

The Heller CEA formally laid out the federal government’s new approach to wage-price policy in the 1962 “Economic Report of the President,” the annual statement required under the Employment Act explaining how the president would fulfill his macroeconomic obligations. Based on the oral reminisces of several CEA staffers, it appears that Solow, the coauthor of the American Phillips Curve, was heavily involved in writing this discussion.^{Footnote 37} The report introduced the wage-price guideposts as the solution to the inflation-unemployment trade-off and a way to strengthen the balance of payments without weakening aggregate demand. The key principle of the guideposts was that labor compensation should grow at the same rate as labor productivity did for the entire private economy. If an industry’s own rate of productivity growth exceeded the national increase, its unit labor costs would fall, allowing the industry to pass on these savings in the form of lower prices. Conversely, for those industries whose productivity grew more slowly than the national rate, prices would be allowed to rise to offset the excess cost absorption. On average, the result would be price stability with rising real wages, permitting the government to reduce unemployment without fear of weakening the value of the dollar.^{Footnote 38}

With the Jaw of an Ass

The economic report contained one of the most detailed discussions of wage-price policy to date, but there was little new in its economic content. Solow soon after expressed his surprise that “so much originality and special character have been imputed to the guideposts” when even the Eisenhower CEA had included a similar discussion in its own economic reports. ^{Footnote 39} Nevertheless, the 1962 report represented a major shift in economic policy through its implicit threat that the government would take actions to ensure that firms and unions followed these microeconomic rules. As Heller would explain to Kennedy in comparing the guideposts to the British Government’s recent demands for wage-policy compliance from labor, the CEA’s euphemism of informing “public opinion” was a “cautious subterfuge” intended to achieve the same result.^{Footnote 40}

The first target of this new approach was the steel industry, whose 1960 contract was set to expire in mid-1962. Heller had calculated that steel’s output per man-hour had risen by 2.4 percent a year since 1947, although adjusting for different rates of capacity usage produced a trend of 3.4 percent, about equal to his estimate of the national postwar productivity rate. Given these trends, Heller advised Goldberg that a wage settlement within the range of 2.5–3 percent would be in line with the industry’s productivity trend, preventing an increase in unit labor costs that would legitimize higher prices under the guideposts.^{Footnote 41} After several weeks of backroom telephone calls, Goldberg arranged for David McDonald of the USW and Roger Blough of U.S. Steel to meet with Kennedy on January 23, 1962. According to McDonald’s recollections of this meeting, Kennedy asked the union president if he would accept the limit of a 3 percent productivity factor. McDonald recognized the concept from the economic report, and he reluctantly agreed. When negotiations hit an impasse a month later, Goldberg stepped in to suggest a compromise settlement of about 10 cents/hour or 2.5 percent, which formed the basis of the final settlement.^{Footnote 42}

Despite having finally brought the 8 percent wage trend of past decades in line with its productivity growth with help from the White House, the steel industry still intended to raise its prices to improve its finances. Heller urged Kennedy to dispute the industry’s arguments that “would make steel eligible for a price increase under that section of the wage-price guidelines which allows price increases to industries with below-average productivity trends.” Unfortunately for Heller’s efforts to ensure that Kennedy “[went] down in history as the Man Who Broke the Wage-Price Spiral,” this memo arrived on the president’s desk five hours too late to be anything but “an ironic note, now mainly of historical interest.”^{Footnote 43} Earlier that day, April 10, 1962, Blough informed Kennedy to his face that U.S. Steel would raise its prices by 3.5 percent, an average of $6/ton, to “catch-up” with the long-run excess of labor compensation above productivity.^{Footnote 44}

