0 Reserves - = I~R <0 monetary and fiscal policies. It contrasts in this respect with the "conflict" case reflecting imported inflation or deflation. The evidence of the present very simple test does not make it possible to generalize on the relative importance of the two cases, except perhaps that conflict seems to be more frequent for developed countries within this sample and period. The data are quite unambiguous, however, in demonstrating that conflict cases are in no way exceptional for the countries and the period of the sample. It can be shown, moreover, that the frequency of policy conflict is likely to mount the closer countries come to success in their attempts at maintaining overall equilibrium. The simultaneous attainment of full employment and payments balance is likely to be a relatively infrequent event. But if either is achieved, anything then done to reach the second will tend to undo the first. Since the interest target is preferable in conflict situations, evolution toward greater world stability, as well, of course, as toward greater international mobility of capital, will strengthen the case for the interest strategy. APPENDIX Sources of Data International Financial Statistics, International Monetary Fund; Yearbook of National Income Statistics, United Nations; various country sources. S PAGENO="0051" 47 Quantity Theory and Quantity Policy 279 Selection of Data Countries were selected exclusively on the basis of availability of data, the most restrictive criterion being interest rates. The period beginning in 1959 appeared optimal in view of the desirability of disposing of five years' prior price data without disturbances going back to the Korea period. Data for the five years 1959-1963 were pooled, providing a total of 215 observations. Adjustments Income data represent GNP in all but a few cases where NNP or national income only were available. GNP was estimated in these cases. Per capita income was stated in logarithms, to minimize the effect of extreme values. Alternative experiments with a linear form gave somewhat inferior results. Per capita incomes were converted into dollars and were adjusted by a purchasing power factor, derived from Paul Rosenstein-Rodan, "International Aid for Under- developed Countries," Review of Economics and Statistics, May 1961, pp. 107-138. In cases of multiple exchange rates, the highest official rate was used except where this was clearly unrealistic. Experiments without the purchasing power adjustment gave some- what inferior results. Money and all its components as well as claims on the private sector and total assets of the banking system were taken from IFS, freely translating "quasi-money" as "time deposits." The heterogene- ity of these data probably is higher than of the national income accounts, reflecting the differences in national monetary institutions. Omission from M2 of important intermediaries, such as savings and loan associations in the United States, following domestic practice, is a serious shortcoming. Money supply was taken as of the end of the year to reduce feedback upon per capita income. The per capita income variable was not lagged because in an inflationary situation this would lead to severe distortions. Price changes represent average annual changes for the five years preceding the date of the dependent variable, as a proxy for "in- flationary climate." Contemporaneous price changes, aside from being very unstable, are likely to be significantly affected by feed- back from changes in money supply. The cost of living index was used wherever available. PAGENO="0052" 48 280 HENRY C. WALLICH Interest rates are government bond rates wherever available; in a few cases discount rates or call money rates had to be used. Since the effect of inflation on money/income ratios is separately accounted for, its linear influence on interest rates was removed, providing an approximation to a "real" interest rate. A one-year lag was employed to reduce the feedback of money on interest rates. Countries Australia Germany Peru Austria Greece Philippines Belgium Iceland Portugal Brazil India South Africa Burma Ireland Sweden Canada Israel Switzerland Ceylon Japan Syria Chile Korea Thailand China Mexico Turkey Colombia Netherlands United Arab Republic Denmark New Zealand United Kingdom Ecuador Nicaragua United States of America El Salvador Norway Uruguay Finland Pakistan Venezuela France PAGENO="0053" 49 Chairman PRox~iniE. Thank you, Mr. Wallich. I want to commend all three of you gentlemen for a superlative performance. I am sure you understand that, for Members of Congress, this is not an area in which we are expert. Some of us know a little bit about it, some of us know a little less. But you have certainly given us, I think, a won- derful picture of the tremendous complications involved here and some very helpful caveats. I might point out here that although all of us have the greatest re- spect, approaching almost reverence for Henry Reuss, he is a very fine person and a kind of expert in these areas, lie did not set forth the view of the committee when he set forth the seven exceptions. That was his idea, not ours. The committee's position is without these ex- ceptions. I would agree with you that if you ran these exceptions, as Governor Maisel and Congressman Reuss would advise us, you might as well throw the whole thing out. You do not have any rule at all, just ex- ceptions that give the Federal Reserve Board discretion to operate as they wish. I would like to call your attention to what you gentlemen who `have indicated are, `after all, mistakes, and your assurance we are not going to make mistakes `like that in the future. Since 1960 or so, the Federal Reserve Board has made what appear to be, in hindsight, three very serious and conspicuous mistakes. In the period of 1962, at `a time when `we had relatively low economic activity and relatively high un- employment, the Federal Reserve Board increased the money supply almost not a't all. It was almost stable. I am looking now `at the mohey credit and security market section on page 29 of the April 1968 Economic Indicators. (Page of Economic Indicators referred to follows:) PAGENO="0054" 50 MONEY, CREDIT, AND SECURITY MARKETS MONEY SUPPLY The seasonally adjusted money supply rose $0.9 billion in Mardi after remcsirting unchanged in February. Time deposits increased $1.6 billion, slightly more thon the February increase. [Averages of daily figures, billions of dollars] Period Money supply Cur- Dc- rency snand Total out- de- banks poSits I! St ~ do. posits i Total oney supply Cur- D - rency d out- d banks posits ~U.S. Time em- do- nsent posits I demand ~ 1962: Dee 1963: Dec 1964: Dec 1965: Dec 1966: Dec 1967: Dee 1967: Feb Mar Apr May June July Aug Sept Oct Nov Dee J. 1968: Jan... Feb Mar e Seasonally adjusted Unadjuste d 147.4 153.0 159.3 166.8 170.4 181.5 171.5 i73. 1 172. 7 174. 5 176. 2 177. 9 179. 1 179. 2 180.3 181.2 181. 5 182.5 182.5 183. 4 30.0 32.5 34. 2 36.3 38.3 40.4 38. 7 38.9 39. 1 39.2 39.3 39.5 39.6 39.8 36.9 40.0 40. 4 40.5 40.7 41. 1 116.8 120.5 325. 1 330.5 332.1 141.1 132.8 334.2 133. 6 135. 3 136.8 138.4 139.6 136. 5 140.3 141.2 141. 1 141.9 141.8 142. 3 97.8 112.2 126.6 146.9 158. 6 1S3.S 163. 5 166. 1 16S. 1 170.0 172. 4 174. 6 177. 2 178. 9 180.8 182.5 183. 8 183.7 185.0 186. 6 151.6 157.3 164. 0 172. 0 175. S 167.2 370. 6 171.9 173. 6 171. 1 174.3 175.8 175. 9 178. 4 180.6 182.5 187. 2 187.8 181.5 182. 1 31.2 33.1 35. 0 37. 1 39. 1 41.2 IS. 3 39. 5 36. 7 3S. 9 36. 3 39. 6 36. 6 36.8 40.0 40.4 41. 2 40.5 40.3 40. 7 120.3 96.7 5.6 124.1 111.0 5.1 125. 1 125. 2 5.5 134. 9 145. 2 4. 6 136. 7 156.9 3.4 146.0 161.5 5.0 132.3 164. 0 5.0 133.4 166.7 4.9 134. 9 1GS. S 4. S 132. 2 170.8 6. 5 135. 1 173. 0 3. 0 136. 2 175. 1 1. 6 136. 2 177. 7 4. 3 138. 6 178. 9 1. 0 140.6 180.3 6.2 142.1 181.1 5.2 146. 0 181. 8 . 5. 0 147.3 183.5 4.9 141.3 185.5 7.2 141. 4 167. 4 6. 7 Deposits at aU coaoesseoois( baaks. Data tsoiude A(soku osd lOoses. Nosz.-Effeottse Jose 5. 1(66. bo(a000s ooouoouloted Coo psyrrost of ersoost Source: llcsed of Gcrcs:sro c tIe l66eee.f Reesose Syoe. loans (about $1.1 billion) see esoludeot loom tine deposits sod loose (ours at alt oeaoesooois( busks. 29 Ohairman PROXMmE. Then, later on, in 1965, and there was a ra.pid increase in the money supply and this coincided with a. whole series of great stimulating elements in the economy, as you reca.ll. It was in the beginning of the Vietnam escalation, there were two massive tax reduc- tions, an unprecedented record of business investment in pla.nt a.nd equipment, `so that the money supply increased at a time when the economy was expanding rapidly. Perhaps the most conspicuous example of what seems to be in error is what happened last year when we seemed to be suffering from serious PAGENO="0055" 51 inflation and during one point, the Federal Reserve pumped money into the economy at an annual rate of 10 or 11 percent. In hindsight, it seems we would have been far better off to have followed the prescription the Joint Economic Committee, as a com- mittee, recommended, that we fall within the band of 3 to 5 percent or so, or 2 to 4, depending on whether you are a Republican or Demo- crat, and try to have a fairly stable kind of monetary policy. This would not have put the handcuffs on in the sense that they could not vary; there is a considerable difference between 2 percent on th'e one hand, and 4 percent on the other, between 3 percent and 5 perceiit. But it does suggest that we might have followed a more moderate monetary policy which, in hindsight, might have been better. What is your answer to that? Mr. CHANDLER. I would like to speak `about the-I do not remember the 1962 epi'sode as well as I should, but I would like to speak about 1965 and 1967. With the benefit of hindsight, the restrictive policy by the Federal Reserve was several months too late. That discount rate increase and some tightening up on unborrowed reserves should have been initiated some weeks earlier and should have been progressing more rapidly toward restriction. However, I think one needs to remember that until the latter pare of 1965, there was an unemployment rate of around 5 percent, and there was a great deal of adverse reaction to the initia- tion of the tightened money policy when it was initiated. My guess is that this was a mistake. They did not tighten it quickly enough. But my guess is that a major reason for that was that no one knew at the time how rapidly the defense expenditures were going to rise. It is my impression that not only the Federal Reserve, but even this committee was not fully informed as to how quickly and how rapidl~r Government expenditures' would rise, and that that made a great deal of difference. With respect to 1967- Chairman PROXMIRE. You see, what I am getting at is that this is part of the whole problem. We were able to predict that. We may be able to predict these things a little more in the future, but if the admin- istration had been completely frank and given us the defense indicators, we would have been better informed. I am not sure we would have been well-enough informed to have made a different kind of policy judg- ment. But as Professor Wallich so well indicates, the problem is one of considerable lags. You initiate a money policy in which you think you are going to try to follow policies to increase money supply be- cause you think the economy needs the stimulation this would warrant. This does not have an effect for several months. The paper of Dr. Wal- lich indicates from 3 to 22 months, but he says you can turn the econ- omy around if you take drastic action in 6 months. The Bureau of Economic Research has made what I think is a corn- petent and objective study, that indicates forecasts for more than 6 months to the economy are poor, no matter who makes them. This seems to me the heart of it. If you gentlemen can convince us that you can forecast pretty accurately what is going to happen for a year or a year and a half or two years in advance, then I think there is no ques- tion that we should just leave it to the discretion of the Federal Reserve PAGENO="0056" 52 Board completely and let them do what they wish to with the money supply. But if this cannot be forecast accurately, it would seem to me to make sense to have a policy which would provide for a. fairly regular and moderate expansion of money supply. Mr. CHANDLER. It should be noted that the problem. of lags also exists in the case of a steadily increasing money supply. For example, suppose that a boom ends, investment demand falls off. If one does not use fiscal policy at that point for a stimulus, note the length of time before there is any significant stimulus from the monetary section. You have to wait for the very slow rate of increase of the money supply, plus a fall in the level of the income, to buying a decrease of interest rates and greater availability of money. And the lag also applies in this case, except that it starts at a later time than it. presmuably would under a discretionary policy. Chairman PRoxI~1Im~. This is on the assumption that we say you should have a fixed 3 or 4 percent of the increased money supply. I would not argue, certainly, with widening the band. But I think the thrust of our position has been that there should be an increase. It is hard to argue that in the kind of economy that we expect in the future you should at any time have a. decrease, but that you can have a rather large increase in the money supply, or a rather mild one. After all, a 6 percent increase in the money supply over a year's period has not happened very often in our history. It happened last year at the time it should not have happened, in the. view of many peo- ple. But it is not very often that you can go back and find a money in- crease of this size. Professor WALLIGH? Mr. WALLIOH. I think it is fair to sa.y that what today loom as the obvious mistakes of t.he Federal Reserve are not as obvious as they seem. In other words, the type of mistake that the Fed makes is not the sort of mistake that I would be making if I came to this hearing on the wrong day, an obvious error. It is more nearly like an investment adviser guessing wrong on the way the market. moves or failing to pick Xerox or IBM. It is a high-grade mistake that is almost certain to happen to some extent. Perfection such as we demand in the light of hindsight is simply impossible. The question is how badly will the results of a fiscal rule depart from perfection? In my judgment, more. In terms of the particular example you cited, Mr. Chairman, 1962 called for expansive policy. The reason it was not. done was the balance of payments. We would have had to be prepared to pay our la.rge amounts of gold or go off gold had we been trying to expand mone- tarily very sharply. We have certain principles about the mix of fiscal and monetary policy. When there is unemployment and a payments deficit simultaneously, the proper mix-I know this committee has heard this many times-is tight money and easy budgets. It was as much a failure of fiscal policy as of monetary policy to do the right thing at that time, although I think basically, our fiscal policies were not bad at that time, either. In 1965, it is evident the Fed acted too late, with the long lag to which monetary policy is subject. But recah1~ this does not excu~e dis- cretion, but it excuses the Fed-their first step in raising the discount PAGENO="0057" 53 rate in 1965, December, was very ill-received. They acted too late, not too early, as many of us said at that time. In 1967, their reason- Senator PROXMIRE. All of us could have been wrong in 1965. I think I was one of those who criticized them. I think I was wrong. In hind- sight, though, I say reflecting on what would have been the best policy over the past several years, it might have been better if they had had the guideline. Mr. WALLIcI-I. We would have been better off had not a stable rule gotten us into this ditch before. I think this is very likely. Now, 1967 is a case in point. The demand for money changed. After many years in which corporate treasurers were proud of not having a cent too much nor uninvested, it became fashionable in 1967 to have money for 5 years to spare. They all rushed out and borrowed. This demand for money could not have been accommodated by the rule. Had the rule been followed in 1967, I feel fairly confident that the 1mm-recession would have become a normal recession. Mr. M0DIGLIANI. I would like to really indicate full agreement with Mr. Wallich on his explanation of the three episodes; 1962 is within the period to which I referred in my testimony when I spoke of the conflict of goals between the balance of payment and domestic employment and how the Federal Reserve had chosen the balance of payments. The explanation in fact for that behavior is visible from the very same chart you have, if you will turn to the chart which gives the bond yields and interest rates. You will observe that in 1962, despite the fact that money supply was not rising, interest rates were stable or flexing. If you will look particularly at the treasury bill rate, it was in fact quite stable and some of the other rates were rather flexing. And the balance-of-payments situation essentially as interpreted by the Federal Reserve required that short-term interest rates preferably rise, but certainly should not fall. Now, you see, if you have a stable pattern or a slightly declining pattern with a constant money supply, you can see you would have declining short-term interest rates with an expan- sive monetary policy. They just did not feel it was appropriate. I think it is quite clear that during the period of the 1960's, until the tax cut, the Federal Reserve Bank was concerned that the short-term rate would not decline, and should move up whenever possible. So as the demand expanded, they used part of the pressure to raise rates. This is the type of situation to which I referred earlier where it would have been helpful if the conflict between goals would had come out in the open that w-e could not, relying just on monetary policy both maintain the dollar as the reserve currency of the world by avoiding a balance-of-payments crisis, and pursue the goal of high-level employ- ment. The conflict might have been partly resolved only through an expansionary fiscal policy. I think the administration was in favor of a tax cut earlier and I think Congress delayed in passing a tax cut. It took the death of the President to get through a tax cut. If we had acted quickly, we would have been able to have a more rapidly ex- panding money supply, without risking a deterioration in the balance of payments. As for 1966, I think on the whole, the tight policy of 1966 was exactly what was required under the circumstances. And the rapid expansion of 1967, I completely agree with Professor Wallich, was a PAGENO="0058" 54 good piece of statesmanship. I think they handled it quite well. We had the beginning of a contraction. I am sure that with the C-NP falling in real terms in the first quarter of 1967, and long-term interest rates rising, very few people would really have advocated then that the increase in the money supply be kept to some 2- or 3-percent rate or even 4. Senator PR0XMIRE. In hindsight, you say it would have been wise, but that is another story. My time is up. I yield to Senator Miller. Senator MILLER. Thank you, Mr. Chairman. Professor IVallich, in your statement evaluating the rule proposed by Dr. Friedman, you say that the rule rests upon a statistical and theoretical finding, that the rate of growth of money supply and the level of economic activity are closely related. What do we mean by level of economic activity? Are we talking about gross national prod- uct, for example? Are we talking about other factors in the economy? Could you elaborate on that? Mr. WALLICH. Yes, Senator. I personally would take gross national product as the best indicator. I would want. to shade that jucTgment possibly by looking at the production index. We have had periods where C-NP rose and the production index remained constant. That has to do with the growth of services while there was stagnation in manufacturing. That means unemployment in manufacturing and that is a consideration of great seriousness. Now, the standard way, as I am sure you know, of defining when ac- tivity in general is rising or falling is to take the National Bureau of Economic Research's turning point.s. This great body of experts, long after the event, tells us that indeed there was a turning point. in Au- gust 1957, and I think there was a turning point in February 1961. These things can only be defined after all the series are in. So it. is completely right that contemporaneously, we do not see what. happens. We see only with a. lag whether we are turning the corner on the upside or the downside. Senator MILLER. But you can get about. a 3-month iiidicator on the increase or the decrease in C-NP? Mr. WALLICTI. Yes. In fact, you can do even better than t;hat. The GNP being published quarterly, we usually have some data from the first 2 months and the major series that go into the C-NP. like retail sales, are early available on a flash basis. The Federal Reserve produc- tion index is available monthly. Some series-steel, autos-are avail- able every week or every 10 days so that. we have a pretty good fix on which way things are going in a. broad sense. Senator MILLER. When we talk about C-NP, I assume for this purpose that you are referring .to real dollar C-NP and not inflated dolla.r C-NP? Mr. WALLICH. That is an important question, because in an infla- tionary periodi such as we have had, dollar C-NP may be rising and real C-NP may be falling. By oiie test. we may have had a minireces- sion in 1967; by another test., we may not. This dhstmction exists and it is easy and dangerous to fudge it. Senator MILLER. You would be more inclined to look at. the real dollar C-NP rather than the inflated dollar C-NP, would you not? Mr. WALLICH. Yes, sir; andi I also would look at the rate of unem- ploymemit and plant excess capacity. For instance, if for some reason, PAGENO="0059" 55 real GNP leveled off and unemployment did not rise as one would expect it to do as the labor force grew, then I would conclude that the labor market for some reason had remained tight and that there was less room for compensatory expansion than one would have hoped there to be. And the same is true of utilization rates in manufacturing. If, for instance, as at the present time, unemployment, is low but utilization rates are high, there is some indication that the economy is off balance. We ought to be able to utilize plant and equipment better without putting a bigger strain on labor markets than we are already puttmg. Senator MILLER. Getting back to this economic activity again and GNP, I `think you were here one time when the committee went into this feature of it. I believe there was a conclusion on the part. of the panel appearing before us that `GNP-that is, just plain dollar GNP, is interesting, real dollar GNP is much more important, and per capita. increased real dollar GNP is even more important. Mr. WALLIGH. That is certainly true, Senator. If we try to measure the growth of welfare, since welfare relates to the individual, we have to look at per capita GNP in real terms, not in inflated dollar terms. When `we look at the business cycle and `ask ourselves, should money be eased or tightened, then `we are dealing with total GNP. There I would add the qualifications that we have already talked about. Senator MILLER. Might we go a step further a.nd say that of even greater interest than real dollar increased GNP per capital would be that figure coupled with the real dollar increased per capita debt. I am talking about, now, all kinds of debt-National, State, individual, and private. Mr. WALLICH. Debt can become a very serious problem when it be- comes excessive. I think it quite evidently became excessive for some families in 1967, when interest rates rose high, when it became hard to get mortgages, and people who, for instance, had to refinance for some reason just were unable to do this. It just froze them into their existing home if they did not own their home outright and could not sell it for ca.sh and buy another home. Debt in `the aggrega.te for the economy as a whole worries me less. I think we are in reasonably good shape there, among other :things, for an unfortunate reason: the inflation is reducing the burden of debt. This year, the Government took about 4 percent off the Federal debt by inflating the price level `by 4 percent. This is not. a policy I recommend, but one has to recognize that is the result. So I would focus the debt problem principally on the individual households that are hit in par- ticular periods by inability `to refinance their debt., to pay off their debt, and to incur new debt. Senator MILLER. So looking at the debt side of the pic'ture, you would be more interested in the private sector of the debt `and `the increase therein `than in the public sector of the debt? Mr. WALLICH. That is certainly true even in the aggregate; not just speaking of households but looking at the t.otal private sector. What ha's happened is that the private sector has greatly increased its in- debtedness relative to the income base from which it must service that debt. The same happens to be true of States and municipalities. It is not `true of business and it is least true of the Federal Government. It is the consumer, the `homeowner, who has most heavily gone into debt. PAGENO="0060" 56 This can become a problem for those who have gone farthest in that direction. Senator Mir2r~it I recently did a. little research and I found that over the last 7 years, 1961 through 1967, we had a very dramatic in- *crease in our gross national product; as I recall, in the neighborhood of $250 billion. But then I found that during the same period1 of time, we had an even more dramatic increase in total debt, Federal, State, local, and private, amounting to around ~5O0 billion. When one realizes that much of that debt would be reflected in turn in pur- chases going into t.he GNP increase, assuming the general accuracy of my figures there, Professor, would that not. indicate to you that GNP, without taking into account the debt. increase, is a rather soft basis for reaching economic conclusions? Mr. WALLICH. I think, Senator, there is a longrun relationship of debt to GNP that is a little below 2 to 1. Since 1929, that relation- ship has been going, I think, at. an average ratio of 1.85 of debt to GNP. But it is certainly clear that debt can become burdensome for particular people and sectors and most particularly, there is a danger that debt ca.n be financed badly. If debt. is too heavily financed by the banking system, then too much money is created. Excess money causes inflation. And if we allow increases in debt to be excessively financed by the banking system, and excessive means that more is created than the amount of money that ought to be created annually, then we have nothing to expect. but inflation. Senator MILLER. My time is up. I would like to go into that with you in a little more detail. But I would just like to footiiote this last question. Do you think that. ratio of 1.85 of debt to 1 of increased GNP is a healthy ratio? Why should it not be 1 to 1, or even less than 1 to 1? Mr. WALLICH. Well, it depends on the amount of investment that the economy needs. After all, for everybody who goes into debt, there is somebody else who wants to save money. Now, sa.vings need to be invested; otherwise, money is withdrawn from the income stream and jobs are lost. Therefore, every time somebody saves a. dollar, somebody else, or maybe himself, needs .to invest a dollar. I would not want to discoura.ge borrowing in the face of a high rate of saving. Our prob- lem, I think, is to prevent excesses to make sure that. particular sectors, particular firms, households, do not go beyond their debt capacity. Senator MILLER. Thank you very much. Chairman PROXMIRE. Mrs. Griffiths? Representative GRIFFITHS. Thank you, Mr. Chairman. May I ask you, each or aiiy of you. Do you really think this country can survive full employment merely with the use of monetary and fiscal policy? Survive? Mr. M0DIGLLkNI. What do you mean by survive? Representative GRIFFITHS. WTell, we would not have to take some sort of drastic action in some other area, with full employment, just by the use of fiscal- Mr. WALLICH. The answer surely is "No," Mrs. Griffiths. Representative GRIFFITHS. I agree. Mr. WALLICH. One policy instrument among two, driving toward full emnlovrne.uf ard th~ other seeking to achieve all our other objec- tives-it. depends, of course, on what we mean by full employment. PAGENO="0061" 57 Representative GRIrrITias. I mean hunting up all these people- those that the unemployment security people in all these States are now ignoring. Mr. WALLIcII. If by full employment, you mean that we really solve the problem of these pockets of unemployment, knowing that some European countries did and go `to a one-half of 1 percent unem- ployment rate, then it is very clear that by trying to do the same we would go up in rapid inflation. It does not help to say, let us use fiscal policy to stop that inflation, because fiscal policy and monetary policy pull on the same string. They both work an aggregate demand. There are n~ known instruments that really work that will accom- plish what you would like to accomplish, short of tight controls on prices and wages. I do not believe those will work in peacetime, because it is basically the Congress that would feel the pressures to break these contracts-and I think they would be broken. Now, there is one piece of very cold comfort. If a 2-percent unem- ployment rate is inflationary, we do not really have the choice of saying let us accept that inflation. If the inflation is 3 percent., let us live with it `and if it is 8 pecent, let us live with it, too. There is every reason to believe that this inflation would accelerate. At a 2-percent unemploy- inent rate, labor will not be satisfied with `a real wage increase of 3 percent, which productivity permits, but they may want, let us say, 6. The economy cannot give 6 percen't. If wage settlement such as are now made at a 6-percent rate, inflation will occur that reduces the nominal 6 back to a real 3 percent. When labor observes that, they will have to add that inflation into the next wage demand and will ask for a higher rate. That will give a still higher rate of inflation. In the next round thereafter, labor will again have to escalate its demand. Business, also counting on inflation, will always be willing to grant it. Representative GRIFFITHS. Because they are escalating, too. I ob- served the other day one of the drug companies in this town on a 17- percent increase in sales got a 61-percent increase in profit. Mr. WAI,r1IcH. Business can take care of itself. If labor asks for 7 percent instead of 3, business raises prices by 4. Labor asks for 11; business takes care of that by moving inflation up yet again. Representative GRIFFITH5. Now, may I ask you, when we are talking about stability and trying to create it in the economy with monetary and fiscal controls, what we really are talking about is stabilizing `it at the status quo. If you could fight y~'ur way into the economy stream, we may `accept you, but we are not going to do `anything under our stability policy that really puts any pressure on them to take in new people. Is that not really right? Mr. WALLICH. T'he means to that, I think, are different. We have to recognize that aggregate demand policy will only carry us so far. But there is `a vast range of other policies that we can pursue-job training, increasing mobility, tax incentives to `business. We have not even begun to scratch the surface of what can be done t'o reduce `the equilibrium level of unemployment. Mr. MODIGLIANI. I would like `to comment. Mr W'allich h'as used this sort of mysterious sentence of equilibrium level of unemployment, which is sort `of economic j argon. What we ought to say is that we should at all times aim at the lowest level of unemployment that is consistent with stability, `and at the same `time try to lower that mini- mum level that is consistent with stability. PAGENO="0062" 58 At any particular point in time, given the structure of the labor market, I think it is sensible to suppose that there is some minimum level of unemployment that is achievable while maintaining relative price stability-not absolute, but a~ reasonable amount of price sta- bility, and no explosive developments. Just what it is, we do not know precisely. We lrnow it is less than five, probably less than four; and are pretty sure at the present time that it is -not. less than three. But in aiming at the lowest unemployment consistent with reason- able price stability we should remember that what matters is not just level, it is also how we get there. I believe the problem we are facing now, where we seem to be running into an inflationary spiral at something over 3.5 percent unemployment is that we have been approaching it too rapidly. In 1966, when we were already at the 4-per- cent level we kept pushing rather hard. I think as you approach this lower boundary, you have to approach it. very slowly to maintain sta- bility. But beyond that, I think it is absolutely clear that we should aim at lowering that minimum figure. I do not see why. at some point, it should not be as low as two and a half. But. it. takes some programs, particularly training programs and anything the Congress could do in this direction would be a great help in the long run. Representative GRIFFITHS. Do you think the proposed tax and ex- penditure cut policy is recessionary and if *so, how much? Mr. CHANDLER. I certainly would not expect it. to be recessionary. It might take some of the inflationary steam out of the economy. But given the rate of increase of expenditures and the rate of increase of prices at the present time, surely an increase of taxes by SlO billion and a. cut in expenditures of $4 billion would not put. us in a recessionary situation. My own estimate is that. we would still be in an inflationary situation. Representative GRIFFITHS. How much do you think it would require to make it recessionary? Mr. CHANDLER. At least $20 billion at the present. time. I would say. Representative GRIFFITHS. May I ask you, suppose we take a prac- tical problem. Suppose 15,000 poor people showed up here and we decide that, well, we will not cut into any other program, but. we will make the money available to train these people and we will see to it that they are hired; by the Government. if necessary, but hired. What dĝ you think the effect of this would be upon the economy? Because it is going to cost money to train them. You are going to have to spend money to train them. Mr. WALLICH. Mrs. Griffiths, we do have a precedent for this. That is the WTPA, which some of us remember. The experience was at least minimal in the sense that it gave these people an income. It did not give them pride in their jobs, it did not produce anything worthwhile. It turned out that the Government as an employer of last resort is not a. very efficient employer. I really think it. would be better to give, these people the money. say via a. negative income tax, then let. them scout around to see. if they can earn some money for doing real work on top of that. Mr. M0DIGLIANI. I would like to comment by saying that there is a question of priority~- within expenditures. I would agree with you that the training of people who want to be trained and are trainable is, in my view, the highest priority. But I think there are many pro- PAGENO="0063" 59 grams that could be cut and I think everybody is familiar with what these programs are-supersonic jet and other things of this kind, and some fat in the defense expenditure. I feel that we should cut those expenditure programs and really look at these training programs and some of the other poverty programs as highest priority items which should be regarded as absolutely untouchable and scrounge else- where. Representative GRIFFITH5. I want to thank you. My time is up. But I think that we spend a lot of our time trying to stabilize the economy that stabilizes a lot of people out of the mainstream of the economy. This really worries me. I do not think we can ask for sta- bility only. I think this is American and we have to pull these people into this economy. Mr. CHANDLER. May I make one comment on this? Chairman PRox~rIRE. Yes, Mr. Chandler. Mr. CHANDLER. I certainly agree with the point of view you are expressing and also the views of my colleague, Professor Modigliani. It seems to me that a stabilizing fiscal and monetary policy, even if we had complete and accurate control of aggregate demand, is not enough in the American economy. We have to find ways of improv- ing the performance of both output markets and labor markets in terms of their response to whatever we do to aggregate demand. We need retraining programs. We need rehabilitation programs. We need to knock down all sorts of barriers to freedom of movement and entry in order to get a more favorable response to whatever the monetary and fiscal policy may be. It would be absolutely marvelous if the markets were purely competitive markets, with high degrees of mo- bility, and so on, that a lot of us like to think of in perfectly competi- tive systems. But w-e do not have them. This is one of the reasons we have serious trade-off problems that Professor Wallich was talking about. Representative GRIFFITHS. Of course, we stabilize out a whole lot of people, but no matter what we do, we are not going to touch those w-ho are highly organized or those who are in a monopoly. Those pro- grams are not going to touch these things. Mr. WALLICH. On the boards of companies u-here I serve this is a No. 1 discussion topic. One encouraging thing is that there seems to be known way's of accomplishing this retreading of people. It is not that one is in front of a blank wall. The personnel experts can tell us it will take this, that, and the other, there will be an attrition ratio of so much, the total cost of the program will be such. If the organiza- tion will underwrite this, it is 1ossible to bring into the organization so and so many blacks. Representative GRIFFITHS. Thank you very much, all of you. Thank you. It was excellent. Chairman Pnox~in~. Senator Jordan? Senator JORDAN. Thank you. I want to commend all of you for your constructive statements and the colloquy you have had with the members of the committee, which has been very instructive to me. I am going to direct a question to the entire panel and I will call on you, each one, in the order in which you have presented your statements. I am concerned about where u-c go from here with respect PAGENO="0064" 60 to current policy. True, we have had an increase in gross national product of some $20 billion in the first quarter of this year, which includes about 4 percent inflation. We hear in many quarters that the economy is overheated, and we have to take some steps to cool it down. Yet, I would submit that there are some segments of the economy which are not overheated. I come from an agricultural State. Farm parity prices are the lowest they have been since farm parity prices were introduced way back in the depression years. I had a call from a very substantial farmer in my State the other day. I think his farmland, his machinery, and storage facilities would be worth in the neighborhood of a million dollars. He has a $300,000 operating loan at. the bank and he pays 81/2 percent interest~ He says, I have not paid any income tax for the past 4 years out of 5. He said, please plead with Mr. Martin of the Federal Reserve Board to reduce interest rates and to ~ut as much emphasis as is necessary on fiscal restraint by increasing income tax or surtax or what have you, because, he said, I am not paying any income tax-the interest rate is driving me out of business. So I would ask you what do you see as the most prudent monetary policy to relieve the current inflationary pressure? You may make whatever assumptions you like about fiscal policy. I will call first upon Professor Chandler. Mr. CHANDLER. We have really reached a dangerous state in the country in terms of price expectations. In 1965, we were in a rather fortunate position in that. prices had been pretty stable since about 1958 and not too many people were worried about. l)rice increases. ~ow, as a result of the price increases we have had for nearly 3 years, the expect.ational situation is extremely dangerous. You see it built into the new wage contracts, you see it built into forward pricing of prod- ucts and so. I feel something has to be done to slow down the run- away behavior of expectations. My own feeling is tha.t in the absence of fiscal restrictions, the Fed eral Reserve simply cannot relax its restrictive policy and it might even have to go farther in the direction of restriction. I would much prefer to see some effective restrictive fiscal action taken so we could live with a somewhat lower level of interest rates. I do not think the present level of interest rates and the present level of reliance on mone- tary restriction is conductive to growth of the economy. I think you have eloquently indicated some of the differences in the impact of restrictive fiscal policies as compared with monetary policies. Senator JoImAN. I will adldl one question to it and ask you to com- ment on this, Professor Chandler. What fiscal restraint would you recommend to go along with the. present monetary policy? Mr. CHANDLER. I would hope that the gentlemen in Congress wouldi continue to look for expenditures that. can be cut with little loss to the country as a whole. I would hope that you would keel) m mmdl. however, a sense of priorities about expendlitl.lres andl not cut back the ones that are, as Mr. Modiglia.ni said, of the highest priority. I would prefer heavy reliance on tax increases, especially personal and corporate income taxes. Senator JORDAN. Mr. Modigliani? PAGENO="0065" 61 Mr. M0DIGLIANI. I think I fundamentally agree with what Professor Chandler has said. The high level of interest rates we have reached now reflect a combina ion of causes. They reflect a very expansionary fiscal policy. These expenditures were not accompanied by corresponding increases ~n revenue. It reflects to some extent expectation of rising prices which typically do lead to higher interest rates, because people essentially are willing to borrow at higher rates if they expect to gain from the increases in the prices of the things they buy, or the plant they buy while it is being used. There are also other factors, however, that contribute to the high interest rates, and I think perhaps people should be more aware of it. I believe that one of the forces that has led to higher interest rates are fiscal incentives such as the investment credit. The invest- ment credit makes it more profitable for firms to acquire equipment, and they are, therefore, willing to pay a higher interest rate because of this higher profitability. If one were really concerned with trying to reduce interest rates, and I think there is some point to that, one might want to look at the possibility of eliminating some of the incentives that now exist for borrowing at higher rates. In the short run, the tightening of fiscal policy would contribute toward making it possible to at least have no further escalation of interest rates and possibly, by reducing ex- pectations, by changing the mood, to also reduce interest rates. After all, we do know that every time Congress seems to be close to passing a tax bill, the bond market responds by higher bond prices, lower interest rates. So I think that step would be a helpful step in that direction. Needless to say, I think it is important to act very fast, because the Federal Reserve has been in some sense holding its horses hoping for such passage. And at some point, it just will not be able to hold any longer. So I think time is of the essence, and those steps are not so easily retraceable. So I hope the tax increase will be passed very fast. Senator JORDAN. And you, too, would go along for selective cuts in spending ~ Mr. M0mOLIANI. Oh, absolutely. Senator JORDAN. Thank you. Professor Wallich? Mr. WALLIGH. Senator Jordan, I agree with what my predecessors have said and would say very briefly, high interest rates are very largely due to inflation. I would favor as low interest rates as we can get con- sistent with economic stability. If the Government will stop inflating, interest rates will be a lot lower. As a mild consolation to the farmer who seems to be caught wearing these two millstones, there is the possibility that on the debt he already owes, the true interest rate is substantially reduced by inflation. A four percent price increase means that the real value of his debt in purchasing power is that much less. That does not help him very much, however, if the value of the things he produces is not going up. It is also possible that the value of the real estate he owns is going up. That would be a compensation. Senator JORDAN. That has been his only salvation so far. But if he does not sell, he does not realize a capital gain, and he does not wish to sell his property. 