- Welcome once again as MIT Professor Paul Samuelson discusses the current economic scene. This series is produced by Instructional Dynamics Incorporated. This program was recorded December 20th. 

- This is the occasion for my annual outlook tape on what's going to happen to the American economy in 1974. A year ago, I had the same task to try to peer into the future and decide how the odds looked with respect to the American economy in 1973. It's worth a word or two at the beginning to go back to that time to see how things developed in 1973 and compare that with how they looked to be a year ago. At the turn of the year from 1972 to 1973, there was the usual fashionable forecast that the fashionable forecast was on the whole an optimistic one. It predicted a strong increase in money GNP. It looked forward to a continuation of substantial real growth not as rapidly as in 1972 itself, but more rapidly than is required just to keep up with the long term trend of the American economy. And that fashionable forecast was reasonably optimistic with respect to some abatement of the rate of price inflation. Indeed, it was in the backwash of that rather optimistic fashionable forecast that the Nixon economic team made the fateful decision on January 11th 1973 to suspend the phase two price controls. How did things shape up? In the event, we now know that the money GNP did increase strongly in 1973. The experts were right in that respect but they were not right for precisely the correct reasons because the experts all underestimated the degree of price inflation. They underestimated the degree of food price inflation in the first part of the year. These are supply and demand prices. They underestimated the amount of increase in industrial prices under the decontrol program as the phase two was gutted on January 11th. And the experts overestimated the rate of real GNP growth. This is very striking because within a couple of months, two to three months after the turn of the year, the more canny of the experts were changing their tune. And you could see the new fashionable forecast forming. And actually if we turn to the shading which had taken place by March from the January unmitigated optimism, it had moved in the following way. Namely, there was then by March came to be universal agreement among the fashionable forecasters, the experts, that there would be a growth rate slow down in real terms in the last half of the year. And as a matter of fact, they shifted their position just in time because just as they were shifting their position in the second quarter itself, the so-called growth recession already began to set in. So I would say that this has been a pretty good year for the experts. I was at a meeting just recently and they were all congratulating themselves on how closely they had hit the year. I was not quite as congratulatory to them as they were to themselves because there was after all that period from January to March before they really got the word of what was going to happen. Namely, that we would be moving into the growth recession sooner than before. Actually, there's a panel of 60 economists followed by the American Statistical Association and their median forecast has done pretty well over the years. It does as well as the random experts in the fashionable forecast. It does better than pure monetarism and it does better than non-judgmental computer forecasts, but perhaps not quite as well as the very best of the eclectic computer judgmental forecasters. Well, more interesting perhaps than the median figure given by the experts was a number which they collect which is the probability of a downturn two months ahead, four months ahead, and so forth. And already by the end of 1972, the probability of a downturn ahead was going up on the part of these experts. One of the reasons that the experts are complacent is that they give themselves the alibi that they couldn't have foreseen the increase in food prices and other prices. Well, if in the year when your price forecast turns out right, you take credit, then I would say those who take credit for the sun must be prepared to be blamed for the rain in some part. And so that is a defect of the forecasting art if price increases happen because of exogenous factors, harvests, and so forth, and if you aren't able to predict those, then you must admit that that is part of the imprecision of your forecasting ability. Let's turn from the past to what the outlook is ahead. And here, I think we should do it in two steps. We should begin with what the outlook was prior to the October war in the Mid East because once again there was forming a consensus, a clustering of the fashionable forecasters around a particular scenario. That scenario, you know very well. It was that 1974 was to be a year of growth recession. That the real output in 1974 was to grow positively. It was not to be a national bureau year of genuine recession, not even of the mini-recession type. But that positive rate of growth of real output in the four quarters of 1974 was to average out perhaps at 2% per year annual rate, 3% per year annual rate. Some of the fashionable forecasters might have said 1%. But within that range, you would capture most of their forecasts. They also forecast there would be some degree of inflation abatement so that instead of enjoying or suffering a 7% rate of increase in price inflation of the overall price index that's used as the GNP deflator which is what we did experience in '73. In '74, the optimists thought that we might go down to 5%, five and a half percent. There were a few optimists who even went down below that and a few optimists, and now I mean a few optimists with a good forecasting record, who thought that as far as the cost of living index is concerned, the improvement in the rate of inflation