If steel could violate the guideposts with impunity, others would not be far behind. So much, then, for preventing the Federal Reserve from safeguarding the balance of payments despite the adverse effect on domestic employment. Fortunately for the CEA, after all the administration had done to achieve a noninflationary settlement, Kennedy took Blough’s action as a personal insult to himself and the institution of the presidency. As he told McDonald over the phone that evening, “You’ve been screwed and I’ve been screwed.”^{Footnote 45} Kennedy blasted the industry at his press conference the next day, the Department of Justice opened an antirust investigation, and the Senate Committee on the Judiciary subpoenaed the industry for cost-price justification.^{Footnote 46} These threats failed to keep the other major steel firms from following U.S. Steel, but when a few of the smaller companies hesitated, the CEA recognized that these companies could inject the needed price discipline. Undersecretary of Commerce Edward Gudeman contacted Joseph Block of Inland Steel to urge him against raising prices, and on April 13, 1962, Inland’s board rejected following U.S. Steel. Seventy-two hours after first announcing the increase, U.S. Steel capitulated.^{Footnote 47}

With the administration united in its opposition to the steel price increase, jawboning had scored a stunning success for the guideposts. Kennedy quickly followed up on this victory by showing intense interest in a more regularized system of guidepost enforcement. He personally directed the CEA to prepare studies of how Western European governments exerted control over their economies’ wage-price decisions, no doubt seeking inspiration for future confrontations.^{Footnote 48} At the White House Conference on National Economic Issues in late May, Kennedy even suggested that businesses acquaint themselves with European-style planning and public-private cooperation, although he was careful to denounce a “regimented economy.”^{Footnote 49}

But there was a problem with this adversarial approach to inflation management: the private sector could fight back. Unease about Kennedy’s intent to intervene in other markets and a gloomy outlook for profitability if forced to absorb labor settlements contributed to a growing business pessimism. When on May 28, 1962, the Dow-Jones Industrial Average experienced its largest one-day decline since the Great Depression, Kennedy and many in the financial community believed that the president’s apparent hostility to corporate profits played a large role in this drop.^{Footnote 50} Ironically, the threat of an economic downturn provided an opening for a coalition of shared macroeconomic interests between Heller and the same businessmen who decried the guideposts. From the relatively liberal Committee for Economic Development to the conservative National Association of Manufacturers, business groups not only sought lower income taxes but, like Heller, desired a way to ensure that the tax system would not automatically siphon away economic growth. Heller made sure that the president was aware of the business support for this program of tax cuts, and when Kennedy feared businesses would not accept a tax cut if it raised the deficit, these groups continued to proclaim their support. Kennedy and Dillon finally endorsed the tax cut that the Keynesians had wanted all along: a permanent reduction in both the corporate and individual income tax schedules that would clear fiscal drag.^{Footnote 51}

As Kennedy embraced the business community’s preferred fiscal policies to shift the economy along the Phillips Curve, he backed away from his efforts to shift the Curve itself. By July 1962, at Tobin’s farewell reception, it was clear to the guest of honor that the president “was obviously having second thoughts about [the steel crisis] and the whole matter of wage-price guideposts. With a knowing look at me, he said we may have bit off more than we can chew.”^{Footnote 52} When Secretary of Labor Goldberg resigned in September 1962, the appointment of longtime mediator W. Willard Wirtz as his replacement also signaled to the business community that the Department of Labor would now take a less interventionist approach to wage-price policy than it had previously.^{Footnote 53} Even when the steel industry raised prices on selective products in the spring of 1963, Heller cautioned the president that the White House did not need “to overdo the spectre of inflation lest we give aid and comfort to price increases and to the Federal Reserve Board [to raise interest rates].” Heller thought it would be useful for Kennedy to continue to endorse the guideposts in public, but there was no evidence of a budding wage-price spiral. Although the guideposts “have inevitably been bloodied a bit . . . most recently by the [1963] steel price increases,” Heller concluded that the steel industry’s actions in April 1963 would at worst provide less impetus to inflation than those of April 1962.^{Footnote 54}