94-340-68----5 PAGENO="0066" 62 Mr. WALLICH. It gives him no cash and his dilemma of paying 8 percent or 81/2 percent at low farm prices remains unchanged. Senator JoRDAN. What fiscal restraint would you recommend at this time, Professor Wallich Mr. WALLICH. I would go for a. tax increase plus expenditure cuts. My preferred tax increase is not a surcharge, but an across-the-board increase. The reason for that is that we always try to mix economic reform or economic equity with a tax change. That is why we get hung up on accomplishmg it. If we instituted once and for all a rule that when ta.xes need to be raised, they are raised across-the-board, and when they need to be lowered, they are lowered across-the-board, then we have removed the distributional effect, tile impact. oil the. upper and lower income brackets. I think these changes will go through tile Congress with much less difficulty than they do now. As far as expenditure cuts are concerned, everybody has his priori- ties. My colleague, Professor Modigliani, mentioned the SST. Surely, that looks like a very useless expenditure now. We do not know 10 years from now how we are going to feel about it. We may now feel in our balance of payments the failure to make certain R. & D. ex- penditures 10 and 20 years ago that now would be giving us an income. I would go slow on cutting things that will improve the balance of payments 10 years from now. Senator JoiiHAx. Instead of being selective, could you give us a percentage of cut that you think would be a good target? Mr. WALLICH. I could very easily, Senator, generate $6 billion-I cannot do it in percents, but I can do it in billions. Senator JORDAN. Yes. Mr. WALLICH. I could do it in billions and bring it up to six or more. But I am not sufficiently unrealistic to think that some of the programs that are deeply imbedded in our legislation or in our politi- cal structure could easily be cut. When I look at the programs that I think are cuttable, I have quite a hard time getting to 6 percent. I just want to note that a civil service increase ranks as equally important in our program at the margin as the poverty program. Senator JORDAN. Would you two gentlemen agree that $6 billion is a desirable target for cutting? Would you say more or less? Mr. MODIGLIANI. I would say $4 to $6 billion. I would think that would be quite adequate. Senator JORDAN. Professor Chandler? Mr. CHANDLER. I would find it difficult to answer that without knowing which expenditures were going to be cut. If a. major part of it came out of the antipoverty program, I would not be happy. If it came out of the supersonic program and perhaps nonessential mili- tary expenditures and some things of that sort, I would be much happier. Senator JORDAN. Thank you. My time is up. Chairman PROxMmE. Congressman Moorhead? Representative MOORHEAD. Thank you, Mr. Chairman. I would like to continue with Senator Jordan's line of questioning. My question is: Given the proposed package before the Ways and. Means Committee of a $4 billion cut in expenditures plus approxi- mately $10 billion increase in taxes and recognizing that there mi2tht be a better way, do you economists feel $14 billion is too much. ~iot. enough, or just about right for our situation? May we hear from `each of you? PAGENO="0067" 63 Mr. CHANDLER. I would say it is a minimum package and that if it goes through, it probably will not be enough to permit us to have any- thing like a sensational turnabout in levels of interest rates. But as a minimum it would probably head off the necessity for still higher interest rates. I would like to see a larger package, but at this point, I am willing to take anything I can get. Representative MOORHEAD. Professor Modigham Mr. M0mGLIANI. Yes, I would agree that this is about the right figure to shoot at at the moment. I do not think we can be any more pre- cise at this time. As developments unfold, 6 months from now, we may want to take a new look and see what the situation looks like then. It seems to me that at the moment, this figure is realistic. That is, it is within feasibility. And I would rate urgency above being precise about quantity. I think the first thing is to get it going. One other comment. I would like to stress one point Professor Chandler has made in his presentation, namely, the while we have been concerned here with development of rules for the Federa.l Re- serve, we should stress the great importance of a flexible fiscal policy as a long-run program. In particular, I think the proposition-well, some of the results of the study I have been undertaking together with the Federal Reserve do confirm these long lags in monetary policy and do suggest that monetary policy is not a good instrument for fine tuning. Representative MOORHEAD. That monetary policy is not-_ Mr. M0mGLIANI. A good policy for fine tuning. In other words, there is a point in saying we would like to live in an environment in which the tasks of monetary policy are to bring about only slow changes, changes which result from slow developments. But for the fast developments such as sudden changes in expenditures or other kinds of rapid changing conditions, fiscal policy is more suited. I think one point that needs attention is the development of fiscal tools which are flexible and also which have the correct expectational aspect. You see, there is one problem. We have talked frequently about the possibility of using temporary changes in the income tax; that is, raise it and lower it temporarily. These temporary changes have one trouble, that they have the wrong expectational aspects. If the people know the taxes are going to be put up for just 3 or 6 months, chances are there would be little change in their consumption because they would look forward to be- ing able to recoup later. Therefore, I think attention should be given to finding measures that have the right incentives. An example of such a measure is a suspension of the investment credit. Temporary suspension of the investment credit has the effect of encouraging a postponement of spending until the credit has been reinstated. Therefore, besides reducing expenditure by reducing income it also reduces it by inducing a postponement to a time at which the higher expenditure will be useful to support aggregate demand. A similar provision can be made with respect to excise taxes. They would have the right expectational characteristics and I think this would be an excellent tool to add to our box of tools. Mr. WALLICH. These last two remarks of Professor Modigliani are exactly those I wrote down here: Income tax changes do not operate well on a temporary basis because people will cover the gap by PAGENO="0068" 64 borrowing when it is an increase and save the windfall when it is a decrease in taxes; investment credit changes and excise taxes are the things that cause postponement, precisely because at a later time, one one will be able to buy more cheaply; or at a later time, it will cost more when the tax was changed in the opposite direction. As far as the effect of this package-I believe it is a 10-8-4 pack- age-is concerned, I share the views of my colleagues. It will not stop inflation, it will keep the situation from getting worse. What we have learned about prospective business cycle developments in the last month or so points toward strength in t.he economy in t.he second half. The danger of overkill thus is less. We have to resign ourselves to some continued inflation in the years 1969 and 19T0 because we are already building it into the wage structure by 6 or more percent wage increases in 3-year contracts. Representative MoORIIEAD. I am very much interested in the excise tax increase-decrease. Is there any wa.y that this can be made to oper- ate automatically, or does it have to be. either by congressional action or action by the Congress to delegate this power to the President or some other agency? Mr. WALLIOH. We have backed away largely from automatic de- vices, Mr. Moorhea.d. In the ea.rly postwar period there was talk of trigger mechanisms. If unemployment rises above 5 percent or if inflation goes faster t.ha.n 3 percent, certain actions are automatically taken. We have seen evidence that most of these triggers would give the wrong signals, just as I think the automatic. monetary growth rule would, in effect, be the wrong kind of automaticity. So we are talking about discretion. If it were not so cornpl~tely unrealistic, I would say t.urn the whole thing over to the Federal Reserve. The President has shown that he may have reasons why it may not be advisable for him to recommend a tax increase at certain times. The Congress has shown that at certain times, as Mrs. Griffiths says, a tax cha.nge goes through the Congress like a declaration of war and other times it takes a year a.nd a half. It is not a timely instriunent in the hands of either of these part.ies. If you could find a good outside group to whom you could delegate this power, you could prevail upon yourselves to give it up; it would be a. good thing. Representative MOORHEAD. I have a suggestion I would like to pro- pose to you gentlemen. I think it is possible that Congress would be willing to delega.te the unpopular .task of raising the taxes to the President-hilt not the power to lower them, because a President in seeking reelection would be sorely tempted to lower them just at the right time to get the maximum political effect. If we delegated the power to raise them, I thhik that the Congress has learned the good economics and the good politics of cut.ting t.he taxes, and I believe we could get tha.t through the Congress in very short order. Do you think this would be a way of solving the clilemnia? Mr. WALLIGH. That is the first time I have heard this proposal, Congressman. I am sorry that it did not originate in the private sector, as it were. I think it is a very interesting proposal. Representative MOORHEAD. I introduced a bill one time to give the PAGENO="0069" 65 President the power to raise taxes during the time that Congress is not in session. But I did not get too much support for it. Mr. CHANDLER. I would like to make a comment on a statement by Professor Modigliani. He pointed out, I think quite properly, that an income tax cut with a stated terminal date might not be very effective because people would go ahead and spend. That would argue very strongly against a tax increase that would expire, say, on December 31 of this year. But I should not expect it to apply to a tax increase of indefinite duration. In other words, if the tax were put in and would stay there until you gentlemen took action to take it off, I think you would avoid the escape that Professor Modigliani indicated. Mr. M0DIGLIANI. I would like to comment on one point. I would not agree on the idea of entrusting that power to the Federal Reserve. I think it is to be entrusted to elected officials. I think if the President makes the mistake of not raising taxes when they should be raised, he should bear the blame. He can be defeated next time. One hopes that this is the way democracy works, that at least in the medium run, it works. I think it should be left to the Congress and to the President. I think your idea that the President could raise taxes, I suppose this is subject to the approval of Congress. I suppose Congress could dis- approve, and, also, Congress could propose that the tax be cut, but it could not be done by the President on his own authority. That is what you are suggesting? Representative MOORHEAD. Oh, yes. Mr. M0DIGLIANI. This strikes me as quite possibly a very good device, although there is something to be said for announcing in advance a terminal date for this kind of tax and then, perhaps subject to some conditions under which the termination would not be automatic or something of the sort. Representative MOORHEAD. Of course, I would put a limit on the amount that he could raise them. I am not sure what that should be. Mr. MODIGLIANI. Oh, of course. He could choose within some limited range. Representative MOORHEAD. Take something like the Reorganization Act, the Congress could disapprove it if he acted. But otherwise, the Congress would retain the complete power of cutting taxes. Mr. WALLIOH. ~ould I add one thing? Representative MOORHEAD. Yes. Mr. WALLIGH. I think it is extremely important to put a terminal date on this, even though I recognize that it reduces the effectiveness, because if there is not, it is very likely that the supposedly temporary tax becomes permanent, like the telephone taxes. This mechanism then generates a gradual rise in the size of the public sector that was not intended. Representative MOORHEAD. Thank you. Chairman Pimoxa~rIRE. I would like to pursue that on the basis of the same questioning that Congressman Moorhead was engaging in. I agree on the terminal date. I would make the date about the day after it was enacted, because I am against the tax increase~ entirely, probably for the very interesting arguments that you gentlemen have properly made concerning it. You point out that a tax, an income PAGENO="0070" 66 tax, with a terminal date is less likely to have an effect on expenditures and consumption by the taxpayer, for obvious reasons. This is a tax that is being imposed now, this $10 bfflion tax-$7 billion of it would be on the mdividuat taxpayer-that would expire within a year. Testi- mony we have had heretofore has indicated that tax increases that we have had m the past or tax changes we have had in the past have a lag of 9 months. Some have argued a year or 2 years. Again, in view of the unpredictability, as we look at. the. international situation, the Vietnam war, and so forth, it would seem to this Senator that it is just a shot in the dark to impose a tax which is going to have its effert probably in a yea.r or so if at all, and although you gentlemen seem qiute sanguine on the notion t.hat if you put a. terminal date on it it will expire at that time; I would disagree with you. because we have had very few taxes that have expired .a.t the time that they were scheduled to do so. They are usually reenacted. You are likely to have a situation, in my view, where you have in- creasing unemployment, but also continuation of rising price.s if we are realistic about it, so it is going t.o be hard t.o get that tax repealed. We all think it is easy to stop taxes or at least. to lower taxes. but I think if you will recall the last. tax cut. experience, in 1964. President Kennedy struggled and fought. and pleaded and tried t.o persuade the Congress for 2 years before it was finally put into effect.. So that this whole-I do not want to get. into an argument, of course, on fiscal policy, because that is not our purpose here, except. to express t:he notion that I think it is a mistake to say we can rely on monetary policy for the lon~t'-t.erm effect and hope that we can have a fiscal policy which is going to be more responsive to the immediate need. That may be very good economics, but I think it. is very bad politics. Our experience has just indicated that we are not. going to do it. lYe are not going to put business on a yoyo with this investment, credit. My experience is that Congress has had it with that. We put it on, took it off, put it on again. Congress does not want to fool around with tha.t any more. I cannot think of anything worse politically than to put an excise tax on, ta.ke it off, put it on again. The s~na.ll businessman does not like it, the businessman reacts most violently to it. The consumer does, too. So this relying on tax increase for economic short-run effects I do not think is very realistic. Professor M0DIGLIANI. I think in terms of the lags you have, referred to, I think t.he studies we have been conducting do suggest that the lags are not that long. Six months, yes, but there is some impact effect wit.hm the first quarter and the effect builds up. So that I don't think one should be that. pessimistic. Also I believe. that under the present circumstances, the.re is a psychological impact which is extremely important. I think I would expectS in fact, that it would have some immediate effect.s in the financial markets. That is one of the .things we seek. We do seek to put an end to the escalation of in- t.erest rates with the da.nger this poses to some sectors of our economy, such a.s the construction. Chairman PROXMIRE. Let me pose t.he question a little more sharply and specifically. Supposing t.his package does go through~ the $10 billion tax increase, the $4 billion expenditure cut, et cetera. Mr. Chandler indic.ates he PAGENO="0071" 67 wanted a $20 billion package, and I take it he means a bigger tax in- crease. I think we all recognize the pressure from the balance of pay- -ments to maintain a tight monetary policy, maintain high interest rates. Under these circumstances do you foresee the possibility that the Fed- eral Reserve Board could wisely follow the notion of easier monetary policy, given the international situation, or will we not be constrained to have, No. 1, tighter fiscal policy with the $14 billion package and the. continuation of a tight monetary policy to ke.ep our capital here, or attract capital from abroad? Mr. M0DIGLIANI. A mix of the sort I have suggested would, I am sure, be quite acceptable to the foreign central banks. Chairman PROXMIRE. They do not vote in this country. Mr. CHANDLER. That is right. But if you are talking about the balance-of-payments effects, the most severe part of that is the gold problem. They `do not like us to have high interest rates in this coun- try because of the effects on their own domestic economies. They have been pleading for a more restrictive fiscal policy here so that we would xiot tend to draw funds away from them in the loan markets. So I would be quite sure that you would get cooperation from the -foreign central bankers even if the interest rates were lower. They would welcome that. Chairman PROXMIRE. They may welcome that, but would this help our balance-of-payments situation? After all, if our interest rates are lower here, would there not be a tendency for capital not to flow abroad or more capital to flow here? Mr. CHANDLER. This is true, but there may be no more gold -conversion. Senator PROXMIRE. Less gold conversion. Mr. M0mGLIANI. By the cooperation of the foreign central banks, I think he means they would also come along with the easier monetary policy. If we stopped increasing or perhaps eased a little on our long rates, I think the foreign central banks would try to pursue a policy of the same kind and this would not deteriorate our balance of payments. Senator PROXMIRE. They might try to, but our past experience with them is that they tend to serve their own economic needs. Mr. M0DIGLIANI. This time I think there is a willingness to cooper- `ate and they have indicated a willingness to pursue an easier monetary policy if we will let them, as it were. Chairman PROXMIRE. I am surprised none of you gentlemen have espoused the position taken by Governor Robertson. He appeared before the Senate Banking Committee last week. He said in his view we should completely ignore the balance-of-payments policy when it comes to monetary policy. Our monetary policy should be completely based on our domestic economy and the needs of t.he domestic economy. He said you can ignore the balance of payments and do it with an in- terest equalization tax and that is what we should do, that you cannot solve both problems at the same time. If you do, you are going to have a monetary policy that is going to conflict with your domestic needs that are much more important; there is going to be slow growth or you need more growth and it is going to be inflationary. Mr. M0DIGLIANI. I think y.ou raised this international aspect, so I was responding to you. PAGENO="0072" 68 I think I would agree with Governor Robertson to a point, that there are devices we can use to insulate our economy. I do not think the insulation is ever going to be complete. The interest equalization tax, after all, is one that works on long-term bonds, on long-term instru- ments. Chairman PROXMIRE. Why not? Why can you not devise an inter- est equalization tax that will work on everything? Whatever you have to have, you provide that kind of tax. Mr. MODIGLIANI. I would be very much in favor of the extension of the interest equalization tax. I was an early proposer of that. t.ax. I think one could try, although problems get more and more compli- cated as you move from more formal instruments like securities to less formal instruments like loan arrangement. But I think this is very much worth pursuing, a.nd I think it would be a perfectly good idea to give attention to increasing t.he interest equalization tax if it becomes necessary. I think this is within the range of desirable changes. But I do not think one ca.n completely disregard the foreign aspects, either at the level of interest rates or at the level of the effect. of do- mestic demand and prices on foreign trade. Unless we make recourse to quota.s or additional import duties, there is no way in which we can prevent higher domestic prices from affecting adversely the balance. of payments and, in this case, balance of trade, which is of course the mainstay of the whole thing. Chairman PROXMIRE. Let me ask you gentlemen if you all oppose under present circumstances imposition of eit.her price controls and so forth or credit controls. Mr. WALLIOH. By credit controls, Mr. Chairman, do you mean a credit ceiling, such as~ Chairman PROXMIRE. No, of course we have, as you know. consid- erable controls in that respect. I was referring to a limitation on a requirement for a downpayment that would be a certain proportion of the cost of an automobile, for example, and that payment would have to be over a limited period of time so that we could tend to re- strain the inflationary tendencies in that area. Mr. WAIr~IoH. We have tried those and it looks as though they were appropriate at a time when the housing industry was overextended, the automobile industry overextended. Then they served a purpose on a temporary basis. In the long run, they tend to be undermined if liquidity runs high- people begin to buy with their own money what they caunot buy on credit. At the present time we have what is called a. balanced imbalance.. All sectors are a little overextended and I see no reason particularly to bit at the housing industry, which is in great jeopardy from tight money. Automobiles are not visibly overextended. If we went to direc.t credit controls, I would favor what has always been used abroad when they really meant business to tighten and that was, in addition to high interest rate.s and tight money, a ceiling on overall lending. Each bank is told, "You can increase the volume of your credit by only 1 percent per month or a half percent per month," and let them then allocate among different customers so that the allocational function of the market is not completely destroyed. PAGENO="0073" 69 Chairman PRoxMIIu~. I think it would be very helpful because we do have a problem trying to get money into the housing industry, which is most serious now and is going to continue to be serious, in my view, for months and years to come unless we work something like this out. Mr. WALLIOH. If the housing industry were given this leeway while, say, other intermediaries were also under constraint, this might make for better distribution. I would like to add one thing to the discussion of whether we cannot ignore the balance of payments. There is just one way by which one can do that, and that is to cut loose from gold and let the dollar float. It will always float low enough so that we can pursue any domestic policy we please and not have to worry about a disequilibrium. If we do it in any other way-~interest equalizution tax, direct con- trols on corporations, tourist tax, surcharge on import-I would pre- dict that independent domestic policies that do not pay attention to what happens to the balance of payments, and particularly the trade balance, as Professor Modigliani said, will within 5 or 10 years get us to where some European countries were during the 1930's: one needs a license for every single international transaction. A tourist gets 10 units of the local currency as he departs and he can then see how he makes out abroad; direct investment is stopped, all foreign assets are under control and possibly being sequestered by the Government. That makes for a perfectly horrible situation. Chairman PR0XMIRE. So we come back to a situation where, in view of the international balance-of-payments situation, no matter what we do with fiscal policy, we are going to have a reasonably tight-con- tinuing tight monetary policy. At least interest rates cannot be ex- pected to fall very rapidly. Mr. WALLICH. We live in this world and we have to watch the bal- ance of payments. I agree with what h'as been said that tighter fiscal policy will help on interest rates. Whether it will bring them down very much, I do not know. But in the absence of a tax increase, I foresee very sub- stantial escalation at the short end and some escalation, say 71/2 per- cent or so, on bonds at the long end, a crunch on housing again, not quite of the same kind as last time because the market learns to defend itself. In general, I foresee again this overuse of monetary and underuse of fiscal policy. Mr. CHANDLER. Might I comment on two things here? First, with respect to the `ceilings `on the total amount of `credit extended by a bauk-this may work with more or less success in a country that has anywhere from five to 20 `banks. Just contemplate the situation with 13,700. And even if you exempted the bottom 2,000, you would still have a problem. On your question `abont wage-~ Chairman PROXMIRE. Why? More banks, but why `any harder? Mr. CHANDLER. It is much harder primarily for this reason: You th'en have the problem `of `allocating your overall quota `among the different banks. If `one thing is certain, it :i,s that demand for credit will *b~h'ave very differently at the different `banks. The only way it could work with anything like `satisfactory allocation would be if one bank had some way `of transferring `its quota to another bank. Perhaps PAGENO="0074" 70 someone could work out such a scheme, but it would be very difficult. I would like to comment also on the wage-price control. I do think with some feeling, having spent three hectic years of my life as a. price controller and we just barely held on until the war was over- almost as soon as the war was over, the whole thing collapsed. Ohairman Pnox~rrn~. Which war was that? Mr. CHANDLER. World War II. Ohairman PROxMIRE. I meant by that- Mr. CHANDLER. By the end of that war, I thought I had been in iti since \~Torld War I. We had the most favorable possible conditions- a feeling of natural unity, of patriotism, and the rest. The thing worked very well during the war, given the pressures, but it could not survive peacetime conditions. Given the. divided opinion we have in this country and the nearness. to violence that we experience all the time, wage and price controls do. not have a prayer. Chairman PROXMIRE. I take it that is the unanimous position. Mr. MODIGLIANI. That is right. Also, I would indicate I am very much against this idea of the credit ceiling. I think there are other devices by which we control the banks- namely, thr:oug~h the Federal Reserve-and possibly controls on the interest rate they can offer to their depositors on the time deposits and on CD's. I think that is somewhat less discriminatory. I think Mr. Chandler is quite right in pointing out the problem,. particularly with so many banks, that you will have a poor allocation of credit and it will just be working against an improved efficiency. It does not seem to me that the present emergency is in any way that serious. I also would argue that to some extent the balance-of-payment prob- lem is now complicated by the gold problem a.nd the problem of the dollar as a reserve currency. I very much hope that. the new ad- ministration will try to organize and arrange an international con- ference like Bretton Woods in which there will be a chance of changing radically the international monetary arrangements a.nd in which the T.Jnited States will give up its privileged position as a. re- serve currency. Then I think certain other things will be easier to handle because we wifi have more goodwill a.nd cooperation. Chairman PROXMIRE. Senator Miller? Senator MILLER. Thank you, Mr. Chairman. First let me say that I have enjoyed very much the discussion by the panel. It is my observation that. this is about the most. agreeable panel among themselves we could find. Professor Chandler, I take it from what you have said that you would conclude it would be whistling in the dark to suggest a fixed rule on monetary policy without taking into account the gyrations of fiscal action-not just fiscal policy, but fiscal action. Mr. CHANDLER. That is true. Mr. MODIGLIANI. True. Senator MILLER. Now, all of you seemed to a.gree that we ought to go for about a $14 billion package. although Professor Chandler suggested it may be more than that. But looking a.t fiscal 1969 with a $29 billion deficit. in the offing, and this does not. take into accoirnt possible supplemental appropriation requests, a $14 billion package PAGENO="0075" 71 would only cut that deficit in half. That would give us a $14 billion budget deficit. My recollection is that during calendar year 1967 our deficit was in the neighborhood of $19 billion. This laid a foundation for $25 billion of inflation, and the comment was made later that it seems as though we may have been seeking stability in the economy which has resulted in excluding many people from the mainstream of our economy. I would be inclined to suggest that perhaps we have not been having the stability in our economy, because I cannot see much sta- bility in an economy with $25 billion of cost-of-living inflation, not to mention about another $18 billion of erosion away of the purchas- ing power or the value of life insurance or pension fund reserves and savings accounts and the like. Now, this $25 billion can be allocated among the various States on a per capita net income basis. If that is done, in turn it can be translated into an impact on the individual citizens of a State ac- cording to a sales tax equivalent, because it operates in about the same way in taking purchasing power away from people. Wiscon- sin's share-I was over in the chairman's home State a couple of weeks ago, and I pointed out that Wisconsin's share of that $25 billion cost-of-living inflation of 1967 was the equivalent of a 17-percent sales tax. I believe it was in the neighborhood of the equivalent of a 12-percent sales tax in New Jersey. If you come along with that kind of an impact of inflation on people, it seems to me that the lack of stability in the economy is in- deed going to exclude the poor and underpr~ivileged people from the mainstream of our economy. I do not see how they can even afford to buy the necessities of life if that continues. Do you think that this is a realistic approach of the impact of inflation on the people who are presently excluded from the main- stream of our economy? Mr. CHANDLER. The analogy with a sales tax is a rather interesting one and carries you a certain distance. There is, however, a very great difference, in that the very same process that brings about the rise of prices and the decrease in the purchasing power of the dollar also throws a lot more money income into the hands of the public, but does it in a most erratic type of way, so that some are more than compen- sated for the sales tax type of thing that you mentioned and others are not compensated at all. Senator MILLER. And those that are not compensated at all or scarcely at all are the poor and underprivileged, are they not, by and large? Mr. CHANDLER. They range widely. Certainly among the poor and underprivileged you have a lot of them whose wages do not go up if they are working or whose welfare allowances do not go up if they are relying on those. Of course, at the other end of the scale is the chap who is living off bond income, who gets hit proportionately just as hard, though the pain may not be as great. Senator MILLER. Except that he may also have an estate to fall back on, which the poor and underprivileged do not have. Mr. CHANDLER. That is why I ~ay the pain may not be so great. But this is not true of all of them. There are some who may have retired on fixed incomes which are barely adequate to maintain a re- PAGENO="0076" 72 duced standard of living from what they had when they were working. There can be very serious hardships in many of those cases. Senator MILLER. Right. Professor Wallich, you made a statement that surprised me a little. You said business can always take care of itself in connection with t.he rounds of wage and price increases. But do you not have to take into account the competitive position in world markets? Mr. WALLICH. Yes. I think as particular businesses are concerned in particular sectors, that may well be so. You see it. in the steel indus- try, for instance. Historically-that is what I was referring to-in- come shares as between capital and labor have been remarkably stable. The efforts of labor to increase the income share by pressing for Ihigher wages have been quite unavailing. Over short periods that may vary, because profit margins undoubtedly get squeezed at cer- tain times. And we have never had a period like the present of a heavy payments deficit and heavy pressure of foreign competition. Senator MILLER. I would like, to ask each member of the panel a double-barreled question. And I irnow how difficult it is for members of the economics profession to make a.n absolute statement. But I sup- pose there are certain axioms in the economics profession-not many, perhaps, but there are prdbably some. But would you say that it would be axiomatic that `an increase in the money supply over and above the amount of the increase in real economic growth would lead to inflation? Mr. M0DIGLIANI. I can definitely say that it is not so. There is no such axiom. There is nothing that says than an increase of the money supply above the growth of real GNP meets- Senator MILLER. Now wait a minute, please. I do not say real GNP. I worded it this way: above real economic growth. I might say I cer- taimily do not subscribe to the thought that GNP has any necessary relationship to rea~I economic growth. Mr. MODIGLIANI. Right. Well, I think even to that, the answer is that there is no simple relation between the rate of growth of the money supply, in relation to the capacity of the economy or whatever other measures you want, and inflation. Senator MILLER. Suppose the three of you all agreed that during the last 3 months we had real economic growth in this country of Sb bil- lion. Now, that is quite an assumption, because we would have quite a time figuring out what indeed constitutes real economic growth. But suppose that you could come up with a fornmla in computing that that would be reasonably agreeable among the three of you. And we saw an inflation in the money supply of $15 billion. Mr. M0DmLIANI. Yes., Senator MILLER. Would it follow that we would have had some in- flation as `a result of the `disproportionate increase in the money supply over and above the real economic growth? Mr. MODIGLIANI. I have tried to precisely answer this quest.ion. If you give the specific figures you give, I would say that today, if in fact the capacity rose by $10 billion, however measured, and the money supply rose by $15 billion, I would have no doubt that would generate inflation. However, it would not follow that if the money supply grows faster than the thing to which you refer, inflation must neces- sarily result. PAGENO="0077" 73 You asked if it is an axiomatic thing, something which has no ex- ception, and I would say it `has exceptions. Senator MILLER. Do the other members of the panel agree on that? Mr. CHANDLER. I would agree from your example that you most likely would have inflation. Normally, a monetary increase of something like $5 billion would finance an increase of $10 billion of GNP. Mr. MODIGLIANI. Less than that. More like $2.5 billion. Mr. WALLIOH. I agree with that. Senator MILLER. If it is likely that this will prove out, recognizing there could be some exceptions, might it not be a good idea for the Federal Government to try to `seek out a formula for arriving at what could be called real economic growth? Instead of all this attention being paid to various factors-gross national product, production, all that business-and come up with a formula that will tell us whether or not we have had any real meaningful economic growth? For exam- ple, a year ago you may remember that during the first 3 months the entire amount of increased GNP consisted of inflation. And we were just standing still. That does not mean that we had no real economic growth. Possibly our real economic growth went down. I do not know. But our committee went into this some time ago, I think, Mr. Chair- man, when we encouraged the development of a long-range balance sheet for our economy. I am just wondering why we have not developed something along the line of a concept of real economic growth which would be uni- formly recognized by the economics community. Mr. CHANDLER. I would like to make two comments on that. The first one is that I think the number of exceptions would exceed the rule. I think they would be very frequent indeed. The second thing is that if we are going to approach it from your point of view, we would certainly have to use some concept of potential real growth, because the actual rate of growth is surely not independent of the behavior of demand for output, which in some sense is related to the behavior of the money supply. So one would have to deal with potentials rather than actuals. Mr. MODIGLIANI. And I think in this connection, while it is hard to construct a single-a one-dimensional measure of economic growth, I think most economists would agree that a measure of capacity to produce GNP in constant prices is as good an overall measure as one can have, and I think you would want to accompany this by a few related measures such a's productivity measures and measures `of em- ployment and whatnot. But, in principle, this notion of the full employment C-NP, real C-NP, is a good measure, and the way it behaves over time will give you a reasonable measure of real economic growth. Senator MILLER. You do not agree with Professor Wallich that we. could refine that still further to real dollar increased C-NP per capita? Mr. MODIGLIANI. You see, when I speak of a potential economic growth, I mean the amount of C-NP in constant prices that could be produced at high-level employment. That still tells you the maximum you could do and what you should shoot for. You can then, if you want, express it on a per capita basis, that is fine. PAGENO="0078" 74 Senator MILLER. And you do not think that we ought to take into account increased per capita debt? Mr. M0mGLIANI. It is automatically taken into account- Senator MILLER. No, I mean increased per capita debt. Mr. M0mGLIANI. I do not see why we should worry at all about debt. I think debt is a phenomenon of growth and well-being. I do not see why we should worry particularly about debt. You have to look at it this way: National wealth is about 4½ times aggregate disposable in- come, 4 to ~½ times. And so people like to keep their wealth in the form of other people's debt. Senator MILLER. What about Senator Jordan's farmer? What about the agricultural community as a whole? Now, I understand, looking at this from a 1-year standpointS that you are not going to get increased income. But looking at it from a 7-year standpoint, we have an increased agricultural net income of over $13.5 billion. We have an increased agricultural debt of over $25 billion. The net income per farm is up 55 percent in the last 10 years while the net debt per farm is up 110 percent. What are the farmers supposed to do? Sell off their real estate in order to pay the debt? I think this debt situation is deeply important, at least to some segments of our economy. Mr. MODIGLIANI. It may be important to some segments of the economy regardless of the aggregate. It may be that some firms are overloaded with debt while the overall of the economy is shrinking 50 percent a year. So I think it would be wrong to look at any overall measure of debt. While it is quite true that some people may be in unsatisfactory debt conditions, it is perhaps because the market for their product. has not been developing at. the same pace other things have been developing. But I would say this is a symptom of some other malaise or disease. I think there is not any real reason to become concerned with the fact that the debt is growing. The growth of debt is a symptom of economic growth. Essentially everything grows more or less in proportion. To some extent the growth of consumers debt. for instance, which some people have paid attention to, reflects simply a long-drawn consequence of the fact that more and more things are nowadays produced in the household. There was a time when transportation was made by public conveyances, when entertainment was made by firms. Nowadays a great deal of this has shifted to the household and tile household is holding the capital goods with which it is producing these services. If it is turning into a firm, it will also borrow like a firm did before. So one has to look at this phenomenon in terms of the entire sit.uation~ and I see no reason to think there is any special danger coining from that angle. Senator MILLER. You are not concerned that we have had a $500 bil- lion increase in debt and over a $250 billion increase in 0-NP over tile last year Mr. M0DIGLIANI. That is about par for the course. Senator MILLER. That is about par for the course, but look at the in- flation we are in. Mr. M0DIGLIANI. But the inflation has nothing to do with this phenomenon, because I think much of that growth of debt to which you refer occurred between 1959, let us say, and 1965, a period of great PAGENO="0079" 75 price stability. That was one of the periods of greatest stability in *our recent history. During that period, if you will look at the figures, you will find that the debt grew ~ut about that pace, if not faster. Senator MILLER. You do not think that may have laid a foundation for the hardship we are in now? Mr. MODIGLIANI. No; I believe the inflation that followed after came when we were approaching full employment and we kept pressing the throttle when we were already at the speed limit. Senator MILLER. Thank you again for your very fine testimony. I am sure we all derived benefit from it. Chairman PROXMIRE. I just have one more question of Professor Chandler. One of the members of the staff asked me to ask this. If the major drops in velocity are avoided or mitigated at least by ~ gradual expansion of the money, is this not a desirable goal? Because arithmetically that would tend to minimize the recession and tend to minimize inflation. Certainly that is a proper and appropriate, desir- able economic objective. This comes back to the argument you were making, Mr. Ch~tndler, that the drop in velocity to which you referred in your postcycliea'l dis- cussion seems to be generally preceded by increases of money of less than 3 percent. We seem to be getting at a notion that there is a connection and ~t favorable connection between velocity and a gradual change in the money supply rather than abrupt changes in the money supply. If we could favoi~abiy affect velocity in this particular way, it seems to me that this might be a desirable argument for the Friedman thesis. Mr. CHANDLER. There is no question that the behavior of the money supply has some effect upon velocity. I would say that, for example, an increase in the money supply that shows up in a fail of interest rates will probably mean somewhat lower velocity than you would have had otherwise. But my point would be, and here is where I would de- part very markedly from Mr. Friedman, that there are a lot of other things that would affect velocity as well, emanating not from the be- havior of the money supply. Chairman PROXMIRE. Yes, he could agree to that. I do not know whether he would, but I would agree that there are many other things that affect it. But if you have a factor, to wit, the change in the sup- ply of money that would seem to affect it favorably, why should we not encourage that kind of policy? Mr. CHANDLER. The important thing here is not the level of velocity but the variability of it. The point I was trying to make was that it is the variability that is important and also that if you move from a boom period to a depression period you will probably have unfav- orable expectational effects if you do not increase the money supply. I do not really see much point in lowering the average velocity of money. Chairman PROXMIRE. Frankly, what I get back to is that the Fried- man thesis, to the extent that we have modified it, depends on the assumption that the economic future, more than 6 months or so, is very, very hard, impossible to forecast, no matter how competent the people are that you have forecasting for you. You subscribe to that, that you cannot tell, t.hat you do not know, that you have no knowledge of what economic conditions will be a PAGENO="0080" 76 year from now. Then I think you can make an argument for the policy this committee subscribes to. On the other hand, if you contend that you can make a pretty good, pretty wise, prediction as to what the economic situation is going to be when your policy takes effect, then I think you can argue that you should rearrange, cut the money supply, increase it, increase it by 20 percent if that seems to be the thing at the time-do what you wish without any restraint or any guidance whatsoever. Perhaps you assume that the Federal Reserve can forecast economic conditions-I do not think they can and that is why I subscribe to this position. Mr. CHANDLER. I guess at some stage you come back to a certain amount of faith and hunches. Chairman PROXMIRE. That is just what I do not have, faith in hunches. Mr. CHANDLER. In the first place, much of Professor Friedman's material is based on a study of monetary phenomena from 1867 to the present. Chairman PROXMIRE. Do you criticize that because he did not go back far enough? Mr. CHANDLER. On the contrary. Chairman PROXMIRE. Well, he went up to the present. Mr. MODIGLIANI. But you mix two periods which have, no relation to each other and what you get is garbage. Mr. C~aNDr~R. I would say the history of the Federal Reserve and much of his monetary statistics before 1951 are just irrelevant to the new situation. Chairman PROXMIRE. We tried to go back to 1962 and not before that in our discussion here. Mr. CHANDLER. So many of his findings simply do not hold for the period since 1951. His forecast of a declining velocity of money has proved to be absolutely wrong, and I think that his comments about the ability of the Federal Reserve to forecast do not apply to the present situation. I admit they made virtually every mistake in the book before World War II. Then they made another big mistake after World War II. Chairman PROXMIRE. From now on, they are going to be right. Mr. CHANDLER. They have adopted stabilization objectives, too many of them, in fact. And their whole set of objectives has changed. Chairman PROXMIRE. I certainly agree that the competence. of the board is enormously improved. Now you have economists on the hoard and that is what we should have had. We have not had them before. Economists have their weaknesses, as we all know. But at least this is their life, their job, their training. That makes a difference. Tomorrow we will have three gentlemen who will disagree with you gentlemen. I think that should be stimulating. We all agree you have done a marvelous job today, most impressive. We recess, to reconvene tomorrow at 10 o'clock in this room. (Whereupon, at 12:50 p.m., the Joint Economic Conimittee re- cessed, to reconvene Thursday, May 9, 1968, at 10 a.m.) PAGENO="0081" STANDARDS FOR GUIDING MONETARY ACTION THURSDAY, MAY 9, 1968 CONGRESS OF THE UNITED STATES, JOINT ECONOMIO COMMITTEE, Washington, D.C. The committee met at 10:10 a.m., pursuant to recess, in room S-407, the Capitol, Hon. William Proxmire (chairman of the joint commit- tee) presiding. Present: Senator Proxmire; and Representative Griffiths. Also present: John H. Stark, executive director; William H. Moore, senior staff economist; John B. Henderson, staff economist; and Donald A. Webster, minority staff economist. Chairman PROXMIRE. The Joint Economic Committee will come to order. This is the second of our current hearings on monetary problems. Yesterday our witnesses gave testimony that was in the main skeptical of the usefulness of simple general rules to guide the operations of the Federal Reserve Board. The objectives could be formulated in general terms they thought but not the specific limiting guidelines. Today by contrast at least two of our witnesses are known to be sympathetic to the idea of guidelines for monetary policy. We wel- come Professor Christ of Johns Hopkins, Professor Dewald of Ohio State, and Professor Selden of Cornell. Professor Christ, you might go right ahead. You understand that we have a limitation of 20 minutes on the presentation, although I see you have a nice concise statement and I presume you can present it in less than 20 minutes. STATEMENT OF CARL F. CHRIST, PROFESSOR, DEPARTMENT OF POLITICAL ECONOMY, THE JOHNS HOPKINS UNIVERSITY Mr. CHRIST. I was told 10 and I hoped you might give me an extra 10 percent if I needed it. Chairman PROXMIRE. Of course. Mr. CHRIST. I am very glad to be here today, Senator, to contribute what I can and also to learn from the committee and my fellow witnesses. The central questions before us today are whether the Federal Reserve (a) can and (b) should cause the stock of money to increase fairly steadily at a rate of about 3 to 5 percent a year, and (c) what circumstances, if any, would justify a higher or a lower rate of growth of the stock of money. The main objectives of monetary policy are full employment and a stable price level. (77) 94-340-G8---------6 PAGENO="0082" 78 At the outset we have to admit that. we cannot hold the Federal Re- serve responsible for everything that happens rn the econo1fly. In the first place, there are other actors on the scene, and the Federal Reserve cannot accurately forecast what they will all do. In the second place, the effects of Federal Reserve policy are not all felt immediately; they are spread out over a period of variable length, but at least several months. These two facts mean t.hat the Federal Reserve often cannot know what is the proper action to take today, in order to offset some disturbance that will happen next week and whose effects will be felt next month or next quarter. But even granted perfect prediction, we could not hold the Federal Reserve responsible for everyt.hin~, for there are times when a. choice must be made between two conflicting aims, and even the Federal Reserve cannot have both. For example, suppose-not unrealistically-that the Treasury, act- ing under instructions from the Congress, undertakes a large increase in spending, and that the Congress does not increase ta.x rates-when I wrote this, the Congress didn't look as though it was going to in- crease tax rates and I am very pleased that it now looks as though this may happen. The obvious result would be a large increase in the budget deficit, if there were an increase in expenditure with no increase in tax rates. The Treasury would have to finance this deficit by offering new U.S. Government securities for sale. What will happen? Consider two possibilities. First, the Federal Reserve could assist in the financing by buying and holding whatever portion of the new securities is not taken up by private investOrs. In that case, the stock of money would increase, because part of the money that the Treasury spends would be created when the Federal Reserve buys new Treasury securities. Or, take the second possibility, the Federal Reserve could decline to assist in the financing; that is, buy none of the new Treasury securi- ties offered. In that case, the Treasury would have to offer better terms to the private market; that is, higher interest rates, in order to induce the private market to buy all the securities offered. Then the stock of money would not increase, but interest rates would increase. Thus, the Federal Reserve has a choice, when faced with a. Treas- ury deficit; the Federal Reserve can increase the money stock while maintaining interest rates about the same, or hold the money stock fixed while permitting interest rates to go up. Of course, one could imagine a policy somewhere between these two, permitting some in- creases in both the money stock and in interest rates. But the Federal Reserve cannot stabilize both the money stock and interest rates in this situation when there is a large deficit. Similarly, when faced with a Treasury surplus, the Federal Reserve has a choice between stabilizing the money stock while interest rates fall, or sta:bilizing interest rates while the money stock falls, but can- not stabilize both. It is pretty clear that the Federal Reserve can control the stock of money within narrow limits. I mean they can make the stock of money come within plus or minus one-half percent of any desired level, 99 weeks out of 100. By the way, the money stock concept I am using is the Federal Reserve's own: currency and demand deposits. PAGENO="0083" 79 It is certain that a policy of increasing the money stock at 4 percent a year, or between 3 and 5 percent a year, would not be the best possible Federal Reserve policy, if we knew everything about how the economy operates. But we don't know that, and therefore, we don't know what the best possible policy is. I would like to argue first that, given our present knowledge, we will probably have better monetary policy if the Federal Reserve sees to it that, during every calendar quarter, the increase of the money stock is at a seasonally adjusted annual rate of between 2 and 6 per- cent, better I mean than we would have if the Federal Reserve follows policies like those of the past. I would like to argue second that the Federal Reserve ought not to change this rate of change abruptly, from a 2-percent annual rate in one quarter to a 6-percent annual rate in the next quarter, or vice versa. Third, it is more important to stabilize the rate of growth of the money supply than to stabilize interest rates, whenever the Federal Reserve must make a choice. For the long run, a 4-percent annual growth rate in the stock of money is about right. Real GNP has been growing at 3.9 percent a year since 1948-when one might say the economy had returned to normal after World