The significance of the distinction between what is inside the parentheses of the z function and what are listed as constraints can be expressed as follows: The variables in parentheses can vary over some range; and, given the policymaker's rough notions about the nature of the function, he can seek very approximately to maximize welfare by seeking to change the values for these "target variables." His freedom to do so is limited by the constraints. These play a negative or restraining role. The policymaker is not free to vary these elements to any significant degree as he seeks to increase his conception of social welfare.

This way of looking at things permits us to differentiate among our aggregative goals. One can say that employment and growth are positive goals. Both can vary over some range, and economic policy can seek to change them so as to increase some notion of economic welfare. Welfare will be increased as the unemployment rate is reduced and as the rate of growth of output is accelerated. Welfare is also related to the rate or change in prices, but in a complex way, and the nature of this relationship throws some light, I think, on the different ways the employment and growth goals have been pursued in various European countries and the United States.

First of all, virtually all governments and the vast majority of their citizens place some positive value on a stable price level, and a movement in the price level either upward or downward presumably detracts from welfare as viewed by the policymaker. But I should like to submit that this relatiouship, taken by itself, is a relatively weak one. Within a considerable range, variation in the price level in and of itself is not considered to have an important effect on economic welfare. Germany is perhaps an exception to this generalization. Price stability is important, but it is important chiefly as a constraint and as a constraint at two different levels. To understand this, we have to look at the entire set of constraints listed in connection with our welfare function, beginning with that for the balance of payments.8

AGGREGATIVE GOALS AS CONSTRAINTS

We expressed the balance-of-payments constraint as:

=k±e A

This states the condition that the percentage change in international monetary reserves should be equal to k plus or minus a margin of error, e. The value of k might be zero. In this case, no change in the stock of monetary reserves is desired, and any change in excess of e requires compensatory action.

In terms of our social welfare function, what does it mean to say that the balance-of-payments objective should be viewed as a constraint? For simplicity, let us take just two of our other goals-employment and growth-and write the welfare function

U

Let us assume now that the constraint is in danger of being violated through disequilibrium in the balance of payments. The overriding need to stay within the limits of the constraint means that and Y cease to provide the same guide to policy as before. Steps will be taken to preserve or restore equilibrium even if the needed action has an effect on unemployment and growth that, taken by itself, would reduce welfare.

Notions as to how welfare is related to changes in these target variables depends on: (1) One's value judgments; and (2) one's understanding of how each target variable is related to other variables-both the other target variables and other variables not included in the welfare function that represent costs or benefits to society. The term "target variable" is borrowed from Tinbergen.

For a similar distinction between full employment as a "final objective" and price stability and balanceof-payments equilibrium as "means-to-end objectives," see C. Weststrate, "Economic Policy in Practice: The Netherlands," 1950-57 (Leiden, H. E. Stenfert Kroese, 1959), esp. pages 7-8.

U

Paradoxically, one or more of the variables inside the parentheses of our welfare function may now themselves become constraints. Assume that the steps that would ordinarily be taken to reduce the external deficit would also being about a substantial increase in unemployment. But the policymaker's welfare function may imply an absolute ceiling on the unemployment rate. We have expressed this in our list of constraints as <q, where q is the maximum rate of unemployment that would be tolerated. In more usual terms, it may be considered "politically impossible" to permit the unemployment rate to rise above, say, 5 percent even for a short period, regardless of the consequences for the balance of payments. In this case the conflict of the two constraints would lead to unusual steps, depending on the circumstances-from emergency arrangements for international credits to, as a last resort, currency devaluation.

This is a fair approximation of the way these constraints have operated in Europe in the last decade. Various European countries, particularly those for whom foreign trade is particularly important, have been forced from time to time to sacrifice some employment and growth because of the balance-of-payments constraint. But they have been willing to do this only so long as the steps needed to restore external equilibrium did not force unemployment above what was considered politically tolerable. This upper limit on unemployment in Europe has clearly been much lower than in the United States."

Let us now look at the way in which price stability operates as a constraint. I think it is fair to say that the goal of price stability influences policy in three different ways, all of which are represented in the symbols presented earlier.