As the summer of 1963 went on, however, the CEA rediscovered its concern about cost-push inflation. The Federal Reserve raised the discount rate from 3 percent to 3.5 percent in July 1963 as part of efforts to stem an outflow of funds to foreign countries, and Heller feared that Martin would continue to tighten monetary policy at the latest whiff of inflation.^{Footnote 55} The CEA forecasted that once Congress passed the requested income tax cuts, the removal of fiscal drag would finally generate a drop in the unemployment rate from the mid-to-high 5 percents around which it had hovered since late 1962. As employment rose and idle capacity went into operation, preventing inflationary wage-price movements would become more difficult. The CEA still considered retarding aggregate demand in order to prevent cost-push inflation to be self-defeating, but it also foresaw that Chairman Martin would not hesitate to take this action unilaterally if rising prices threatened the balance of payments. Incomes policy would henceforth be an even stronger prerequisite for attaining noninflationary growth than it had been during the sluggish early 1960s.^{Footnote 56} The minutes of a confidential CEA staff meeting on September 21, 1963, reveal that the CEA was preparing to secure Kennedy’s renewed backing for the guideposts: “Get implicit or explicit support from the President. Plug in the fact that the Europeans are getting serious.”^{Footnote 57} When the steel industry again raised prices in October, Heller now urged Kennedy to act before Martin interpreted a creep in the industrial price level as a threat to the balance of payments. “Jawbone control,” Heller wrote to Kennedy, was unpleasant, but it “may be a reasonable cost to incur” to preserve macroeconomic expansion alongside price stability. ^{Footnote 58}

“A New President with a Different Style”

Kennedy’s assassination on November 22, 1963, provided the CEA with an unhappy opportunity to reinvigorate the guideposts approach. Lyndon Johnson was less economically sophisticated than his predecessor, but he was also well known for his willingness to twist arms in order to get his policies enacted, the so-called “Johnson Treatment.” As new CEA member John Lewis wrote to Heller, this “new President with a different style” offered the CEA the perfect chance to reaffirm its microeconomic objectives through “selective personal presidential non-publicized jawbone control.”^{Footnote 59} Behind the scenes, Lewis also suggested formally endorsing 3.2 percent, the five-year moving average of labor productivity, as the official wage guidepost. While his staff dissuaded him from taking this rigid approach, that figure nevertheless appeared in several tables in the 1964 economic report. When the press reported that 3.2 percent was the official guidepost, the CEA did little to dissuade this impression.^{Footnote 60}

Johnson initially tempered his interest in enforcing the guideposts to minimize any political fallout from jawboning. Most notably, he declined the CEA’s proposal to intervene in auto industry collective-bargaining negotiations before the 1964 elections lest he alienate both the United Autoworkers and a business community newly appreciative of Johnson’s role in securing tax reductions. Following his reelection, however, the president began to take a more active approach to jawboning as urged by his new CEA chairman, Gardner Ackley of the University of Michigan. Ackley possessed more experience with price controls than almost any other economist in the country, having previously served as the chief economist at the Office of Price Stabilization during the Korean War. Ackley had learned from that experience how steel prices served as the linchpin for stabilization, and he warned Johnson that the 1965 steel industry wage negotiations would serve as “the key test of the guideposts—both for wages and prices.” Ackley explained that the steel industry had become “the symbol of the Government’s determination to hold the price-cost line.” Failure to obtain a guidepost-compliant outcome could deprive Johnson of the macroeconomic levers needed for economic expansion: “If prices start to rise, it will be hard to hold Bill Martin in check.”^{Footnote 61}