War II. At roughly constant interest rates, which we have not had within the last 20 years, a roughly constant price level, the demand for money grows roughly in proportion to real GNP. If the money stock grows much faster than 4 percent a year, say 8 percent or more, then aggregate demand is induced to grow much faster than capacity. When demand catches up and overtakes capacity, there is upward pressure on the price level. If the money stock grows much slower than 4 percent a year, say it doesn't grow at all, or even declines, then aggregate demand is induced to fall rapidly behind capacity. When this happens, we have deflation, downward pressure on prices, and unemployment. During 1941-45, the money stock grew at 22 percent a year; every- one agrees that this was far too fast for stability. During the de- pressions of 1921 and 1929-33, and all the recessions since 1921- they were in 1924, 1927, 1938, 1949, 1954, 1958, and 1961-the money stock actually declined in absolute terms, which in my opinion should not be permitted. I think that is a very important criticism of Federal Reserve policy in the past, that they have permitted the stock of money to decline during depressions. The evidence so far is not persuasive in favor of the claim that small variations in the rate of growth of the money supply cause business cycles. But it is clear that an actual decline in the money stock, or a prolonged period of little or no growth, aggravates any recession that is in progress or that might develop. Simi1arly~ a pro- longed period of rapid growth in the money stock aggravates any overheating that is in progress or that might develop. Furthermore, rapid changes in the rate of growth of money stock are themselves a disturbing factor. That is why I would like to see the Federal Reserve keep the rate of growth of the money stock fairly steady, between 2 and 6 percent a year, and to vary this rate of growth only gradually. It should be pointed out that if the Congress were to require the Federal Reserve to follow any such rule, the Congress would thereby PAGENO="0084" 80 restrict its own freedom of choice in some. situations. Consider again the case in which the Congress provides for a. large increase in expen- diture with no increase in tax rates, so that a large deficit develops. If the Federal Reserve is prohibited from increasing the money stock at a rate greater than 6 percent a year, say via a. congressional rule, then `a large share of the deficit would have to be financed by the sale of Treasury securities to the private sector, thus driving interest, rates very high, `and not completely preventing inflation e~t.her-an undesir- able situation. Notice that, if the Federal Reserve is required to keep the money stock from growing faster than 6 percent. a year, and if the Congress increases expenditures greatly. then the Congress has only the following choices open: to endure high interest rates and some in- flation, or to increase tax rates, or some combination of these two. The basic alternatives among which the Nation must choose may be seen more clearly if looked at from another angle. There are three important ways in which the Treasury's expenditures may be financed: (1) by taxation, (2) by increasing the stock of money, and (3) by in- creasing the amount of Government debt in private hands (that is, by borrowing from the private sector). By choosing the level of Govern- ment expenditure and `the level of taxes, the Congress determines the amount of the Government budget deficit., or surplus. Let's suppose there is a deficit. Then, it must be financed by some combination of increasing the stock of money, and increasing the amount of Govern- ment debt in private hands. The most important function of t.he Fed- eral Reserve is to control how this deficit financing is to be divided between increasing the stock `of money and incre.asing the amount of privately-held Government debt. This the Federal Reserve does chiefly by deciding what amount of Treasury securit.ies to buy and hold (thus increasing the money stock), and what. amount-that is offered by the Treasury-not to buy, thus requiring private, holdings of the Government debt to increase. I have be.en speaking of a. deficit, but if there is a budget surplus the opposite choice is open to the Federal Reserve, decrease either the money stock or the private holdings of Government debt. Just as the Congress has the aut.hority to fix Government expendi- tures and taxes, and thus to fix t.he budget deficit, so the Congress has the authority to decide ho.w much of t.he deficit should be financed by increasing the money stock, and how much of it should be financed by borrowing from the private sector. I have suggested that. the Federal Reserve ought to make the stock of money grow at a. rate between 2 and 6 percent. a year. But the fore- going discussion makes it clear that such a policy will not work well unless the Congress keeps the budget deficit or surplus within suitably narrow limits, so that the amounts of Government securities clumped on the private market by a budget deficit are not too large, and con- versely so that the amounts of Government securities taken out of pri- vate hands by a budget surplus a.re not too large. When I say the budget deficit or surplus should he kept within suitable limits, I mean a range something like a deficit of from 15 to 17 billion on the one hand t.o a. surplus of 10 or 12 billion on the other hand. In this sense, fiscal policy, which determines the size of the budget deficit, and monetary policy, which determines the stock of money, PAGENO="0085" 81 ought to be in harmony. The Congress is the only authority that can make them so. Treasury and Federal Reserve actions can be substitutes for each other with respect to aggregate demand. For example, the Treasury alone can stimulate aggregate demand by selling new securities to the private sector and using the proceeds to buy gods and services for Government programs. Or the Federal Reserve alone can stimulate ag- gregate demand by buying securities for the private seciTor in the open market, thus increasing the stock of money. But the effects of the two methods upon interest rates are different. When the Treasury buys goods financed by borrowing from the private sector, interest rates are bid up; when the Federal Reserve buys securities in the open market, securities prices are bid up and interest rates are pushed down. The Federal Reserve can counteract the aggregate-demand effect of this Treasury action, or in the interest-rate effect, but not both. Treasury and Federal Reserve action can be substitutes for each other when a certain effect on aggregate demand is desired, or when a cer- tain effect on the general level of interest rates is desired. But when there is a desired level of aggregate demand, and a desired level of interest rates, then cooperation between the Treasury and the Fed- eral Reserve is required. It is extremely important to realize that the policies required of the Treasury and the Federal Reserve to achieve the domestic objec- tives of full employment and stable prices will sometimes conflict with the achievement of balance-of-payments equilibrium at a given ex- change rate. This conflict has persisted in the United States for several years, programs 3 or 4 years. It may still be with us even if the present buoyant business temper moderates. In the face of such a conflict, we have several choices. Since we have gold and foreign exchange re- serves, we can continue in deficit on our balance of payments, but only until the reserves are gone. Our other choices, among which we may choose now, but among which we must choose when our reserves are gone, are these: reduce Government spending and lending abroad; impose restrictions on private foreign trade and capital movements; impose a recession on the domestic economy to dampen private import demand and possibly increase exports; or seek a new exchange-rate level where equilibrium is possible. The last of these alternatives, in my view, is the best. It is encouraging to see the development of econometric models of the U.S. economy, in greater sophistication and detail. I believe that they hold promise of teaching us ever more about our economy and how it operates and responds to public policy. In spite of substantial improvements in the past generation, I am sorry to say that I know of no model that I would now trust with the task of formulating stabilization policy for the United States. In summary, my answers to the questions before us are these: First, the Federal Reserve can control the stock of money very closely. Second, I believe it would be an improvement if the Federal Reserve would increase the money stock each calendar quarter at a seasonally adjusted annual rate of between 2 and 6 percent. Third, the Federal Reserve should adjust the rate of growth of the money stock within these limits, making only gradual changes in the rate of growth, and raising or lowering that rate of growth in accordance with its best PAGENO="0086" 82 judgment as to whether economic conditions are-or soon will be-too buoyant or too slack. Fourth, this policy will work best if the Congress will keep the budget deficit or surplus from being very large, and from changing very rapidly. The.re is the end of my opening statement, Senator Proxmire. I have an appendix at the end of the prepared statement. that might be useful- Chairman PROXMIRE. Without objection it will be printed in the record in full. Mr. CmusT. Thank you very much. (Appendix follows:) APPENDIX TABLES TABLE 1.-DECLINES IN THE U.S. MONEY STOCK (DEMAND DEPOSITS AND CURRENCY, SEASONALLY ADJUSTED) DURING DEPRESSIONS AND RECESSIONS SINCE 1921 Percentage decline on the Number of months before Month during which the money stock reached its peak money stock during recession the money stock regained ito previous peok level March 1920 December1922 September1925 October 1929 March 1937 15.0 2.0 3.0 33. 0 6.0 53 10 26 79 20 January 1948 July 1953 July 1957 July 1959 2.0 .2 1.0 3.0 27 9 9 27 Source: M. Friedman and A. Schwartz, "A Monetary History of the United States," pp. 709-15, and Federal Reserve Bulletin, June 1964, pp. 682-90. TABLE 2.-RATE OF CHANGE OF THE U.S. MONEY STOCK (DEMAND DEPOSITS AND CURRENCY, SEASONALLY ADJUSTED) ANNUAL PERCENTAGE GROWTH RATES FOR CALENDAR YEARS AND QUARTERS, 1956-68 Year Rate for calendar year Rate for calendar quarter 1 2 3 4 1953 11.1 11.9 `1.6 `0.3 `0.6 1954 2.7 `1.2 2.2 3.1 4.2 1955 2.2 4.0 2.4 `1.8 `.6 1956 11.3 11. 5 1* 9 1~ 6 2. 1 1957 `-.7 `.0 `.0 `-.3 1-2.6 1958 3.8 `1.8 5.6 3.2 4.6 1959 1.6 4. 0 2.5 1 -~3 1 -3*9 1960 `-.6 1 -2. 8 1 -2.3 2.9 `.0 1961 3. 0 2. 6 2. 8 2. 5 4. 2 1962 1.4 11.7 `.5 `-1.1 4.4 1963 3.8 3.8 4.3 2.9 4.0 1964 4. 1 2. 9 3. 9 1 6. 2 3. 3 1965 4.7 2.5 3.5 5.7 1 6. 8 1966 2. 2 5. 8 3.3 1 -. 2 1 -. 2 1967 `6.3 1968 `6.3 `7.2 `6.8 5.1 4.2 1 Denotes a rate of change outside the range from 2 percent to 6 percent a year. Source: Federal Reserve data for monthly averages of daily figures. Each rate is calculated from the difference between' the last month of the period (year or quarter) and the last month of the preceding period. PAGENO="0087" 83 TABLE 3-AVERAGE ANNUAL GROWTH RATES OF SELECTED INDICATORS FOR THE U.S. ECONOMY OVER THE PERIOD FROM 1948 TO 1967 [In percent] Total Per capita 1. Price level (GNP deflator) 2.1 2. Population 1.6 3. GNPin money terms 6.0 4.4 4. GNP in real terms 3.9 2.3 5. U.S. Government debt privately held 0.7 -0.9 6. Time deposits (commercial banks) 8.7 7.1 7. Money stock (currency plus demand deposits) 2.4 0.8 8. Money stock plus time deposits 4.6 3.0 9. U.S. Government debt privately held, in real terms -1.4 -3.0 10. Time deposits, in real terms 6.6 5.0 11. Money stock, in real terms 0.3 -1.3 12. Money stock plus time deposits, in real terms 2.5 0.9 13. Velocity of money (GNP divided by the money stock) 3.6 14. Interest rate (Aaa bonds) 3.6 Source: Federal Reserve Bulletin, and Economic Reports of the President, 1968. Chairman PROXMIRE. Thank you, Professor Christ. Professor Dewald, you are recognized. STATEMENT OF WILLIAM a. DEWALD, PROFESSOR OF EcONOMICS, OHIO STATE UNIVERSITY Mr. DEWALD. I have a series of questions that I have raised myself. Chairman PROXMIRE. You have a somewhat longer statement too, I see. Mr. DEWALD. I am not going to read it, if that is acceptable? Chairman PR0xMIRE. All right. That is why I mention that because the entire statement will be printed in full in the record. Mr. DEWALD. The first question: Has the Federal Reserve controlled the money supply? I think there is persuasive evidence that it has not attempted to or at least has not effectively controlled monetary growth. There are very erratic movements in the quantity of money from week to week or from month to month as is evidenced by the behavior in 1967 and so far in 1968. The tremendous increase in money in January of this year, essentially no change in February, a rapid in- crease again in March, and though the April statistics are still prelim- inary, apparently very little change in April. On again, off again. Perhaps that makes sense from the point of view of short-term pat- terns, but when one looks at cyclical movement of the quantity of money, I wonder whether it does. On the average monetary growth proceeded at a 2.6 percent annual rate over the period 1957 through 1967. From the period August 1962 through August 1965, as the economy was proceeding on its course toward full employment, there was an acceleration in the rate of monetary growth to 3.6 percent. That also made sense perhaps. But conceivably that increase in monetary growth would have made more sese if it had come earlier in the period, when the level of employment relative to capacity in the economy was a lot lower. But then, from the period August 1965 through April 1966, when increased spending threatened to be inflationary, monetary growth occurred at a 7.6 percent annual rate. PAGENO="0088" 84 Over the next months, April 1966 through December 1966-the period before and after the credit cruch-there was essentially no monetary growth at all. And in 1967 annual monetary growth was 7.2 percent, a rate that has not quite been matched through the present. On the basis of that on again, off again performance, I think that the Federal Reserve is looking at something else than the. quantity of money. Whether it should or not is another question. But in any event I am willing to conclude that it has not attempted to control monetary growth. Question two: Could the Federal Reserve control monetary growth? I think there is good evidence that it could, but we can't be sure be- cause central bankers here or any place else have never, to my knowl- edge, made any direct attempt at controlling the quantity of money. Let's look at the evidence as fa.r as the qua.ntity of lawful money is concerned-that is the monetary obligation of the Government con- sisting of currency and coin and the deposit obligations of the Federal Reserve. I classify the Federa.l Reserve as part of the Government-I hope no one objects. The amount of lawful money depends on factors tha.t are outside the control of the monetary authority, and other fac- tors that it can control. Quite obviously there is a problem in predict- ing the effect of noncontrolled factors on the amount of lawful money. This is done by the Federal Reserve. Daily and weekly and monthly projections of these noncontrolled factors are made. For reasons that I really don't understand, these projections are not made. available outside the Federal Reserve. But I know that they are available in- side. Independent estimates have been made. These would suggest that. over the course of a week or two almost all of the variation in noncontrolled factors could be account.ed for and adjusted for by open market operations that were directed at a. target comparable to the bracketing of a target by an artillery officer. To hit a target. one would overshoot a.nd undershoot until the desired average level of lawful money were achieved. Controlling the amount of lawful money does not control the money supply, however. The ratio between the qua.ntity of money and the qua.ntity of lawful money is affected by policy instniments. for ex- ample, required reserve ratios, the discount ra.te, a.nd Federal Reserve holdings of securities. It is a.lso affected by fac.tors that. are outside the control of the monetary authority. Hence, one has a second level kind of prediction problem in relating the instruments of monetary policy to the quantity of money. I label these factors that. are not con- trolled as the "distribution of money." It involves the distribution be- tween kinds of money that are subject to different reserve require- ments, between kinds of assets that are defined as money and those that are not, between bank required and excess reserves a.nd the like. On the basis of these noncontrolled but predictable factors. given the instruments of monetary policy, a very substantial percentage of the variation in monetary growth can be explained. Professor Christ has mentioned the quarterly models that have been prepa.red in recent years. Many of these have t.aken the instruments of monetary policy as exogenous or independent factors. a.nd subject to tha.t limitation have estimated money flows, with upwards of 80 percent of the money flows from quarter to quarter being expla.ined. I would suggest that a much greater degree of accuracy in monetary PAGENO="0089" 85 control is possible than would be indicated `by that 80 percent figure, on the `basis of a kind of monetary policy, if directed at moderating variation in monetary growth, that would react to recent observations. The Federal Reserve does have weekly average statistics on the money supply, and if the greater monetary growth one week is out of line from that which is desired, quite obviously there are changes of policy instruments in the subsequent week that can affect the amount of money. And on the basis of the reasonable predictability of the~ non- controlled fa:ctors that affect money, I `think there is no question that over `the course of a period as long as a quarter, the rate of monetary growth can be `made anything that the Federal Reserve wanted it to be-or if directed by the `C'ongress, anything `that the public wants it to `be. `There is a statistical problem in terms of feedbacks in the effects of changes in instruments on `the quantity `of money. However, on the basis of such a bracketing policy as I suggested, and the degree of predictability of noncontrolled `factors, tha't is likely, I thin'k it is quite reasonable that money could be controlled. As far as questions about the effects of moderating monetary growth, let me `point out that I do not think that a fixed rate of monetary growth is necessarily the best policy. But it is a norm again'st which we might compare particular policies. If we moderated monetary growth, `there would be some important effects on market interest rates. From the point of view of day-to-day and week-to-week money market conditions, `there would `be a greater degree of interest rate variability than presently. I don't think you can establish `that on the b'asis of the evidence in the United States over the `course of the Federal Reserve period, because of the fact that the Federal Reserve has taken as its objectives to act as a kin'd of shock absorber to buy securities when the market is tighter than it wants it to `be, and to all securities in the opposite circumstances. But there is evidence elsewhere. I spent last year in Australia `at the Reserve Bank of Australia. The money market there is operated on a `somewhat different basis than here. There are wider spreads than in the United `States between the buy and sell prices on securities that the Reserve Bank `of Australia uses in stabilizing the money market, and there `are correspondingly wider variations in short-term interest rates on a day-to-day, week-to-week, or `seasonal basis in Australia than in the United `States. Increased short-term variation in interest rates is one of `the likely consequences if there were moderation in the rate of monetary growt'h variation. There is additional evidence about this. If you look at the period before the Federal Reserve, there was much seasonal variation in interest rates. There is still a bit but certainly there was a greater amount of it before the establishment of the Federal Reserve. Also, there was a period in the 1930's when the Federal Reserve conducted no market operations-the Pontius Pilate effect, it washed its hands of the whole matter. If you look at that period there was interest rate variability on a short-term basis, which resulted from noncon- troiled factors. And finally, if you look at statements of Federal Re- serve officials, they have in mind that they are stabilizing money market conditions and interest rates in response to variations in the short-term demand for money that would otherwise cause variability in market conditions and interest rates. PAGENO="0090" 86 I would like to point out that this interest rate variability that would occur as the result of moderating variation in monetary growth, would be importantly constrained by the market. Changes in interest rates, if they aren't. expected to obtain for very long, will induce a market response by people who e.xpect that. they can earn a short- term profit in taking a position. At. least that is the experience, that we have on the basis of the operation of government security dealers here and everywhere else; and there is a. parallel experience in other markets. As far as longer term considerations are concerned, moderating variation in monetary growth on the basis of the conventional wisdom would be expected to increase interest rate variability. This is a possi- bility, but I am not sure, and I think that a reasonably strong case can be made that if variation in monetary growth were moderated, it would have t.he effect of moderating interest rate variability over the business cycle. I argue that t.he slowest rate of monetary growth over business cycles is around cyclical peaks in economic act.ivity. If monetary growth proceeded at. the average rate of the ent.ire cycle, the effect would be to moderate the peak levels of interest rates that are typi- cally reached .at about the peak of the cycle. And furthermore, there is a reasonable probability that t.he peak in interest rates would occur sooner than it does now. If, as we all expect, there are lags in the effects of monetary policy and interest rates on the economy. certainly it would make sense for interest rates to peak and begin to decline in anticipation of a cyclical peak. One can't be sure that. this effect would occur but it is a reasonable probability on the basis of the kind of monetary growth and the kind of interest rate peaks we have. seen in the postwar period. The result would be tha.t int.erest rates would be lower at cyclical peaks and their peak would pre-date the cyclical peak in economic activity. A similar argument could be made with respect. t.o the increase of interest rates in anticipation of t.he economy achieving a full level of activity. Perhaps the most important long period interest rat.e effect of mod- erating variation in monetary growth would be that., if it were effec- tive in damping t.he cumulative deflationary and inflationary experi- ences of the economy k. would limit extreme interest rate variability such as that observed in the 1930's. Interest rates went to almost nothing on Government securities t.hat were very close substitutes for money. Indeed int.erest ra.tes were pretty high on some ot.he.r kinds of loans where dc-fault risks were high. Because of a. variety of fact.ors hut at least partly accountable to unduly tight monetary policies in the early 1930's-we had substantial deflation which affected people's expectations. And they found it would be appropriate for them to hold additional default-risk-free assets denominated in money terms. Interest ra.tes were low because people anticipated additional deflation. Lenders were willing to accept low rates because of expected increases in the real value of the money that was promised to them. Interest rates are high today because of pa-st monetary policies in pa.rt a.nd be- cause of the associated fact t.h.at people expect the value of the dollar will depreciate. PAGENO="0091" 87 This kind of long-term, secular peak and trough interest rate varia- bility would, in my mind, certainly be moderated by a policy of moder- ating variation in monetary growth. As far as economic efficiency is concerned, the average level of unein- ployment would likely be reduc.ed as a result of a policy of moderating variation in monetary growth. This is accountable in part to the cycli- cal effect, but in addition there is an argument included in the paper that if we moderated monetary variation over the course of the sea- sons and permitted interest rates to vary instead, and if this happened every year, it is conceivable that we could avoid some seasonal varia- bility in unemployment. For example, there is peak economic activity and employment in October and excessive unemployment during the summer months. I don't want to make much of an argument for this because it is mainly conjecture, and there is little evidence that bears on the possible effects of seasonal interest rate variability on the economy. As far as the effect of moderating variation in monetary growth on foreign exchange rates, it is conceivable that it would be necessary to change foreign exchange rates from time to time as a result of a drift in prices and interest rates here in comparison with overseas. Nevertheless it is possible that the fixed exchange rate system would work better than it does now to the extent that excesses in terms of inflation and deflation were moderated. Finally, would moderating monetary growth be a better policy than what we have got? I certainly think it would be. I don't think a constant rate of growth in the quantity of money is necessarily the best policy but it `is a norm against which we ought to compare what monetary policy should be. I think that over the course of a cyclical downturn, it is reasonable that the rate of monetary growth at least expand at the average of the business cycle; and during a period of high level economic activity aiid threatening inflation, it is reasonable that the rate of monetary growth not exceed its average of the business cycle. That has not been the historical pattern no matter how you define money. Thank you. Chairman PR0x3IIRE. Thank you, Mr. Dewald. (Prepared statement of Mr. Dewald follows:) PREPARED STATEMENT OF PROF. WILLIAM G. DEWALD COULD THE FEDERAL RESERVE CONTROL THE MONEY SUPPLY AND WHAT WOULD HAPPEN IF IT DID? The Federal Reserve (F.R.) has not tried to control short term variation in monetary growth, but it could if it tried. Limiting variation in monetary growth would probably increase day-to-day and week-to-week variation in market inter- est rates; decrease variation in interest rates over the business cycle; reduce average unemployment and increase economic efficiency; necessitate changes in the foreign exchange rate of the dollar if U.S. prices and interest rates got out of line; and not be the best possible monetary policy but be better than what we have had. I. HAS THE FEI)ERAL RESERVE CONTROLLED MONETARY GROWTH? If this is interpreted to mean that the F.R. has consciously sought to limit variation in monetary growth, the answer is no. The evidence is that monetary growth has been very erratic. Money narrowly defined increased 7.2 percent dur- ing 1967. If that were `the desired rate, there would have been a very strong PAGENO="0092" 88 tendency for weeks when the rate of monetary growth deviated from that average to be followed by weeks when its growth rate deviated from the average in the opposite direction. The fact is that there were 27 periods in 1967 when the actual percent change in seasonally adjusted money deviated in the same direction from the annual average for two weeks or more; ten periods, for three weeks or more: and three periods, for four weeks. It is not reasonable that these changes could have occurred without the FR. finding out soon enough to try to react: Prelimi- nary `but quite accurate weekly data are pi~b1ished with a lag of only one week. Observed deviations from average monetary growth over longer periods than weeks are even more persuasive that the P.R. does not control monetary growth. The average annual rate of increase in money was 2.6 percent from 1957 through 1967. Relative to that historical trend, monetary growth accelerated to a 3.6 percent annual rate from August 1962 through August 1965. This probably made sense, though it could have come earlier. But then as the economy approached capacity utilization, the monetary growth rate. rather than decelerating, ac- celerated further to 7.6 percent from August 1.965 through April 1966. From April through the rest of 1966-during the "credit crunch"-there was no growth at all. As mentioned, monetary growth accelerated to 7.2 percent in 1967. A similar on-again, off-again monetary growth is shown in money broadly defined to include commercial bank time deposits. The directives of the Federal Open Market Committee to the Manager of the Open Market Account in New York offer the best testimony of what it is that the P.R. tries to do. The directives are usually phrased in terms such as reserve "positions" or "availability" and money market "conditions" or "pressures". This is measured by net borrowedreserves (negative free reserves)-the arith- metic difference between member bank borrowings from the Federal Reserve and excess reserves "Long experience has shown that any departure from a relatively steady ratio between bank credit expansion and the reserves supplied at Federal Reserve initiative sets forces into operation that tend to encourage bank credit expansion when free reseres exist and to restrian bank credit expansion when net borrowed reserves exist." 1 Net borrowed reserves and market interest rates are corrolated; and it is to one or both of these that the Committee usually refers. In the terminology of the Committee, easing conditions are measured by declines in interest rates or net borrowed reserves, while tightening or firming conditions are measured by the comparable increases. Where conditions differ in New York from elsewhere the Manager may indicate that the "feel of the market" is tight, aggregate measures to the contrary. Statements about money market pressures in the directive have sometimes been made conditional in recent years. The Committee has directed that desired conditions be attained subject to particular developments that might occur between meetings. Shocks related to Treasury financing, bank credit, money, and liquidity developments have been referred to in this way, though it has been unclear what precisely would have to happen to change desired market conditions and by how much. According to the record for the December 12. 1967 Meeting, the Committee directed the Manager to conduct operations for the purpose of ". . . moving slightly beyond the firmer conditions that have de- veloped in money markets partly as a result of the increase in Federal Reserve discount rates, however, that operations shall be modified as needed to moderate atly apparent significant deviations of bank credit from current expectations or any unusual liquidity pressures." 2 During the intervening period until the January 9, 1968 meeting, bank credit. estimated by total bank deposits, increased at a 3 percent annual rate but money narrowly defined increased at an 11 percent annual rate. It is presumably not a coincidence that free reserves did decrease as directed and were widely inter- preted as an indicator of tightening policy despite the fact that monetary growth had proceeded at such a rapid rate. A similar directive was issued by the Com- mittee at its next meeting. During the following four weeks; free reserves fell further; the rate of bank credit growth was about the same; and monetary growth proceeded at about a 1.5 percent annual rate. It is clear that the P.R. has not tried to control monetary growth, at least not directly. The proximate targets at which the P.R. has aimed have typically 1 "The Federal Reserve and the Treasury Answers to Questions From the Commission on Money and Credit." Englewood Cliffs, N.J.: Prentice-Hall, Inc.. 1963, p. 9. "Federal Reserve Bulletin,' March 1968, p. 306. PAGENO="0093" 89 been achieved. The timing of changes in desired money market conditions reveals that the F.R. has been quick to pick up evidence of a need for action. But actual policy actions and money supply changes have often been in the wrong direc- tion and of inappropriate magnitude. The analogy is made that the policy of manipulating money market conditions or interest rates is like a baseball player who can't hit curve balls. The policy is all right if market conditions are at an equilibrium associated with achievement of objectives. But otherwise, when the economy throws curves, tardy adjustments in desired money market condi- tions lead to strikeouts by swinging at where the economy was rather than where it is. II. COULD THE FEDERAL RESERVE LIMIT VARIATION IN THE RATE OF MONETARY GROWTH IF IT TRIED? Generations of American university students have learned how F.R. open market operations could be used to control bank reserves and other "lawful money." This is also called "high powered" or "base" money. It in turn has been interpreted as the cornerstone on which the money supply depends. The quantity of money is determined within a supply and demand or market frame- work. But this market process operates subject to important policy constraints including the amount of lawful money and the legal requirements imposed on banks to hold lawful money. A number of empirical studies of the determination of the quantity of money within a market framework have been made in recent years.3 Most have used quarterly data and have accounted for about 80 percent of the variation in quarterly changes in the money supply. But these statistical results are not al- together relevant from the point of view of actual monetary control. It is not necessary to fix the quantity of the F.R. open market account or reserve require- ments over the span of an entire three-month period as is the assumption Of the quarterly models. The F.R. has weekly money supply statistics that are pub- lished with a lag of one week. It is in a position to observe when deviations in monetary growth from a desired rate are sufficiently great to warrant a reaction. It is certainly true that the FR. must take into account various non-controlled factors that affect the supply or demand for lawful money. It presently makes day-to-day and week-to-week projections of likely changes in these non-controlled factors. Independent estimates show a large part of the variability in non-con- trolled factors that affects average bank reserves and other lawful money could readily be offset over a week or two by open market operations of sufficient magnitude.4 Changes in the ratio of money to lawful money are accountable to changes in the distribution of money among deposits subject to different reserve require- ments, between monetary and non-monetary-deposits, between lawful money reserve holdings of banks and currency holdings of the public, and finally, be- tween bank required and excess reserves. These changes reflect both supply and demand factors in the money market. There is a relatively strong seasonal pat- tern in variation with respect to some of these non-controlled distributional factors; and there is knowledge with respect to their response to market interest rates and to spending. Though non-policy factors are important, it has been shown that a large part of the quarterly changes in money are accountable to changes in reserves (and other lawful money) and in reserve requirements.5 At but one remove from the money supply, another study has shown that more than two-thirds of the variation in changes in net deposits of member banks over half-monthly periods were accountable to changes in bank reserves, changes in required reserve ratios, and predictable changes in distribution of deposits sub- ject to different reserve requirements. Though the deposit distribution is really very stable in the short run, taking account of seasonal factors and market prices reduces prediction errors by about 50 percent from those based on the naive Frank de Leeuw, "A Model of Financial Behavior" In J. S. Duesenberry, G. Fromm L. R. Klein, and B. Kuh. "The Brookings Quarterly Econometric Model of the tiniteci States." Chicago: Rand McNally & Co., 1965, Stephen M. Goldfield. "Commercial Bank Behavior and Economic Activity," Amsterdam: North Holland Publishing Co., 1966. William G. Dewald and William E. Gibson, "Sources of Variation in Member Bgnk Reserves," "Review of Economics and Statistics" (May 1967),, 143-50. William G. Dewald, "Money `Supply Versus Interest Rates as Proximate Objectives of Monetary Policy." "National Banking Review" (June 1966), 509-22; and Karl Brunner "A Scheme for the Supply Theory of Money," "In~ternational Economic Review" (January 1961), 79-109. PAGENO="0094" 90 alternative of assuming that there would be no change in the distribution from period to period. The estimates suggest that more than half of the time predic- tion errors would be $112 billion or less.6 These errors in prediction must be in- terpreted in the light of an attempt to control monetary growth. Errors could be reduced substantially over longer periods than a week or two if monetary policy were implemented so as to offset prediction errors in one period by coin- pensating changes in the target the following period. For given settings of policy instruments, reasonable predictability in deposit changes and changes in the quantity of lawful money over very short periods supports the conclusion that the Federal Reserve could ordinarily manipulate its instruments to have a highly predictable impact on the amount of member bank deposits and money on a month-to-month or quarter-to-quarter basis. A question must be raised with respect to the actual relationship of money to policy instruments if monetary control became the proximate policy objective. If the F.R. utilized its instruments to constrain monetary growth to a desired level, induced changes in interest rates could feed back to affect changes in money. The point is that if the structure of the economy has been one such that policy instruments have moderated interest rate variability, then estimates of financial behavioral patterns could be expected to be biased. A simple illustra- tion can make this clear. Suppose there is a change in demand for bank credit which prompts banks to sell securities. The effect would be to increase market rates on private and government securities. But if the monetary authority con- ducts open market operations to prevent these increases, it would increase the amount of lawful money in the system and in the immediate run moderate the increase in interest rates. Statistical data would show that changes in the amount of lawful money were directly associated with changes in the quantity of bank credit and deposits. The question is whether there would be a comparable in- crease in the quantity of money and bank credit if the FR. initiated the action by purchasing the same quantity of securities where there had not first been an increase in the demand for bank credit. There is little question that the F.R. could increase the quantity of lawful money by any given amount. This would induce banks to extend credit and to issue deposits. In the immediate run this would decrease interest rates. And that in turn would induce the public to borrow and to add to deposit holdings. From cycle to cycle or historically over long periods, it is reasonable to conclude that these policy actions have played an independent role.7 The question is whether they have played an independent role, week to week and month to month; and if they have not, how can one interpret the short term relationship between money and hank credit, and the instruments of policy? Though the evidence is incomplete I am willing to conclude that the predicti- bility of lawful money and the distribution of money is sufficiently great that actual manipulation of controlled variables to limit variation in monetary growth could be accomplished. There is no need over reasonably long periods of time, certainly a quarter-to-quarter basis, for average monetary growth to deviate from desired rates. The money supply could be controlled if it were desired. III. WOULD THERE BE INCREASED SHORT TERM VARIATION IN MARKET INTEREST RATES AND MONEY MARKET CONDITIONS IF THE FEDERAL RESERVE WERE PERSUADED TO LIMIT VARIATION IN MONETARY GROWTH? The evidence must come from someplace else than the present U.S. For many years the F.R. has acted as a shock absorber, preventing short term variability in interest rates or other measures of money market conditions from desired values. The desired values have been subject to change, but, for a given level. changes in any of the uncontrolled factors that would otherwise change market yields and money market conditions have been offset by policy reactions. Indeed there have been many occasions when the immediate effect on money market cOnditionS of one monetary policy action has been almost altogether offset by another. The prediction that there would be increased short term variability in interest rates if the FR. moderated variability in monetary growth is based on the follow- ing evidence: There is greater seasonal and random variability in free market rates of in- terest on short term instruments in other countries where the central bank takes 3William G. Dewald. "Control of Member Bank Deposits," Econometric Society Winter ifeeting, 1964, unpublished. Milton Friedman and Anna J. Schwartz. "A Monetary History of the United States, 1867-60," Princeton: Princeton University Press, 1963. PAGENO="0095" 91 a less active role in moderating short term shocks to the financial system than is true in the U.S. In Australia, where I was visiting economist to the Reserve Bank of Australia last year, there `are relatively wide spreads between the buying and selling prices of the monetary authority. It takes a larger change in money market conditions to induce an open `market operation. The market is free `to determine interest `rates on short `term instruments over a much wider range of values than is true in the U.S. And there is substantially more variability in rates of `interest in the short term money market in Australia than in the U.S., though it is importantly limited by speculation and international capital flows where rate changes are expected to be temporary.8 There was a strong seasonal in interest rates in the U.S. before the establish- ment of the F.R. This has since been moderated by FR. actions. There was no apparent seasonal in interest ra:te variation `from month to month during that period of t'he 1930's when the F.R. did not make any open market transactions for a few years; but there were substantial month-to-month changes in interest rates, presumably reflecting non~policy factors. Finally there is the testimony of the F.R. officials who repeatedly have reported that there are large changes in uncontrolled factors in the short run that would cause sharp changes in market interest rates `and money market conditions in absence of cushioning operations. J :p~m willing to conclude that there would be increased short term variability in market interest rates if `the F.R. `tried to moderate variation in monetary growth rates. IV. WOULD LIMITING VARIATION IN THE RATE OF MONETARY GROWTH INCREA5E INTEREST RATE VARIABLY OVER THE BUSINES5 CYCLE AND SECULARLY? Limiting variation in monetary growth would likely decrease interest rate variability. This is stated with full know:ledge that it is an affront to con- ventional wisdom. Monetary growth in `the postwar `period h'as been lowest around cyclical peaks. It has accelerated subsequently and then, during expansions, has sometimes accelerated further `and sometimes decelerated. It is reasonable to infer that interest rates would have bee'n `lower and would have fallen faster around cyclical peaks if monetary growth had proceeded aJt its long period `average. Similarly a ste'adier rate of monetary growth would have held interest rates higher than the `actual lows a't cyclic~a~l troughs since these periods often coincided with high points in rates of nione'ta'ry growth. There are separate short term and long term forces that affect the relation- ship between monetary policy and interest rates. The argument th'at is most familiar involves the short run w'he're in'creases in monetary growth could be expected to decrease interest rates and decreases in monetary growth could be expected `to increase interest rates. The point is that policies that expand the money supply provide `banks and others with the wherewithal to increase the demand for investments, the effect of which is `to bid up their prices, or equivalently to reduce in'terest rates. This argument depends on the presence of relatively sticky prices and wages, and by implication, less than capacity utilization of resources. When `these conditions hold, it is possible for declining interest rates to stimulate demand without causing offsetting price and wage increases. A `similar argument c'an be made for a decre'ase in monetary growth. Though one `cannot `be sure, it `is reasonable that cyclical interest `rate varia- bilisty of this variety would be reduced by policies that limit variation in rates of monetary growth. The present cyclical interest rate pattern mainly follows the `busi'ness cycle with peaks and troughs `roughly coinciding with peaks and troughs in economic `activity. To the extent that steady monetary growth would represent an acceleration (deceleration) relative to observed growth around cyclical peaks (troughs), moderating variation `in monetary growth would tend to damp interest rate variability `at `the extremes. And it could also `be expected to force interest rates to `decline earlier and to precede cycle Peaks i'n economic activity. The argument is that around cyclical peaks when monetary growth has been slowest, a relative increase in monetary growth would tend to decrease interest rates. The implication is that the timing of interest rates changes, the effects of which `are inevitably lagged, would be reset to start their stimulative effects earlier than under `the present policies. These policies have deliberately taken actions to make high interest ra'tes or tight money market oo'ndi'tions S William G. Dewald. "The Short Term Money Market in Australia." the English Scottish and AustraBan Bank Limited Research Lecture, 1967, Brisbane: University of Queensland Press, 1967. PAGENO="0096" 92 coincide with business cycle peaks and to make low rates coincide with cycle troughs. The argument that is least familiar involves the long run where increases (or decreases) in monetary growth could be expected to increase (or decrease) interest rates. This involves a reformulation of expectations of future prices on the basis of observed effects of monetary growth on prices. Suppose that an increase in the rate of monetary growth supports an increase in demand. This would tend to increase prices which in turn would eventually induce savers and investors to anticipate further price increases. Borrowers would be willing to pay more interest for dollars whose purchasing power was expected to depreciate. And savers would demand to be paid enough interest to compensate them for their sacrifice of present purchasing power in real terms and for the expected decline in the value of money. Tinder these circumstances policies to accelerate (or decelerate) monetary growth would increase (or decrease) interest rates. One cannot be sure what effect moderation in variation in monetary growth would have on overall interest rate variability over the business cycle. But it is reasonable to expect that interest rates would tend to lead economic activity more than presently where rates of monetary growth have tended to lead, and that cyclical extremes in interest rates would be damped. It is eminently clear that limiting variation in monetary growth would be associated with less long term variation in interest rates than has been observed historically. The ex- tremely low interest rates that obtained after the financial collapse of the banks in the 1930's resulted from an extremely low level of demand at least partly accountable to unduly restrictive monetary policies that had occurred earlier. The extremely high interest rates that obtain today are at least partly accounta- ble to the high rates of monetary expansion and aggregate demand that have occurred over recent years. To the extent that moderating variation in monetary growth could damp cumulating inflation or deflation in the economy, it is reason- able to conclude that it would limit interest rate variability too. I believe that lessening variability in monetary growth would have this effect. V. WOULD LIMITED VARIATION IN MONETARY GROWTH REDUCE VARIATION IN UNEMPLOYMENT AND INCREASE ECONOMIC E5TIC~NCY IN THE LONG RUN There is a question whether monetary policy actions have been counter-cyclical in their effects, and whether limiting variation in monetary growth would in- crease or reduce the counter-cyclical effects of monetary policy actions. This is an issue about which there is a lively argument presently in the economics profession. Those who have argued that monetary policy actions are perverse and play a major role in the pro-cyclical variation in monetary grow-th rates would conclude that limiting such variation would reduce the applitude of the business cycle. This implies reduced variability in capacity utilization or unemployment and an increase in economic efficiency. But even if monetary policy actions have affected the economy in the right direction, the question is whether that effect is as great over the cycle as the effect that would have resulted if monetary growth had been stabilized. This depends on the timing of the reaction of policy to economic performance and the effect of policy action on objectives. Empirical results suggest a relatively short lag in the response of policy aims to changes in economic conditions but a rather long lag in the response of the economy to policy actions. Part of this response comes in a very short time but overall it is distributed over many months and is variable from cycle to cycle. Empirical results would suggest important responses in expenditure to interest rate changes in six months to a year though much longer average lags have been estimated.