1. A modest positive value is attached to price stability for its own sake. Hence we have included the rate of change in the price level within the parentheses of our welfare function, the assumption being that welfare is inversely related to the absolute rate of change in the price level.10 But I am prepared to argue that, in both Europe and the United States, the independent link between domestic price stability and social welfare is relatively weak. Within a wide range of price variation and apart from the balance-of-payments problem, no Western European government would be prepared to sacrifice any significant degree of employment or growth in order to reduce the rate of change in the price level." On the whole, I think this has been true in the United States, also. The emphasis on price stability in the United States in recent years is associated with the balance-of-payments problem, and to this relationship we now turn. 2. We now come to the second and most important way in which price stability influences policy. This is through its importance as an instrument to achieve balance-of-payments equilibrium. In serving in this capacity, price stability is viewed not as making a positive, independent contribution to welfare in its own right. Instead, it is viewed as a constraint. In this case, it is a constraint of the second order, which is required if the first-order constraint, balance-ofpayments equilibrium, is to be observed.

When we think of price stability as playing this role, the relevant target is not stability in the domestic price level but some desired relationship between the domestic price level and that of the country's chief trading partners-between, to put it roughly, domestic and foreign price levels.

Cf. Walter S. Salant et al.. "The United States Balance of Payments in 1968" (Washington, the Brookings Institution, 1963) for a good discussion of the role of the balance-ofpayments constraint on both sides of the Atlantic.

io This, for example, is the position taken in William Fellner et al., "The Problem of Rising Prices" (Paris, OECD, 1961). It might be argued that the prevailing view in most countries, particularly among those groups with some influence on policy, is that the optimum rate of change in the price level is not zero but some positive number; say, 1 or 2 percent per year because the moderate stimulus thus provided to economic activity more than offsets, in its effects on welfare, the redistributional effects which benefit debtors at the expense of creditors and those on fixed incomes. Contrast this view with the unqualified declaration that "rising prices are not compatible with steady growth" in Fellner et al., op. cit., p. 75. Among economists, Neil Jacoby may be correct that the prevailing view seems to be that "creeping inflation *** is in the long run a drag upon national progress, and that it is both feasible and desirable to prevent its occurrence." S. S. Alexander et al., "Economics and the Policy Maker" (Washington, the Brookings Institution. 1959), p. 48; also the references on p. 49. But a number of economists have expressed the contrary view.

11 Germany seems to be a partial exception. The official emphasis on price stability in that country is well known. and it is probably true, as Herr Erhard declared in his 1963 economic report to the Reichstag, that some economic growth would be sacrificed in the interest of greater price stability, apart from balance-of-payments considerations. But my own observations lead me to doubt that it would be considered politically possible to permit the unemployment rate to rise much above, say, 2 percent in order to slow down the rise in prices. This was admitted to me by more than one German official. But, subject to this qualification, it is undoubtedly true that German policy attaches greater positive value to price stability than is the case in other European countries.

that is, the difference between the rate of change in the domestic and foreign price levels should not exceed an amount m-plus or minus, in the short-run, a margin of error, f. Obviously this constraint does not require a stable price level. If P, is rising rapidly, Pa may also rise rapidly. All that is required is P P

that Pa rise at a rate no greater than ·+m. The difference, m, can, of course, be zero or negative. It has been a fundamental tenet of American policy in recent years that m should be negative. The rise in the American price level must be kept below that of the European in order to improve our competitive position and so eventually restore balance-of-payments equilibrium.

Most of the countries in Western Europe have been able to permit their domestic price levels to rise moderately rapidly, since for each of them P, was also rising and thus m could be kept close to zero. The German revaluation in 1961 represents an exception. The German balance-of-payments surplus might have been eliminated by taking m as a significant positive figure-that is, by encouraging the domestic price level to rise faster than in other countries. Instead, the mark was revalued upward.

3. Now we come to the third way in which the behavior of the price level influences policy. There is some upper limit to the rise in the price level beyond which the functioning of the economy is impaired through speculation, the development of politically disturbing inequities in the distribution of wealth and income, and the beginnings of a "flight from the currency." This is the rationale usually offered, over and above that involving the balance of payments, for seeking to maintain a stable price level. Germany is the country in which presumably this rationale operates most strongly to influence policy. I expressed this constraint in the form'

I suggest that n has a much higher value than is generally assumed, and no country in Western Europe has come close to it in the last decade. Several South American countries have exceeded it. My guess is that n is large enough so that it has, in fact, not been a restraining influence on policy in Europe or the United States in the last decade. And I include Germany in this generalization, despite the numerous official pronouncements that may suggest the contrary.

I might put the matter in another way. Whatever the value of n, it is a powerful constraint if and when it is brought into operation. The governments of the advanced economies on both sides of the Atlantic would feel obliged to make substantial sacrifices in terms of both employment and growth if they thought that inflation threatened to get out of control (apart from balance-ofpayments difficulties) and that deflationary policies were necessary to prevent the rise in prices from exceeding their estimate of n. It is clear, however, that this has not happened.