With the steel union souring on a half-decade of restraint and the industry threatening to resort to a lengthy strike to hold down wages at the risk of intensified steel imports, Johnson agreed to intervene. After meeting with representatives of the steel industry and union in Washington in early September 1965, Johnson essentially locked them into the Executive Office Building and refused to let them out until they had agreed to abide by the guideposts. In the early hours of September 3, the two sides accepted a settlement brokered by Wirtz and Secretary of Commerce John Connor that Ackley conveniently evaluated as 48 cents over 39 months, or 3.2 percent a year.^{Footnote 62} When Bethlehem Steel then announced a price adjustment on structural steel on December 31, 1965, Johnson’s aides detected a sinister expectation on the part of the industry that Johnson would not take the political risk of being seen as “anti-business,” as Kennedy had been in 1962.^{Footnote 63} Johnson instead replicated Kennedy’s fury and announced to the industry that it could no longer “consider the interests of your country and your company with complete freedom.” The Defense Department then banned companies that raised the price of structural steel from receiving defense contracts, and the industry quickly gave in.^{Footnote 64} The stock market fell early the next year, but observers attributed it to uncertainty over tax policy, Vietnam, poor sales by blue-chip industrials, and the psychological barrier of the Dow Jones breaking 1,000. The market no longer considered jawboning a force for economic uncertainty.^{Footnote 65}

Through 1965, the Johnson administration had presided over an economic expansion accompanied by virtual price stability. Unemployment fell in response to the tax cuts of the Revenue Act of 1964, and when the civilian unemployment rate finally hit its full-employment target of 4 percent in January 1966, the consumer price index was only 6.7 percent over its level when Kennedy had taken office five years before and the wholesale price index only 3.5 percent more. Unit labor cots for the manufacturing sector had actually fallen since 1961, while real wages had increased.^{Footnote 66} Keynesians attributed at least part of this success to the guideposts, although their causal arguments did not go unchallenged by contemporaries.^{Footnote 67} As the economy now stood poised to pass the 4 percent mark of full employment, however, even Keynesian economists agreed that wage-price policy would have little effect on an inflation that resulted from an excess of demand relative to supply and not cost-push pressures. In early 1966, Ackley warned Johnson that it was necessary to siphon off purchasing power through higher taxes lest inaction “[turn] a creeping inflation into a canter, which would force us to slam on the brakes and risk brining the Johnson prosperity to an end.” Unless the administration took fiscal action against demand-pull pressures, Martin’s Fed would not hesitate to raise interest rates, threatening a steep drop in investment and growth.^{Footnote 68}

Yet Johnson delayed in undertaking macroeconomic restraint, unwilling to sacrifice his signature spending programs on the Great Society and the Vietnam War and cognizant that a tax request could also quickly become an unpopular war tax. Only in January 1967 did Johnson request any income tax surcharge, but seven months later, with negotiations with Congress stalled over spending cuts, deteriorating macroeconomic conditions pushed his initial request for a 6 percent income tax surcharge up to 10 percent.^{Footnote 69} In the meantime, the White House had doubled down on jawboning to keep wages and prices from rising. The 1966 economic report formally endorsed the 3.2 percent wage standard, even though the five-year arithmetic moving average used to calculate that result in past years in fact now yielded 3.6 percent. Wirtz had informed Ackley that labor would not look kindly on lowering the guidepost without an overall austerity program to restrain the cost of living, but as labor productivity had risen only 2.8 percent in 1965, a higher wage target would result in rising unit labor costs. Ackley thus ignored the warnings to stick with 3.2 percent.^{Footnote 70}

Perceiving that the CEA had changed the rules in the middle of the game, organized labor resolved to shatter what now appeared to be a limit dictated by political rather than economic calculations. The definitive union victory over the guideposts occurred later that year, when the International Association of Machinists (IAM) struck the nation’s major airlines. Both Ackley and Wirtz understood that the IAM was using this dispute to eliminate the guideposts, but where Ackley urged Johnson to stand behind the anti-inflation program, Wirtz recognized that the IAM would never accept 3.2 percent. Johnson sided with Wirtz and brokered a settlement that cost a full percentage point above the guideposts, but the militant rank and file of the IAM rejected even that presidential compromise to obtain a settlement estimated to cost 4.9 percent a year.^{Footnote 71} When Johnson then offered a compromise far above the guideposts to prevent a strike from disrupting GE’s defense production, it became clear that Johnson no longer judged wage guideposts as worth the risk of angering his labor supporters. The 1967 economic report included a general discussion of the productivity principle and the need to restrain prices, but it omitted specifics, an approach that Ackley later described as “an essentially meaningless formulation.”^{Footnote 72}