~ An interesting theoretical model has been developed in recent years that suggests that changes in the money supply, if made an independent factor, would tend to cause augmented changes in market interest rates which would have the effect of speeding the adjustment to monetary policy actions in comparison with ° Michael 3. Hamburger "The Impact of Monetary Variables: A Selected Survey of the Recent Empirical Literature," "Staff Economic Studies" (August 1966) : anti Robert H. Strotz, "Empirical Evidence on the Impact of Monetary Variables on Agrregate Expendi- ture" in George Horwich (Editor), "Monetary Process and Policy: A Sythpcsium." Home- wood, Ill.: Richard D. Irwin, Inc., 1967: and such unpublished econometric studies as fliOid o~ ~te~hen II. Q6ldf8ld an~ ATh@rt A~do, Ronald Toi~on, and tile MIT-Ped axodel. PAGENO="0097" 93 the lag that one would expect simply Oil the basis of the relationship of expendi- ture to interest rates.'° If one assumes that limiting variation in monetary growth would have the effect of increasing interest rate variation seasonally, it is reasonable to expect that economic efficiency would be improved and that unemployment variation over the year would be reduced, though perhaps not very much. The argument is that where interest rate variation is moderated over the year, the economy loses the effect of one kind of price change that could direct factors of production to employment during periods that would otherwise be slack. Over the year there are periods of intense employment utilization, peaking at the end of the harveSt season and the pre-Ohristmas production in October. The high point in un- employment is in June when the labor supply is increased after school-leavings; and hard on its heals comes the low point in industrial production in July. One should expect that relatively lower interest rates before and during June would make it easier for businesses to finance their operations and to increase their utilization of labor in June arid July and that relatively higher interest rates later in the year would marginally shift production to earlier periods. If there is no financial penalty to operating during periods of high level resource utiliza- tion, other than the relative scarcity of labor, then part of the potential power of the price mechanism in directing resources toward employment during slack production periods is emasculated. The potential effects of interest rates on the allocation of resources are much greater over cycles than seasons. Low interest rates in recession serve a purpose in stimulating demand. As mentioned, if monetary policy actions and accelera- tion in monetary growth lag behind cyclical peaks, it follows that a more stable rate of monetary expansion at cyclical peaks would speed declines in interest rates. Similarly, it could stimulate an earlier increase in interest rates where the economy approaches full utilization of resources. Gradual declines in interest rates after cyclical peaks have been the bane of F.R. policy. Since policy actions affect the economy with a lag, it is incumbent to introduce counter-cyclical policies of sufficient magnitude to have a measurable effect and not to delay their intro- duction. Where the need for policy response is established, gradualism in declines in interest rates or increases in free reserves have often got the FR. into the difficulty of taking policy actions that were actually perverse in preventing interest rates from falling as far as they would have in the absence of `actions.'1 This has typically been associated with a misconception on the part of the FR. It has often interpreted declining interest rates or easing money market condi- tions as expansionary and rising interest rates or tightening money market condi- tions as contractionary without taking account of the independent effect of its own actions. The actual change in quantity of money (and bank credit) can give important clues about whether policy actions have been sufficiently expansionary in the face of a declining economy or sufficiently contractionary in the face of infla- tion. The money supply might not always increase even with expansionary policy actions, because of the effect of factors outside the control of the FR. Nevertheless, where there has been a decline in the demand for commodities at the onset of recession, it would be reassuring that the impulse of policy was in the right direction if the money supply actually increased, at least at the aver- age rate it had grown in the past. And where there has been an inflationary increase in the demand for commodities, it would be reassuring that the impulse of policy was in the right direction if the money supply actually increased at not more than its long period average rate. By this standard money grew too little in the year ended June 30, 1900, as the economy moved into recession and too much in 1967 in opposite circumstances. The rate of growth in the supply of money can be given the interpretation of early election returns which provide an indi- cator of the final outcome of an election. The quantity of money can reflect the thrust of policy action on the economy before the actual effects of those actions are felt in expenditure, employment, and prices. This has been the main point of my colleague, Karl Brunner's argument with respect to the interpretation iO Donald P. Tucker, "Income Adjustments to Money-Supply Changes," "American Economic Review" (Juno 1966), 433-449, and a related empirical study, Harold T. Sharpiro, "Distributed Lags, Interest Rate Expectations, and the Impact of Monetary Policy: An' Econometric Analysis of a Canadian Experience," "American Economic Re- view" (May 1967), 444-461. ":The episode of the 1059-60 decline in money is discussed in William ~. Dewald, "The Monetary Policy Guide," Money and Bank-lag Workshop, Federal Reserve Bank of Mm- neapolls, May 1961 and "Free Reserves, Total Reserves and Monetary Control," "Journal of Political Economy" (April 1963), 141-153. 94-340-68----? PAGENO="0098" 94 that one should put money changes. Analysis by Brunner and his collaborator~ Allan Meltzer, has shown a much closer correspondence between economic activity and the money supply variously defined that between economic activity and alternative measures of the stance of monetary policy such as interest rates and free reserves.'~ It is reasonable to conclude that limiting variation in monetary growth rates and letting interest rates vary seasonally would moderately reduce average un- employment. Limiting monetary growth variation cyclically would be expected to reduce the amplitude of the business cycle and increase economic efficiency. VI. WOULD LIMITING VARIATION IN THE RATE OF MONETARY GROWTH REQUIRE FOREIGN EXOHANGE RATE ADJUSTMENTS? An implication of a policy to limit variation in monetary growth rates is to commit the U.S. to put domestic policy objectives firSt. It might be necessary to change the value of the dollar in terms of other monies from time to time. But there is no reason why one should expect balance of payment disequilibrium to be any more of a problem than presently. In fact, if moderated variation in monetary growth had the effect of damping the business cycle, the critical prob- lem of inflation and an associated balance of payments deficit would be reduced. This would make the dollar more attractive as an international reserve cur- rency. If not only the U.S. but other countries initiated policies of moderating variation in monetary growth and other policies that had the effect of stabiliz- ing domestic prices and maintaining production reasonably near capacity, there would be much less reason than now for the price of one currency to change in terms of others. Over the years, as tastes and productive capabilities changed in different coun- tries, one should expect that it would be necessary to adjust foreign exchange rates. But such fundamental disequilibrium in currency values is best eliminated by foreign exchange rate adjustments and not by inflation in surplus countries or deflation and depression in deficit countries. It is more than a remote possibility that the present fixed exchange rate system would operate a lot more efficiently than now if the U.S. and other countries took steps to limit variability in the growth rates of their domestic money supplies. Nevertheless, it is an implication of domestic stabilization policies that any resulting balance of payment disequili- brium be adjusted by exchange rate changes. If more stable monetary growth rates than we have had should result in greater relative inflation here than over- seas, the implication is that foreigners would eventually get more dollars than they would want and the price of the dollar would fall. On the other hand. if limiting variation in monetary growth should result in less inflation here, the implication is that we would accumulate additional foreign currencies or gold- eventually more than we would want-and the price of the dollar would have to rise in terms of other currencies. VII. WOULD MODERATING VARIATION IN MONETARY GROWTH BE A RETTER POLICY THAN WHAT WE HAVE HAD? I have argued that moderating variation in monetary growth would be an improvement over past policies. This does not mean that a constant rate of growth in money would be the best policy. But it is a reasonable norm against which to compare counter-cyclical policy actions. The economic record suggests that a constant rate of increase in the money supply would have provided more expansive action before and after cyclical peaks than what we actually got. It would have provided less expansive actions during the Korean War and the present Vietnam War. It is reasonable to conclude that a constant rate of increase in the money supply would have moderated the extremes of postwar booms and recessions. The reason why the FR. has so often pursued policies that caused monetary growth rates to accelerate with accelerating economic activity and to decelerate with decelerating economic activity is associated with the idea that the thrust of policy actions is measured by interest rates and money market conditions. An implication is that monetary policy actions have often tagged along behind fis- cal policy, rather than exerted an independent role. This is probably even more 12 Karl Brunner and Allan' H. Meltzer, "The Meaning of Monetary Indicators." in George Horwich (Editor), "Monetary Process and Policy: A Symposium," Homewood, Ill.: Richard D. Irwin, Inc., 1967. PAGENO="0099" 95 of a problem in most other countries than it is in the U.S. Expansive or contrac- tive monetary policy actions can be induced by budgnt deficits or surpluses where FR. acts to prevent interest rt(tes from changing as much as they otherwise Would. The test of whether the F.R. has added to the inflationary or deflationary impulse of fiscal policy is not whether interest rates went up or down but whether the F.R. sold or bought securities or took equivalent actions with its other policy instruments. it is typical, though not necessary, for rising budget surpluses such as in 1959 to induce deflationary P.R. policy actions and for budget deficits such as 1967 and 1968 to induce inflationary P.R. actions. Central bankers the world over share the P.R's misconception of the proper measure of the stance of their policy actions.13 This misconception is particularly dangerous when the level of total demand is at a peak and begins to decline. In this situation it is natural for interest rates to decline and money market condi- tions to ease in the absence of any P.R. policy actions. The danger is that the FR. may be fooled into interpreting declines in interest rates as a sign of expansion- ary policy despite the fact that it takes actions to prevent interest rates from falling as far or fast as they would if there had been no policy actions. Similarly during inflationary periods rising interest `rfites can lead the P.R. to misinterpret its policy stance. Earlier I mentioned the analogy of this policy to a baseball player who can't `hit a curve. That analogy can be extended to include the policy of m'oderat- `tog variation in rates of monetary growth. It's a natural curve ball hitter just as the P.R. policy is a natural `strike~out. Moderating variation in mone- tary growth-on the basis of the kind of curves the economy has offered in the postwar pelrio'd-~would automatically tend to damp the worst excesses of induced monetary police reaction to the economy. Fifty-five years of swinging at where the economy was, not where it is, would seem `a fair chance for the central `bankers' policy. It may be time to substitute :a new policy-particularly when one considers the ominous prospects our economy faces today because of policies in the recent past. `Chairman PROXMIRE. Our final witness is Prof. Richard Selden, of Cornell. Professor Seiden? STATEMENT OF RICHARD B. SELBEN, PROFESSOR OF ECONOMICS, CORNELL UNIVERSITY Mr. SELDEN. I appreciate very much `having an opportunity to par- ticipate in this important discussion of the role of guidelines in gov- erning Federal Reserve policy. My statement this morning consists first of some general ~bserva- tions about guidelines, and then some more specific comments about the proposal `of Representative Reuss `which appeared in the commit- tee's 1968 report. The quest for monetary guidelines goes back at least to the famous controversy of the 1940's in England between the currency school and the banking school. In the 1920's in this country, there was `lively dis- cussion of proposals to direct the Federal Reserve to attempt to stabilize an `index of commodity `pric'es. In 1936 Prof. Henry S'i'naons published an article titled "Rules versus Authorities in Monetary Policy" in `which, after surveying a variety of monetary `rules, he con- cluded that the `selection of a particular `gu'i'deline, such as stabilization of the price level or of the volume of money, was `less important than acceptance of the principle that some rule s'h'ould be adopted and announced to the public. Simons saw three main advantages to the adoption of a monetary rule. First, it w'ould tend to stabilize `business expectations. According 13 William G. Dewald, "Indicators of Monetary Policy," Economi~ Papers, "The Economic Society of Australia and New zealand, New South Wales and Victorian Branches" (August 1967), 16-43. PAGENO="0100" 96 to Simons, the major source of the uncertainties that plague business planning and lead to fluctuations in investment spending is govern- ment itself-and especially the monetary authority. The announce- ment of a simple rule that would be adhered to steadfastly would create a stable environment within which rational decisionmaking could pro- ceed with comparative calm. Second, Simons was disturbed by the antidemocratic implications of vesting great power in the hands of a quasi-independent agency such as the Federal Reserve Board. Con- gress, he felt, should retain closer control over this important area. However, the only feasible way of establishing firm congressional control over money would be for it to lay down guidelines within which the Federal Reserve would have to operate. Third, adherence to a rule would prevent the monetary authority from following perverse poli- cies. The case that usually is cited is the 1929-32 period when the vol- ume of money fell by about 2.5 percent during one of the most severe business contractions the country has ever known. It is generally agreed that a policy of maintaining a constant money stock-assuming this could have been achieved, and I have no doubt at all that it could have been-would have been far preferable to the one actually followed by the Federal Reserve, and it is plausible to suppose that instead of suffering through a great depression the economy would have expe- rienced something more closely resembling our mild postwar reces- sions after 1929. This point of view received empirical support from the work of Dr. Clark Warburton, former chief economist for the Federal Deposit Insurance Corporation, who found that every business cycle peak during the interwar period was preceded by a lapse of mone- tary growth from its "normal" upward trend of 5 percent per year. Warburton concluded that the Federal Reserve should aim at a growth rule that would prevent such lapses-as well as inflationary excesscs-~in the future. It is probably fair to say that the contemporary phase of the guidelines debate grows out of Prof. Milton Friedman's work on lags in the effect of monetary policy, which has provided a fourth reason for adoption of a monetary rule. While by no mea.ns rejecting the arguments of Simons `and Warburton, Friedman has argued that a flexible; that is, discretionary, monetary policy is likely to intensify business fluctuations rathei than moderate them. The reason is that policy changes influence t.he economy only after very substantial time- lags. The policy initiated in May 1968 may not reach its maximum im- pact until, say, July 1969. But neither the Federal Reserve nor anyone else possesses dependable means of forecasting the state. of the economy a year or more in advance; hence there is every likelihood that today's policy will turn out. t.o be inappropriate by the time it matures. And to compound difficulties, Friedman believes that monetary lags are highly vai~iab}e, `and unpredictably so. Hence even if we could foresee the state of the economy a year or two from now there would he no assurance that the policy changes initiated today would blossom forth precisely when intended. Friedman's doctrine of long and variable monetary lags has not gone unchallenged, of course. Critics have disagreed with his~tasricai n~e.t.h- ocls and his choice of variables for timing comparisons. It has been pointed out that the. effects of monetary policy are likely to he spread out over lengthy `time spans and that a significant portion of the. effents PAGENO="0101" 97 will be felt fairly soon. However, work by others, including Prof. Thomas Mayer and Prof. John Kareken and Robert Solow and even the Federal Reserve Board's own staff, has established rather defini- tive the reality of monetary lags. Moreover, Friedman readily ad- mits that some of :the effects of policy changes will be felt, quite quickly; what is vital to his position is that a substantial portion of the effects are not felt until long after they are needed, and his critics have not been able to fault him so far on this point. While nearly everyone now acc~pts long monetary lags as .a fact of life, most students of monetary policy remain unconvinced about the wisdom of setting guidelines for the Federal Reserve. This is par- ticularly true of the policymakers themselves. Failure of the pro- and anti-guidelines advocates to reach agree- ment can he attributed largely to disagreements on the following three points. First, the advocates of discretion seem to have different objec- tives of monetary policy in `mind than do the advocates of guidelines. Second, there is disagreement on the theory of monetary policy, that is, on the channels through which policy changes influence the econ- omy's ultimate goals. Third, although this is something of a red her- ring, it is contended by the advocates of discretion that the best rule for the 1960's may be wholly inappropriate for the 1970's or some later period; rules inevitably become obsolete. I shall offer a few comments on each of these sources of disagreement. It is commonplace to observe that the ultimate goals of economic policy, including monetary policy, are to maintain (1) high levels of employment of the economy's resources, (2) a stable price level for goods and services, (3) equilibrium in the balance of payments, (4) efficient patterns of resource use, and (5) an adequate rate of economic progress, whatever that may be. The Federal Reserve authorities, of course, affirm these objectives like everyone else. Yet at least three other objectives seem to play a role in the Fed's determination of proper policy. One such objective is to aid the Treasury in its task of man- aging the Federal debt. A second objective is to avoid making member- ship iii the system unattractive to member banks. This unspoken objec- tive appears to be the major explanation of the Fed's forthcoming liberalization of policy at the discount window. A third implicit objec- tive, often lost sight of by academic critics of the Federal Reserve, is protection of the money market against the random shocks that con- tinually buffet it. One gets the impression from reading their commen- taries that Federal Reserve officials regard the money market as a deli- cate plant that needs constant attention in order to survive. It should be noted that lags probably do not interfere significantly with the Fed's attainment of these three "lesser" objectives-in sharp contrast to the ultimate goals discussed earlier. On the contrary, adop- tion of simple monetary guidelines such as Friedman's 4 percent growth rule or mandatory stabilization of a price index would require abandonment of at least some of these special Federal Reserve objec- tives, especially that Qf protecting the money market. My own view is that these are unworthy objectives that should be rejected in any event. Although I cannot pose as an expert on the money market, I am inclined to think that the Fed as an exaggerated view of the value of the role it is playing in the market. Furthermore, I see no justification for constraining monetary policy in order to PAGENO="0102" 98 accommoclate the Treasury's borrowing plans. Finally, I believe that Congress should make all insured banks, whether members of the sys- tem or not, subject to the same reserve requirements. A much more important source of disagreement on the advisability ĥof establishing guidelines is the lack of consensus on the way in which monetary policy influences economic activity. Typically monetary, fis- cal, debt management, and other policy changes take place simultane- ously, along with a multitude of "exogenous" nonpolicy changes-all of which influence the economy with varying lags. At any moment it is impossible to say with certainty just what the contribution of mone- tary policy has been to the end result. It is possible, therefore, for competent economists to hold rather different views about the relative importance of the money stock (variously defined), bank credit, total unborrowed reserves, the monetary base, etc., as fac.tors influencing the ultimate goals. Even if the general idea of guidelines is accepted, there may be disagreement over the selection of an appropriate target. There may also be disagreement about the ability of the Fed to hit whatever target is selected, although I certainly agree with Professor Dewald that there is not a whole lot of room for disagreement on that point. But one should not exaggerate the extent of our ignorance of monetary economics. In my judgment adoption of target growth rates for any of fh~ variables just listed would probably give better results than we have been getting from monetary policy in recent years. This leads us to the third source of disgareement-the likely ob- solescence of any monetary rule. I have called this a red herring because those advocating guidelines have always recognized the desirability of continuous appraisal of results and the possibility of occasional modi- fications when the results turn out to be negative. Several years ago I `suggested a mechanical device for imparting some flexibility into the `monetary growth rule by making the growth rate of money depend on a moving average (say over a 15-year period) of past growth rates in real output and in the velocity of circulation of money. Perhaps a more sensible procedure would simply be an annual review of the guidelines to determine whether they need revision. Of course, the spirit of the whole guideline approach would be violated by sudden re- visions of a substantial magnitude but this would in no way preclude a high degree of flexibility in the long run. I turn now to Representative Reuss' suggestion that the Fed keep monetary growth (money defined narrowly) within guidelines of 3 to 5 percent per year. I think this is a reasonable suggestion and one that would achieve better results over the long haul than those we have attained in the last decade or so. My only criticism is of the loopholes Representative Reuss has created by design. I have no quarrel with the idea. of allowing for changes in the relative importance of time deposits and other liquid assets so long as this is restricted to taking account of what seem to be longrun trends. However, if we are convinced that the demand for `money is highly sensitive to variations in yields on these assets, then `the solution would be to expand the scope of our monetary target to include them. Similarly, I am skeptical of the value of Representative Reuss' second and third qualifications, which would permit suspen- sion of the guidelines during slack and inflationary periods and dur~ ing periods when businesses "are making exceptionally heavy demands PAGENO="0103" 99 on credit" in order to replenish liquidity. What we know about lags in the effect of monetary policy suggests that these deviations from the guideline would be ill advised. The next three qualifications seem to be especially questionable. The fourth, relating to the accommodation of cost-plus inflation, would guarantee a secular rise in the price level. The basic reason why cost- plus inflation has been such a minor problem in the U.S. economy has been the unwillingness of the Fed to underwrite "excessive" wage in- creases through monetary expansion. With respect to the accommoda- tion of the Treasury, I see no reason why the Federal debt should be managed in such a way that large indigestible blocks of debt must from time to time be refunded, with the tacit cooperation of the Fed. A more even spacing of maturities over a long time span would obviate any special function for the Fed in aiding debt management. With re- spect to the balance of payments, I certainly share Mr. Reuss' dislike for subjecting the domestic economy to monetary change because of balance of payments problems. However, I believe he is much too optimistic about what can be accomplished through strategies such as "Operation Twist." Ultimately it will turn out that monetary policy can ignore the balance of payments only if exchange rai~e variations are used as an equilibrating device. This is an expedient I am quite content to see us follow, especially if "exchange variability" means a regime of floating rates. Finally, I think it would be most unwise for the Fed to engage in open market operations in obligations of the FNMA and the FHLB's Down this path, it seems to me, there is a real danger lurking-that gradually the Fed will be drawn into all sorts of overt interferences with the free market in order to "improve" the allocation of resources. The Fed already has too many responsibilities_for example, regula- tion of bank holding companies and administration of "voluntary guid~lines" for bank loans to foreigners-to permit devotion of its best efforts toward achievement of our ultimate goal; it should not be encumbered with this additional duty. Moreover, in my judgment the difficulties that beset savings institutions and the housing industry in 1966 were in part unique events that are not apt to be repeated and in part the result of the absence of monetary rules in 1965 and 1966 of the very sort Mr. Reuss is proposing. In my opinion the credit crunch was a result mainly of excessive monetary growth, well above 5 percent per year, during the 18 months or so prior to the summer of 1966. I should like to close by making a few observations on the Federal Reserve Board staff comments on Representative Reuss' proposed guidelines. At the top of page 2 it is stated that "the Federal Reserve should be chary of rules that seek to specify, once and for all, what growth of money over the long run is appropriate." Of course, but that is hardly the issue. The problem that the guidelines are aimed at is excessive short-run variations in money, as in 1965-67. The guidelines could be adjusted gradually to take care of long-run changes in the demand for money. The illustration of dire consequences that may result from adoption of a monetary rule given on pages 2-3 of the comment also is not very convincing. One can always select time periods that are congenial to a particular point of view; calculation of growth trends in money over PAGENO="0104" 100 the period 1947-67 is highly misleading. Suppose, for example, that the Fed staff had taken 30-year trends instead of 20 years. I have not bothered to make the computations but. it. is clear that a rather differ- ent. picture would emerge. And as stated in the. preceding paragraph, there is no reason why the guideline could not be adjusted gradually to conform more accurately to the growth trends in output and velocity. The Fed staff has rightly criticized, Mr. Reuss' recommendation that monetary growth be accelerated during periods of cost-plus infla- tion. Identifying such period1s is an extremely tricky business and certainly dould not be clone quickly enough to assure reasonable results, even in the absence of significant monetary lags. Most of the remainder of the Federal Reserve Board staff comment deals with the specific qualifications that Mr. Reuss has built into his proposed guidelines. In general I find myself in agreement with the positions taken by the staff. In summary, I would like to state my recommendations with respect to the guidelines issue. I certainly would oppose any attempt to set up a rigid x percent per year guideline for all future monetary growth. At the same time I feel strongly that the U.S. economy has been sub- jected to excessive fluctuations in the growth of money and bank credit, in the recent as well as more distant past., and I would welcome adoption by the Fed of a 3 to 5 percent per year guideline-without the loopholes contained in Mr. Reuss' proposal. In addition I would like to see a. willingness on the part of the Federal Open Market Com- mittee to announce exact growth goals in the money stock within the 3- to 5-percent band-for example, 4.6 percent-these targets to be sought over periods of 2 or 3 months. There would, of course, be ran- dom weekly deviations from the desired trend but the public would not mistakenly interpret these as harbingers of change. The targets could be adjusted at any time, preferably in small steps, and a public a*imotmce- ment to this effect would be made. Hopefully, however, the FOMC would resist the temptation to attempt a fine tuning of the economy as in 1965-67. Thank you. Chair~na.n PRoxMI~n. Well, thank you, gentlemen. These are three more very, very fine papers, more helpful and most enlightening. Yesterday, as I say, we had witnesses who disagreed with you, and I have discussed with the staff why they didn't have panels who dis- agreed among themselves. I think we would have had a. more lively discussion but they say that professors don't like to disagree. They like consensus. Mr. DEWALD. Who says~ Chairman Pnox~rinn. lVhether it is good judgment or not, I dont think it is. Mr. SELDEN. I am sure we will find something to disagree about. Chairman Pnox~im~. I am sure you will. Anyway, I will try to raise some of the arguments. One of the arguments that might appeal to a good many people, is that in 1967 we were confronted with a situation in which interest rates were high and seemed to be rising and repre- sented a terrific burden on borrowers, on the homebuilding industry, and so forth. They have been worse in 1966 but in 1967 they were still bad. PAGENO="0105" 101 The Fed increased the money supply, as you gentlemen have said, at a very rapid rate But because of liquidity preference which was pretty high `at that time, `and because of other elements the Fed was unable to `bring interest rates down. If they had followed the policy you are advocating and limited their increase in the money supply to, say, 6 `percent and presumably it would be less than that because it was an inflationary period, they might have limited monetary expansion to the 2-percent level, under those circumstances what would have happened to interest rates? Mr. Christ? Mr. CHRIST. If we start at the beginning of 1967, where the 7-per-, cent rate of increase in the money supply began, and if we had limited the increase in the money supply at that point to 6 percent, I think interest rates would have risen more in 1967 than they actually did. But we can- Chairman PROXMIRE. Wouldn't there have been an argument, even at that time on the basis of the philosophy that I understand lies be- hind the thesis that you are advancing, that in view of the dominant inflationary element and the low level of unemployment, and the rela- tive strain at least on manpower resources, this would have been a logical time to have increased the money supply at the low end, that~ is at 2 or 3 percent rather than at 5 or 6, in which case you would have an even still higher rate of interest. Mr. CHRIST. Well, possibly. But let me go back a little bit into early 1966. There was a period of the last 8 months or so of 1966 when the money supply changed for practical purposes not at all. It shows a slight negative change and I think that was a mistake, and it is hard to begin at one point- Chairman PROXMIRE. I see what you mean. Mr. CHRIST. And say what should be done from here on and expect there will be no heritage from what happened a few weeks before you began your rule. So there is probably no time at which one can begin a guideline of 3 to 5 percent or 2 to 6 percent when you wouldn't be a little bit sorry about something that happened at the beginning, but we have to look on the beneficial effects of such a guideline in the long run. Chairman PROXMIRE. You see what I am getting at is the contention that although you gentlemen say the Fed will be able to increase the supply of money, we might agree to that, the argument is whether they can increase the supply of money at a rate which will result in a level of interest rates which give you the optimum public interest. The point that was raised yesterday by Mr. Chandler and Mr. Modigliani, was that the velocity interferes with all this, and you can't control the velocity. You can increase the supply of money but if the money is being used at a more-at a less rapid rate you don't have the kind of effect on economic activity that you would like to have to compensate. Mr. CHRIST. Velocity is not absolutely constant and Chandler is `known for saying that it varies greatly and can't be predicted. It varies, that is demonstrable. I think it is reasonably easy to tell what is going to make it change. High-interest rates make velocity increase, as a rule, and low-interest rates make it decrease as a rule. Twenty years ago we had very low interest rates, and much lower velocity. Now, we have higher interest rates and higher velocity. PAGENO="0106" 102 But it is a mistake to pay heavy attention to attempts to smooth out the interest rate. It is more important to see to it that the money stock grows at a fairly steady rate. I would like to see the Fed have some opportunity to increase the rate above 4 percent when they think it is necessary, and to reduce it below 4 percent when they think it is necessary. But they have gone too far. Usually they have reacted about as soon as you could expect an authority to react, but they have reacted too much, and I would like to see them not worry so much about changes in the interest rate and to worry more about moderating the rate of change of the money stock. I think that the long run effect of this would be that we would have smoother variation in the things that really matter, namely rea:l output, and we would have some Pe- nods when we would have to face high or low interest rates, but I don't think that is as important as smoothing the general level of activity. Chairman PROXMIRE. Mr. Selden? Mr. SELDEN. I would like to disagree a little bit with one aspect of Mr. Christ's comment just now. To go back to the beginning of 1967 and suppose that we did have a policy of slower monetary growth, say ~1/2 or 6 percent, I think that the pattern of interest rate changes dur- ing 1967 would have been different from what it was. But I think by the time the end of the year had been reached, it is just as plausible to expect that interest rates would have been lower than they, in fact., turned out to be rather than higher. Chairman PROXMIRE. You think there would have been possibly an expectation element here if the public, if the borrowing public, the banks, the bankers and others who were aware of this recognized the fact there was a limitation on the rate at which the Fed would in- crease money and that they would try to stabilize it around 4 percent, give or take 1 or 2 percent, that this would have been constructive in maybe stemming the liquidity preference. Mr. SELDEN. Yes. Chairman PRox~nnE. Liquidity preference, I take it or at. least affect- ing the liquidity preference one way or the other? Mr. SELDEN. Well, I simply think it is wrong to argue that we raise interest rates by reducing the stock of money. I think that tight. money paradoxically leads to lower interest rates rather than to higher in- terest rates. There are various ways in which this can be argued. Chairman PR0xMIRE. That certainly contradicts the conventional wisdom, doesn't it? Mr. SELDON. It certainly does. ~ha~irman PROXMIRE. The argument is that money is like other com- modities, you increase the supply and the price drops. the. price or interest rate drops. You reduce the supply and the supply or interest rate increases. Why isn't there that tendency? Mr. SELDEN. I think one has to distinguish between a. rather short run effect which works over a 3- or 4-month period possibly and the longer run effect. Over a relatively short period I think that the. con- ventional wisdom is correct. In other words, if the policy of slower growth had been instituted in January 1967, the course of rates through maybe April or May of 1967 might have, been different-I think there was some easing tendency in interest rates at that time. Under the policy I am proposing there would ha.ve been less easing probably. PAGENO="0107" 103 Chairman PRoxMniE. This suggestion though, it seems to me, that the money authorities have less capacity to influence rates than we might otherwise think. I notice that one of you gentlemen suggested. that in the 1930's, at least in the beginning of the 1930's, we followed a perverse monetary policy, but certainly in the 1930's, the mid-1930's and on, we followed a policy of keeping interest rates so low they were almost negative. Remember short-term Federal obligations yielded very little more than zero. Mr Dewald, you apparently disagree. Mr. DEWALD. Very strongly, yes. Chairman PRoxMni~. Good. Mr. DEWALD. The quantity of money fell by about 25 percent nar- rowly defined from 1930 through 1933. After the economy had gone through this traumatic experience, banks were afraid of their shadows,. as they should have been. The public was afraid of the banks. People didn't just talk about a change in liquidity preference. You really had it in that period. People did want to hold the most liquid asset, namely Government money. In that situation the monetary authority certainly played a role in the change in liquidity preference by scaring the wits out of the banks and the public. You had very low interest rates on some kind of highly liquid instruments, not on all. The low interest rates on close substitutes for money were partly the result of a change in liquidity prefernce which implies an increase in interest on loans that,. to lenders, aren't such close substitutes for money. Another point is. that during the 1930's, the Federal Reserve asked for additional au- thority because of the fear of inflation. This is hard to believe, but it's true. There were a tremendous amount of excess reserves in the system, so the Federal Reserve asked for the authority, and Congress gave it to them, to double reserve requirements, to reduce the inflation- ary potential. That is precisely what they did, and the effect of doubling those reserve requirements, of course, was to increase interest rates in that period. Subsequently, there was a further increase in the demand for highly liquid kinds of assets, and it was in that period, 1938-39, following this. painful experience-you know recession within a recession, to which the Federal Reserve contributed-that you had these close to zero rates of interest. Chairman PR0xMIRE. Of course, we are speaking about relatively different things. It is hard to look now at 1938 or 1937 as a period of high interest rates because we are not accustomed to interest rates that are so much higher. But what I am trying to get at is it is difficult to see how the monetary authority could have done much more to stimulate the economy during the period say from 1933 on than they did. Perhaps they could, you are undoubtedly a much closer student than I, but the Martin notion of pushing a string by using monetary authority to keep their rates down and, therefore, the borrowing attrac- tive to industry, just seemed to be quite sterile in that period. Mr. DEWALD. The argument of pushing a string I think is just a rationalization for perverse actions. The period of the 1930's was one where monetary policy could have been very different. Let's con- sider this possibility. Suppose that monetary policy actions had been taken commencing in 1930, such that the quantity of money had in- creased at the average rate that it increased over the period of 1920's~ This i~ really the kind of thing that we are suggesting. PAGENO="0108" 104 Chairman PROXMIRE. Right. Mr. DEWALD. That means that instead of the money supply fall- ing, broadly defined, by a third from 1930 through 1933, it would have increased, by several percentage points-net difference probably about a 75-percent larger quantity of money in 1933 than there actually was. If the money supply had been 50- to 100-percent higher than it was in 1933, would that have made a difference? Would fewer banks have failed? Would that have affected the demand for currency? chairman PROXMIRE. After 1933 none of them failed. The FDIC was established. Mr. DEWALD. No, when we lost that many thousands you Imow people were sufficiently frightened that I think the effect of the policy- Chairman PROXMIRE. Maybe it is Democratic instincts, I am trying to defend Roosevelt's policies and keep Hoover out of it. Mr. CHRIST. We can stop at March 1933 and still make all these statements. Mr. DEWALD. By all means. Mr. CHRIST. The greatest damage was done by 1933. It is perfectly clear that the central bank could have prevented the stock of money from declining. Chairman PROXMIRE. My time is up but it is just a revelation to me you very, very distinguished economic scholars contend, at least the implication is, that much of the depression a.nd terrible unemployment that we had in the 1930's, and it continued until 1941 really might well have been avoided if we had followed a policy of creating money in view of the fact that I had always had the notion that during much of this period 1935 on that intere~st rates were very, very low. But. again I will have to go back and review that more closely. It has been most enlightening. Mrs. Griffiths? Representative GRIrnrnIs. Thank you. Would it be true or not that the more rigid t.he monetary policy the more flexible the fiscal policy would have to be? Mr. CHRIST. Do you want to ask anyone of us in particular? Representative GRIFFITHS. Any one of you to answer. Mr. CHRIST. I will be glad to volunteer. I think the monetary and fiscal policy are connected to each other in the sense that, as I tried to point out, the Government expenditures are going to be financed `by some combination of taxing, borrowing from the public and increasing the money stock. And if we impose a rule `on what the Federal Reserve can do with the money stock, then whatever adjustment has to be made in financing Government expend- itures will fail more heavily on taxation and on borrowing from the general public. So in this sense, if we should, through the Congress, state to the Federal Reserve `that we want them to follow a rule, then I think it would `behoove the congressional authority to realize that it is going to have to make some adjustment in order to keep the deficit and the surplus from being too large or else the burden will be very great on the debt market when the Treasury tries to sell securities. Representative GRIFFITHS. Have you noted recently how hard it is to change the fiscal policy of the Government? Mr. CHRIST. Yes, I have, and I am very pleased at the. news this morning. PAGENO="0109" 105 Reesentative GRIFFITHS. It is very difficult. Mr. CHRIST. Yes; that is right. Representative GRIFF.ITHS.. F;irst, the Federal Reserve was crying havoc 15 months ago and asking for a tax increase. Mr. `CHRIST. Rig~ht~ Representative GRIFFITHS. Now, it fell really on deaf ears. Then finally, approximately 2 months ago, it was decided that you could only h'ave `a tax increase `if you cut expenditures. Now, we are frozen into that position. But 2 months have passed and everything looks con- siderably worse, and I would think you would try for a tax increase only. Mr. `CHRIST. I think that would be better. Representative GRIFFITH5. I am sure it could be done. Mr. CHRIST. I `think the Federal Reserve `could have pointed `up the issue more strongly `and perhaps `incurred `some congressional dis- pl'easuer but perh'a~'s `also have raised the flag more vigorously in favor of a tax increase by keeping the increase in the money `stock last year below what it was. What the Federal Reserve did, in effect, was to say "here we have `thi's `deficit, it is rather `large. W'e will support it by increasing the money stock very greatly." If they had `done that a little `less, if they `had increased the money stock a `little more slowly, interest rates, my guess is, would have been `at first, higher, `and this would have been more of a `signal `in the economy that we needed a tax `increase, I think. Representative GRIFFITHS. The real proof is that it would be better if both policies were in the same hands. Mr. CHRIST. Ultimately they are, they are in your hands, you and the other 500- Representative GRIFFITHS. We have nothing to do with the monetary policies. Mr. CHRIST. Oh, yes, you do. Representative GRIFFITHS. Not that much. Mr. CHRIST. The Constitution gives you the right to tell the Federal Reserve how to act. Representative GRIEFITHS. But we never really have done much about any of it. We are too slow to react. We are not really reacting. We are already frozen into a position that in my judgment is ridiculous. Mr. SELDEN. I think there are two kinds of lags that are involved in what you and Professor Christ are talking about. There is a lag between the need for a policy and the adoption of a policy. But there is a second kind of lag which we were talking about earlier in reference to monetary policy-between the taking of the step by the Congress or by the Federal Reserve and the effects of the step on the economy. So it is even worse than you are saying. It may be sometime before the policy changes are made, and after they are made it will be some- time before they are having their full effects on the economy, and it may very well be. Representative GRIFFITHS. At the worst time. Mr. SELDEN. Be completely inappropriate at that time. Representative GRIFFITHS. I would like to ask you about the velocity of money. Wouldn't there be a certain level of income where the velo- city is constant. Mr. DEWALI. No; I don't think so. PAGENO="0110" 106 Representative GRIFFITHS. Why not? I mean everybody has to eat- Mr. DEWALD. Well, the reason, I suspect, is associated with the fact that the velocity of money is a reflection of the usefulness that money serves in peoples holdings of various assets, and if interest rates are high, if the opportunity cost of holding money is high, they will hold less of it utilizing the money more intensively. Hence, as a result you could have the same income associated with a number of different velo- cities depending on the particular kind of institutions that are there that can issue assets that are utilized by the public in making payments. It is a complicated affair, of course. It is associated not just with market interest rates, but it is associated with a market mechanism, :and that reflects not just these prices, but it reflects the institutions that. are available to provide services. Representative GRIFFITHs. Thank you. Thank you, Mr. Chairman. Chairman PRox~IIRE. I would like to get back very briefly because I do want to get on .to some other points, but I am fascinated by look- ing at these intere~t rates in the 1930's. They did reach a peak for 3 months' Treasury bills of less than one-half of 1 percent in 1937. Mr. DEWALD. Yes. Chairman PROxMIRE. They are now more than 10 times as high as that. During most of this period they were yielding less titan one- fifth of 1 percent, they were very consistently less. In 1940, for ex- ample, they were yielding a little more than one one-hundredth of 1 percent. Furthermore, when you go over and take a. look at. prime commercial paper you find that the rate kept dropping, and this would, it seems to me, be. a better reflection of the impact on the commercial