might be even more than that. You could begin to talk in some of the quarters in 1974 of 3% rate of increase in prices and not more than that. This growth recession did mean some lessening of the steam in the economic boiler. It would imply some upward climb in the rate of unemployment. But the unemployment rate which had gone down in the fall of this year just before the Mid East war to four and a half percent could stand a bit of climb in the view of lots of economists, particularly non-university business economists. They were concerned whether the natural rate of unemployment at which inflation would begin to accelerate was as low as four and a half percent. So they thought of us as being in an overheated economy, the result in part of stimulating the economy for an election year. And so they were prepared to suffer. Of course, they wouldn't be out of jobs, but they were prepared to suffer fairly cheerfully an increase in the unemployment rate from four and a half percent to four and three quarter percent, to 5%, to five and a quarter percent, five and a third percent. And they were only going to begin to worry about that unemployment rate if it seemed to threaten to go to five and a half percent and above five and a half percent. With respect to profits, there was some spread of opinion among the forecasters, but on the assumption that the decontrol program would be favored by the administration and politically, it would be acceptable. They had some optimism that profits would not fall off in this growth recession in any degree. Some of them had a very slight drop in profits. Some had profits level throughout the growth recession to be followed by a climb later. And some even had an increase in profits. I'm of course speaking of money profits. Those are the kind that the accountants let you report. As an afterthought, many analysts pointed out that those profits were swollen by inventory valuation upward adjustments due to the inflation itself. And so if you put everything on a reproduction cost basis including the cost of reproducing the machinery that was being depreciated during the year in order to produce the output on which you made a profit, then you would find that your real profits corrected for price inflation were by no means as rosy as the reported money profits. The dollar looked as if it was going to improve. The medicine of exchange rate devaluation (mumbling) that took place in February. The even stronger medicine more often applied of depreciation of the dollar relative to some key currencies which took place in February and in March on an official basis and which continued on a floating basis of pretty much of a clean float basis up until June meant that the dollar was becoming more comparative all the time. And although we were troubled by our rate of inflation here in this country in 1973 and in 1972, when we looked abroad, we realized that the rate of inflation abroad was even greater than here. And so more and more of our export industries felt that they were becoming competitive. A very good example, of course, a dramatic example is that of the compact car and the mini car in Detroit, the American Motors Company cars, the Ford Maverick, the Javelin, the Vega, the Pinto. These were holding fairly constant with respect to price at a time when Volkswagens were going up in price in part because of the depreciation of the dollar which meant the appreciation of the mark. The Toyota, the Datsun, the Mazda, the Honda, they too were going up in price. More than that, with food scarce all around the world with the United States having in Iowa on our commercial farms great comparative advantage in foodstuffs, we were finding ourselves with very ready markets and at high prices. You might say that what the Arabian countries are experiencing this year which is a very high price for their exports, we were experiencing early in the year for our foodstuffs. And therefore, there was a very nice comeback in our merchandise balance of payments, a comeback in our current balance of payments on current accounts including invisibles, net export surplus rising nicely. And the basic deficit which takes into account the fact that the United States became a pretty good place to buy into, to invest in, to buy land if you were Japanese, to buy stocks if you were from Western Europe. The basic deficit was also improving. And so one had reason to look forward to a continuation of this trend. All in all, since following periods of overly strong expansion, there tends to be some need for periods of relaxation the way we have to run our mixed economy these days. That was a fairly cheerful picture and although it didn't seem so cheerful to many of us who were making that forecast at the time, in retrospect, we look back with nostalgia upon it. Then came the Mid East War. The impact of the belligerency itself on the economics is not particularly notable. Obviously, that was a very intensely fought war. It meant that inventories of tanks and munitions were depleted on both sides so it meant some nice reorders for the Russians on the part of the oil liquid Arabians, those countries which had oil giving Egypt and Syria which didn't have oil the revenues to support them in that rearming. It meant to some degree for the U.S. repurchases either by the Israelis who were paying for it themselves out of their own resources or to the degree that we were making loans, or putting it in the cuff, or making gifts as the so-called aid program, it meant some increase for the defense business, but this is negligible. If you reckon the total of this in comparison with what is needed to change the business situation for 1974, the Mid East War as a war has no important macroeconomic repercussions on Western Europe, on Russia, or on the United States. But in the aftermath of the