Though guideposts and jawboning had failed to combat wage pressures, the CEA continued to promote restraint against inflation on the pricing side. Ackley turned to Joseph Califano, Johnson’s chief domestic policy aide, to appoint an administration “price czar” responsible for discussing pricing concerns with industry representatives and warning them of potential consequences. These efforts scored some jawbone victories for the administration, most notably when the White House dissuaded General Motors from raising the price of its 1968 models mid-season and forced the rescission of yet another steel industry price increase in the summer of 1968. Yet for every fight the administration won in newsprint, gasoline, or x-ray film in 1967 and 1968, it was inescapable that the problem of inflation was growing worse. New wage settlements, after tracking the guidepost figure up to 1965, leaped ahead in 1966–68 as workers found their real wages shrinking in the face of inflation. Unit labor costs in the nonfarm business sector, which had remained stable in 1961–65, began to rise, as did the nonfarm price indexes.^{Footnote 73}

As the CEA had long feared, the Federal Reserve now took the initiative. The Fed had raised interest rates and slowed the growth of the money supply beginning in December 1965, hoping to force Johnson to accept a tax increase. Faced with an overall excess of demand beyond supply and a strained industrial capacity and labor force, Martin warned Johnson that guideposts would also have little impact: “Persuasion can be helpful, but it has limitations.”^{Footnote 74} Yet when tight money crippled interest-sensitive segments of the economy and encouraged financial disintermediation, Martin eased up in the summer of 1967. Although Martin hoped he could trade monetary ease for fiscal restraint, this gambit aggravated inflation.^{Footnote 75} Only after two years of struggles with Congress and the Federal Reserve would Johnson accept fiscal responsibility in the form of the Revenue and Expenditure Control Act, which he signed on June 28, 1968. The Act imposed a 10 percent surcharge on income taxes and required the president to reduce fiscal expenditures by $6 billion in the next fiscal year, with an overall estimated effect of a $20 billion reduction in the federal deficit.^{Footnote 76} The White House called for inflationary expectations to adjust in the face of government fiscal responsibility, but instead the wage-price spiral continued, peaking in the second quarter of 1970 at a 5.6 percent annual increase in the GNP deflator.^{Footnote 77}

The Return of the Guideposts

The original Phillips Curve model as interpreted by Paul Samuelson and Robert Solow had predicted that an economy would encounter demand-pull inflation if policymakers selected a trade-off to the left of the point of full employment. What this model could not explain was why the rate of inflation had begun to accelerate at a given level of unemployment during the Johnson years. To answer this question, Friedman and University of Pennsylvania economist Edmund Phelps separately devised a new Phillips Curve model that cast doubt on the power of active fiscal policy. Policymakers could temporarily reach a trade-off past full employment by raising the actual value of inflation beyond what firms and households had anticipated, essentially fooling them into producing more. Yet as expectations of inflation adapted, the Phillips Curve would shift upward until unemployment had returned to its natural rate with a higher rate of inflation. Because policymakers could only decide the level of inflation at which the economy attained full employment, not a point along a static inflation-unemployment trade-off, the implication of this model was that the government should cease to blame private market actors for its own irresponsible polices and adopt a passive monetary policy year after year.^{Footnote 78}

Just as Samuelson and Solow had encouraged Kennedy to adopt their Phillips Curve model in the 1960s, Friedman and Phelps found a ready disciple for their anti-inflation approach in a 1968 presidential candidate, Richard Nixon. In the late 1950s, Vice President Nixon had watched as Eisenhower and Martin had tackled creeping inflation and the balance of payments deficit through budget surpluses and tight monetary policy. Nixon begged Eisenhower to ease up before the economy fell into recession on the eve of the 1960 elections, but Eisenhower held firm, and Nixon lost the election.^{Footnote 79} With this experience in mind, Nixon was in no mood to put the economy through the wringer to stop inflation, but he also agreed that guideposts deflected the government’s own macroeconomic responsibility onto the private sector. Nixon had briefly worked at the Office of Price Administration during World War II, and that experience had left him with the lasting impression that price controls not only produced inequities and shortages but also led to the abuse of government power.^{Footnote 80}