part of the economy. Here is what they were: 1933, 2.73 percent. The following years 1.73, 1.02, 1.76. In 1938 they dropped again to 0.75. In 193T they came up, but they came up to 0.94. This is an annual yield. Then 0.81, 0.59. You can see why the bankers were not exactly Roosevelt sup- porters. But at any rate the argument I ant making is that I do think there is a lot you can do with monetary policy `and especially in times like this, but I `do question whether or not in a period of very serious depression you can do a. great deal with monetary policy. It has to be, you have to have a fiscal policy that is pretty emphatic and far reaching if you a.re going to really stimulate the economy very much. Well, you are right about that 1936 policy which was. of course. wrong and perverse doubling the reserve requirements. recognizing t.hat it still seems to me the monetary policy in the 1930~s was about. as expansionary as it could be made, a.nd if we had doubled the supply of money, I don't know just how that money would have gotten `into circulation. After all, it was so easy to borrow at such low rates would you say instead of being able to, if instead of coin- mercial pap'er yielding three-quarters of 1 percent, it had yielded half that., it would `have made any difference? Mr. CHRIST. I t.hink by the time we got to 1933. and maybe you will like this `being a Democrat., it was `a little late. If we look at the Fed- eral Reserve's `action `in the period from 1929 to 1933. they were doing the right thing with discount rates for `a couple of years from 1929 to 1931, but `then in 1931 they raised the discount rate substantially, and. PAGENO="0111" 107 worsened the decline in the la'oney stock which had been proceeding from 1929 onward. Yesterday, Mr Wallich made one statement, or at least it is in his printed statement here, saying that the Federal Reserve should have the authority to depart from any preassigned rule, and he said in a depression, for example, when the Federal Reserve would be inclined to inflate would we want to restrict them by preventing them from increasing the money stock beyond any certain rate? Well, there never has been a depression so far when they have not permitted the money stock to decline, `and I think if as soon as a downturn is detected they begin purchasing bonds massively in the open market, there is no doubt that the stock of money could be kept from falling. Chairman PRoxMiua. This is a good point of departure because you say never before, this is one of the things the three economists yester- day disagreed with you gentlemen on. For instance, they attacked with great vehemence the Friedman analysis going `all the way back to the middle of the 19th century which they said was just irrelevant, just a completely different kind of a situation. Now, another element that `occurred to me `and I think is significant is we have changed the quality of `the Federal Reserve Board. Until recently people were appointed to the Federal Reserve Board without much reference `as to whether they had `any economic knowledge at all. They may `be `a businessman and very successful businessman, but with- out any understanding of how the money market works or the impact `of monetary policy on the economy. The `appointments recently have been far different. If you have people of ability who `have `devoted their `lives `and `are recognized scholars and experts in this area, as members of the Federal Reserve Board and, therefore, able to evaluate the staff which has always been professional, don't you have a much different situation? What I am getting at is aren't y'ou putting handcuffs, this would be thei'r objection, I suppose, `aren't you putting handcuffs, on `the Federal Reserve in the event you do `have a recession `by saying you should not increa'se the supply of money or a `depression, more than 6 percent `a year. You ~ay in the past they haven't done it. Mr. `CHRIST. Right. Chairman PROXMIRE. Well, in the future you have got some real pro- fessionals here wh'o are dedicated, `as all `of us are, to eliminating heavy unemployment by whatever means we have to use. Why `shouldn't they be `allowed to go `a'he'ad with an 8-percent, 10-percent-whatever seemed appropriate-increase in the supply of money if this is going to `help us reduce unemplOyment? Mr. CHRIST. It is a very good question and I think that in 1933 I probably would have been, if I had been old enough and known what I know now, in favor of permitting an increase in the money stock at greater than 6 percent. But my point is that I think it is extremely unlikely that we will get into severe depressions if we don't permit the money supply to decline in a depression. Now, it has been 6 or 7 years since we have had a test here, it has been 6 or 7 years since there has been a recession, and Mr. Maisel and Mr. Brimmer have been appointed to the Board, these are two professional economists, and you say the composition `of the Board has changed and maybe PAGENO="0112" 108 they will do better. But even since World War II there has not been a recession in the United States where the stock money did not de- cline in absolute terms at least for a while and take a.t least 9 months to catch up to its previous level and start. to grow again and I feel that at a time when people are uncertain, which they are in a de- pression, a.nd when they want to hold more money rather than less because of this uncertainty that it is a great mistake for the mone- tary mechanism of the United States to allow the amount of money to decline. Chairman PROXMIRE. Now, Mr. Dewald, how about the other side of this, aren't there circumstances where the situation is so inflation- ary, and the unemployment rate is consistently low and expected to be lower, and perhaps you have military commitments overseas that we expect to go on for a long, long time and so forth, aren't there such circumstances where it might be wise for a period not to increase the money supply at all, maybe even to retard the money supply in order to restrain the economy? Mr. DEWALD. Yes. Chairman PROXMIRE. Is this conceiva.b~e? Mr. DEWALD. I certainly agree that it is. But first, getting back to the point you raised in terms of the professional qualifications of the people who make these decisions I think you judge people not on the basis of their degrees, but on the basis of what they do and on those criteria, certainly the kind of performance that we have observed from our Federal Reserve with its Ph. D. `s today is not far different from the performance of the Federal Reserve or central bankers any- where over the course of the long history of central banks. I think also in this period of inflation as you suggest, that moderat- ing the level of monetary growth to a somewhat lesser growth rate than its average, would indeed make sense. But you should know that monetary policy typically has not taken an independent course. That is associated with a particular myopia that is present in people who run central banks whether they have Ph. D.'s or not and that myopia, I think, is associated with looking at something called money market conditions or interest ra.tes as a measure of what it is that the mone- tary authority is doing, rather than looking at the actions that are actually taken by the monetary authority. Look at the present period, there was a tremendous budget deficit last year and this year. What happened to money last year? Did monetary policy take an independent stance of his budget deficit? It certainly did not, and if you look back in history you see exactly this same pattern of response. I shouldn't make such speculative arguments, but it is conceivable that the kind of thing that happened in the year ended mid-1960 which was a very sharp decline in the money supply, was accountable in part to the fact that the Federal Reserve was just laggard in its response to the economy but in pa.rt it was induced by the tight fiscal stance of the preceding year. The very big increase in the budget surplus in 1959 certa.inly played a role in this very tight mone- tary policy. And with rare exceptions, monetary policy and fiscal policy rather than standing independently have stood together during periods of inflation as well as deflation. Chairman PROXMIRE. Well, after all, I am not sure I understand when you said independent, are you arguing that monetary policy PAGENO="0113" 109 ought to be, might go, in one direction and fiscal policy in the other? Mr. DEWALD. Hopefully that is what we mean by mixtures of policy. During a period such as 1967 when we just happened to have in- herited a budget deficit because of one thing or the other that was in the works-the war and other factors, the effects of which could not be readily predicted-presumably a flexible monetary policy should have been expected to take an independent stand to achieve the objectives of price stability, sustainable levels of economic growth, et cetera. Chairman PRoxMnu~. Again may be it is just the word that is con- fusin~ me somewhat, an independent stand. You would argue in which inflation is the principal problem that both fiscal policy and monetary policy should be restrained, we ought to have a fiscal policy which tends to slow down the economy to some extent, and a monetary policy that would do the same thing. They ought to work together, they should not go in opposite directions. There have been so many periods when they have charged in oppo- site directions, `and that kind of independence, it seems to me, is coun- terproductive. That is, if you have monetary policy expanding the economy while fiscal economy is contracting it. Representative Giw?FITH5. I think he is suggesting, Mr. Chairman, that central bankers are all first cousins. [Laughter.] Mr. SELDEN. I wonder if I could add my 2 cents on the qualifica- tions for membership on the Federal Reserve Board, and I do not wish to be disrespectful to any of the Ph. D.'s or non-Ph. D.'s on the Board at present. I think they are very able people. But, personally, speaking as a Ph. D. in economics and a monetary theorist, I do not welcome the presence of Ph. D.'s on the Federal Reserve Board any more than I would welcome a five-star general as the Secretary of Defense. Chairman PRoxMn~. That is very interesting. You want incompe- tence raither than competence on the Board; is that correct? Mr. SELDEN. No; not at all. I think, as Mr. Dewald has said, that a review of the last 2 or 3 years does not do anything to shed a feeling of confidence among us that- Chairman Pnox~inm. You fellc~ws are too defensive. All of you are Ph. D.'s. Mr. SELDEN. I do not want to denigrate Ph. D.'s, but when it comes to forming public policy, I would trust the intelligent layman to have competence in these things. Chairman PnoxMnm. It is awfully hard to find the intelligent lay- man. I do not know why it should be such a handicap for somebody to have been trained in this area of monetary policy, who can have certain limitations and have certain opportunities, and so forth- why should this be- Mr. SELDEN. I think, perhaps- Chairman PRoxMIlm. This is a strange kind of anti-intellectualism. Mr. SELDEN. All I do say is that I do not think we ought to bias it one way or the other. I do not think we ought to go out of our way to find professional economists to serve in this capacity, although I am sure that sOme of them are able to make a fine contribution to prob- lems of monetary policy. 94-340-68----8 PAGENO="0114" 110 Chairman PROXMIRE. Is there not a great difference between-when you talk about having a five-star general as Secretary of Defense ? After all, here is a man who, presumably, his whole life has been in the Army and whose whole attitude is military, and there are many limitations, if you had that kind of a life, as far as being Secretary of Defense, and relating it to the broader national needs and integrat- ing it with the program to promote peace in the world, and that kind of thing. On the other hand, where you have a Ph. D. whose whole life has been one of studying this problem, and teaching it., and learning about it, and debating it, and discussing it, it would seem to me that he would be in an excellent position to exercise judgment. Mr. SELDEN. I suppose a better analogy would be appointing a banker like David Rockefeller to the Chairman of the Board rather than-he happens to be a Ph. D. in economics, incidentally, so my thesis is consistent. Chairman PROXMIRE. Would that. be good or bad then? You would or would not? Mr. SELDEN. I think I would have some hesitation frankly in select- ing a man who was~ Chairman PR0XMIRE. Qualified except for that doctorate that he got. [Laughter.] Mr. CHRIST. I think a better rule would be we should not take the members of the Board from the present staff of the Board. This is a better analogy to the five-star general as the Secretary of Defense. Chairman PROXMIRE. That has not been done very much, has it. ? Mr. CHRIST. No. Mr. DEWALD. I am sorry; but it has been done. Not in terms of the Board itself but in terms of the Federal Reserve System. In fact, that is the most consistent route by which the present Ph. D. `s on the Board got to where they are. Chairman PROXMIRE. Well, they may have served a little while in the system, but certainly the principal occupation of Brimmer and Maisel, and so forth, were not as staff men on the Federal Reserve Board. Mr. SELDEN. I think though, fine economists as these men are. and I certainly would not want to leave the impression that I think they are not, I will fault them on one point. They all talk as if they do not believe in the existence of monetary lags, and I think that they are simply wrong. They talk as if the policies that they are initiating today will have important effects within the next month or two. Chairman PROXMIRE. Very good. I think that is very crucial to this whole thing, the monetary lag situation. You say it is controversial in your paper, and you say there is some dispute about it, and you quote Modigliani testified yesterday against this kind of restraint of the Federal Reserve Boa.rd, with great empha- sis, you quote him as an expert on lags. He recognizes this, but he apparently feels that this is not a. serious handicap. I think this is the strongest part of your case, because every- thing I have seen suggests that we cannot predict or forecast the eco- nomic ~uture very well more than 6 months or so in advance. You can~ not do so, and if predictions are likely to be wrong a.s often as right, it might well be that we should follow this policy of a steady rate of growth in the monetary supply. PAGENO="0115" 111 Can you document this except by saying some economists have said it is so? Mr. SELDEN. In the January issue of the Federal Reserve Bulletin there is an account of the new Federal Reserve-MIT Quarterly Econo- metric Model, and for whatever they are worth it is very, interesting to look at the simulations which have been conducted on the basis of the model. They indicate very substantial monetary lags, so this is evidence that is developed within the system itself, in addition to the other evidence that can be cited. I really do not think that there is any disagreement on the existence of lags. The Federal Reserve Board itself stands out, I think, as an /exception to this statement. They seem to talk as if there are no lags. Academic economists, on the other hand, have come rather close t.o ~an agreement on this point. They have different ways of measuring lags, they have different estimates of the lags, but I think there is something close to- Chairman PRoxMnu~. How long are the lags, by and large? More than 6 months, more than a year? Mr. SELDEN. Oh, yes; probably a year or more, on the average. Chairman PROXMIRE. And you feel that this is pretty universal in the profession, recognition? Mr. SELDEN. I would like to get the opinion of my fellow panelists. Chairman PRoxi~rnn. Do you agree with that? Mr. DEWALD. I think the existence of lags is certainly recognized in `the profession. Whether it is a year or not is a difficult estimation problem. However, most economists would argue there is a lag in the effect of policy actions that is distributed over time. There is some effect of monetary policy actions or any other kind of policy action that occurs instantaneously. In fact, if you could detect what is going to happen there might even be a lead. But on the basis of the kind of empirical work that has been done, one could say there are reasonably substantial effects to changes in interest rates within 6 months, al- though the average lag-looking at the lag over the entire period of its effect-the average lag would typically be much longer. There has been some important work of a theoretical nature in recent years that would suggest a more rapid response of the economy to monetary policy. If the monetary authority really did use the money supply to take a countercyclical stance, that is, if money became independent indeed instead of just in terms of assumptions in eco- nomic models, there might be a much faster response to independent monetary policy actions than you would estimate on the basis of the responsiveness of the level of expenditures to interest rates. That argument goes in this form: if you take account of the inter- action of the various elements of the economy and if monetary policy took an independent stance, changing the rate of growth of the. money supply would have a prompt effect a.nd a large effect on interest rates that would speed up the lag in response of the economy to the policy action. I think this is a very important argument. It is a new idea that has practical importance. Economists are starting to test it empirically. These results indeed suggest that the length of lag in response of the economy to monetary policy actions is not as long as we might have t.hought earlier. PAGENO="0116" 112 On that basis, I think we can fault the Federal Reserve not on the fact that lags are as long as some once thought, but on the basis of the fact that its policy stance has not been countercyclical. assuming that there is no lag. Chairman PROXMIRE. Would you all agree that during the last year or so the policies of the Federal Reserve have been inflationary? This is a period of inflation, and they have been increasing the money sup- ply at a much more rapid rate than the growth in the economy? Mr. DEWALD. Over the past year? Certainly. Mr. SELDEN. Yes; over the past 3 years, on net. Chairman PRox3Inn~. Inflation. You all agree that this policy has been in error? Mr. SELDEN. Yes. Chairman PROXMIRE. Of course, we have the advantage of hind- sight, but it has been in error; it has been wrong. Mr. DEWALD. Yes. Chairman PROXMIRE. The national interest would have been better served if they increased the money supply at a lesser rate during this period, just as it would have been much better served if we increasecL the money supply at a much morerapid rate in the thirties and in much of the fifties, perhaps. Mr. DEWALD. And in 1966 as well; yes. Mr. SELDEN. Yes. Chairman PROXMIRE. It would have been steadier. Mr. DEWALD. Yes. Chairman PROXMIRE. Let me just ask about the point that you make on Congressman Reuss' proposals. It seems to me, Mr. Seiden, you say they are good, and then you knock them all down. I am inclined to your knocking them all down because the testimony yesterday was they liked the Reuss proposals because they just seemed to destroy the limitation. In other words, if you say you have a limitation of 2 to 5 percent or 3 to 6 percent or some- thing, and then say but, you can make exceptions pretty much when- ever you want to, it would seem logical to do so, you do not have any effective limitations. Mr. SELDEN. My feeling was that- Chairman PROXMIRE. Why do you think they are a good idea, better than what we have now? Mr. SELDEN. I thought the preamble or the major statement of the proposal was the thing we should focus on, and I took that as the guts, so to speak, of the proposal. I think Representative Reuss' heart was in the right, place, and then I think he had some second thoughts perhaps. He was a little afraid that this was too constraining, and so he built in contingencies. He is trying to take account of contingencies in all of these six qualifications or seven qualifications that he has listed. So I will accept the first state- ment, but I do not think the qualifications are needed. Chairman PRox~rIRE. None of the exceptions. Mr. SELDEN. Yes. Chairman PR0xMIRE. It is kind of a list of-I think it would help our monetary policy very, very greatly if we could follow what Gov- ernor Robertson suggested to the Senate banking committee the other day, and that was insulate our monetary policy from considerations PAGENO="0117" 113 of the international balance of payments by utilizing a comprehensive interest equalization tax, something of that kind. At any rate, you may disagree with the device, but to find a way to insulate it from international considerations so it would be much easier for the Federal Reserve Board to concentrate on the domestic objectives, if they could ignore the balance of payments. Now, you have two obviously conflicting objectives. You could have a kind of situation where you have deflation here but continued ad- verse balance of payments. Do you think there is a constructive way and a practical way in which we can insulate other than exchange rates, exchange rate fluctu- ations; is there any other way that we can insulate our monetary policy from the international balance of payments? Mr. CHRIST. There are several ways in which we can attempt to in- sulate it, but it seems to me every one, except permitting the exchange rate to change, gives up an important objective. We could impose a large tax on capital outflows, as Governor Robert- son proposed, but I think this would be a mistake. I think that it would grossly distort resource allocation. It would also build up a severe balance-of-payments problem some time in the future when our foreign earnings would not increase any more because we would not be able to make investments abroad in the future, and I do not think it is wise to interfere with current trade either by imposing large tariffs or quotas. I do not think it is a good idea to have exchange control, rationing the amount of foreign currency that people `are allowed to have. I do not see that the present foreign exchange rate is sacred, and I do not see why we must maintain it. Chairman PROXMIRE. You feel a logical, sensible, practical answer is just to permit the exchange rate to float. Mr. CHRIST. Yes. Chairman PROXMIRE. I see, Mr. Selden, you seem to agree with that. Mr. SELDEN. I certainly do. Chairman Pnoxmrnmi~. Do you agree? Mr. DEWALD. I am not sure. I think it is an empirical question, and you cannot really answer this question until you measure the bene- fits of fixed exchange against the costs, and there are allegedly bene- fits that I, at least, would espouse. People can make plans to trade on the basis of fixed exchange rates. Presumably the reason why fixed exchange rates make sense is associated with the fact that they stimulate trade, permit specializa- tion and exchange, and increase the standard of living. The peculiarity of the present situation is that fixed exchange rates are defended by policies that reduce standards of living by preventing trade `and specialization. I think that, even though it is a bit of a play on words, it is pos- sible that we could insulate the rest of the world from us and de- fend the fixed exchange rate system better if we emphasized domestic stability instead of the on again, off again kinds of policies that we have had; that is, if we put domestic policy goals first, it is not inconceivable that the fixed exchange rate system would stand better than it does presently. PAGENO="0118" 114 Mr. SELDEN. Yes. I have always felt that if we could somehow or other achieve a stable price level that the inflation that is bound to take place in Western Europe, Latin America and other parts of the world woulcL probably eventually turn our balance of payments toward a surplus.. But that, of course, would just be pushing the problem off onto others.. I do feel that if we could follow a steady course in this country perhaps we could get by by asking our trading part.ners to do the adjusting through appropriate monetary and fiscal policies and exchange rate changes. Chairman PROXMIRE. I have two more. quick suggestions by the staff. One is this: In 1967, assume we would have had a. 2 percent growth in the money stock. This is because of the inflationary situa- tion which would have slowed clown. How would the $20 billion deficit have been financed? Mr. DEWALD. By selling securities. Chairman PROXMIRE. Well, would this have taken $20 billion out of housing? Mr. CHRIST. It would have ta.ken some out of housing. Mr. DEWALD. We argued this point earlier, and I think it is a cor- rect argument. From the point of view of the immediate impact, if a policy to reduce t.he rate of monetary growth were initiated in early 1967, I think there is little question that short-term rates of interest. would have increa.sed. I am not so sure~ Chairman PROXMIRE. Short-term rates of interest.? Mr. DEWALD. Short-term rates of interest, that is, interest on securi- ties. Chairman PRox~nui~. Why would not all of this- Mr. DEWALD. Well, the reason why not all interest rates would. necessarily have gone up, at least not as much. Chairman PROXMIRE. Because the price would have gone up. Mr. DEWALD. Is associated with the fact that people anticipate what the future holds in terms of the interest that they can ea.rn on alterna- tives over the entire pe.riod t.o maturity of a security. Hence if that lesser rate of monetary growth in early 1967 lead people in the money market to anticipate that interest rates would be lower in the future because this was a restrictive policy that would damp inflationary ex- penditures in the economy, then it is altogether reasonable that long- term rates of interest would have declined. Indeed, the period of 1967 was peculiar in that short-term rates went down associated with. the rapid monetary growth while long- term rates, as you know, went clown very little, and then they turned around and increased very sharply in mid-1967 to the levels now that are really unprecedented. It seems quite reasonable that if the money supply had increased at a 2-percent growth in 1967, although we cannot be sure what would have happened at the beginning of 1967, I think it quite reasonable that at the end of 1967 long-term interest ra.tes would have been lower than they were, and short-term interest rates might have been too. Chairman PROXMIRE. Well, may be. Mr. DEWALD. There is one wa.y of testing this. Chairman PROXMIRE. It is awfully hard for me. to understand ho~ if you reduce the supply of money, you reduce its price. PAGENO="0119" 115 Mr. DEWALD. Well, you do it on the basis that people cannot be fooled indefinitely by the changes in value of money. Money is a kind of veil in the long run. People get their pleasures out of other things than money, for the most part. Chairman PRoxMn~. You are talking about Confederate money~ [Laughter.] Mr. DEWALD. Well, let us hope that is not an apt analogy. No; I am talking about our money and, the reason why people de- mand such high rates of interest now on the loans that they make, and the reason why people are willing to pay them is because of the fact that there is general expectation of a decline in the value of money. A person, in his right mind, that is, is not going to lend a dollar now at the rate of interest of 5 percent, if he expects the value of money to be worth 10 percent less or 5-percent less, or whatever a year from now. Chairman PROXMIRE. So you think the trouble is that too many people feel the Federal iReserve Board is going to continue to have this expansive policy of increasing the supply of money at a rate more rapid than the growth of the economy. Mr. DEWALD. Yes. The people in the money market and other in-- vestors are very sharp. They make a handsome living by anticipating what is going to happen to the economy over its future course. Chairman PRoxMI1u~. They figure that this is the case because this is one of the two instruments, along with fiscal policy, for preventing unemployment, and they feel that--or reducing unemployment, keep- ing it at the lowest possible level, and they feel that the President will appoint members of the Federal Reserve Board who are going to have that in mind, and the result of that is going to be a long-term infia-- tionary policy. Mr. DEWALD. Yes. Chairman PRoxi~IIRE. Well, let me ask this other question which Mr.. Henderson of the committee staff has just handed me. It is this :- Why are you so confident that with stable money growth, variable performance of interest rates, on both investment capital and on money market instruments, will not induce instability in investment? Mr. DEWALD. That must be directed at me, I guess, since that was a point I made in my paper. I am confident of this on the basis of the fact there are strong natu- ral tendencies for greed to rule on this matter, and speculators, other- wise known as investors, will take positions on securities when they anticipate that a price change is temporary, and to the extent that a short-term money market dealer, for example, expects that interest rates are relaively high today, and he expects them to fall, he will jump into the market to take a position in that security in order to earn a capital gain because of the expected decline in the interest rate and increase in is value in the future. At least, this is the experience that we have observed historically in the United States when we did not have the Federal Reserve acting as. a shock absorber on these things, and this is the experience, as I mdi- cated, that you see all throughout the world. Chairman PRoxMn~. The point that Mr. Henderson is making is: that the Fed's discretion sometimes creates instability in your view, and will not rules do the same thing? PAGENO="0120" 116 Mr. DEWALD. I am not sure I follow. Changes in the rules and reg- ulations and changes in the rate of monetary growth introduce insta- bility. I think to the extent tha.t you did get a. response of the economy to the changes in interest rates associated with staJble monetary growth, the direction would probably be the correct one. Chairman PRox~rreu I am going to ask Mr. Henderson to put the question. Mr. HENDERSON. My question, Professor Dewald, was concerned with real investment. If you had variability in t.he pattern of interest rates that went through from the money markets to the long-term rates, and then affected real investment, is it not possible that the variability of the demand for real investment resulting from that vari- ability of the cost of investing would be destabilizing? Mr. DEWALD. That is always a possibility. However, presumably in- vestments depend not only on short-term rates of interest that are going to reflect immediate day to day a.nd week to week, changes in the demand for money, but they are presumably going to depend much more sensitively on longer-term rates of interest, a.nd there is abso- lutely no reason why there should be much variability in long-term rates of interest as t.he result of stabilizing monetary growth. So I see no reason why there would be increased variability in long- term rates of interest and hence, I see, no reason why there should be instability in investment. Mr. HENDERSON. How are long-term rates of interest to be effectively stabilized in the event that t.he money market has unstable interest rates? Mr. CI-IRI5T. I do not t.hink any explicit stabilization would be needed. If we were to see the money stock growing more steadily, not increasing its growth rate so much at some times and not decreasing in a recession, then I think the recessions would be less severe, and the need for a recovery from the bot.tom of a recession would be. less severe. This would create an expectation of smoother increases in real output than we have now, and without such great interruptions as the business cycles have given us in recent years. I think that given a steady growth of real output, then long-term rates would not fluc- tuate very much. The short-term rates might. But the long-term rates are based, as Mr. Dewald said, on expecta- tions about what is going to happen in the future. Mr. DEWALD. Could I comment further on that? Suppose you had a period when the monetary growth was accelerated relative to what we would ha.ve under the present regime of policy. Consider the early 1930's again. Indeed interest rates in that cir- cumstance might have fallen faster than t.hey did. and from t.hat point of view you would, of course, stimulate response in expendit.ure. So that even if interest rates become more variable over the cycle, associa.ted with stabilizing variation in monetary growth, the effect., I think, is in the right direction. R.ather than destabilizing the economy, the effect of those interest rate changes would be to stabilize t.he economy. I cited the seasons. It is conceivable that if we had more interest rate variability over t.he seasons of the year, we would have less im- employment variability, which would be a. good thing. Mr. HENDERSON. May I try t.o paraphrase what I think your main point is, that some of the effects that have been taken into considera- PAGENO="0121" 117 tion-for example, in Mr. Reuss' exceptions-are, in large measure, the product of, and the response of the public to, the actions of the mone- tary authorities. Mr. SELDEN. I think that is correct. Mr. HENDERSON. In other words, the stabilization in your sense would eliminate or at least very considerably reduce some of the things that are the excuse for contingency exceptions. Mr. SELDEN. Precisely. When he mentions corporations borrowing to build up liquidity, that whole syndrome came out of uneven Federal Reserve policy in 1.965-66. Chairman PROXMIRE. Thank you very much for a very enlighten- ing-did you have a final point? Mr. CHRIST. Could I make a proposal on something you said earlier? Chairman PROXMIRE. Yes. Mr. CHRIST. I would make this proposal: Let us encourage the Fed- eral Reserve to let the money stock grow between 2 and 6 percent a year, and when we find them in a depression making it grow at 6 per- cent and saying that is not fast enough, then I would be happy to con- sider whether they ought not to have more latitude. So far I think they have been on the wrong side in depressions. When they are on the right side and want to go further then I would like to reconsider giving them more freedom. Chairman PROxMIRE. You see one of the arguments made by one of the distinguished economists yesterday was that Congress would not stand still for that. Congress would insist in a period of recession or depression that they have a more expansionist policy, and in a period of inflation a more restrained policy. Mr. SELDEN. Thank God for Congress. Chairman PROxMIRE. When you recognize what they have done, and with very little congressional outcry, at least nothing that is very broad or deep in Congress, I think that you would get a Congress that would thide by this rule and have more influence on the Federal Reserve Board than you have ever had before. Mr. SELDEN. As a bare minimum, and I think the panelists from yesterday would surely agree to this, too, the Federal Reserve should never, never let the money stock decline under any circumstances. If we could even have that much of a guideline I think that would be a clea~r gain. Chairman PROXMIRE. Never let the money stock decline? Mr. SELDEN. Decline. Well, we realize that the weekly series are going to be jagged. Ohairman PROXMIRE. Over a period longer than a month. Mr. SELDEN. Over a period longer than, say, a month; yes. Ohairman PROXMIRE. Regardless of how inflationary the situation is? Mr. SELDEN. I would say so. Mr. CHRIST. The longrun nature of this rule comes in here. I think if the money stock had just gone up 20 percent the preceding month there might be a case for letting it decline 19 percent this month. But, you see, we are pi~oposing that there should be a steady rate of change here, and if we can- Chairman PROXMIRE. It would not be a steady rate of change. PAGENO="0122" 118 Mr. CHRIsT. No, a 20-percent rise would not. That is exactly the point. But if we could have a fairly steady rate of change then it would be a very good rule not to permit the money stock to decline ever. Chairman PRoxi~rIRE. Once again thank you for a superb job, very, very helpful and enlightening, and it is especially useful because on next Wednesday, May 15, we are going to have George Mitchell and Daniel Bril here to respond and give them equal time. Mr. CHRIST. Thank you very much. Senator Proxmire. Mr. DEWALD. Thank you, Mr. Chairman. Mr. SELDEN. Thank you, Chainna.n Proxmire. Chairman Pnoxi~nnu. Thank you, gentlemen. (Whereupon, at 12:10 p.m., the committee adjourned, to reconvene at 10 a.m., Wednesday, May 15, 1968.) PAGENO="0123" STANDARDS FOR GUIDING MONETARY ACTION WEDNESDAY, NAY 15, 1968 CONGRESS OF THE UNITED STATES, JOINT ECONOMIC COMMITPEE, Washington, D.C. The committee met at 10 a.m., pursuant to recess, in room 5-407, :the Capitol, Hon. William Proxmire (ohairman of the joint commit- tee) presiding. Present: Senators Proxmire and Miller. Also present: John R Stark, executive director; William H. Moore, senior staff economist; John B. Henderson, staff economist, and Don- ald A. Webster, minority staff economist. Chairman PROXMIRE. The Joint Economic Committee today holds the third of its series of four hearings on "Standards for Guiding Monetary Action." We welcome as witnesses Governor Mitchell and Mr. Brill of the Federal Reserve Board. Governor Mithhell comes to bring us the experience of two long and distingui~hed careers, as a tax official in the State of Illinois, where he was for a while director of finance, and as a central banker, first with the Federal Reserve Bank of Chicago, and now as a member of the Board of Governors of the Federal Reserve System. I might add, most important of all in many respects, the fact that he originated in the State of Wisconsin. I am very proud of that, in Riohiand Center. His fine character and intelligence were nourished in the soil of our State. Mr. Brill is the Fed's staff man par excellence, senior adviser to the Board of Governors, Director of the Division of Research and Statistics, and Economist of the Federal Open Market Committee. Since the Federal Reserve System is the agency charged by the Con- gress with the task of managing the Nation's money, your evidence, gentlemen, will carry the weight of responsibility and experience. I think that you are familiar with the testimony that we have had from some of the Nation's outstanding monetary economists, both sup- porting and opposing the positions taken by the Federal and support- ing and opposing the suggestions that the Congress provide definite guidelines. Governor Mitchell, you may go right ahead. (119) PAGENO="0124" 120 STATEMENT OF GEORGE W. MITCHELL, MEMBER., BOARD OP GOV- ERNORS, FEDERAL RESERVE SYSTEM; ACCOMPANIED BY DANIEL H. BRILL, DIRECTOR, DIVISION OP RESEARCH AND STATISTICS, BOARD OP GOVERNORS, FEDERAL RESERVE SYSTEM, AND ECON- OMIST, FEDERAL OPEN MARKET COMMITTEE Mr. MITCHELL. I am pleased to have this opportunity to appear be- fore this committee to discuss the principles of conducting monetary policy as part of an overall economic stabilization program. My formal statement is addressed to a question that has been widely discussed in the past several years, and in which this committee. already has dem- onstrated an active interest: what financial variable or variables should be used as intermediate targets of monetary policy? More specifically, in assessing whether monetary policy has been tight. or easy. what interpretation should be assigned t.o the movements in the stock of money, as against movements in other financial variables such as broader measures of liquid assets, credit flows and terms. money mar- ket conditions, or the level and structure of interest rates? On a question as complex a.nd as controversial as this, there are bound to be differences in views among observers-even among those whose vantage points are very similar. Consequently. I could not hope to express adequately the judgments of the Board as a whole, nor shall I try to do so. The opinions t.o be expressed are my own. The central question with which I shall be dealing-the intermediate targets of policy-has been debated extensively in the. professional journals, although without sufficient agreement having been reached to provide any automatic guide for monetary polic.y dec.isions. Some economists affiliate exclusively, or primarily. wit.h changes in the rate of credit expansion, either in terms of total credit. expansion or some critical segment thereof, such as bank credit. Others look principally to changes in the. economy's liquid assets, either in the aggregate or in some segment of the total, such as the money stock. Others look principally to the terms and conditions on which funds can be. bor- rowed, regarding changes in the level and structure of interest rat.e.s as the basis for establishing the course of monetary polic.y. To set forth the conclusion of my argument briefly, it seems to me that in our dynamic economy, no single variable-whether it be. the money stock, money plus time deposits, bank credit. total credit. free reserves, interest rates, or what have you-always serves adequately as an exclusive guide for monetary policy and its effects on the econ- omy. It follows from this that excessive concentration of our atte.ntion on any single variable, or even on any single group of related variables, would likely result in a potentially serious misreading of the course and intensity of monetary policy. It may be helpful to establish the rationale. for this conclusion in rather general terms first, a.nd then appraise. in this context, the. con- duct of monetary policy in some recent critical periods. Monetary policies pursued by the Federal Re.serve do have an important effect. on the Nation's money stock. While our knowledge. of the effects that reserve injec.tions have on the time. diine.nsion of monetary expansion is imprecise, .the Federal Reserve generally could make the money stock grow or decline in line wi.th wha.t was t.hou~ht to be appropriate for economic stabilization purposes. But it is a. mistake to assume tha.t PAGENO="0125" 121 Federal Reserve policies are the only factor influencing the money stock. It is equally mistaken to assume that policy actions do not extend beyond the money stock to `affect `growth rates of `other financial assets, expectations `of market participants, and the terms on which borrow- ers in a variety of different credit markets find funds available to finance spending plans. Failure `to appreciate the potentially `distui~b- ing effects of policy actions on `aspects `of the monetary and `credit en- viroument other than the money stock could easily lead `to serious mis- takes in monetary management. We must, and do, guide Federal Reserve policies with a careful assessment of the effects those policies have on the money stock. But in interpreting movements in the money stock `over time it is essential to recall that they movements are the result of the interaction of many forces: The behavior of the nonbank public, acting in respons'e to its desire to hold money and other financial `assets; the `behavior of Federal Reserve in supplying bank reserves, and in setting discount rates, reserve requirements, and ceiling rates that banks may pay on time deposits; the behavior of the commercial banks in using the reserves supplied to them by the Federal Reserve; the behavior of all financial institutions in bidding for the `savings of the public. It is erroneous to interpret changes in the money stock as though they represented exclusively the result of the operation of a guidance system for the economy administered by the central bank. Variations in money holdings over any period represent the supply behavior of the central bank acting together with the demand factors existing in the private sector of the economy. A meaningful interpretation of changes in the growth rate of the money stock. must try to take into account, therefore, the factors under- lying the public's demand for money and its ability to ,substitute between money balances and other financial assets. It is particularly important to assess properly what is happening to growth rates of other financial assets that are likely to be close substitutes for money in the public's financial asset portfolio. Our monetary history, as I read it, does not indicate that there is any unique financial asset, or combination of financial assets, which satisfies the public's liquidity preference. Indeed, over the past decade-and especially in the past 5 or 6 years-there have been significant changes in the public's preference for various types of liquid assets. For example, in the late 1950's we observed that the growth rate `of time deposits of commercial banks was beginning `to respond to changes in monetary conditions. Mone- tary policies that limited the overall supply of bank reserves and `bank credit tended to raise rates of interest on market securities. Because rates paid on time deposits by commercial banks were generally less flexible, these deposits became less attractive to the public, relative to market securities, and their growth rate slowed. Expansive mone- tary policies, contrariwise, tended to accelerate time deposit growth. Manifestly, a given dollar increment to bank credit associated with a rise in time deposits need not `be any the less expansive, in terms of its effects on spending, than if the increase in bank credit were sup- ported by a rise in demand deposits-and hence by a growth in the stock of money. Indeed, it might be more expensive, since banks might channel funds received through time deposit growth into types PAGENO="0126" 122 of uses more likely to stimulate economic activity. For some tirne,~ therefore, we have taken into account the growth rate of commercial bank time deposits, as well as the money stock, in trying to steer t.he~ course of monetary policy. But the meaning to be assigned to any given growth of time deposits is not easily determined. It means one thing if rapid growth in time deposits reflects aggressive bidding for these deposits by the banking system, with the public responding to banks' efforts to obtain loanable funds through this route by reducing money balances. The meaning would be very different if the funds attracted to time deposits at commercial banks represented funds diverted from the close cornpeti-~ tors of banks in the savings field-the mutual savings banks and savings and loan associations. Still a third meaning would be sug- gested if an increase in time deposits represented funds that someone- would otherwise have invested in Treasury bills, while t.he hankmg system puts the funds into morbgage loans. Thus, interpretation of the economic impact of changes in corn-- mercial bank deposits involves understanding the sources from which funds flow into these `assets, and the reasons for these flows. And increasingly, it has become evidence that the posture of monetary policy-as it affects yields on market securities and the desire and'~ ability of banks to bid for funds-influences also the flows of funds to nonbank thrift institutions, and through them the supply of funds seeking long-term investment, especially in mortgages. When the effects of policy spread this pervasively through the financial struc- ture, efforts at setting the course of policy by specifying a relatively inflexible pattern of behavior for a single financial variable, suciL as the money stock, could produce seriously disequilibrating changes in economic activity. The problems we face are not likely to be solved by concocting alternate definitions of money, in hopes that by doing so we wifi find the magic statistical series whose behavior tells us just what we need to know to establish the posture of monetary policy. Undoubtedly, our~ understanding of monetary processes is improved by expanding our vision beyond the narrowly defined money stock and' its immediate- determinants, but we should not expect to find a magic divining rod f or monetary management. What we need is a better underst-anding of the meaning of changes in money and in other liquid assets, not new definitions of what money is. This point can perhaps be illustrated briefly by reference to the debate in the course of policy during the early 1960's, when growth in the money stock was quite moderate, but growth rates in total bank credit were relatively high. In 1962, particularly, growth of the money stock receded to only about 11/a percent, while the growth of bank credit-iinder the impetus of an 18 percent ri~e in commercial bank time deposits-increased to almost a 9 percent rate. Earlier in the postwar period, that high a growth rate of bank credit, had been- associated with strongly expansive monetary policies. The result was a critic's paradise; Federal Reserve policy could alternatively be criticized as exceptionally expansive, or unusually restrictive, depend- ing on the monetary variable used by the crit-ic~. I argued at that time-and I would still argue now; given' the-benefit of hindsight-that both of these interpretations; of monetary- policy' PAGENO="0127" 123 were inaccurate. The growth of time deposits in 1962-and more generally, throughout the early years of the 1960's-reflected partly a reduction in the public's demand for demand deposits. This reduced demand for money was a response to both the higher rates banks paid on time deposits, and the spread in the use of negotiable CD's by large corporations as a liquid investment medium. Slow growth of the money stock was thus reflecting predominantly a reduction in the public's desired money holdings relative to income. But, in part, time deposit growth also reflected an increase in the banking system's role as an intermediary in the savings-investment process. Banks were bidding