war, we did have developing the oil boycott. The OPEC Monopoly of 1216 leading oil producers primarily in the Persian Gulf but not all of them Arabian was already flexing its muscles and increasing prices all the time. There was squeeze play on. Typical monopoly operation. And isolating each of the big consuming countries, some of which were very dependent upon Mid East oil. I'm thinking of Western Europe and Japan in particular. The monopolist was able to strike some very sharp bargains. From the standpoint of the monopolist and from the standpoint of the non-Arabian countries, the war was a godsend because it enabled a vast increase in the price of oil. And so the whole outlook has changed. If we are to have for as long as say half a year of 1974 a shortfall in oil from the Mid East which by the President's reckoning will be in the order of magnitude of 17% of our oil needs. Let's say three million barrels per day out of an 18 million barrels per day needed. Then all of the fashionable forecasters began to go back to their computers, began to recompute the picture and they were able to find that we went from a likely growth recession with minority odds for a genuine recession in which you had at least two quarters of drop in real output to the odds favoring that real recession. And so I have to say that premised upon that prudent man's view with respect to energy that 1974 is going to be a year of genuine recession. The first half of the year is going to be weak. That output is going to decline for the first half of the year. The unemployement, if it was previously going to grow to five and a third percent, perhaps five and a half percent, then I have to go along with the fashionable forecasters who think that by the end of 1974, we'll be talking about 6% unemployment. In the case of some forecasters, even more. Now, I'm going to qualify this if proposition about energy in a moment, but let's stick with it because I think a prudent man must do so in the absence of knowledge to the contrary. This means for the year 1974, stagflation with a vengeance because instead of there being an abatement of the rate of price inflation, whatever abatement there may tend to be with respect to foodstuffs, whatever abatement there would tend to be with respect to international metals because Europe is going to be in a growth recession or now with an energy cut off to her too and I'll include Japan in this. She's going to move into a more genuine recessions. Whatever abatement you could have expected on the rate of inflation from those factors is going to be much more than outweighed by the increase in the cost of energy itself which is dramatic. Many of my listeners will have known that just a week ago, 86 million barrels of oil were sold at auction by Iran not at the one dollar and two dollar price per barrel which was typical of just a couple of years ago, not at the three and four dollar per barrel which are typical of what's going on now, but at the 16 dollars a barrel and for low sulfur oil, for as much as 17 dollars and 40 cents a barrel. The part of the country where I am, we're beginning now to get the fuel bills which have gone up from 20 cents to 40 cents a unit. And the end is not yet. So when you take into account the energy induced shortages. I just saw a large tire company. I saw a letter to their suppliers speaking of a 26% increase in the price of tires by the spring. I make that out to be an annual rate of 100%. There is no way of reckoning all these matters without having for the first half of the year a horrendous increase in the annual rate of the cost of living index. In fact, everybody should begin to talk about the GNP deflator because that won't show quite such horrendous figures. And so we're now talking about stagflation. On this basis, a drop in profits is implied year over year. A drop in profits is implied from the fourth quarter of this year where we are now to the fourth quarter of next year even though that may be followed, according to the most fashionable forecast, by an increase in profits from say the fourth quarter of a year from now to the middle of 1975. I've looked at a round up of the conventional wisdom and it's amazing how a monetarist economist who does detailed forecasting has a figure which is just like that of a Keynesian economist. The different consulting firms, the Wharton School model, they all show pretty much a similar picture. And therefore, in summary, that is the single most likely picture. However, more valuable than having a particular number is to have a probability spread. And so I must call your attention to something very important. If you've read the London Economist this last week as I'm speaking, you will have been alerted to the fact that there may be an element of charade going on in the oil boycott. If you calculate how many tankers have been loaded in the last weeks of the boycott from the Persian Gulf on their way to Western Europe, to Japan, to the United States, then you would expect a tremendous shortfall from an earlier period or from what could have been expected from this period. And yet when the alert journalist of the London Economist did their numerical exercise, they found that not to be the case. I heard from a well-placed journalist with respect to Japan that he couldn't understand how the flow of oil was still continuing there in view of the tough talk of the Arabian nations and in view of the cries of pain by the Japanese government and the Japanese public. He still couldn't see it in the actual tangible statistics. Even Holland which is being made the special victim of a power play of diplomacy seems to have in Rotterdam pretty good inventories. A bank economist in the Midwest took a poll of the customers of his bank and not one of them had yet suffered from any energy shortage. And