The expectations-augmented Phillips Curve offered a third approach to the wage-price dilemma. By pushing up the unemployment rate so that the economy was only slightly below full employment, expectations of inflation would subside, and the economy would eventually return to full employment at a lower, nonaccelerating rate of inflation with the free market left intact.^{Footnote 81} Nixon’s speechwriters came to label this approach “backboning.” Where jawboning amounted to the “government wagging a finger at business and labor to act with restraint while government acts without restraint,” backboning required the government to quite literally put its money where its mouth was: “Government setting an example of restraint by its own, admittedly unpopular, belt-tightening actions, thereby earning the right to call for others to follow that example.” Nixon thus pledged to do what Johnson had not: ensure that the government credibly demonstrated its own macroeconomic responsibility and established market incentives before calling on the private sector to exercise its own microeconomic restraint. ^{Footnote 82}

Unfortunately for Nixon’s gradualism, Federal Reserve Chairman Martin had learned from his mistaken easing of 1967–68 that it was necessary to prescribe an unambiguous posture of restraint to combat inflationary psychology. The Fed reduced the growth of the money supply from 7 percent in 1968 to only .7 percent in the second half of 1969, far below the gradual trend urged by the administration.^{Footnote 83} When Nixon took office, unemployment was 3.4 percent. By December 1970, it had reached a first-term peak of 6.1 percent, a situation uncomfortably reminiscent of the monetary-induced recession of the Eisenhower years. Furthering this parallel to the late 1950s, Keynesian economists, including Heller and Galbraith, again called for some form of incomes policy that would combat wage and price pressures directly and so allow monetary policy to provide relief in the face of recession.^{Footnote 84} In 1969, the Democratic Congress heeded these calls by passing legislation enabling the president to implement credit controls. When Nixon unsurprisingly declined to exercise this authority, Congress granted him the power to implement wage and price controls, a move intended as much to bolster the Democratic Party’s claims to possess an efficient program of disinflation as it was to stop inflation in actuality.^{Footnote 85}

Though Friedman urged Nixon to continue his gradual program of backboning, many on the right now accepted incomes policy as an alternative to recession. Arthur Burns, whom Nixon selected to replace Martin as Federal Reserve Chairman in January 1970, unexpectedly endorsed an incomes policy in his public speeches on the grounds that monetary policy could do little to stop cost-push inflation without inflicting politically unacceptable economic costs.^{Footnote 86} Even the businessmen who had previously been on the receiving end of Kennedy and Johnson’s jawboning conceded that government intervention was necessary to combat inflationary wage pressures. These executives described how union members with seniority and supplementary unemployment benefits would not be dissuaded from seeking higher wages except by the most serious of depressions. As firms could not voluntarily hold wages to the productivity trend, prices would have to follow wages to avoid a profits squeeze unless the government intervened.^{Footnote 87} As Nixon’s Treasury Secretary John Connally summarized the situation in late June 1971, “Businessmen think that we’ve given up on inflation, because we’re not putting in controls, wage controls.”^{Footnote 88}

According to Nixon’s memoirs, it was only when Connally spoke that the president realized that his political future required the abandonment of backboning in favor of the Keynesian combination of jawboning and macroeconomic expansion.^{Footnote 89} When misaligned real exchange rates, domestic inflation, and American monetary policy brought about the final collapse of Bretton Woods, Nixon and Connally seized upon this golden opportunity to implement a new approach to economic management. On August 15, 1971, Nixon imposed a three-month freeze on wages and prices, the start of almost three years of wage and price controls. Nixon also ended the ability of foreign governments to exchange their dollars for gold, largely removing the constraint of Bretton Woods on the pursuit full employment.