for funds that would otherwise have been channeled directly by savers to market securities, or indirectly through nonbank thrift institutions to the mortgage market. High growth rates of bank credit were in large measure a reflection of the increased intermediary role of the banks. On balance, I have always thought that the posture of monetary policy in 1962 was properly described as essentially accom- modative, or perhaps moderately expansionary, rather than un- usually stimulative or unusually restrictive. The best evidence that this interpretation is the proper one stems from what was happening at that time to interest rates, and what happened subsequently to economic activity. If policy had been un- usually restrictive, as the slowdown in money growth suggested, we should have expected to see a sharp rise in interest rates-followed by a subsequent marked slowing in GNP growth, or at least in those sectors of the economy most sensitive to monetary policy, such as resi- dential construction. If policy had turned exceptionally expansive as suggested by the marked increase in bank credit growth, we should have expected to see a marked decline in interest rates, and a subse- quent surge of spending, particularly in those areas most responsive to policy. What in fact happened was neither of these. Long-term interest rates were gently declining through most of 1962, while short-term interest rates remained relatively staible throughout the year. GNP growth did slow down temporarily in late 1962 and early 1963, but this moderation in the rate of expansion could scarcely be attributed to tight money. The homebuilding industry-a good barometer of the effects of policy on spending-experienced a generally rising level of activity during the year, made possible by relatively ample supplies of mortgage money. Interest rates, therefore, provide potentially useful information as to the course and intensity of policy, and can never be ignored in set- ting the targets of policy. Observing interest rate changes can help immeasurably in assessing the meaning of changes in money and other liquid asset holdings. Of course, given sufficient time, the impact of monetary policy on interest rates tends to disappear. Expansive monetary policies which initially lower interest rates will eventually increase spending, and the resulting rise in credit demands and income will tend to push interest rates back up again. Nonetheless, there are lags between monetary policies and their final effects on spending and incomes-and in the interim, the impact of monetary policies will be recorded in interest rates. Interest rate changes, consequently, are often of substantial value as indicators of the posture of monetary policy. PAGENO="0128" 124 Of course, using changes in an interest rate or a matrix of interest rates as the sole guide for policy would be as misleading as depending solely on changes in the stock of money. For one thing, some of the important effects of monetary policy in credit markets do not show up in interest rates, but in other aspects of loan contracts-down pay- ments, maturities, or the ability of a borrower to get credit at all. These changes in credit availability may well be as significant as in- terest rate movements in stimulating or restricting particular types of spending. More important, perhaps, is the fact that changes in interest rates result from changes in credit demands as well as supplies. As with the money stock, interest rate changes are partly the result of Federal Reserve policy, but they are partly a product of the behavior of the nonbank public, the commercial banks, and other financial institutions. If we are to make use of interest rate movements as guides to policy, then, we clearly cannot assume simply that monetary policy is moving toward restraint every time interest rates rise, or conversely that fall- ing interest rates always imply greater monetary ease. Interest ra.te movements ha.ve to be interpreted in the light of accompanying changes in such financial quantities as t.he money stock, commercial bank time deposits, and claims against nonba.nk savings institutions. Similarly, interpretation of changes in financial quantities, such as in the money stock, must be made in the context of changes in the prices and yields of a. wide range of financial assets among which in- vestors may choose to hold their funds. Thus, neither financial prices nor quantities alone tell us enough of the story to permit either to serve as an exclusive guide to policy. Moreover, at each juncture the interplay of quantities a.nd prices in financial markets take on substantive meaning as a guide to policy only in light of developments in the real sectors of the economy. For it is only by disentangling the complex inter-relationships between financial markets and markets for real goods and services tha.t we can hope to assess adequately the separate roles of both demand and supply factors in determining quantities and prices of financial assets. This analysis does not lead to any obvious and simple prescription for gaging and directing the course a.nd intensity of monetary policy. This is regrettable, not just beca.use it maximizes the potential for disagreement among policyrnakers and observers evaluating the same set of facts, but also because it implies that we have found as yet. no simple device for circumventing the arduous tasks involved in making judgmental decisions at every step of the game. I would not want to pretend that our economic judgment-or that of any other economic policymaking body-is infallible. But I would argue that the procedures we do follow-blending judgment with com- prehensive, quantitative analysis of current and prospective develop- ments-have produced better results than would have, been achieved by following any of the simple rules advocated by some economists. I have already described how misleading it was to have described the course of monetary policy in 1962 by relying solely on changes in the money stock. Let me turn to a more recent-and more controversial- period, the conduct of monetary policy since the middle of 1965. A frequently voiced criticism of policy in this period, as typically set forth by those who judge the posture of policy either exclusively or PAGENO="0129" 125 mainly on the basis of the growth rate of the Nation's money stock, is that monetary policy became excessively stimulative shortly after the middle of 1965, and remained so until the late spring or early summer of 1966. The high rate of growth of money balances during this period, it is contended, was a principal source of the inflationary pressures we suffered in 1966. Also, it is alleged that monetary policy became ex- cessively restrictive in the late spring or early summer of 1966, and re- mained so until late in the year-as the monetary authorities charac- teristically overreacted, it is said, to their earlier mistake of excessive ease. This criticism goes on to argue that monetary policy Once again swung too far in 1967, producing an unusually high rate of expansion in the money stock that set the stage for a revival of inflationary forces late in 1967 and on into the current year. There is an alternative interpretation of monetary policy during this period, derived from a more careful and comprehensive view of devel- opments in the real economy and in financial markets from late 1965 to date, that accords more closely with the unfolding facts of the situa- tion. As this committee knows well, the problems of excess demand, economic instability and inflation that have plagued us for nearly 3 years first made their appearance in the summer and early fall months of 1965. Our defense effort in Vietnam had just begun to be enlarged, and defense orders were pouring out in volume. At the same time, growth in the stock of money accelerated from a rate of about 3 per- cent in the first half of 1965 to about 6 percent in the final 6 months of that year. Whatever one's views on the. relative importance of the defense buildup, as opposed to the rise in the monetary growth rate, as factors in the ensuing increase in the growth rate of aggregate demand, hind- sight points clearly to the view that prompter and more vigorous efforts should have been taken to counter the inflationary head of steam that was developing in the latter half of 1965. By imposing measures of fiscal restraint then, and adapting monetary policies to the altered environment, we might have preserved the balanced, orderly growth that. we had been enjoying over the previous 4 years. We did not, largely because the magnitude of the defense effort that was get-* ting underway then, and the reverberations it was having in virtually every corner of the economy, were not fully recognized until late in 1965. Given the knowledge that we have presently-which was not then ~ivailable-the course of monetary and fiscal policies in the latter half of 1965 looks inappropriate. Once a program of monetary restriction was initiated in December of 1965, however, we moved to a posture of restraint much more quickly and decisively than the figures on the money stock alone would indi- cate. The accompanying chart shows the percentage changes, at annual rates, of the money stock, money plus time deposits at commercial banks, and savings acounts at a major nonbank thrift institutions. (These percentage changes are calculated from 3-month averages to smooth out some of the erratic monthly movements in these series.) The chart indicates some rather critical differences in the timing of these three series in the period from mid-1965 to mid-1966. Thus, though the money stock continued to rise briskly over the early months of 1966, the growth of money and time deposits together began to de- dine in the late fall months of 1965. And the growth rate of nonbank 94-340-68-------9 PAGENO="0130" 126 savings acoimts was already declining sharply by the end of 1965, as depositors of these institutions responded to the attraction of rising yields on market securities and on commercial bank time deposits. Thus, the supply of credit represented by the growth of all these fi- nancial assets together began to decline well ahead of the downturn in the rate of expansion in money. This decline in supply, operating jointly with the heavy credit demands arising from rapid growth in current spending, underlay the marked and pervasive rise in interest rates we were experiencing in the first quarter of 1966. Monetary re- straint was beginning to develop in financial markets ear'y in 1966, even though rapid money stock growth continued. If any doubt existed that monetary restraint was beginning to pinch before it became evident in the banking figures, those doubts should have been laid to rest by what happened to the volume of hornebuilding during 1966. It is widely recognized that monetary policy affects spending for goods and services only with a variable and often a rather considerable lag, and that it has a larger impact on housing than on any other sector of the ecnonrny. In 1966, however, housing starts leveled out in the first quarter and then began to drop abruptly in the second, reaching a trough in October. This timing of the response of housing starts to financial restraint can be explained, I believe, only by recognizing that the principal indicators of monetary restraint in early 1966 were not recorded iii the money stock, but in the steep decline in the inflows of funds to nonbank financial institutions. Had we guided policies solely by the money stock in early 1966, we could easily have overlooked altogether the strong effects on housing that monetary restraint was in fact producing. But as the year 1966 progressed, an increasing intensity of monetary restraint was signaled by almost every indicator of monetary policy customarily observed. Growth in the money stock was halted for a pe- riod of 7 to 8 months and the expansion in commercial bank time de- posits declined marketedly after midyear. Large banks, particularly, were put under severe strain, as the maintenance of ceilings on large CD's at 51/2 percent-while yields on competing financial assets were rising rapidly-led nonfinancial corporations and other large investors to shift there funds out of the CD market. Inflow of funds to nonbank intermediaries, meanwhile, continued at low levels through the summer and early fall months. These signs of monetary restraint in the quan- tities were also reflected in interest rates, which rose rapidly during the summer of 1966 to the highest levels in about four decades. Perhaps a case could be made for the argument that some of the financial indicators in the summer and early fall of 1966 overestimated the degree of monetary restraint generated by policy actions. Some of the financial pressure suggested by the declining growth rate of commercial bank deposits, for example, was being cushioned by large inflows of funds from abroad-rn the form of increased liabilities of our banks to foreign branches. But the relief to the bank system as a whole was relatively limited. The fact of the matter is, I believe, that monetary restraint became quite severe in the summer and early fall of 1966, a conclusion that would have been drawn from a wide variety of indicators of monetary policy. As noted earlier, some critics of Federal Reserve policy have con- cluded that monetary policy became excessively tight during this PAGENO="0131" 127 period and point to the slowing of real growth in output late in 1966 and on through the first half of 1967 as confirmation of their point of view. I would not question that some of the restrictive effects on spending of earlier tight monetary policies were still being recorded in the first half of 1967-although it may be noted that outlays for residential construction began to rise as early as the first quarter of that year. What I would question is the contention that the inventory adjustment of early 1967 was entirely, or even primarily, caused by tight money in 1966. The undesired buildup of inventories that occurred in the last quarter of 1966 reflected mainly the inability of business to foresee the slowdown in final sales that resulted when consumers began to exercise more cautious buying attitudes. Personal consumption expenditures had been rising at a rate of about $8 to $9 billion per quarter in the year ended with the third quarter of 1966-and so far as anyone knew at that time, they might well have continued to do so. But consumer buying slowed materially in the fourth quarter, as a major increase occurred in the personal savings rate, and consumers con- tinued to exercise caution in their buying habits throughout 1967. At best, this behavior of consumers can be contributed only in small measure to tight money in the summer and fall months of 1966. Many other factors were undoubtedly of fundamental importance-includ- ing a reaction to the rapid income growth and the buildup of stocks of durable assets in the immediately preceding years, resistance to rising prices, and the general uncertainties emanating from our involvement in Vietnam. But whatever its origin, the economic slowdown of early 1967 did require compensating adjustments in monetary policy to keep the economy from slipping into recessionary conditions. Fortunately, the inventory correction of early 1967 was anticipated in time to take the initial steps toward monetary ease in the fall of 1966, and this helped to bolster residential construction through the first half of 1967. With fiscal policy also turning expansive and helping to bolster final sales substantially during the first half of 1967, excess inventories were worked off relatively quickly, and by July industrial production had begun to turn up again. The pickup in business activity after midyear 1967 was foreseen by a number of forecasters, including our own staff at the Federal Reserve Board. Why, then, did monetary policy not take earlier and more decisive steps to reduce the rate of expansion in the money stock and in bank credit during the latter half of the year? There are two parts to the answer to that question. First, the high rate of expansion in the money stock during the final 6 months of lass year greatly overstates the actual degree of monetary ease promoted by monetary policy. What it represented was the supplying of funds through monetary policy to permit the satisfac- tion of a sharp increase in liquidity preference on the part of non- financial corporations. Their desires to rebuild liquid asset holdings stemmed only in part from the experience with tight credit policies in 1966. Of more fundamental importance were the trends in cor- porate liquid asset management over the previous several years, together with the heavy toll on corporate liquidity resulting from the acceleration of tax payments that began in 1966. PAGENO="0132" 128 In the years immediately prior to 1966, businesses in the a~rega.te had little need to concern themselves with their liquidity ~sitions or with the availability of bank loans or other sources ~f funds to meet their credit needs. Partly as a consequence of this, additions to liquid asset holdings were relatively modest. Titus, increases in liquid asset holdings of nonfinancial corporations were less than $1 billion in each of the years 1964 and 1965. Businesses entered the period of accelerated tax payments. there- fore, with little preparation for meeting a heavy exce~s of tax pay- ments over accruals. For nonfinancial corporations, payments exceeded accruing liabilities by about $2 billion in the second quarter of 1966 and by about $5 billion in the second quarter of 1961. With credit markets taut during a. large part of this period, liquid asset holdings were run down by nearly $3 billion in the year ended in mid-1967, rn reflection of the heavy needs for funds for accelerated payments of taxes and other purposes. Many businesses, consequently, took the opportunity afforded by more ample credit availability in 1967 to do something about their liquidity positions. Corporate long-term security issues began to rise ~rapidly in reflection of these increased liquidity demands during the spring of 1967, and they remained at exceptionally high levels until ~late in the year. Observers close to financial markets reported that ~.n unusual increase in liquidity preference was responsible. The demand for money had thus risen for reasons not associated with intentions to spend for goods and services. This is the kind of increase in demand for money which monetary policy can meet, by permitting an increase in the supply, without inflationary consequences. The behavior of interest rates during the latter half of 1967 provided the confirmation needed that this interpretation was on the right, track. Interest rates on longer term securities had begtm rising in the sprmg months in response to the rapidly growing supply of corporate long term borrowmg. Short-term rates, however, continued to decline, until shortly before midyear. After midyear, however, interest, rates began to rise drastically across the range of maturities, and the increases were much too rapid to be explained by the effects of rising incomes and economic activity generating increased demands for credit. They were reflecting increased demands for quick assets to restore balance sheet liquidity-demands that were not being fully satisfied by the rate of growth in money and time deposits permitted by monetary policy. It seems evident that. monetary policy was much less expansive in 1967 than the high rate of monetary growth, taken by itself, might seem to imply. Nevertheless, had it been known that timely fiscal restraint was not going to be forthcoming, monetary policy would have been less expansive over the summer and fall of 1967, in order to achieve a pos- ture more consistent with a return to price stability. Earlier adoption of a program of monetary restraint would have been difficult., in light of the turbulent state of domestic and international financial markets but it would not have been impossible. Such a program was not adopted earlier, I believe, largely because those of us responsible for making monetary decisions found it almost inconceivable that this Nation would once again, following the painful experience of 1966. choose to rely exclusively on monetary policy to moderate the. growth in PAGENO="0133" 129 aggregate demand and slow inflationary pressures. Let us ferventIy~ hope that the brightening prospects for fiscal restraint we presently see on the horizon provide justification for that expectation. F~NA~JC~AL ASSETS Annual Growth Rates Chairman PROxMIRE. Thank you very much, Governor Mitchell. Governor Mitchell, apparently you and the Board feel that the Congress should not require that the Board follow a policy of a grad- ual but definite increase in the money supply, say between 2 and 6 percent or 2 and 5 percent, 3 and 6 percent. I am told that you are also opposed to an annual requirement of an annual announcement by the Board setting forth what your monetary policy would be, so that the Congress might be in a position to judge the Board's per- formance by its own standard. I understand that the Board is also very much opposed to any con- gressional requirement that you purchase "Fanny May" obligations in order to support the housing market. PER CENT 1964 1965 1966 1961 1968 PAGENO="0134" IC) I .D It' seems to me that althou~li the Constitution makes it clear that the Congress has the authority to coin money and regulate the value thereof and has this money power very clearly, that the position 0ħ the Board is that the Congress should delegate that authority to the Board and then get lost. In other words, listen to these very fine and very erudite and quite persuasive arguments that you gentlemen make to us, but do not ever suggest any policies that would direct the Board to do anything. Give the Board the discretion and rely on the Board's judgment to do the right thing. Mr. MITCHELL. Well, I think that the Board's positton with respect to various monetary variables is not adequately described by the. ques- tion you raise. Chairman PROXMIRE. First I want to ask the overall question. Is there anything at all that the Congress can do in terms of affecting monetary policy that you think would be sensible and wise, or can Congress do nothing? Mr. MITCHELL. My view would be that Con~ress would not be doing the right thing if i~ suggested to the Board~a very narrow band of growth in the money supply, just that single target. Chairman PROXMIRE. I do not. agree with your view of course, but. I understand your objection to that partictilar kind of monetary guidance. My question is, do you think Congress has any-Congress obviously has the authority to do anything it wishes in this regard. Mr. MITCHELL. Certainly. Chairman Piiox~IIRE. But do you think it would be wise for Con- gress to give any sort of guidance of any kind to the Board that affects the monetary policy? Mr. MITCHELL. I think if the state of the art or the state of our own knowledge were such that Congress could prescribe a better rule, one that would achieve a better result than what we are able to achieve now, it would be a fine thing to do. But I do not think you can do it. I do not think the state of the knowledge is such tha.t you are able to do it. Chairman PROXMIRE. Let's get into the specifics. We argue that the state of the knowledge is such that it is necessary to prescribe this. In other words, the lags are great, as you have speci- fled in your presentation here. Mr. MITCHELL. That is right. Chairman PROXM~E. The lags are great between policies that you decide to follow. Mr. MITCHELL. That is right. Chairman PROXMIRE. And the consequences of those policies, income and so forth. And because the lags are great, and because you cannot foresee accurately economic conditions at the. time the policies will take their effect, that for this reason it might be wise to follow some kind of a general principle or a rule rather t.han to go by the seat of your pants. Mr. MITCHELL. Well, I do not. think we go by the seat of our pants. Any policy decision is made with a projection as a background. The projection can be explicit or implicit.. In our case our projections before the Federal Open Market Committee and before the Board are explicit. They may not be perfect, because the state of the forecasting art is not that good. But over a short-time horizon, I think they have been quite good. PAGENO="0135" 131 Some of the monetary lags are short. The effect on expectations is immediate. If monetary policy is moving sharply, the lock-in effect is almost immediate. Chairman PROXMIRE. The lock-in effect? What is that? Mr. MITCHELL. Well, if you bought a Government security, say when interest rates are 5 percent and the interest rates go to 6 percent, the value of your Government security has dropped substantially. Chairman PROXMIRE. I am talking about the effect on the fundamen- tal objectives of the Employment Act, you know. Can you give us any examples in which you can contend that mone- tary policy has a fairly quick effect on employment or on the housing industry or anything of that kind? Mr. MITCHELL. Yes. Well, I think that the effect of monetary policy is to defer decisions oii projects that are in the formulation stage. One of the best examples is the Chesapeake Bay Bridge. The Chesapeake Bay Bridge was on the drawing boards, the plans were complete for, if I recall correctly, a period of about 3 years, but they were unable to sell the bonds be- cause they were revenue bonds, and the market would not take them. Now, that was a project that was vulnerable to the level of interest rates. If the level of interest rates had been eased, the project could be financed. If the level of interest rates was raised, it could not be fi- nanced; and when it was eased they did sell the bonds, and this meant that the project came into being. Now, the amount of money was large and it was spent over a long period of years. Chairman. PROXMIRE. Are you saying that the Federal Reserve Board can follow policies that will promptly result in a change in interest rates? Mr. MITCHELL. That- Chairman PROXMtRE. That will promptly result. For instance, that you can increase the supply of money at a more rapid rate, which.wilI result in a reduction in interest rates ~ Mr. MITCHELL. Yes, certainly. ~Jhairman PRoxMntE. In how long a period? Mr.. MITCHELL. Well, it depends upon the market that you are talk- ing of. In some markets the effect is immediate. In other markets it is more delayed. Chairman PRoxi~m~. Of courseyou do not know, do you? In other words, in 1967 you followed a policy of increasing the money supply rather rapidly and interest rates kept going up. Mr. MITCHELL. In the long-term markets. Chairman PROXMIRE. The price of money kept going up? Mr. MITCHELL. In the long-term market, that is true. Chairman PROXNLIRE. You have explained here the reasons for that. Mr. MITCHELL. That is correct. Chairman PROXMIRE. But that did happen, and the effect in terms of the housing industry therefore could not be foreseen, could it? Mr. MITCHELL. Well, the effect on the housing industry of actions- Chairman PR0XMIRE. The tendency can be foreseen? Mr. MITCHELL. That is right. PAGENO="0136" 132 Chairman PROXMIRE. You might argue if you had not adopted this policy, if you had not increased the money supply by the policies you had followed, interest rates would have gone even higher, and they would have had a greater restraint on the housmg industry than you had; is that correct? Mr. MITCHELL. What the model builders in effect do is construct a forecast or projection of how the economy is going to perform, and what we attempt to do is to use this model to estimate how the monetary variables are going to perform. But this type of analysis, and this type of operation, is in its-I was tempted to say, in its infancy. The studies continue to go along, and a great deal of progress has been made. To give you some evidence of this progress, I would just like to refer to the directives that the Federal Open Market Committee uses. I have copies of the directives here for the past year. The second clause of the directive contains the instructions to the manager of the System's open market operations. Now, there has been a quantitative variable in all of these directives, with the exception of three. For example, here is the directive for January 10, 1967: To implement this policy and taking into account the forthcoming Treasury financing system open market operations untii the next meeting of the committee shall be conducted with a view to attaining somewhat easier conditions in the money market, unless bank credit appears to be expanding significantly faster than currently anticipated. I want to address myself to what we mean by "bank credit expand- bag significantly faster than currently anticipated." The measure of bank credit that we use is the credit proxy, and a credit proxy is computed on the basis of average da.ily deposits at banks. In other words, from the liability side of the balance sheet. We do not have daily records on bank assets. but. we do have daily reports on their liabilities. So we get changes in the movement of their lia- bilities, and we assume that these changes are proportional to the changes in their assets. This is a quantitative variable similar to what we call M-2, which is Milton Friedman's money supply figure. The main differences between the credit supply proxy and the money supply series are that the credit proxy includes Government deposits and M-2 does not; the cre.dit proxy applies to member banks only; while M-2 applies to all banks; and M-2 includes coin and currency. Despite these differences the movements in these two series are quite similar. We not only have up-to-date estimates of what is happening to bank credit, through credit. proxy, but. we have a projection of the credit proxy, a.nd when it says in the directive, "appears to be expand- ing significantly faste.r than currently anticipated," that means then as currently projected. Now this directive, therefore, said to t.he manager, "Maintain some- what easier conditions in the money market, but if you find the bank credit is expanding faster t.hat it is expected to expand in the projec- tion, then do not ease quite as much as you had previously." Chairman PROXMIRE. My time is just. about up. but let me ask two questions, to try to point up how far you are willing, or how far you think the Board would think it wise to cooperate with the Congress. - Again I am sure you recognize the authority of the Congress in this ~respect. PAGENO="0137" 133 Supposing you were required or were asked, requested to come before the Congress after each quarter in which you had either not increased the money supply at the rate of 2 percent, or had increased the money supply at a rate of more than 6 percent, to explain the reason for it, come before this committee, for example; this would not strain you? Mr. MITCHELL. No. Chairman PROXMIRE. You would just come up and tell us why you did it. Would there by any objection to that? Mr. MITCHELL. No, I do not think so. Mr. Brill just reminded me we do it twice a year in the Federal Reserve Bulletin now in effect. Chairman PROXMIRE. You do it in the Bulletin, but we would prefer to have you come up and question you in detail and in public-a vigor- ous cross-examination. Mr. MITCHELL. It would not be onerous, not at all. Chairman PROXMIRE. The other question is whether or not you think it would be useful for the Board to set forth at the beginning of the year as specifically as it could its notion of what kind of monetary policy the economy called for, similar to the kind of program the President sets forth in his Economic Report. Mr. MITCHELL. Yes. Well, this gets to be kind of troublesome. A lot of the meaning, the influence of monetary action is on expectations. Chairman PROXMIRE. You would not be stuck with it and of course you would be able to come up every quarter anyway to explain why you varied from the general guide rule. Mr. MITCHELL. Well, I think the Board feels it has an obligation under the Employment Act of 1946 to aim at maximum growth with stability, and these are the words that we use. They are in our directives. Whether or not you could spell this out, appropriately spell this out publicly against the projections you have for GNP for the year- Chairman PROXMIRE. I think it would help you, I think it would help the business in this country, I think it would help the Congress to have a much better understanding. If, for example, at the beginning of this year Mr. Martin comes to us and said, "We expect that we are going to have a. very difficult inflationary challenge facing the economy, and therefore we think that the monetary policy must be one of restraint," and indicated to some extent that they were going to try to exercise that restraint, then you see we would be in a position to do a number of things. One thing. we could study disintermediation; what we could do about that. We would also be in a position to do what we could, as the Congress, to adopt appropriate fiscal policies. It would be consist- ent with the monetary policy that you called for. Mr. MITCHELL. Well, if we took the Council's projection of C-NP----- Chairman PR0XMIRE. Take your own. Mr. MITCHELL. We would use that one and adapt our projection of the monetary variables to that particular model, but that is not the only model that could be used. You could have other models. But I think the most practical model for us to work with is the Council model. In fact, we are doing the things that you are talking about now, Mr. Chairman. But we are doing them internally. PAGENO="0138" 134 Chairman PROXMIRE. That is it. We want to know. It. would be. very helpful if we knew. And I think this public expression would mean that we would have a basis for judging your performance. much better than we do now. My time is up. Senator Miller? Senator MILLER. Thank you, Mr. Chairman. Governor Mitchell, I wonder in connection with your statement at the end, if I could get a clear picture of what is often referred to as monetization of the national debt.. Suppose that in a given period of let's say 6 months, as a. result. of fiscal action taken by the Congress, there is an amount of $10 billion added to the national debt, a deficit of $10 billion. This has to be cov- ered by borrowing, let's sa.y short- or mid-range securities are issued. Now, where does the Federal Reserve Board come in to react to this addition to the national debt, as a result of whic.h there is an increase in the money supply? Mr. MITCHELL. Well, if the Treasury dec.ides to borrow as long as it can, say 6 or 7 years, they are borrowing savings, and we do not have anything more than a sort of sideline underwriting operation to perform. If the Treasury goes short for this, and sells securities to the bank- ing system, we have to supply reserves to the banking system, and then the banking system, if it is under enough pressure from us, sells the securities out, and competes in the short-term market. The suc- cess of this operation depends upon how much pressure the banking system is under. If it is not under much pressure, it would continue to hold the securities and therefore the money supply would rise. Senator MILLER. How would that happen? Mr. MITCHELL. `Well, if we supply reserves, the banking system buys the securities and deposits are rising, Government deposits rise originally and then the Government deposits are spent and it. gets into the hands of the public. Senator MILLER. On a 1-for-i basis? Mr. MITCIn~LL. Yes. Senator MILLER. Cannot action be taken by the Federal Reserve to make it 2 for 1 or 3 for 1? Mr. MITCHELL. Well, we would not supply any more reserves in the first instance other than to enable the banks to buy the issue. Senator MILLER. Then I would like to have you carry on to show how this can be expanded. Mr. MITCHELL. Let's say the Government has borrowed $5 billion. That is a balance in the commercial banks, and as they spend that. S5 billion, then those balances become demand deposits of individuals and corporations. Here again one does not know. Maybe the corporations and in- dividuals do not want demamid deposits, they waiit. time deposits. so you might get a shift from demand into time deposits. It depends upon the reaction of the business community. If the banking system is under pressure to get rid of these securities, then this has a deflationary impact. Senator MILLER. How do the open market transactions of the Board ~ff~t th~ e~paimion of the money suppiy, based upon this increase in my example of $10 billion in the national debt, in the financing thereof? PAGENO="0139" 135 In other words, what I am getting at is this: As I understand it, with the addition of $10 billion to the national debt, and the financing necessary, there is a foundation laid for the Federal Reserve Board to increase the money supply, not just by $10 billion but by upwards of $20 or $30 billion, and that this is done or can be done through the open market policies of the Board, what is known as monetization of the national debt. Mr. MITCHELL. Yes. Senator MILLER. I would like to have you give us a picture of how that works. Mr. MITCHELL. Well, when the Treasury sells $10 billion worth of d~bt, it sells it to the banking system, not to us. Senator MILLER. OK. Mr. MITCHELL. But if in our open market operations we buy say $10 billion from the banking system, that is something else again. Senator Mun~. Yes. Mr. MITCHELL. They now have a reserve base on which their aver- age expansion is 10 times. Senator MILLER. All right. So that if you indeed wanted to expand the money supply- Mr. MITCHELL. This is the way you do it. Senator MILLER. Then you would purchase the $10 billion? Mr. MITCHELL. That is right. Senator MILLER. From the banks? Mr. MITCHELL. That is right. Senator MILLER. And that would increase their lending capabilities? Mr. MITCHELL. Roughly 10- Senator MILLER. For $100 billion? Mr. MITCHELL. Yes. Senator MILLER. Of addition to the money supply; is that not so? Mr. MITCHELL. Money supply and time deposits. You would have to specify whether you are talking about M-1 or M-2, but I would say over time, given a little time, you would have expanded bank lending capacity by something like 10 times, yes. Senator MILLER. Yes. Well then, this would appear to be a very vital consideration in whether or not there is an excessive increase in the money supply. Mr. MITCHELL. Certainly. Senator MILLER. I have heard criticism of the Federal Reserve Board for being responsible for the inflation, as a result of the ex~ cessive expansion of the money supply through this technique. What does the Federal Reserve Board have to say about that, in defense of that? Mr. MITCHELL. Yes. The technique, like the surgeon's knife, you know, depends upon how it is used, for good or for bad, and obviously our conviction is that we have not overused this tool. Senator MILLER. If you have not overused the tool, then where does this inflation come from? I grant you that- Mr. MITCHELL. I think it comes really from the Government deficit. Senator MILLER. All right, so you can blame the Congress for the Government deficit, because the Congress has seen fit to spend more than it takes in, and it has laid a foundation there. PAGENO="0140" 136 ~Mr. MITCHELL. That is right. Senator MILLER. But it seems to me that once that foundation has been laid, the house of inflation will not be built unless the Federal Reserve Board comes along and builds on to it through the expansion of the money supply through this monetization of the debt. Mr. MITCHELL. Well, there are other ways out of this dilemma. The Congress could have a $20 billion deficit, and if it were financed out of savings there would not be any inflation problem. Senator MILLER. Right. Mr. MITCHELL. But financing it out of savings is impossible to do, given the kind of restraints that we have now. It would require a longer term instrument, at higher rates- Senator MILLER. All right. Mr. MITCHELL (continuing). Than presently can be paid on Gov- ernment securities. Senator MILLER. So you have the banks buy them. Mr. MITCHELL. So the banks buy them on a. short-term basis. Banks and other investors. Banks are really underwriters he.re for a while. Of course they are large holders of Government securities too. Senator MILLER. All right, but if you t.hen t.urn around and permit those banks to e~pand their credit capability by 10 to 1, as a result of buying those, through your qpen *maret operation, then you have started to build that house of inflation, have you not ? Mr. MITCHELL. Well, we have tried iiot. to permit this to happen to any larger degree than is necessary Senator MILLER. Of course I am sure you honestly tried to do some- thing about tha.t. ~`Ir. MITCHELL. Yes. Senator MILLER. But the fact seems to me to he inescapable that if you had not permitted this to happen, that we would not have had the inflation that we have. Mr. MITCHELL. Well, I suppose if we had pushed a lot harder, we `could have driven housing starts down another 200,000 or 300,000 but I do not know. Most people felt that was a terrible convulsion we had in the latter half of 1966. It was a.bout as vigorous monetary restraint as we have had in the last 15 or 20 years. Senator MILLER. Of course nobody wants t.o drive down housing `starts, `but it is possible, is it not, tha.t. those housing starts could have been assured by some other mechanism or some other activity. And I fail to see why an expansion of 10 to 1 through your open market policy would be necessary. Maybe you would only have to expand it by 3 to 1. Mr. MITCHELL. That ratio is fixed by the reverse requirement. If reserve requirements were raised, it would be less. We did raise reserve requirements too. We raised them, if I recall correctly, twice. Mr. BRILL. Yes. Mr. MITCHELL. And the increases in reserve requirements reduced the expansive capability of this. This is one of the techniques of mone- tary restraint. It has been used. Open market opertaions I think have always been on a minimum basis in thrms of Government. financing, and yet it is impossible to have a deficit of this size without having some monetary expansion rather than not having it. PAGENO="0141" 137 Senator MILLER. 1 understand that you have changed the reserve requirements. Mr. MITCHELL. Yes. Senator MILLER. As a tempering influence on this. Mr. MITCHELL. Yes. Senator MILLER. But taking a hard look at the amount of the infla- tion, the question is whether or not you have done enough. Mr. MITCHELL. This is a question of judgment, I think. We did as much as we thought we could. Senator MILLER. As I understand the position of the Board is that you have been doing about the best you can and that monetary policy cannot do what fiscal policy fails to do. Mr. MITCHELL. Yes, sir; I think that is right. Senator MILLER. And I generally have tended to accept this, but I am just wondering what would happen if the Board changed its re- serve requirements during a period of inflation, and said, "We are go- ing to exercise such reserve requirements that the monetization of the debt structure at a ratio of 10 to 1 is not going to come about. It may come about on a ratio of 2 to 1, but not 10 to 1. And if this caused a down-turn in the economy, then let fiscal policy get going. And then we will change. Have you ever thought about doing something like that? Mr. MITCHELL. Well, I think that in the summer of 1966, when we took the strongest stand we could think of taking, that we were close to disorderly markets in municipal securities. We had no growth in the money supply whatever. We had high interest rates, and the bank- ing system was I think deeply concerned about their ability to take care of their customers. Now I think that is about as taut a monetary system as you can run. Senator MILLER. That is so, but it did not stay that way. Mr. MiTCHELL. It did not stay that way, but then one of the reasons was we got that tremendous inventory acumulation, and we were threatened with a dip into something much more than a "mini" re- cession. I think this is the reason the policy had to change. Senator MILLER. But that was not your fault, if I may suggest it. Mr. MITCHELL. No, it was not. Senator MILLER. And I note here in your statement that you say that "Had it been known that timely fiscal restraint was not going to be forthcoming," then your monetary policy would have been less expansive. Mr. MITCHELL. Yes, sir; that is in 1967. Senator MILLER. That is right.. Mr. MITCHELL. I think that would have been the right thing for us to do, but as I said in my statement, we felt quite sure that fiscal action would come along and it would not be very much longer, but you know it went from week to week and month to month and nothing happened. Senator MILLER. Would it not have been more prudent to have said, "We expect fiscal restraint to be taken, but we are going to wait until it hatches out"? Mr. MITCHELL. It probably would have been, in retrospect; yes, sir. Senator MILLER. Yes. I want you to know I am sympathetic with the Board and I am quite critical of the failure of the Congress to take fiscal action, but I think that the Board is in a strong bargaining PAGENO="0142" 138 position, because of its independence, to force the fiscal policies which have not yet come about. I for one would hope that you might use that lever that you have, which I think the country would be better off with if you had. My time is up, Mr. Chairman. Chairman PROXM~E. Governor Mitchell, a number of very able and competent monetary economists have said the Federal Reserve Board has a poor record in their view of adjusting monetary policy to serve the best interests of our country. They point to the fact, for example, that in the recessions of 1949, 1954, 1958, 1961-as well as, of course, the most conspicuous example was in the thirties-they let the money stock decline. This just seems absolutely wrong and it. is hard now with hindsight to understand how there can be any justification ever for that kind of policy. At the same time now all of us recognize, as Senator Miller stressed so well, that we are in a period of inflation, and none more elo- quently or more emphatically than the Chairman of the Board of Governors of the Federal Reserve Board, Mr. Martin, and yet your money supply is being increased rather rapidly and you look a.t the charts that you have at the back of your presentation and you see all of your reflections of monetary policy are pointing toward expansion, according to the latest information I have-April 17. The latest figure they have on the money supply, it is up another $1.5 billion from March. March was $900 million over February, and they are both well over a year ago of course. It is continuing to expand at. a rate of about 6 percent. it just looks as if this does not add up in terms of the overwhelming apparent need to restrain the economy and therefore to restrain, have monetary policy, have a restraining influence. The reason I ask this once again is I want t.o come back to the fact that the Congress ought to have a little more to say about monetary policy. Mr. MITCHELL. Again I think it is a. case of what magnitude you ar~ looking at, and with what kind of a background. Now let us take our magnitude, which is the credit proxy, and which you can think of as being Milton's money supply, M-2. Chairman PROXMIRE. You are not ta.lkuig about the English poet. You are talking about the Chicago economist, Professor Friedman? Mr. MITCHELL. I am sorry; yes, Professor Frieclman. We speak too familiarly of him, but he is well known by everyone. Chairman PROXMIRE. He is kind of a poet too. Mr. MITCHELL. At any rate, using the bank credit proxy, since December it has been rising at a rate of 3.7 percent, a.nd from May to November of 1967 it rose at a rate of 11.3. Now that is quite a. drop in the rise of that proxy. It is a very substantial drop. Chairman PROxM~E. From May to November it rose at a rate of what? Mr. MITCHELL. 11.3. Chairman PRox~rnu~. What year? Mr. MITCHELL. 1967. Chairman PROXMIRE. Do you think that was wise? Mc. MIT0II~LIJ. Well, we have been over that already. I think in retrospect~- PAGENO="0143" 139 Chairman PROXMIRE. It is still rising and it is rising at a substantial rate. Mr. MITCHELL. 3.7, I believe. Chairman PROXMIRE. It certainly is not a restraining rate right now. Mr. MITCHELL. 