only one out of a fairly considerable number had legitimate grounds, tangible grounds for concern for the months ahead. So the conventional wisdom is beginning to think the three million barrels per day is not the correct number, the 17% number. The oil foundation research unit put the number down from three and a half million per day to two and a half million per day. And so we're getting a revisionist viewpoint. Moreover, the whole point of this is for the purpose of resting concessions from Israel. The only way to get those concessions from Israel is to put pressure on the United States to put pressure on Israel because Israel needs the munitions to maintain her security. And so if there seems to be some semblance of successful pressure on the United States and for this purpose, you know, the threat of an oil boycott, a Potemkin oil boycott, an unreal one may be as effective in terms of public relations as a real one. If there's effective pressure on Europe and Japan to put effective pressure on the United States to put effective pressure on Israel to make concessions. And if the Russians are able to put some kind of effective pressure on the Arabians to seem to be going along with the concessions, and we don't know what the Russian interest is whether their interest is in making trouble here. The fact that we have detente going doesn't mean a thing in terms of you're being able to predict what's going to happen. I may also say nobody has the slightest reason to know whether some concessions made by Israel will in fact in any degree satiate the desires of the Arabian countries. Henry Kissinger doesn't know that. He cannot know that. And I'm not sure the powers that be in the principle Arab countries are in a position to know that. Nevertheless, it's possible that having flexed the muscles of the monopoly that there will be a letting up of the embargo and then the stage is set actually for a rather unagonizing reappraisal of optimism, and you could have a lot of tinder around for an overheating of the economy, and an expansion, and for further price rise, and I may also say for stock market boom. But now, since my time is short, let me say that given the oil embargo picture, you must expect that long term interest rates will not come down very much. Housing starts being hard hit by the energy shortage for reasons I needn't detail in this annual survey will mean that mortgage rates will go down some as a result of determined federal reserve and housing agency actions. Corporate bond rates will not go down as much and so if you talk about 50 basis points on the long term rate between now and say the average of next year, you may be talking about all that you can get in the long term sector. In the short term sector in the face of this stagflation, the flation part, I don't see how you can get more than 100, 150 basis points reduction. You certainly are not going to get down to 4% and to 5% in my judgment. With respect to housing, the permits picture looks bad. There's a backup of units to be sold. People don't know where they've got the heating connection if they start to build a house. And so I think we have to be prepared that housing will fall off unless it is given special support. Given the energy shortage, I see no alternative but for the government to be accommodating. The Federal Reserve, I think, will have a countercyclical increase in the supply of money given that assumption. And this, they will be uncomfortable about because it will be in the face of rather horrendous price news. However, six months ahead if we're now talking about the middle of the year, unless you think of the embargo as permanent and I've seen no responsible persons who have been making policy on that basis and I reproached ourselves for that lack. The general picture should begin ahead to look more cheerful. The unemployment rate will be worse but the last half of '74 looks to be better and the conventional wisdom for whatever it is worth looking a year and a half ahead would think that we will be on the upswing again from the middle of next year to the middle of 1975. And this means that the stock market which always tries to discount ahead. Some people say it over discounts matters ahead will before that event actually comes into immediate view will already begin to act upon it. Now, I guess I should tell you if I'm going to be wrong in this general round up of forecasts in which direction I think I'm most likely to be wrong in. I think that we may all be too pessimistic rather than not pessimistic enough. It's part of the elevating of our consciousness with respect to the energy shortage. Even with the boycott being genuine, if the problem is handled at all well in Washington, there are lots of improvisations which can be made and there's a lot of good will on the part of the public which have nothing to do with price which will ration things out. Actually, we've already begun to see in the statistics of energy use some tremendously encouraging amounts of economizing. The trouble is it's like reducing. It's very easy for anybody to reduce for a short time but without the price incentive, it will be very hard to keep patriotism and social solidarity working. In short, the mixed economy is still in a healthy state. We can look forward over the '70s to a satisfactory rate of growth. Undoubtedly, we live in an age of creeping inflation and there is no solution in sight to the unemployment inflation trade off problem. Undoubtedly, we're moving into an epoch where energy is going to be dear. One prediction I can make with great confidence. There will be shortage of economic problems in the year ahead. 

- If you have any comments or questions for Professor Samuelson, address them to Instructional Dynamics Incorporated, 166 East Superior Street, Chicago, Illinois, 60611.