A Better Ending for Samuelson and Solow (1960)

 From mine of 12 November 2017. Text & graphs updated.

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In 1960, looking back on the latter 1950s, Samuelson and Solow wrote:

... just by the time that cost-push was becoming discredited as a theory of inflation, we ran into the rather puzzling phenomenon of the 1955-58 upward creep of prices, which seemed to take place in the last part of the period despite growing overcapacity, slack labor markets, slow real growth, and no apparent great buoyancy in over-all demand.

In the end, Samuelson and Solow could not reject the cost-push explanation:

We have concluded that it is not possible on the basis of a priori reasoning to reject either the demand-pull or cost-push hypothesis ...

Ten years later, Federal Reserve Chairman Arthur Burns was pointing to the increases in employee compensation as the driver of inflation. Robert Hetzel quotes from the Board of Governors Minutes for November 1970, that Burns thought in terms of "cost-push inflation generated by union demands."

Perhaps by 1970 union demands were driving inflation. But in the latter 1950s? In the latter 1950s it was finance, the rising cost of finance that was squeezing profits.

Growing financial cost got the inflation ball rolling. Union demands took the hit for it later, and perhaps rightly so. But union demands did not create the initial problem. The rising cost of finance got inflation started and kept it going until a wage-price spiral emerged.

For domestic corporate business, the cost of interest increased faster than did compensation of employees:

Graph #1: Interest Costs Increased Faster than Employee Compensation

Consider the 1955-1958 period, the years that concerned Samuelson and Solow. For every dollar corporations paid out as employee compensation in 1955, they paid out five cents for interest costs. By 1958 that number was seven cents. For every dollar of employee compensation they paid out, corporate business spent two cents more on interest in 1958 than in 1955. Financial costs gained on labor costs.

Financial costs also gained on profits:

Graph #2: Interest Costs Increased Faster than Corporate Profits

For domestic corporate business, financial costs increased faster than profits. Between 1955 and 1958, corporate interest costs rose from 14.9 cents to 26.8 cents per dollar of corporate profits: a 12-cent increase in interest costs, 12 cents for every dollar of profit.

If financial costs had grown more slowly, if they had grown at the same rate as profits, say, how would things have been different?

In 1955, interest paid by corporate business came to $7.3 billion, something less that 15% of profits. In 1958, interest paid came to $11.4 billion, almost 27% of profits. Other things unchanged, if interest paid in 1958 remained at the 1955 percentage, the cost of interest would have been $6.4 billion. That's $5 billion less than the actual 1958 cost of interest.

If this $5 billion expenditure had not happened, other things unchanged, corporate profits would have been $5 billion higher.

But I can't add that $5 billion to corporate profit, because it changes my interest-to-profit ratio. It changes the result of my calculation, and I don't know how to proceed. In order to work thru the calculation cleanly, I cannot add the $5 billion of interest savings to corporate profits, nor to any corporate spending category. The only way to dispose of the $5 billion is to reduce gross corporate revenue by reducing the price of corporate output.

In 1958, the gross value added (GVA) to the economy by corporate business amounted to $256.9 billion. If we reduce the price of GVA by $5 billion, the reduced number is $251.9 billion. The reduced GVA number is 98% of the original number. So, to make the calculation work we have to reduce the price of corporate output by 2%.

If corporate interest costs in 1958 remained in the same proportions as 1955, corporations could have reduced their prices by 2% without reducing their profits and without reducing the wages and benefits paid to their employees. Without reducing any of their spending, other than interest.

This is an exercise in "other things unchanged". Ceteris paribus. The assumption is not realistic. But the numbers tell an honest tale: The cost of interest increased faster than other corporate business costs, fast enough to push prices up 2% between 1955 and 1958.

This suggests a different conclusion for the Samuelson-Solow paper. It suggests financial-cost-push as the cause of the 1955-1958 inflation.