3.7? Oh, yes, I think it is. Chairman PR0XMIRE. It is rising at a rate more rapidly than the real GNP has been growing historically. So you could argue that this is- Mr. MITCHELL. This is about what real GNP is, is it not; 4 percent? Chairman PR0xMIRE. I am talking about the longrun growth in GNP. It is true that real GNP grew rapidly the first quarter of the year. Senator MILLER. Would the Chairman yield at this point? Chairman PROXMIRE. Sure. Senator MILLER. Are you saying, Governor Mitchell, that the in- crease in the money supply or that the rate is premised upon the real increased GNP as a satisfactory measurement? Mr. MITCHELL. I was just saying- Chairman PROXMIRE. I brought the GNP in. Mr. MITCHELL. Yes. Chairman PROXMIRE. My point is that if the money supply is grow- ing at a more rapid rate than the rise in the GNP, then you can argue it has an expansionary influence in the economy. Mr. Brill is shaking his head, I see-otherwise you can argue it tends to have a restraining influence on the economy. Why not? Senator MILLER. What I am trying to bring out is whether or not the Board uses that kind of a guide in its considerations of the growth rate of the money supply. Mr. MITCHELL. You would not take a 1-to-i relationship here. If GNP is rising at 4 percent, that does not mean that money supply should rise at 4 percent for the simple reason that turnover is rising so rapidly. Chairman PROXMIRE. But turnover is a function in part of the money supply. Mr. MITCHELL. Yes. Chairman PRoxMn~. If you vary the money supply rate of growth, the velocity will tend to vary in response. Mr. MITCHELL. No; it is increasing as a result of technological changes. In New York City now, turnover of demand deposits is two and a half times a week, 128 or 130 times a year, and 10 years ago it was half that. Turnover has doubled in a decade. So money supply does not have to rise as fast as GNP, in order to provide its transaction function. Chairman PROXMIRE. You are making an argument against your- self. Then you are arguing that the 3.7-is it a 3.7 increase in the money supply? Mr. MITCHELL. That is in the proxy. Chairman PROXMIEE. In the proxy? Mr. MITCHELL. Yes; in the proxy. Chairman PROXMIRE. At any rate, the money supply increased more rapidly than that? Mr. MITCHELL. That is right, it did. Money supply between May and November increased 8.4 percent and since Decem~ber it has increased 5.6. Let me give you the others. PAGENO="0144" 140 Time and savings deposits at banks were increasing May to No- vember 14.7, now increasing 5.5. That is a two-thirds reduction in the rate of that increase. And deposits of thrift institutions increased May to November 9.1, and now it is 6.1, a drop of a third there. This is quite a change in these annual rates. Chairman PROXMLRE. All I am saying is that there is some prima facie case that the Federal Reserve Board's conduct in monetary poi- icy can be criticized. As I say, the recessions of 1949, 1954, 1958, 1961, the monetary sup- ply was going down. You can make all kinds of rationalizations that there were other reasons or that it was not really quite as bad as it might seem, yet on the other hand, it does seem perverse. It does not make sense. Would you agree with the position taken by Professor Christ, who said he thinks that the Federal Reserve Boa.rd should never decrease the money supply, never permit it to decrease over a period of say a quarter? Mr. MITCHELL. It depends on what was done in the previous quarter. You may have a situation- Chairman PROXMIRE. Then you would disagree? Mr. MITCHELL. Yes. Chairman PROXMIRE. You would say there are circumstances in which you ought to reduce it? Mr. MITCHELL. Sure. Chairman PROXMIRE. Here is what I think is the kind of thing he is getting at. He is pointing out that you did have this very hard to understand and explain situation that occurred last year, in which the money supply was increasing rapidly and the price of money was going up at the same time. Interest rates were high, although the money supply was increasing. It is hard to understand. He argued, and the other economists seemed to agree, that one reason is because the Fed was expected to continue in the future to increase money supply at a rapid rate. This was in- flationary, and because under these circumstances the economic re- action to the expectation of inflation is to follow policies that tend to drive up the interest rates, people are less likely to lend money if they expect it is going to have a much lesser value in the future. They are going to ask for higher rates before they do lend it. They argued therefore that if the Federal Reserve were committed tO a policy of not increasing the money supply at a more rapid rate than 6 percent per year, that you would not have that kind of expecta- tion, and interest rates would be inclined to be lower. Mr. MITCHELL. I think that the argument that a. steady increase in the money supply gives everyone a uniform expectation about the future, which is basic to Milton Friedman's argument- Chairman PROXMIRE. Yes. Mr. MITCHELL (continuing). Falls apart when you get disequilibrat- ing events such as we had in the fall of 1965, with a major change in the Government deficit and the Vietnam spending. It hasn't anything to do with money supply. Chairman PRoxI~Inu~. We understand that; but you see one of the disequilibrating factors-it would be a fluctuating money supply that could go way up or way down and is likely to continue to increase PAGENO="0145" 141 maybe at a 10 percent rate if you expect the monetary authorities to adopt a philosophy that would lead to that. One of the stabilizing factors would be a solid expectation that the money supply would increase at a regular rate, somewhere between 2 and 6 percent or 3 and 5 percent, something of that kind. Mr. MITCHELL. But if you had not had some difference in the Chairman PROXMIRE. Money supply cannot do everything, but it can stabilize itself. Mr. MITCHELL. I think this is tantamount to saying that you do not want to use monetary policy for stabilizing purposes. Chairman PROXMIRE. Well, you would like to use it for stabilizing purposes, but you cannot foresee the future, and there are lags in- volved, and under these circumstances you think that about the best you can do is to use it, but use it within limitations? Mr. MITCHELL. Yes. Chairman PROXMIRE. That are moderate? Mr. MITCHELL. Yes. I just do not agree with this, because I think we are learning to use it better all the time. I think the farther you go into monetary archeology, you know, the less helpful it is. The thing to do is to be looking at the tools, and the equipment and the statistical improvements that are being made, and the im- proved knowledge that we have of the behavior of these monetary variables. That is why I come back to what you said in the first place. Could you not share with us the kind of analysis that you are makin of the mOvement of monetary variables against the projection of GNP. This is the type of analysis that is being improved, and though it is far from perfect it is better than it was and every year it gets better than it was the year before. Chairman PROXMIRE. You see what we are getting at, however, now, is that I think at least somebody of economic competence in the universities and elsewhere feels that the Board's policies in the past have not been as good as they should be, and in the future they are unlikely to be good for reasons of lags, the state of the art and so forth. No criticism of the people involved. Mr. MITCHELL. Yes. Chairman PROXMIRE. And it seems to me we probably cannot have a rigid rule, at least I do not think Congress will adopt it, and I know the Federal Reserve Board would fight it, and it might not be wise. However, how about stressing once again this compromise notion, that the Congress could suggest a gradual increase of the kind we have here. We could have regular public hearings in which we could ask questions, not just a report in some document that nobody reads, but hearings with the press present and members of the committee here to ask questions on it, and then in addition to this, we could have at the beginning of the year an expression by the Board of what their intention is with regard to monetary policy, recognizing the Presi- dent's Economic Report and recognizing the needs of the economy prospectively. Mr. MITCHELL. Well, I do not see any objection to any of this except the part about a regular increase in the money supply. I think that this prejudices the 94-340---G8------1O PAGENO="0146" 142 Chairman PROXMIRE. Again you are not bound by it. All you have to do is justify, explain why. Mr. MITCHELL. I understand that, but I think that it would be un- wise to focus on this one variable, when there are others that may be much more important. Chairman PRox~rn~. Well, the answer there of course is that if we do not focus on one variable, given the finite ability of the Congress and of all of us here on this side of the table, if you give us all these variables that we talk about and discuss, we are going to be lost. We have to get this as simple as we can. Mr. MITCHELL. Yes. Chairman PROXMIRE. And as reasonable as possible, so that people at least understand this element of it, and then be in a position to evaluate your arguments as to why you depart from it. Mr. MITCHELL. Well, then, I would say on the occasion when you hear the Council of Economic Advisors on the outlook for the economy, there is not any reason that I can see offhand why you could not hear the Federal Reserve on the financial outlook. The outlook for financial variables, that could be expected given this projection for the econorny~ Chairman PROXMIRE. We do not want it that erratic or informal. We want a regular quarterly hearing, at least whenever there is a departure in Federal Reserve policy, so that we will be in a position to he enlightened, the Congress will. We can make our report, make our criticism, make our suggestions, have whatever influence we think we ought to have and perhaps the banking committees of the Congress ought to have on Federal policy at that point. I think it is a matter of getting, eliciting more debate, discussion, and therefore more under- standing of something that is so vital and important for this country's economic health. Mr. MITCHELL. You see what you are asking for is t.he kind of process that now goes on within the Federal Reserve System. Chairman PRoxMnmn. But that is not enough. The trouble is- Mr. MITCHELL. But it is no great problem to translate it into your needs, if all you are saying is, given this kind of an economic projec- tion, what kind of financial flows and what kind of monetary problems are we likely to encounter in the period for which- Chairman PR0xMIRE. Congress I think eventually might come to a position-if they have regular reports of this kind-might come to a position where it feels it would be wise to limit the money supply. It may come to a position where it thinks it would not be. Mr. MITCHELL. Yes. Chairman Pnox~rIR~E. But at this point there are not enough Mem- bers of Congress who followed this or who are interested in it or know about it, and one reason is because we have not had this regular report- ing and regular examination of this, and because it has been-gentle- men like you come up who are extremely learned and give us all kinds of rationalizations and justifications, many of which are eminently justified but are just confusing to Members of the Congress, the press and the public, if they try to put it in some kind of an understandable perspective. Mr. MITCHELL. Well, it is not a simple problem. PAGENO="0147" 143 Chairman PROXMIRE. Of course it is not, and I do not want to try to oversimplify it. Mr. MITCHELL. Yes. Chairman PROXMIRE~ But I want to try to get one kind of a specific guideline to which we can stick. Senator Miller? Senator MILLER. May I underscore what the chairman has said. I think Senator Proxmire has made a very good suggestion here, and I would hope that the Board would respond favorably to it. A regularly scheduled quarterly meeting or hearing would give people a wonderful opportunity to come out with your position on money matters and also your warnings, if warnings are indicated, on fiscal restraint that Congress should follow. As it is now, we get it on an ad hoc basis about once a year or once in a while when there is a serious period in the economy. We will see some statement by the Chairman of the Federal Reserve Board, and I must say I do not think that most of our colleagues respond the way they would or could, if they knew that every quarter there was going to be some kind of a report, and it was going to be accompanied by strong recommendations regarding fiscal policy. It might exert a very good influence on the Members of Congress, and would help you in turn to do your job. Governor Mitchell, in your statement you say: "What I would question is the contention that the inventory ad- justment of early 1967 was entirely or even primarily caused by tight money in 1966." I wonder if that same rationale could apply in reverse, so that you might also say that you would question a contention that the inventory adjustment of 1966 was entirely or even primarily caused by easy money in 1965. In other words, does the tight money or the easy money have- Mr. MITCHELL. I think it does have some influence, but I do not think it is the primary factor. I believe that the tight money in the summer of 1966 did have some- thing to do with the attitude of consumers toward spending, and it may be that easier credit conditions also have a different or the reverse effect, but it was not the primary factor. Senator MILLER. But your warning is not to try to pick out one particular effect as the explanation for everything? Mr. MITCHELL. That is right. Senator MILLER. And that warning of yours would apply not only in a tight money situation- Mr. MITCHELL. Yes. Senator MILLER. But in an easy one? Mr. MITCHELL. In an easy one too, yes, sir; that is right. Senator MILLER. Do you think it is desirable that the banks' and thrift institutions' policies be put under one policy? Mr. MITCHELL. Well, they compete in the same markets, and there- fore, if the regulatory authorities do not coordinate their regulations, you can have a pretty serious competitive impact on one or the other of these types of institutions. Senator Mn~n~R. That is so, and the timelag can be pretty disastrous on some institutions. PAGENO="0148" 144 Mr. MITCHELL. `Well, the coordination as it has been practiced I think has been quite good. Senator MILLER. I can recall a 6- or 9-month period when the savings and loans were in very bad shape out in my area as a result of the time- lag. Mr. MITCHELL. Was it before the legislation on the coordination? September 1966 is when we got the coordinat.ion legislation. We did not have it before that. Senator MILLER. That is correct. Mr. MITCHELL. And part of the problem I think in your State might have been due to a. State law. Senator MILLER. That was a part of the problem. I think the. co- ordination came about in December, I believe. Mr. MITCHELL. We had trouble in Missouri, Iowa, Tennessee, and Indiana. There are several States that had ceiling rates that caused difficulties. Senator MILLER. Yes. Mr. MITCHELL. For the financial intermediaries. Senator MILLER. Well, you think the coordination is working out all right? Mr. MITCHELL. Yes, sir; I do. Senator MILLER. In 1967, as you pointed out, the Board accompanied the great corporate demand for liquidity, or accommodated it, I should say. Mr. MITCHELL. Yes. Senator MILLER. And in doing so, added to the stock of money that was to be held rather t.han spent quickly? Mr. MITCHELL. Yes. Senator MILLER. But in doing this, was not the Federal Reserve Board preventing interest rate trouble then at the risk of inflationary trouble now? Mr. MITCHELL. That is a hard question, but I am inclined to think that the effort to achieve this additional liquidity on the part of cor- porations, after their liquidity had been driven down by the tax acceleration program, was an entirely legitimate one and should not have been thwarted. A lot, of it was also achieved by paying the highest interest rates U.S. corporations have ever paid for long-term money. And so I think they felt very strongly about achieving that liquidity position. Moreover, many commercial banks were increasing their compen- sating balance requirements, which, in effect, required their borrowers to have more money in demand deposits. So I do not believe that it was an unwise thing to do, I did not think it was unwise then and I do not think so in retrospect.. But I have to admit that the question you are asking is a proper one. and unquestionably some risks in this direction were taken, but as far as the corporations are concerned, their liquidity position still remains quite good. They have not, up to this point, run it down. Senator MILLER. I can appreciate the fact that you have to weigh values. Mr. MITCHELL. Yes. Senator MILLER. In making your judgments. and you might say well, t.he need for this corporate. demand to be met is so urgent that we PAGENO="0149" 145 will take action to meet it, even though there may be a risk which we are not sure is going to be fulfilled of inflation, and which we hope may be offset by fiscal policy. This leads me to my last question, and that is, what does the Board have by way of priorities for guidance in reaching these decisions? Do you have anything in writing on it, or is this something that is talked about from time to time? What are the priorities? Mr. MITCHELL. Well, I think the top priority is stability, and an equal priority is given to maximum growth. Senator MILLER. The top priority is stability? Mr. MITCHELL. Stability and growth. Senator MILLER. But stability- Mr. MITCHELL. I ought to define stability. Senator MILLER. Yes. Mr. MITCHELL. I mean economic stability, and then we believe, in order to achieve economic stability and maximum growth, we do need price stability. Senator MILLER. Yes; and so it would seem to me that the No. 1 pri- ority would be to hold down inflation. Mr. MITCHELL. Well, Chairman Martin often says we are the only Government agency concerned with money exclusively, and therefore it has a high priority with us, but I think that is perfectly true. Still, the larger goal I think of all economic stabilization is to pro- vide the Employment Act for jobs and growth. Senator MILLER. Yes; and one other thing, and that is stable money. Mr. MITCHELL. Stable money, this is right. Senator MILLER. Agreed. Now, when Congress legislated that, those were the two objectives, not one? Mr. MITCHELL. That is right. Senator MILLER. Full employment and a stable dollar? Mr. MITCHELL. Yes. Senator MILLER. I do not recall there was anything said in the legislative history indicating that tile Board should give precedence to one over the other. Mr. MITCHELL. There are times, you know, when you have to be more concerned about one than the other. Right now you have to be more concerned about price stability than you do about jobs, because there are more jobs than we can fill anyway. Senator MILLER. It has been that way for quite some time now, has it not, the last 2 or 3 years, as I recall? Mr. MITCHELL. Yes. Senator MILLER. Tile rates have been pretty low? Mr. MITCHELL. Very low. Senator MILLER. But in other words, what you are really saying is that as far as the priorities aer concerned, tile Board is concerned with those two objectives? Mr. MITCHELL. That is right. Senator MILLER. As national economic policy? Mr. MITCHELL. That is right. Senator MILLER. You may put one ahead of tile other? Mr MITCHELL. It depends on the environment of the tlme. Senator MILLER. At a certain particular period of time? PAGENO="0150" 146 Mr. MITCHELL. That is right. Senator MILLER. And it looks like the employment thing has been satisfied, but we have not been doing very well on the other one, have we? Mr. MITCHELL. That is correct. Senator MILLER. And your position would be that the Board ha.~ been doing about all it could on it, and that it is the fiscal policy cf Congress which must make up for what the Board cannot do with respect to that second objective. Would that be your position? Mr. MITCHELL. I think that is right; yes, sir. Senator MILLER. Even though you recognize that it might have been prudent to have not increased the money supply in anticipation of what did not take place by way of physical restraint in 1967? Mr. MITCHELL. I will agree if you will let me add some other monetary variables to money supply. Senator MILLER. Please do. Mr. MITCHELL. Mr. Chairman, could I ask Mr. Brill if lie would like to say something. Chairman PROXMIRE. Yes, indeed, we would like to hear from Mr. BrilL Mr. MITCHELL. He may wish to amplify something that I may not have adequately covered. Maybe you would like to say something, Mr. Brill, about the "chart shows" we use to illustrate these issues and to pinpoint them. Mr. BuLL. Mr. Chairman, I think Chairman Martin alluded to these "chart shows" during the course of the hearings on the Presi- dent's economic report. This is a staff exercise we undertake with some regularity. but par- ticularly at the beginning of each calendar year, when the Economic Report of the President becomes available, incorporating the economic outlook in G-NP terms as developed by the Council of Economic Ad- visers. We collaborate with the Council and consult with them in the course of this work, and then try to. analyze the monetary policy that would be consistent with an economy unfolding as the Council's pro- jection would indicate. In the course of that analysis, what falls out are estimates of what would be an appropriate increase in various financial variables: what would be the appropriate course of interest rates, money supply. money supply and time deposits, flows through financial intermed~- aries? This is all one world and what we try to do is present a picture of what the financial part of the world would look like, consistent witl~ the GNP part of the world as indicated in the Council's report. This, of course, is subject to whatever one's evaluation is of the likelihood of the Council's estimate of GNP being realized, which in turn depends on one's assessment of such things as congressional action on expenditures and revenues, business attitudes toward investments, consumer willingness to spend. But it is one benchmark. WTe have been doing this sort of analysis for several years, and pre- senting it in the form of a slide-show presentation-a chart show- that we then reexamine from time t.o time during the course of the year to see how the economy is deviating froni this pattern and what implications this has for developments in financial markets. I think this is a type of presentation perhaps that might be con- PAGENO="0151" 147 sistent with what you are suggesting, but it is oriented to a particular view of the real world, that is shown in the report of the Council. Senator MILLER. Will the Chairman yield? Chairman PROXMIRE. Yes. Senator MILLER. You indicate that great attention is focused on GNP. I presume you are talking about real increased GNP, real dollars? Mr. BRILL. We have to focus on both, Senator, because the demands in financial markets are related to the total dollar volume of activity that is being financed. The price pressures that emerge are related to the real demands on resources, so that in our analyses we try to focus on both, since they both have different parts to play. Senator MILLER. We have had testimony before this committee by some very fine economists who have indicated that while these are interesting and important figures, that even more meaningful would be per capita real increased GNP. There is also some thinking that that should be leavened with the per capita increased dollar debt. Has there been any consideration given to taking those' kinds of ratios and comparisons into effect also? Mr. BRILL. Yes, sir; particularly over longer periods of time. For shortrun analyses, what is going to happen in the next 2 or 3 quarters, the change in the population usually is not great enough to affect the main contours of the analysis. But over longer periods of time- Senator MILLER. Would you say a year? Mr. BRILL. I would say probably longer, 2 to 3 years. The time peri~ ods might be shorter when we are experiencing reversals in the rate of change in population, which we have had in the postwar period.. I might note that in the committee print that included the reply to Congressman Reuss' proposals with respect to monetary policy, one of the documents incorporated is a staff analysis extending over a much longer part of the postwar period, and in that there was, as I recall, quite a bit of material on a per capita basis. Of course, once one gets into a longer time span, then population changes are quite important. Senator MILLER. It seems to me one real look of increased dollars per capita would be quite feasible, also real dollar increased per capita debt would be entirely feasible and it would be a very important con- sideration as to how our economy is doing. I must confess some misgivings over the fact that I do not see much attention being focused on this per capita look `and the debt side of the picture. I am particularly aware of this in the agricultural sector; because, for example, I noticed a statement in the President's state of the Union message that net income per farm over the last 10 years had gone up 55 percent. Then you wonder why the farmers are not dancing in the streets, and you look at the other side of the ledger and you see net debt per farm has gone up 110 percent. It would seem to me that this debt picture ought to be taken into ac- count. I mentioned that so that you possibly can focus on that.. I know you are always trying to improve your statistics and your data, and I hope you will look into this. Mr. BRILL. Yes, sir. Senator MILLER. Thank you. PAGENO="0152" 148 Chairman PRoxi~rniE. Along this line I wonder, Governor Mitchell and Mr. Brill, if you think it would be wise or proper for the Federal Reserve to give to the Congress the quarterly justifications for the in- ternal-I understand you have now an internal Federal Reserve Board projection for fulfilling the Council of Economic Advisers' gross national product estimate projections. Do you have those? Mr. MITCHELL. Well, it depends upon the way the economy is un- folding. If changes are taking place, these projections are revised. If changes do not seem to be taking place- Chairman PnoxMInE. That is right. Mr. MITCHELL. That justify the revision, we do not do it. Chairman PROXMIRE. Would it not be helpful to the Congress to get these? After all, we have great faith in the Board. Mr. MITCHELL. Yes, I think it might be helpful. Chairman PROXMIRE. And in its staff. Mr. MITCHELL. I think we might be able to help. Chairman PRox~nnE. Would you take it up and ~nd out if we can get those beginning the first week in .July? Mr. MITCHELL. Certainly. Chairman PIiOXMIRE. Now I would like to ask you, Governor Mitchell, about the fact that yesterday the price of gold reached its highest point-I understand, the dollar reached its lowest point-in recent years. I wonder if you have any observations on this in terms of whether this might represent a breakdown or nt~ least a worsening in cooperation among the central banks, whether this means that this two-price system is getting into trouble or whether you had expected it and that we can ride it out? Mr. MITCHELL. I do not have any knowledge of what has taken place in the last few days, which would enable me to comment. How much did the price of gold go up? Over $40? Chairman PROXMIRE. Oh, yes; it is $40.10. Mr. MITCHELL. $40.10. Chairman PROXMIRE. That was the latest price this morning, $40.10. Mr. MITCHELL. Well, I think that the position of the major central banks is reasonably clear, and that the two-price system will be able to function. I think the threat to it probably comes from the price of gold dropping under $35 an ounce rather than rising more. There is a large overhang of gold in the market bought by speculators during the run. Chairman PROXMIRE. Is it not true that South Africa., for example, is not selling gold now? Mr. MITCHELL. They are not selling gold now, but they will have to sell sooner or later. Chairman PRox~IIRE. They are the biggest. producer? Mr. MITCHELL. Yes, they a.re. Chairman PROXMIRE. The biggest supplier. Mr. MITCHELL. But they will have to sell before too long, and these two elements of supply I think put real pressures on the price of gold on the downside a.nd not on the up side. I think you have to expect that for several months we are going to have a. market that is strongly affected by nimors of lack of central bank cooperation. by rumors of any sort that will suit the purposes of the people who want to sell the gold that they have previously bought at a profit.. PAGENO="0153" 149 Chairman PROXMIRE. In general, you and the Board feel that this two-price system is working reasonably well then? Mr. MITCHELL. Yes, sir. Chairman PRoxMn~. Let me ask you in connection with the gold situation, and I want to get back to another thing very quickly, but you did not refer to the Fed's international responsibilities at all, espe- cially in reply to Senator Miller. But sometimes this has been used by those who are defending the Board's position, saying that you have to run contrary to what seems like a logical monetary policy to cope with domestic problems, because the balance of payments is so urgent. Governor R~bertson testified before the Senate Banking Committee that we ought to insulate the balance-of-payments problem with a comprehensive interest equalization tax, so that the monetary policy can always `be consistently appropriate for the domestic situation. Do you think this is feasible absent floating exchange rates; feasible with the present kind of a system we have? Mr. MITCHELL. Well, just to take these answers up seriatum, the reason I did not say anything about it is I think domestic and inter- national objectives both are working in the same direction. Chairman PROXMIRE. Right now? Mr. MITCHELL. Yes, right now. Chairman PROXMIRE. But as I understand it, Senator Miller asked you your top priorities and you said your top priorities are employ- ment and stability, domestic employment and domestic price stability. You left out of account at that point the balance of payments. Mr. MITCHELL. Yes. Well, the international situation can be disequilibrating to the do- mestic obectives all right, and I think my preferred method of dealing with this disequilibration on the capital flow side is with a tax rather than with the kind of voluntary programs we have at the present time. But we must have domestic price stability. If the rest of the world has more price stability than we can maintain, then we are constantly getting into tronble on the trade side. So the domestic goals and the international trade goals are consistent. But the capital flows can be a serious source of difficulty and I think if they are causing difficulty it is better to deal with them through a tax arrangement such as the interest equalization tax rather than the voluntary program we now have. Chairman PROxMIRE. The economists whom I asked about this last week rather consistently indicated that they did not think this was sus- tainable, that the interest equalization tax would be self-defeating, that you would get into a position in effect of protectionism on your capital flows, that it just does not work out, that if you are going to do that you have to go with floating exchange rates or it just is too much of a short-term solution. Mr. MITCHELL. Well, that is one of the other arguments, that if you want to free up monetary policy to deal with domestic situations, you need flexible exchange rates to go with that. But that is not the only alternative. There are others. One of the alternatives is using the. tax system. Chairman Piiox~nnE. And you think that can be a long-term solution? PAGENO="0154" 150 Mr. MITChELL. Yes. I do not think t.hat the voluntary restraint program can be regarded as a long-term solution. It is definitely a short-term one. Chairman PROXMIRE. Why has the Board taken this position on Fanny May purchases? Not only the Joint Economic Committee and both Banking Com- mittees of the Congress, but the Congress itself passed legislation authorizing the Board, to buy the obligations of FNMA to support the housing market. Several times now you have said that one of the reasons why you are following a policy of expanding the money supply, at least not a very restrictive monetary policy in spite of inflation, is that you do not want to kill the housing market. One answer is to have the Federal Reserve Board directly buy Fanny May obligations, so that the differential between the interest rates on Federal obligations, regul ar Federal obligations and mort- gages, could be narrowed. So that you could have at least some influ- ence on bringing down the cost of money for those buying homes. Mr. MITCHELL. Well, let me put it this way: If we dealt in agency issues on a relatively marginal basis, you know, just in small amounts without the intent of doing anything to the rates- Chairman PROXMIRE. That is not what we want, of course. Mr. MITCHELL (continuing). Of significance, you can~ make argu- ments in favor of this, but 1 think the major argument against this is that some issues are really too small, they ought to be pooled. Chairman PRox~rmE. What we want is for you to deal in a big way. Mr. MITCHELL. That is what I understand. Chairman PROX3ImE. To bring the cost of money down for housing. Mr. MITCHELL. Yes. Let's say we have some kind of a bank credit or a proxy that we are watching, which tells us when we are injecting too much credit-you can use your money supply and, say, I use bank credit-and we have agreed that this is about what we want to achieve. Now if in this situation we have to buy housing issues, we would have to sell Treasury issues- Chairman PROXMIRE. Yes. Mr. MITCHELL (continuing). And the sale of the Government issues~ Chairman PROXMIRE. Or at least not buy as many Government issues. depending on what your policy is in general? Mr. MITCHELL. Well, I think, we would have to be selling off some Government issues, and this would put a lot of strain on Government issues. Chairman PROXMIRE. You cannot have everything. Mr. MITCHELL. That is right. Chairman PROXMIRE. The point is that we would recognize that the housing industry is the one that has been most vulnerable? Mr. MITCHELL. Yes. Chairman PROXMIRE. To monetary restraint. Mr. MITCHELL. Well, Government- Chairman PROXMIRE. It has suffered very greatly as you emphasized so well in 1966. Mr. MITcHELL. That is right. Chairman PROXMIRE. And it could suffer badly again. In fact, I think that if we are going to follow the kind of policy that the mter- PAGENO="0155" 151 national balance of payments might dictate and so forth, we may end up with a policy of restraining inflation that we might have another serious problem for housing, at least it will not grow at the rate that all of us want it to. So that this is a very real practical problem now? Mr. MITCHELL. Yes, it is. Chairman PROXMIRE. For the future? Mr. MITCHELL. That is right. Well, I think that under these conditions large-scale purchases of agency issues by the System would probably pull funds out of savings and loan associations, in this kind of a market you are talking about be- cause funds would be attracted to other market instruments that would have higher rates of yield, including Government securities, and whatever the Federal Reserve was trying to get into the housing industry by disgorging Treasury issues and buying housing issues would result in the S. & L.'s and mutual savings banks losing savings funds. And investors who have a choice would be less interested in housing mortages and more interested iii market instruments. Now you have seen this- Chairman PRox~rnu~. We can do our best, at least we can do some- thing by way of legislation to see that S. & L.'s stay in housing. Mr. MITCHELL. You could do this, but investors do not have to stay with S. & L.'s. Chairman PROXMIRE. They do not have to. Mr. MITCHELL. They do not have to go through an intermediary. Chairman PROXMIRE. There is some friction in this area. Is there not a tendency- Mr. MITCHELL. Oh, yes. Chairman PROXMIRE (continuing). At least for some groups to tend to go into housing? Mr. MITCHELL. That is right. Chairman PROXMIRE. It seems to me at least on the short run that. it might be wise for Congress and the Federal Reserve to adopt policies that would do our best to make funds available here. Mr. MITCHELL. Well, I agree with you that we do not want- Chairman PROXMIRE. We ought to at least try it. Mr. MITCHELL. I-lousing at any rate is having a lot of trouble. Chairman PROXMIRE. If we do not try it, we do not know of course. Mr. MITCHELL. Yes. Chairman PROXMIRE. Is that right? The Federal Reserve Board has never done this? Mr. MITCHELL. No. `\T~Te have used repurchase agreements. Dealers have used these agency issues for- Chairman PEOXMIRE. You see, you could have made the same argu- ment on Operation TWIST that you cannot keep short-run Govern- ment obligation interest rates high a.nd long term low. Mr. MITCHELL. It worked for a while. Chairman PROXMIRE. It worked for a while? Mr. MITCHELL. That is right. Chairman PROXMIRE. In the same way, it seems to me you might be able to have some influenceat least in reducing the rates on housing obligations. PAGENO="0156" 152 Mr. MITCHELL. I think a lot depends 011 the economic environment at the time whether you can achieve this. If the Government is nm- mug a $20 billion deficit and all of a sudden you are going to have the Federal Reserve sell $5 billion in Government securities, it is not a very practical operation, but if the Government were in a more balanced position, maybe it would be more feasible. Chairman PROXMIRE. That brings me to the last question I want to ask you this morning. That pertains to this situation: Assume that the Congress does pass the tax increase and the more substantial spending cut of $6 billion, a $10 billion appropriation reduction, do you foresee that. this could have a significant. effect. on easing the monetary situation? Mr. MITCHELL. If they did pass it.? Did you say if they did pass it.? Chairman PRox~rniE. If they do pass it. Say it is put into effect. on June 1. Mr. MITCHELL. I think Mr. Brill is better able to comment on the effects on the markets. I think interest rates expectationallv would drop rather significantly. Chairman Pnox~IIRE. Do you think interest rates would drop? Mr. MITCHELL. Yes. Chairman PRoxMnu~. Significantly? Mr. MITCHELL. Yes. I think that. would be the first. reaction. Chairman PROXMIRE. Mr. Brill? Mr. MITCIIELL. And I think also that. the financial flows into the- Chairman PROXMIRE. How promptly would that drop come about in your view, if we pass it on the 1st. of June? \\ill you get. a drop this summer or fall? Mr. MITCHELL. Oh, yes, you would get it sooner than that. Mr. BuLL. I would suspect. it would be significantly sooner than that. I do not think we can pinpoint it to weeks. but the reversal of market expectations is the initial impetus that will be felt.. Chairman PROXMIRE. The principal reason is because this would reduce the deficit and the Federal Government. therefore would not be out oii the market. bidding up interest, rates by trying to sell obligations? Mr. MITCHELL. People would be trying to take advantage of the existing level of interest rates on the assumption it was going to get lower. Chairman Pnox~rIRE. I see. Mr. MITCHELL. Aildi so they will push the rate dlown quickly. Chairman PROXMIRE. You wouldi have, not a deflationary hut a noninflationary attitude? Mr. MITCHELL. It would change their whole attitude. their whole time horizons with respect. to the level of interest rates. audi they would say, "I am going to get as much as I can with these rates be- cause later on I cannot." Andi that shouldi bring rates down pretty fast. Chairman PROXMIRE. Do you want to addi something. Mr. Brill? Mr. BRILL. As I said, I think the expectationa.l effect. would be the initial impact. Suibsequently, it would depend on the volume of flows, whether there was pick-up in borrowing by the private sectors. Of course initially, even with the proposed legislation, Federal flnancmg PAGENO="0157" 153 demands rise seasonally at this time of year, so the flows for a while would still be high, but there would be such a change in market at- titudes that- Chairman PRoxMnu~. It is funny, you would stress attitude and expectations. There is a strong expectation now, I think a view that there is about a 3-to-i or 5-to-i chance that this tax package will go into effect rather promptly. It may not be $6 billion, it may be 4, but it will be close to it and it will have close to the same effect. You would think the market would discount this. Mr. MITCHELL. The market has been disappointed too many times. They have discounted four or five times in the past. Nothing happened and they got shellacked so they are not going to do it this time until they see the whites of its eyes. Chairman PR0XMIRE. The conferees have agreed to this. They want to wait until the President actually puts his signature on it. Mr. MITCHELL. I think that is right. I think it is because they have been burned on it before. Chairman PROXMIRE. You think it would be that significant and decisive? Mr. MITCHELL. I think so. Mr. BRILL. It removes a very substantial amount of potential borrowing. Chirman PROXMIRE. What would the Federal Reserve Board do to accommodate to this? Anything? Would you expect a change in policy under these circumstances? Mr. MITCHELL. I do not think I could really say much a~bout that until you have a chance to observe the environment. The only thing I would feel fairly sure about now is that the interest rate structure would change, and this is going to have some effect on the competitiveness of the intermediaries against the market. By that I mean that inflows of savings funds into the savings and loan asso- ciations, at the rates they are presently offering would probably rise and they in turn, coming into funds of this sort, would be willing to enter into more commitments. Chairman PROXMIRE. Where is this money coming from? People's incomes would be reduced by the tax increase, and by the spending reduction. Mr. MITCHELL. There are tremendous flows of funds from repay- ments of mortgages, as you know, that have to be reinvested. Chairman PROXMIRE. They would be coming in anyway? Mr. MITCHELL. The flows of funds are enormous, and at the margin they are large enough to have very substantial effects on rates. Chairman PRox~rIiu~. That is very interesting and very, very helpful. Thank you, gentlemen. Senator Miller? Senator MILLER. I just wanted to ask a couple of questions on this point. As I see it, we are faced with a $30 billion budget deficit for the next fiscal year, and if Congress does indeed pass this package, we will be getting about $10 billion more in revenue and $6 billion reduction in spending, we would still end up in the neighborhood of a $14 billion budget deficit. PAGENO="0158" 154 With that amount of a deficit. to cover, I take. it you would no~ anticipate that these interest rates would stay substantially lower very long. I can understand the psychological reaction which you referred to, and of course everybody, most people at least, would like to see interest rates come down, but I am wondering if that could be sustained in the face of this, if things go on the way they appear to be going. Mr. MITCHELL. Well, the goal of the policy is to retard the pace of activity. I would think rather that interest rates that are absolutely at historical highs would come down and stay below those historical highs. Senator MILLER. You said that they would come down, you thought they might come down significantly. I do not know what you meaii by that. I suppose you mean in the neighborhood of 1 percent would be a significant drop, would it not? Mr. BRILL. That would be a significant drop; yes, sir. Senator MILLER. Wit.h the $14 billion budget deficit staring us in the face, if Congress takes this action, you have a very substantial deficit to cover. Chairman PROXMIRE. If the Senator would yield. I thing there. is a difference of opinion on that. The Senator may well be right, but I think there are those who argue t.hat there would be a $6 bfflion deficit. with the tax package, that is a $20 billion deficit without it, and Senator, if you put this combination into effect, it would be reduced by $14 to $16 billion, in which case it would be $4 or $6 billion deficit~ but you may well be right. Senator Mn~L1~u.I do not think anybody knows. I am just using the figure of $10 billion from revenue, which I believe is being used as a benchmark, and a $6 billion reduction in spending, so you have a $16 billion impact on the deficit approximately. Chairman PROXM~E. I start with the $20 billion deficit, and you start with a $28 bfflion deficit. Senator MILLER. I am not referring to the current fiscal year, but to the next fiscal year. Chairman PROXMIRE. 1969. Senator MILI~R. But assuming that it ends up with let's say $12 to. $14 billion budget deficit to cover, I take it that we could not be too euphoric or sanguine about t.he interest rates coining down much lower. Mr. MITCHELL. I think we ought to get Mr. Bril to comment on this. I think he is better equipped to do so than I am. What would you say? Senator MILLER. Please do. Mr. BRILL. I think there are two or three considerations. One is that the order of magnitude of what the change in the deficit would be would bring the number remaining to be fiuianced lower than 14. I am not sure it would be as low as 6, but I thiuk lower than 14 that would remain after passage of the proposed legislation. I must admit I do not have a. precise number, just the impression from what I have seen to date. I think there are two other considerations. One is that if the in. crease in taxes has its effect in cooling off private spending, there will PAGENO="0159" 155 be somewhat less private demand. That may not be a very large amount, because initially people may try to borrow to compensate for some of the income. Chairman Prtoxi~rnm. Save a little less? Mr. BRILL. Save a little less, but I think on balance, if the program is effective it will reduce private spending, including spending financed by borrowing. Third, if the whole program is effective in reducing the rate of in- flation, I would imagine there would be less inhibitions on the Federal Reserve in terms of the supply of funds. So that if all of these factors work, and they all work in the same direction, work in the right order of magnitude, one could see a lower level of interest rates persisting even after the initial expectational impact. But it does depend on all factors breaking right. Senator MILLER. But it would still probably be at a pretty high level. Mr. BRILL. Oh, I doubt whether anybody is considering return to the rates that were reached, say, in the winter of 1958, which were abnormally low. Senator MIlLER. Thank you. Thank you, Mr. Chairman. Chairman PROXMIRE. Thank you, gentlemen, very, very much for a fine job, most helpful. We are looking forward to the information which you indicate will be forthcoming. Mr. MITcHELL. Very good. Chairman PROXMIRE. We will include in the record, at the end of today's proceedings, a submission from Mr. Brill. Tomorrow we are going to hear from three experts from the bank- ing and insurance community, and we will meet in this room at 10 o'clock. (Whereupon, at 1:10 p.m., the committee recessed, to reconvene at, 10 a.m., Thursday, May 16, 1968.) (Mr. Brill's submission follows on page 156:) PAGENO="0160" CAN THE GOVERNMENT "FINE-Tu~&' THE Ecoxou~ ?