To make a long story short, Nixon’s controls failed to stop inflation. Even before spikes in food and fuel prices ruptured ceilings in 1973, Nixon and Burns had made the same mistake that Johnson had by allowing incomes policy to lower their guard against inflationary fiscal and monetary policies. Erroneously believing the natural rate of unemployment to be lower than its true value by several percentage points, efforts to reduce unemployment to a politically acceptable level resulted in the return of demand-pull pressures.^{Footnote 90} Yet even after Nixon’s controls faltered, veterans of the Kennedy and Johnson administrations continued to insist that an incomes policy —provided it stopped short of direct controls—was still the only alternative to the inflation-unemployment trade-off. In 1978, Arthur Okun, who a decade before had succeeded Ackley as Johnson’s final CEA chairman, estimated that a permanent reduction of inflation by one percentage point would require a sacrifice of 10 percentage points of GNP in the absence of “the direct influence of public policy on costs.” Charles Schultze, formerly Johnson’s director of the Bureau of the Budget during the debates on fiscal policy in the late 1960s and now Jimmy Carter’s CEA chairman, agreed that because cost-push pressures did not respond readily to economic slack, “government actions to deal with inflation must accept the existing degree of wage and price inflexibility as a difficult fact of life.”^{Footnote 91}

Responding to concerns about sacrifice in the face of inflation from Okun, Schultze, and other Keynesian veterans of the 1960s, in October 1978 Carter announced a new incomes policy, bearing the suspiciously similar designation of wage-price guidelines, to be overseen by the White House Council on Wage and Price Stability (COWPS). This agency had in fact been requested by Nixon as a successor agency to his controls in order to ensure “that Government have [sic] the information it needs to persuade labor and management to do their duty in the effort to reduce inflation.”^{Footnote 92} Gerald Ford had taken advantage of the brief honeymoon he enjoyed after Nixon’s resignation to win quick approval of this agency from Congress, although he himself would not utilize its powers beyond a handful of interactions with the steel industry and other traditional targets of incomes policies. The Carter administration expanded upon what was by then left of COWPS in order to monitor and enforce the guidelines, but once again, inopportune macroeconomic policy made wage and price restraint impossible to achieve. An expanding budget deficit for fiscal year 1980 led financial markets to build even higher expectations of inflation into interest rates, while the Federal Reserve consistently overshot its monetary target under Carter’s new chairman, G. William Miller.^{Footnote 93} Making a bad inflationary situation even worse, inflation again spiked into the double digits in response to the Second Oil Shock of 1979–80. By the end of 1980, even Schultze admitted that the only component of COWPS that had not outlived its usefulness was its mandate to review the costs of government regulation.^{Footnote 94}

The inflation that began on Johnson’s watch would only come to an end a decade and a half later, once policymakers abandoned their reliance on incomes policy in favor of concerted macroeconomic restraint. Disregarding Keynesian arguments about sacrifice and cost-push inflation, Federal Reserve Chairman Paul Volcker, who replaced Miller in July 1979, sought to create a credible expectation of disinflation. Volcker introduced a new monetary target for the Fed’s operations, with the result that interest rates rose to their highest levels in decades.^{Footnote 95} Keynesian economists complained loudly about the costs of Volcker’s disinflation program as he sent the economy into the double-dip recessions of the early 1980s, but just as Dwight Eisenhower had supported Martin’s course of monetary disinflation in the 1950s, so too would Volcker receive political cover from Ronald Reagan. On the campaign trail, Reagan denounced wage-price policy for shackling the free market while giving the government a free pass to spend recklessly, and once inaugurated, Reagan wasted little time in doing away with the vestiges of COWPS, declaring it a failure that “has been totally ineffective in controlling inflation.^{Footnote 96} Despite the widening federal deficit produced by the Reagan administration’s combination of tax cuts and defense spending, inflation had subsided by 1985 at only about a third of the cumulative loss of output predicted by Keynesians in the late 1970s.^{Footnote 97}