Let me try to summarize. During the last decade, price stability as an aggregative goal has operated primarily as what we have called a "second-order constraint," as a constraint imposed by the need to satisfy the primary balanceof-payments constraint.. As a result, the goal in fact has taken the form not of stability of the domestic price level but of approximate constancy in the relation between domestic and foreign price levels. Stability in the domestic price level itself has entered positively-but rather weakly-into policymakers' welfare functions. This accounts for the official statements frequently heard that the domestic price level should not rise more than, say, 2 percent per year. But it is fair to say that no Western European government-not even Germany-would be prepared to sacrifice much if any employment to bring the rise in prices down from 4 or 3 percent per annum to 2 percent if not forced to do so by the balanceof-payments constraint."

12 A qualification is needed here. If overfull employment existed, a government would be prepared to permit a modest rise in unemployment in order to restrain the rise in prices. The labor market could be so tight that a slight rise in unemployment would be considered as adding to rather than subtracting from total welfare. This has in fact been the case recently in Germany and some other European countries.

Let us now turn to "incomes policy," which I can deal with here only very briefly. "Incomes policy" is a polite way of referring to a policy of wage re straint with a quid pro quo-the latter taking the form of some restraint on other incomes, particularly profits. In terms of my welfare formulation, we have here a negative constraint of the third order: wage restraint is needed to meet the price constraint which is a condition for satisfaction of the balance-of-payments constraint. As the OECD has put it, "The purpose of incomes policies is to control the development of costs and prices."

13

Emphasis on incomes policy is a relatively new development in Europe." It can be said to have been paralleled in the United States by the formulation of the "wage-price guideposts" in the January 1962 Economic Report of the President. The new emphasis on wage restraint reflects the growing inflationary pressures in most European countries and the search for methods of price restraint-from the side of costs-that would not entail the threat to the employment and growth goals that would come from relying only on restriction of aggregate demand through monetary and fiscal policy.

It is clear from the continued upward pressure of prices in most European countries that incomes policy has thus far not provided a very effective constraint. No country has succeeded in keeping wages from rising faster than productivity. Indeed, whatever the official statements, no government has in fact tried to enforce such a stringent requirement. We must remember that an incomes policy is merely a means to a means to an end. If rising prices abroad permit prices at home to rise without balance-of-payments difficulties, then there is no need to keep wage increases strictly in line with productivity increases. It will be remembered that we wrote our expression for the incomes goal as:

If foreign prices are rising, wages can rise faster than productivity, subject to whatever differential (m) between the trends in domestic and foreign prices the government wants to maintain. It has been the hope of the American Government that this country could maintain a negative m virtually as large as the rate of increase in foreign prices so as to improve our competitive position. This does imply holding wage increases down to the rise in average labor productivity. Growing balance-of-payments difficulties in the last couple of years have forced some European countries to try to reduce the value of m to zero or lower-and it is in this recent period that the emphasis on incomes policy has developed.15

Some countries, notably the Netherlands, have consciously had and tried to enforce an incomes policy during some part of the postwar period." The term is not officially used in the United States; but, as we have already noted, the "wage-price guideposts," formulated in the January 1962 Economic Report of the President, amount in effect to the statement of an incomes policy. These guidelines have been repeated in subsequent Economic Reports.

In one important respect, incomes policy stands on a different footing from our other aggregative policies. In economies which emphasize free collective bargaining, the means may not exist effectively to implement the policy. In the absence of centralized wage bargaining on a national scale, with some direct influence by government, an incomes policy, is merely-as it has been charac terized by the Council of Economic Advisers-a set of guideposts. But, as an OECD report has put it, "Once the guidance has been given, the problem is to get people to follow it, and to do so without damage to democratic values. Many governments have moved very cautiously on incomes policy because of their

13 "Policies for Economic Growth" (Paris, OECD, 1962), p. 38. 14 The need for a national wages policy was strongly recommended to OECD countries in William Fellner et al., "The Problem of Rising Prices"; see particularly pp. 55 ff. See also the OECD report which followed: "Policies for Price Stability" (Paris, OECD, 1962), especially pp. 23-47. The Netherlands is one country which consciously had and imple mented a national wage policy from the end of World War II. Cf. "The Problem of Rising Prices," pp. 359-390.

15 While it is correct to say, as I have done, that there has been a new emphasis on the need for an incomes policy in recent years, recognition of the need for wage restraint under conditions of full employment and concern about the "cost-push" aspect of inflation go back to the early postwar years. It is still interesting, in this connection, to reread the Swedish debate in Ralph Turvey, ed., "Wages Policy Under Full Employment" (London: William Hodge, 1952).

10 See, for example, OECD, "Policies for Price Stability," especially pp. 23 ff.

17 It is paradoxical that the Dutch policy of wage restraint, which had considerable success during most of the postwar period, has recently run into serious difficulties. Cf. The Economist, Mar. 28, 1964, pp.

1273-1274.

awareness of the difficulty of securing the necessary cooperation, and of the embarrassing situation which arises if they offer specific guidance which is then rejected." This is true on both sides of the Atlantic."

RAPID GROWTH AS A GOAL

We now come to what we may call our two positive aggregative goals-full employment and rapid economic growth. Limitations of space preclude more than very brief reference to the goal of rapid economic growth." It is not surprising that economic growth should be stressed more in Europe than in the United States. Here again a ratchet effect has been at work. Initial success in generating rapid, sustained growth has led to firm resolves not to permit relapses into relative stagnation-although it is recognized that some of the spectacular growth rates of the past decade cannot be maintained indefinitely."

The new emphasis on growth in the United Kingdom, reflected in the establishment of the National Economic Development Council in early 1962, represents an interesting example of a conscious reformulation of the way national welfare is related to our aggregative target variables. A new emphasis is now put on growth, and an incomes policy has been officially formulated for the first time." Parallel with these restatements of policy objectives has gone an interesting reexamination of the probable relationships among the target variables. The balance-of-payments constraint remains unchallenged, and the price constraint continues as a means of insuring external balance. But there is a new emphasis on achieving relative price stability by accelerating the increase in productivity through stimulating economic growth." This in turn implies the need for an incomes policy to hold wage increases in line with the rise in productivity. Otherwise the balance-of-payments constraint will from time to time require restrictive measures that will retard or halt growth and increase unemployment.24

A good many economists argue that a similar shift in emphasis is called for in the United States-that measures to accelerate growth (and simultaneously reduce unemployment) would accelerate the rise in productivity and thereby reduce the upward pressure on prices. It is also argued that accelerated growth would significantly reduce the outflow of capital. Here again, however, the balance-of-payments constraint requires the existence of a reasonably effective incomes policy-i.e., a policy of wage restraint."

EMPLOYMENT TARGETS IN EUROPE

Now, at long last, we come to employment policy and the target goal of full employment. We have already commented on the marked contrast between Western Europe and the United States with respect to both aspiration levels and success in achieving these levels. European countries set their full em

18 "Policies for Price Stability," p. 35.

19 The following is of interest in this connection. In Sweden in 1963, "the authorities contemplate neither direct intervention in wage negotiations nor the issue of recommendations as to the sort of wage increases compatible with price stability. This attitude is based partly on general political principles. But it is also felt that any official guidance as to the general scope for wage increases would tend to be regarded not as averages, but as minimums to which special claims from individual groups would be added." "Economic Surveys by the OECD: Sweden" (Paris, OECD, April 1963), pp. 17-18.

20 Cf. OECD, "Policies for Economic Growth." The Netherlands seems not to have had as clearly defined a growth policy as most of the other OECD countries in Europe. Cf. "Economic Surveys by the OECD: Netherlands" (Paris, OECD, April 1963). For a useful brief survey of long-term plans in Western Europe, which by now is not completely up to date, see Economic Bulletin for Europe, vol. 14 (November 1962), published by the U.N. For a useful survey of postwar growth trends and policies, see Angus Maddison, "Economic Growth in the West" (New York, 20th Century Fund, 1964).

Cf. National Economic Development Council, "Growth of the United Kingdom Economy to 1966" (London, H.M.S. Office, 1963) and "Conditions Favorable to Faster Growth" (London, H.M.S. Office, 1963); also "Incomes Policy: The Next Step" (Cmd. 1626, London, H.M.S. Office, 1962). See also "Economic Surveys by the OECD: United Kingdom (Paris, OECD, July 1963). This change in emphasis is said to have begun with proposals put forward in Parliament by Selwyn Lloyd in 1961. See British Parliamentary Debates (Hansard): House of Commons, 5th series, vol. 645, July 24-Aug. 4, 1961 (London, H.M.S. Office, 1961), pp. 218 ff. Another interesting case of a shift in the priorities attached to the various aggregative goals is to be found in Belgium. Increased emphasis was put on the employment goal from the midfifties on, and in the late fifties a new importance came to be attached to the growth objective.

23 Cf. "Conditions Favorable to Faster Growth," p. 47.

24 Ibid., pp. 50-51.

For a useful survey of this range of issues, see Walter S. Salant et al., "The United States Balance of Payments in 1968," especially ch. IX.