~ If we're going to generate much argument this evening, we'll have to begin by redefining the subject of our debate. The announced topic. "Can the Government `Fine-Tune' the Economy?" isn't likely to find me in disagreement with my fellow panelist. ~`Fine-tuning," as econ- omists have taken over the phrase from a sister discipline-TVwatch- ing-implies the Government twiddling dials to offset every minor tendency of the economic picture to waver or fade or to lose its focus on full employment and price stability. Obviously I haven't that much faith in the powers of economic prognostication or therapy, and I doubt that Harvey Segal does either. Nor do I see much basis for argument in the explanatory note on the program: Adherents of Keynes and the "new economics' believe strongly that the Gov- ernment can and should use fiscal and monetary measures to maintain economic stability and growth. However, many question the wisdom of Government inter- vention in the economy. As I understand the views of anti-Keynesians, including those who write editorials for the Washington Post, t.he question is not whether there should be Government intervention in the economy. Tinkering w~th the money supply-even to stabilize its growth rate-is interven- tion, as much as is tinkering with tax rates. The questions which divide us are not those relating to whether the Government should intervene in the economic process, but rather how the Government should inter- vene, when it should intervene, and for what purposes it should intervene. Disputes over issues such as these are certainly within the province of legitimate economic controversy. My concern tonight, however, is only in part with the substance of this arguntent. It is equally with the methods by which the arguments are being carried on. In the tran- sition from scholarly disputes, conducted in the learned journals and at professional meetings, to public debate on policy issues conducted in newspaper cOlunins and congressional hearings, our profession seems to be losing its cool. It is showing an alarming tendency in its (freely offered) policy prescriptions and advice to ignore the impor- tant qualifications so carefully noted in a professional setting. And there are times when references to facts and time periods seem to be mainly on the basis of whether or not the results appear to provide support for a pet thesis. In short, debate in the arena of political economy has begun to lose those elements of scholarly humility and objectivity which are so essential in any scientific inquiry. My plea °Discussion paper by Daniel H. Brill, Board of Governors of the Federal Re- serve System, to the Washington chapter of the American Statistical Association, Feb. 28, lOGS. NOTE-The views set forth in this paper are the responsibility of the author alone, and do not necessarily reflect the views of others in the Federal Reserve System. (i~3) PAGENO="0161" 157 tonight is for a return to a little more scientific dispassion and a little less polemics. Though I am sure all of us deserve to be given stern lectures on this score, I'll start tonight by chastising my money-supply friends. The hallmark of the contemporary anti-Keynesian is his disdain for the use of fiscal tools of stabilization policy, just as the hallmark of the primitive Keynesian a generation ago was his disdain for monetary policy. On what theoretical grounds does this reversion to economic monotheism rest? An elegantly simple-and therefore attractive- formulation of the theory of causal forces in the determination of changes in aggregate economic activity and prices, buttressed by vol- uminous (if not always persuasive) statistical evidence to support the thesis. Changes in the money supply emerge as the major determi- nant of changes in nominal income. From an exhaustive study, covering the monetary evidence of almost a full century of U.S. experience, the most distinguished proponent of the theory-Professor Friedman- arrives at the following conclusion: While the influence running from money to economic activity has been pre- dominant, there have clearly also been influences running the other way, particu- larly during the shorter run movements aSsociated with the business cycle. ~ * * Changes in the money stock are therefore a consequence as well as an independ- ent source of change in money income and prices, though, once they occur, they produce in their turn still further effects on income and prices. Mutual interac tion, but with money rather cle~arly the senior partner in longer run movements and in major cyclical movements, and more nearly an equal partner with money, income and prices in shorter run and milder movements-this is the generaliza- tion suggested by our evidence. While my own reading of the evidence puts less weight on money as a causal factor than does Friedman's, I do want to call attention to the judiciousness with which he words his conclusions. Money mat- ters, and is apparently a "senior partner"-though, note, even so only a partner-over longer run episodes and major cycles in the economy. But in the short run, changes in money may be as much a result as a cause of economic fluctuations. More importantly, the statement leaves a clear field for factors other than money as causal forces affecting changes in economic activity, particularly so with respect to milder and shorter run economic fiuctuations-~presumably of the kind we have had since World War II. What happens, however, when Professor Friedman begins to inter- pret recent economic history for a lay audience? Take, for example, his interpretation of economic events since mid-1965, in the October 30, 1967, issue of Newsweek. It turns out, as you might expect, that the vil- lain of the piece is monetary policy-which permitted too rapid a growth in money supply up to April 1966, too slow a growth from then till December 1966, and too rapid a growth in 1967. Did the massive buildup of defense spending from mid-1965 on, without adequate offset by higher taxes, have much to do with aggregate demands on goods and services and on the behavior of prices? Not much apparently. "What happens to taxes," says Mr. Friedman, "is important. it may affect the level of Government spending. It may affect the rate of interest that accompanies whatever monetary policy is followed. But it is not decisive for the course of prices." Thus, in scholarly works, nonmonetary factors are assigned signifi- cant weightS in influencing activity and prices in shortrun economic 94-340-68-----11 PAGENO="0162" 158 changes; in writing for popular consumption, nonmonetary factors fade into insignificance: It is money that matters and money only, for all practical purposes. What justifies these divergent interpretations, from a. guarded and qualified reading of monetary history to the relatively unqualified conclusions on the causes of recent fluctuations in money income and prices ? I don't find support for the money, only interpretation of re- cent developments in either Friedman's own evidence concerning the long sweep of TJ.S. history since 1867, or in the behavior of monetary variables and economy over the postwar years. If money were tightly linked to money income, then income velocity would be stable, or at least it would change only slowly and in a predictable fashion. If such a statistical association existed, and were to be useful for shortrun policy decisions, the evidence would have to show a constant or pre- dictable relation between changes in money and changes in money income. I don't see that Friedman's own evidence satisfies these conditions. Velocity fluctuates widely in the short run. Friedman takes comfort from the facts that over the nine decades for which he compiled the relevant statistics, the year-to-year changes in velocity were most often less than 10 percent, and that the changes most often fell within a range of plus or minus 15 percent of the long~term trend in velocity. But a 10 percent fluctuation in velocity, or a deviation of 15 percent from trend, is hardly an adequate standard for determining the useful- ness of a guide to public policy. For example, a difference of 10 percent in the velocity of a given money stock, at today's level of the money stock, would result in a difference of about $80 billion in GNP. The Council of Economic Advisers gets roasted when the errors in its aunual forecasts are a fraction of that amount. Moreover, the cyclical amplitude of velocity has tended to be even wider than the year-to-year changes. This record obviously would not encourage one in assuming that changes in the money supply are a sufficiently consistent and tight predictor of the course of the economy as to warrant the exclusive de- pendence on money stock changes as the tool of economic stabilization. Nor do I think that prcthlerns raised by this kind of instability of velocity can be avoided by relating the demand for money to perma- nent income, rather than to current income, as Mr. Friedman does. It is possible to explain some of the movements in measured velocity by this device, but not all of them. In some respects, indeed, the introduc- tion of permanent income as the variable to which money demand reacts raises some lmotty problems for Mr. Friedman's own evidence on the lags between policy actions and their effects on income. Jim Tobin points out, in an unpublished paper, that if the demand for money changes only as slowly as permanent income changes, then an injection of money into the economy should have a prompt and power- ful bang on activity. Mr. Friedman himself has acknowledged as much, when he has argued that shortrun money multipliers should be larger than longrun money multipliers. But this seems inconsistent with his own statistical findings-and those of others-that suggest a long lag between an injection of money and its effects on activity. Friedman can't have it both ways; the effect of money stock changes can't be both prompt and delayed. I haven't seen this theoretical dilemma re- solved, either in Friedman's work or elsewhere. PAGENO="0163" 159 Neither do I find any basis in Friedman's findings to explain why there should have been a change from the long-term declining trend in velocity to a rising trend in the decade and a half after World War II. Over this period, the income velocity of money (defining money to include time deposits) rose from about 1947 to 1957, leveled out for a few years, and then hit its postwar high in 1960. Using Fried- man's formula for calculating money income from the money stock, one would have expected a vastly lower level of income than what was actually obtained by 1960. Why doesn't Friedman's thesis work in the postwar period? There is an explanation-supported by extensive statistical analy- ses-which centers around the behavior of interest rates as a major factor determining postwar changes in the demand for money. But Friedman rejects this thesis, arguing that it fails to explain the be-~ havior of velocity before World War II, and that it doesn't explain all of the rise in velocity in the postwar period. Of course, it would be nice to have a single explanation for all economic phenomena over the entire span of recorded history. But I don't see why an explanation covering a period different in many characteristics `from earlier stages of our history would not be accept- `able, particularly if the explanation is both plausible and has substan- tial statistical support. Certainly, the interest rate explanation makes as much sense as the thesis tentatively advanced by Friedman, that people have `become so convinced that there will never be another m'ajor recession they feel confident in holding smaller cash `balances relative to their `transactions needs. Clutching at `the straws of the "confidence" explanation seems out of charac'ter for so careful a craftsman as Fried- man. Even he himself seems to find it a bit hard to swallow, as noted in his statement: "This qualitative account is plausible but alone can hardly be convincing." Perhaps it's because the alternative-the behavior of interest rates- opens a wedge in what would otherwise `be a beautifully monolithic structure. Let interest rates in your life and it causes more trouble than women. Once the "inexorable" link between changes in money and changes in activity is broken, one then has to trace the monetary in- fluence on economic fluctuations through a circuitous route via effects of demands for and supplies of fund's on interest rates and the effects of interest rates on spending, and tO `admit the role of fiscal policy in affecting incomes directly and the demands for funds directly and indirectly. Life for the economist becomes messy, and the beautifully pat solution to all economic questions doesn't seem to serve as welL Scientific inquiry does indeed put a premium on the simplest answer to complex questions. But scientific inquiry also demands a willingness to reexamine the best-designed theoretical structure if `the actual ob- servations stubbornly refuse to fit the structure. Neither is scientific inquiry fostered by debating policy issues in a context almost completely devoid of reality. Abstraction is, of course, a necessary part of scientific inquiry. Furthermore, it is quite proper to consider solutions that might be feasible under ideal conditions. But a scientist offering immediate operating advice is under obligation to examine the viability of his solution under actual conditions, which in an imperfect world are o'f ten very far from ideal. PAGENO="0164" 160 For example, recommendations to keep the money supply growing at a constant rate of between 3 and 5 percent per annum might or might not iron out all wiggles or cycles in economic activity in the long run. But in the short run, it could raise hell in an economy replete with imperfections and rigidities in its financial structure. I am not defending or excusing these imperfections. In fact, the Board has strongly recommended a number of changes in one iniportant area- housing finance-to remove some of the rigidities which contribute to a disproportionate channeling of monetary restraint onto t.he housing industry. And I'm delighted by the current proposals of the adininis- tration to introduce more flexibility into the structure of housing finance. But even with extensive reforms in this area, we do have to live with the fact that maj or participants in the financial system are stuck with portfolios that change only slowly. They are, therefore, ill- equipped to survive a rapid and very large change. in financial condi- tions, such as might be encountered in a circumstance where strongly rising credit demands were accompanied by a monetary policy rigidly adhering to a "Friedmanian" rule of monetary expansion. And serious impairment of the solvency of any major element in the. financial system could well shake confidence in the rest of the structure. No responsible public official can ignore the potential effect of actions that-with the best of long-run intentions-might endanger the vi- ability of the whole financial systhm in the short run. This failure to recognize the difference between assumed conditions and actual condi- tions, does n~t enhance the reputation of economists as advisers to men who, by their decisions, shape the. destiny of our economy. The cause of science is certainly not advanced by becoming more strident in defense of a theory that doesn't fit the facts. Unfortunately, that seems to be what has been happening. Froni the judicious conclu- sion that "money matters," we have moved on to the battle cry "oni~j money matters." Semantic warfare among monetary economists would be amusing but not terribly serious, were it not for the alarming fact that policy makers have started to take economists seriously. When economists graduate to this stage of importance, their social responsi- bilities demand more attention to the potential consequences of their advice. Unfortunately, this responsibility hasn't been displayed in the con- temporary dispute on fiscal policy, which seems to be producing games- manship instead of balanced appraisals of economic development and policy needs. If the economy pauses because of a major strike, the current production figures are trumpeted as proof of general economic weakness that doesn't justify a tax increase. If activity rebounds after a strike is over, the earlier analysis is forgotten and the rebound is depreciated as merely the result of termination of the strike. If retail sales are sluggish, or new orders drop for a month, these aspects of the current flow of economic data are emphasized. But if unemployment falls below the full employment level, emphasize that women left the labor force or that employment increased only slightly. Ianore the pos- sibility that women may have decided to stay home during the snow storms of January, or that the same storms may also have held down the rise in male employment, particularly among outdoor workers, such as in construction. And if consumers begin to spend a little more freely, PAGENO="0165" 161 and price and wage increases accelerate, then raise the hobgoblin of recession later in the year. After all, the economy always looks weaker to economists 6 months from now. But it's not enough to distort the interpretation of the current flow of economic information. The true holder of the monetary faith has to prove that heresy has never led to heaven. If the devil seduced us into fiscal actions in the past, prove that the economy had to pay for its sins until it repented: Just this past week we were treated to a fine example of such religious fervor displacing scholarly analysis. An analysis. An editorial in the Washington Post contended that fiscal re- straint had been ineffective in the time of the Korean war, and that it wasn't until the money supply-that magic variable-was brought under control that inflation was curbed. The editorial concluded with an admonition to us-I use the editorial "us," since it was addressed to "Mr. Martin and his colleagues"-to learn something from history. Let me assure you that we have looked very carefully at the Korean experience, and have frequently revisited the statistics and the liter- ature evaluating economic policy actions in this period. And let me assure you also that I find almost nothing in support of the editorial's position. It is true that consumer prices rose by almost 13 percent over the 3 years of the Korean war. But what the editorial failed to point out is that over half of this rise occurred in the first 7 months of the war, when the control apparatus was being created, and the rest of the price rise dribbled out over the remaining 30 months. During the summer and fall of 1950, direct controls were imposed on consumer credit and mortgages, priorities were established for purchases of a number of materials, and voluntary and mandatory price and wage stabilization program were instituted. Income taxes were raised in two steps, the first effective in October of 1950 and the second in January 1951. It was in this period, when the fiscal and selective control mechanisms were just being established, that prices soared. The consumer price index rose at an 11-percent annual rate, and wholesale prices at a 25-percent annual rate, between June 1950 and January 1951. But after January, the CPI slowed down dra- maticaly, except for one final spurt in the last half of 1951; the in- crease over the 30 months from January 1951 to July 1953 was at an annual rate of only 2 percent. The wholesale price index-never men- tioned in the editorial-actually peaked in the first quarter of 1951 and declined thereafter. All this occurred long before the turnabout in the magic variable on which the attention of the Washington Post seems to be riveted. In the first year of the war the money supply rose at a 4-percent annual rate. From June 1951 to December 1951 it hopped up to a 7-percent rate of growth, then fell back to a 4-percent rate through 1952. It didn't really decelerate until after December 1952, long after price pressures had been brought under control. Admittedly, one can argue as to whether it was the tax actions or the selective controls that slowed the pressure of consumer demands- or, for that matter, whether it was simply a reaction on the part of consumers following an earlier spending spree. But I do think it's important to note that there was a moderating in a number of private sector demands, including inventory investment and business capital outlays, long before the significnat slowing that occured in the money PAGENO="0166" 162 supply after 1952. The case against fiscal restraint is certainly not proven-nor is the case for exclusive dependence on monetary re- .straint-by artful averaging that obscures the sigmficant turning points in economic pressures. It seems to me that this editorial is another example of the extent to which zealous protagonists of a. cause permit themselves to be blinded to any other explanation of events. Friedman just cant see interest rates; Segal just can't see fiscal policy. Neither the state of econOmic welfare nor the state of the economic art is being advanced by this sort of "tunnel vision." And it unfortunately tends to engender strident and unbalanced argument on the other side. For example, we're having drummed into us, ad nauseam, that wise economic policies have enabled the economy to enjoy 7 consecutive years of expansion. This stretches the facts some, of course, since growth in real G-NP did halt, briefly, in the first quarter of last year. But a more fundamental objection to this sort of overstatement is that it extends, by implication, more credit to the profession of eco- nomics than is warranted. I don't really see much for our craft to boast about in the record of the first 5 years of this period. It shouldn't have taken the combined wisdom of our profe5sion 5 years to figure out how to reduce the unemployment rate from 7 percent to 4 per- cent. We apparently didn't learn much from the iessons of the thirties and forties, to have taken so long to achieve full employment. Or if we learned the lesson professionally, we certainly failed in learning how to persaude policymakers. Neither do we deserve any gold stars for having maintained reasonable price stability in the early 1960's, not with the unemployment prevalent then. These past `2 years, when we have been operating at relatively hioh use of resources for most of the time, provide a better testing of t~e economist's capability. Does the record show tha.t we know how to manage a full-employment economy, once we achieve one? If I may be permitted to continue to act like Professor Samuelson and award grades to policymakers, I'm not disposed to grant a gold star for this period either. After all, the Employment Act of 1946, which established the objectives of Government economic policy, stipulates multiple goals of "maximum employment, production and purchasing power." We seem to have done pretty well by the employment criterion, but have failed pretty miserably on the price score, with potentially serious consequences for sustainability of domestic expansion and interna-~ tional financial stability. Must we, then, abandon hope for making any contribution to bal- anced economic expansion? Must we despairingly fall back to the nihilism underlying Professor Friedman's policy prescriptions? You know, of course, that his recommendations for an unswerving increase in the money supply-month by month, day by day-is based not so much on his faith in the efficacy of a stable expansion in the money supply as on his lack of faith in economists. He stated, to a congres- sional committee: I am saying that in the present state of our knowledge-my knowledge, your knowledge, the knowledge that economists in general have-we simply do not know enough to be able to know what way the wind is going to blow next year sufficiently to be able to adjust it. PAGENO="0167" 163 Despite the failure to achieve all the goals of the Employment Act, I think the record of economists' diagnostic ability is better than Professor Friedman suggests. Looking back to the record of the past 2 years, I would chalk up the score for Washington-type fore- casters-of which I number myself one-about as follows : a late start in recognizing the implications of the upsurge in defense requirements after mid-1965, and an even later start in recommending an appropri- ate and timely combination of policy actions; a pretty good job of recognizing the intensity of demand pressures in 1966, but lack of suc- cess in promoting a balanced program of restraint policies; prompt and correct calling of the shots in late 1966, as inflationary pressures crested, with appropriate policy measures recommended and set in train; a very accurate projection of the contours of economic activity in 1967, with appropriate policies recommended but not sold-even yet. Admittedly, as one of the local forecasting fraternity, my evaluation may be too generous. And the importance of our economy to world stability demands and deserves even better performance than this, from both economists and policymakers. We still have much to learn about using the tools of stabilization policy in a full employment econ- omy, and the present limits of our knowledge should be reflected in a greater humility in advancing and evaluating policy recommendations. But I don't find the recent record so discouraging as to be willing to abandon our efforts to learn. I may be an incorrigible optimist, but my ifaith in man extends eveix unto economists. PAGENO="0168" PAGENO="0169" STANDARDS FOR GUIDING MONETARY ACTION THURSDAY, MAY 16, 1968 CONGRESS OF THE UNITED STATES, JOINT EcONol\nc COMMITTEE, Washington, D.C. The committee met at 10 :10 a.m., pursuant to recess, in room S-407, the Capitol, Hon. William Proxmire (chairman of the joint commit- tee) presiding: Present: Senator Proxmire; and Representatives Reuss and Rumsfeld. Also present: John R. Stark, executive director; William H. Moore, senior staff economist; John B. Henderson, staff economist, and Don- ald A. Webster, minority staff economist. Chairman PRox~mu5. The Joint Economic Committee will come to order. Today's hearing is the fourth and final hearing of the Joint Economic Committee study, "Standards for Monetary Management." Having had the testimony of distinguished academic economists, many of whom have had direct experience with the problems of policy- making and yesterday having heard Governor Mitchell and Dr. Brill of the Federal Reserve System on the viewpoints of the policymakers themselves, we now turn to the representatives of the financial community. S We welcome today three outstanding analysts of the money and Government securities market, Mr. Guy Noyes, Mr. Tilford Gaines, and Mr. Orson Hart. Mr. Noyes, who is senior vice president and economist of the Morgan Guaranty Trust Co. of New York, has a fairly recent experience in seeing policy from the inside. Until late 1965 lie was Director of Research and Statistics of the Board of Governors of the Federal Reserve System and economist to the Open Market Committee. Mr. Gaines, too, has been at one time a central banker. He went from the Federal Reserve Bank of New York to the position of vice presi- dent in charge of Government bond operations of the First National Bank of Chicago, and he is now vice president and economist at the Manufacturers Hanover Trust Co. of New York. Among the biggest participants in the Government securities market are the insurance companies. Mr. Orson Hart, vice president and director of economic research for the New York Life Insurance Co., will explain how he advised on the management of an insurance corn- pany's portfolio. Gentlemen, I might say that I think it is proper and desirable at this point that I make some kind of recapitulation of the reason for the proposed guideline limitations which tIre Joint Economic Committee is considering and may well propose. (165) PAGENO="0170" 166 As you know, we have had suggestions of this kind in our Joint Economic Committee reports for each of the last 2 years. It is based on the following reasoning: No. 1, that the economy should, from an optimum standpoint, grow at a rate which reflects the growth and productivity in the economy, which varies from perhaps 2 percent to 3 percent, sometimes a little less or a little more; and the growth in the work force, which together would suggest a real growth of around 4 percent perhaps, a little less or a little more. That a neutral monetary policy would therefore provide for a growth in the money supply to reflect the growth in the real gross national product, on the assumption that, as I say, the resources are utilized. The 4 percent growth, however, should of course be tempered on the down side or the up side, depending upon the situation, and we suggested that 3 to 5 percent or 2 to 4 percent, and it has been suggested~ ~- to 6-percent. The reason for the limitation is that there has been a record of what appears to be perverse action by the Federal Reserve Board. In each of the recessions-1949, 1954, 1958, 1960-the Federal Reserve Board decreased the monetary supply. We know the monetary supply is only one indication, only one evidence, maybe not even the best evidence by a long shot, of monetary policy; but it is one, and it is a simple one, and it is one many people understand. Therefore, in view of the fact that the policy has been perverse~ and we have had an even more appalling example in the 1930's, when reserve requirements were doubled in 1937, at the time when we had terrific unemployment, and underutilization of resources, we feel that perhaps it might be well worth considering the possibility of this kind of limitation. I might say one more thing before I ask you to go ahead. Yesterday I think we arrived at a position which may be a little more realistic from a political standpoint. We feel that rather than try to press through the Congress a mandatory money supply limitation which is very hard to get with the unanimous opposition of the Federal Reserve Board, and such relatively little interest on the part of many Members of Congress, that it might be desirable to provide for a. 2- to 6-percent suggested limitation, and at the end of any quarter in which the Federal Reserve Board fails to increase the money supply by at least 2 percent, or increased it by more than 6 percent, that they come up before the Joint Economic Committee and explain why they did it; and that in the second place, that we follow a. policy of request- ing the Federal Reserve Board to make a monetary report at the beginning of each year, like the President's Economic Report, settmg forth the expectations that they have for monetary policy during the coming year as specifically as they can make them, with indications. of why they think restraint or expansionary policies are called for and desirable, and then, of course, that could be explained; any deviations from it could be explained at the time of the quarterly hearings. We feel that this might be a way of getting a much greater discus- sion, interest, understanding, rationalization on the part of the Fed.. Many of the thinks they do now are very well reasoned, but nobody PAGENO="0171" 167 knows about it. Nobody knows the reasoning. We think this might be a way of getting into it. So I apologize for that long explanation, but I think maybe it will be helpful to you. And I want to thank you for your prepared statements. As recipients of the impact of Federal policymaking and as respond- ents to the challenge of reading the future of the markets and of the intention of the Fed, I am sure you are going to give a good explana- tion of your viewpoints, so you go right ahead. Our first witness, and we may as well move from left to right, as that is the usual course, is Mr. Gaines. STATEMENT OF TILFORD C. GAINES, VICE PRESIDENT AND ECON- OMIST, MANUFACTURERS HANOVER TRUST CO., NEW YORK, N.Y. Mr. GAINES. Mr. Chairman, it is a pleasure to be here today. I will plunge right into the statement. Chairman PROXMIRE. Fine. Mr. GAINES. An attempt to develop more precise guidelines for Federal Reserve policy than those contained in the Federal Reserve Act and in the Employment Act of 1946 should start with an appraisal of what effects Federal Reserve policy might be expected to have and of the process through which these effects are achieved. Many analyses have imputed to the Federal Reserve far greater power than it actually has, and have related monetary policy to the economic process through channels that are not fully relevant to the strategic areas of impact of policy. In any given set of economic circumstances, Federal Reserve policy can have a regulating but not controlling influence upon the size and composition of credit flows, upon the level of interest rates, and upon money supply-however defined. To be effective, policy must be con- strained by the need to keep financial markets functioning normally. Efforts to force credit or money growth into an arbitrary mold, with- out regard to the demand for credit and money that the economy is generating, could have wholly unpredictable consequences upon the ability of the financial markets to function and thereby upon economic stability. Orderly monetary policies from one year to the next in combination with orderly fiscal policy can help to avoid extreme swings in the demand for credit nnd money; but when such s~vings do occur, responsible Federal Reserve policy can do no more than temper them. The policies pursued by the Federal Reserve System in 1966 and 1967 offer excellent illustrations of the limits within which monetary policy can be responsibly effective. During the summer and fall of 1966 the F'ed, out of concern for the inflation spiral that had developed, attempted to do more than monetary policy is able to do. It should not be held responsible for the disintermediation from the savings institutions and the troubles for residential construction that occurred at that time. The disinter- mediation resulted from the existence of large, interest-sensitive de- posits in many savings institutions, including commercial banks, and their withdrawal could have been prevented only by pegging market interest rates and thereby permitting unlimited credit growth. PAGENO="0172" 168 The Federal Reserve is responsible, however, for forcing a huge contraction in bank certificates of deposit `that created very real dangers for the orderly functioning of the financial markets. The crunch, as it has come to be called, has had pervasive and continuing effects upon the credit demands of business corporations and upon the willingness of banks to enter into new credit commitments. On the other hand, Federal Reserve policy in 1967 was responsibly adjusted to the limits within which it could be effective given the. total demand for credit a.nd money. Net. credit. raised by nonfinancial sectors of the economy rose to a. record high of S8~ billion, some 810 billion more than the previous record set in 1965. Yet, funds raised by private borrowers were less than in 1965, and also less than in 1966, in spite of the much higher dollar level of economic. activity; the. difference was Federal Government borrowing. If the Fede.ra.l Reserve had attempted to squeeze more out. of the private sector in order to finance the huge Government deficit, the consequences for interest rates, for the ability of the. credit. markets to function, and for the economy could have been most upsetting. G~IDELIXES FOR POLICY The guideline for Federal Reserve policy most. often ProPosed is in terms of some ta.rget ra.te of growth in money supply, usually defined as demand deposits and currency in circulation. In an operational sense, this is not the most useful guideline since it is not as much subject to direct Federal Reserve influence as either credit flow or interest rates. While changes in money supply are influenced by Federal Reserve policy, the influence tends to be at a second remove rather than at the direct point of entry of the central bank into the economic process. Again, 1966 and 1967 experience is illustrative. Tile failure. of money supply to grow in the last half of 1966 result.ed primarily from more intensive use of demand deposit balances occasioned by the difficulty many business concerns and individuals encountered ill get- ting access to credi.t. ~Thile part of the phenomenon no doubt represented voluntary economizing on money to take advantage of the high rates of return available on short-term investments, most. of it Probably was an in- voluntary repsonse to credit tightness. The unusually large rate of growth in money supply in 196T was due partly to the rebuilding of cash balances to desired levels once credit was again available. More importantly, however, it was a back- lash effect from the 1966 credit crunch. In an effort to build good will with their banks to help assure access to credit in tile event of another 1966-type crunch, most. business con- cerns increased their compensating balances-usually with some en- couragement from t.lleir banks. As a. consequence~ demand deposits increased proportionately more in New York and other money centers than elsewhere; that is, at banks the bulk of whose deposits are from business concerns. Monetary analyses often seem to imply that the Federal Reserve is able to regulate money supply growth to wllatever target it might choose. In this analysis tile Fed creates reserves, tile banks create PAGENO="0173" 169 credit, and the holders of demand deposits passively absorb whatever deposits a~e generated.. In actual fact, demand deposits are oniy one among a variety of financial claims, and holders of deposits, determine through a rational allocation of their resources the size of their demand deposits and, therefore, the size of the money supply. If fiscal and monetary policies are successful in maintaining an orderly rate of economic growth, the money supply will grow in some easily predictable relationship to the growth in the economy. But the process runs from economic growth to a need for more money rather than from monetary growth to economic advance. A money supply guideline employing a broader definition of money to include commercial bank time deposits is even less meaningful. In the eyes of the saver, except as risk considerations may enter in, and in economic significance there is no difference between savings at coin- mercial banks or savings and loan associations, mutual savings banks, credit unions, et cetera. In the eyes of the investor and in economic significance there is no difference between investing in bank certificates of deposit or Treasury bills, finance paper, Government agency obligations, et cetera. To select commercial bank liabilities as the critical variable in devel- oprng a policy target is not only irrelevant, it runs the risk of having policy respond to what is nothing more than normal period-to-period adjustments in the relative competitiveness of various saving or investing media. Probably the most useful guideline for Federal Reserve policy would be in term,s of net credit raised by the private nonfinancial sector of the economy. As indicated earlier, the existence of unusually large Government credit demands will ordinarily require some limitation upon private credit, stopping short of restraint that would damage the economy. Unusually large Government surpluses leading to debt retirement would ordinarily call for some effort to encourage private credit usage. With this marginal adjustment to the demands of the public sector, however, it should ordinarily be feasible to construct estimates of the amounts and types of credit that would be required to support the desired rate of economic growth. Targets so derived would be strategic since it is through alterations in credit flows that the Fed has its immediate effect upon the economy, and they would be operational since the Fed is able to have direct influence upon credit flows. None of this is intended to suggest that there is anything like an invariable relationship between rate of economic growth and net private demands for credit. There is a close relationship between residential construction and demand for mortgage credit and between sales of durable consumer goods and the demand for installment credit. In the case of business credit demand, however, variations in internal cash flow, shifting tax dates, and so forth, influence the amount of external credit required to support any given rate of growth-in-busi- ness activity. These influences are broadly predictable within a flow of funds model, however, and may be allowed for in setting targets. Credit is used only because it is needed to cover expenditures. The availability of credit and the rate of credit growth, therefore, are immediately relevant for the total of final purchases in the economy. PAGENO="0174" 170 Moreover, the Federal Reserve is able to have a relatively direct effect upon the total of credit used. Part of this effect is through the influence the Fed is able to have upon interest rates. Interest rates probably are not as effective a. rationing device as are prices in other markets, but interest rates do unquestionably have some influence on decisions as to whether or not credit should be used. A more important effect of Federal Reserve policy upon total credit is upon the ability and willingness of commercia.l banks to lend. Through regulation of bank reserves, the Federal Reserve has consid- ~rable power to control the availability of funds to banks, and thereby, the availability of bank credit. In our complex credit markets, there is considerable latitude for bor- rowers to shift to commercial paper or other media when bank credit is not available, as happened in 1966, so that regulation of the ability ~f banks to lend does not provide precise regulation of total credit actually used. But the very process of forcing credit flows through other channels does create frictions that have a limiting effect upon credit used and upon credit-supported economic activity. Interest rate changes probably should be viewed as t.he consequence of the effort to regulate credit flows rather than as a target in setting guidelines for policy. Given responsible fiscal and monetary policies, it is unlikely that the private economy would generate changes in the demand for credit that would cause interest rates to fluctuate widely. There would be justification, however, in establishing guidelines for Federal Reserve policy in maintaining a viable relationship between interest rates in the United States and in the international money market. One of the most promising developments of the past decade has been the emergence of a truly international money market and, more recently, of an international bond market. It will be impossible in the future for any industrialized nation, including the United States, to pursue autonomous credit and monetary policies that do not take account of this market. Once it is possible to remove the present restraints on international credit flows, interest rates in our market will be closely tied to and influenced by interest rates in the international money market. The operation of market forces will tend to maintain interest rate structures here and abroad in line with one another, with the necessary allowance for the cost of hedging the investment. In executing domestic monetary policy in this setting of a broad and fluid international money market, the Federal Reserve from one time to the next will wish to move our interest rate structure marginally above or marginally below interest rates abroad, depending upon the economic circumstances~t the time. For example, at a time of relatively slow economic growth in our economy, Federal Reserve policy aimed at promoting credit availabil- ity would lead to interest rates in this country moving somewhat below interest rates abroad. At such a time, the U.S. trade balance should be relatively strong so that the outflow of short-term funds induced by this interest rate differential would be appropriate. At times of unduly rapid and inflationary growth in this country, Federal Reserve efforts to limit credit availability would lead to higher interest rates here than abroad, inducing a flow of funds rnto the L .S. PAGENO="0175" 171 market that would be consistent with the pressures one would expect at such a time upon our trade balance. In effect, pursuit of the proper policy with respect to credit flows would automatically lead to the type of interest rate relationships described here, so that the interest rate relationship would be more a reflection of policy than a target of policy. Finally, a critical guideline for Federal Reserve policy should be to avoid unduly sharp shifts in one direction or another, shifts that would be reflected in widely fluctuating interest rates. In the face of the huge Government deficits that have had to be financed last year and this year, the Federal Reserve System has had no choice but to permit credit growth at a faster rate than is desirable, with the sheer pressure of the demand for credit creating historically high interest rates. If one may assume that fiscal policy in the future will be better adapted to economic requirements, however, it should be possible for the Federal Reserve to vary the impact of its policies as economic cir- eumstances warrant by relatively minor degrees that would not oc- casion wide interest rate movements. In summary, then, my proposal is that Federal Reserve policy be guided primarily toward regulating credit flow rather than money stock. Working through the financial flows model recently developed by the Federal Reserve System, it should be possible to measure with some degree of exactitude the total of credit flow consistent with opti- mum utilization of labor and material resources and, therefore, opti- mum real growth rate. Pursuit of such a policy would, over time, in all likelihood generate a fairly regular rate of growth in the money stock, but this outcome would be a secondary consideration rather than the object of policy. With the proper fiscal policy, the appropriate monetary policy aimed at growth-supporting credit flows would not require sharp policy swings from one year to the next or sharp movements in interest rates. Such policy would set an orderly framework for sustained economic growth and for steady development of the scope and usefulness of the international money market. Mr. Chairman, I think an analogy might be helpful here. In regu- lating the speed of an automobile, we could regulate it by looking at the odometer and the speed with which the odometer changes, but it ordinarily is more useful to regulate it by looking at the speedometer and regulating our gas consumption that way. Thank you. Chairman PRoxMnu~. Thank you very much. Mr. Hart? STATEMENT OP ORSON H. HART, VIGE PRESIDENT AND DIRECTOR OP EOONOMIC RESEARCH, NEW YORK LIFE INSURANCE CO., ~EW YORK, N.Y. Mr. HART. Thank you, Mr. Chairman. I appreciate very much the committee's invitation to me to testify on this important matter. The statements of previous witnesses that I have read have addressed themselves, for the most part, directly to the questions of standards for monetary policy. PAGENO="0176" 172 I will offer a few comments later on the relation of fiscal to monetary policy, but it seems to me that I can be most helpful to the. committee if I confine myself mostly to the response of the life insurance business to the exercise of monetary policy. Standards to guide. the Federal Reserve Board, whether formulated by the Board or by Congress, must take into account the impact of credit policy ~n the operations of financial institutions. Let me start with the development of net investment funds by life insurance companies and then move on to what the various statistics show about the response of the companies to changes in monetary conditions. Like all savings institutions, life insurance companies compete for a share of the consumer's dollar, with the implicit intention of divert- ing income into the capital market.. The principal asset producing con- tracts under which life insurance is sold are long-term and they tend to accumulate funds for investment in a very stable. rising trend. The essential instrument in this accumulation is the level premium which produces reserves in the early policy years to offset. the higher mortality costs as the policies age. I am sure the committee does not want me to go into detail on the arithmetic technicalities~ of level premiums, but you should know that an increase in the net sales of life insurance is necessary to maintain the upward thrust of fund accumulation and asset growth to cover re- serves. One precent a year is not quite enough to do this on a year-in and year-out basis in an established company. Five percent, however, does quite nicely, and 10 percent produces really spectacular results. These facts are illustrated in the first two charts at the end of this testimony. The first chart shows the annual increase (or decrease) in funds on a single year's net sale of $100 million of whole life insurance (age 35), as well as the increase in funds for continued sales of $100 million each year. The second chart shows the results when net sales rise at a 1 percent, a 5 percent, and a 10 percent annual rate. As you can see from chart I, ~he annual fund growth on policies issued in a single year continues for about 30 years but on a declining scale after the first few years. The growth becomes negative after 30 years and continues so, virtually to the expiration of the last policy. Even if additional sales of $100 million a year are made, the annual increase in funds starts to decline after about 30 years, as withdrawals are made to meet the rising mortality costs. PAGENO="0177" Chart I FU~D U~IT~t 1$ ~1EATA1Jj~ ~* .-.~---Increase in Fund on Continued Level Sales Increase in Fund on One Year's Issue ($100 Million Issue) 20 15 10 5 o -`! ~ C-.--. -~ ~ ~ I _f -5 .5 10 15 20 25 30 35 40 45 50 55 60 65 YEARS. PAGENO="0178" 174 To overcome this arithmetic, the companies must sell additional issues each year and the net sales trend must be upward. Thus if you will look at chart II, you can see that a 1-percent increase wifi not pre- clude a small decline in fund accumulation and asset growth after about 30 years, but that an increase of 5 percent will produce a steady rise, and a 10-percent increase, as noted above, will be very productive indeed.' Of course, there are many kinds of life insurance, such as annuities and pensions, that also create asset gains. However, whole life policies loom largest in the aggregate and all require a rising trend in net sales if they are to contribute to the asset gains of the companies. The curves may be shaped differently, but the principle is the same-rising net sales are necessary to produce fund and asset growth. As you probably all know, net sales of life insurance have been rising for many years. The savings performance of the industry thus reflects a cumulative process that persistently diverts funds from the general income of the public into the capital market. The arithmetic of life insurance does not react to the usual forces of the marketplace; as a result, life insurance savings, essentially the reserve accruals of the companies, comprise the most stable of all the sources of capital market funds. However, this is not the whole story. For life insurance companies, like other financial institutions, invest their entire cash flow, including repayment of investments made in earlier years, not just the savings they divert from the general income of the public. Some of these repay- ments, like the amortization and partial prepayments of mortgages, are very stable. Others, however, like the redemption of securities and other repayments of mortgages, while relatively stable in periods of credit restriction 10 years ago, proved much more vulnerable to market conditions in 1966. Furthermore, policyholders have a contractual right to borrow on their policies and repay the resulting loans at their conveneince, options they are utilizing on an increasing scale, particularly when funds become unavailable through normal channels. These developments are illustrated in chart Ill, which shows the principal elements in the basic cash flow of the companies for the past 10 years.2 To provide some reference points, the chart is marked for periods of monetary ease, monetary neutrality, and monetary stringency, prin- cipally as set forth by Eugene Banks, "Institutional Investment Guides." ~ 1 VisualIze this as a whole series of curves at 1-year Intervals similar to the dotted curve In chart 1, but with each curve slightly larger than the preceding one. A summation of such curves is what is shown In chart 2. 2 The series is quarterly and is based on reports from companies accounting for 70 percent of the Industry's assets. Beginning in 1967, the statistics cover several additional com- panies and are not strictly comparable with the figures for the earlier years. However, the additional companies were small and the distortion Is not large enough to destroy the essential continuity of the series. Source: Life Insurance Association of America. 8 A service furnished institutional investors by Brown Bros., Harriman & Co. PAGENO="0179" Chait II A~UAL HJ~~ .i~ ~L ~5, ~EJ ~ALE~ moo 100 10 MiII.S 5 10 15 20 25 30' 35 40 45 50 55 60 65 YEARS PAGENO="0180" 176 Key to MoneVary Policy~ Restrictive Easy Neutral As you can see, the rise in ledger assets (reflecting reserve accruals) is steady and persistent, apparently not much affected by changes in monetary policy even in 1966. The amortization and partial prepay- ment of mortgages also seems to be pretty impervious to capital market conditions. But security repayments and other repayments on mort- gages, only moderately affected by the credit tightness of 1959-60, ap- parently lose their relative immunity when credit changes are sub- stantial, as they were 2 years ago. Note also that when ledger assets are adjusted for the net increase in policy loans, the impact of credit tightness was apparent in 1959- 60 and sigmificant in 1966. There is an obvious explanation for this growing response of policy loans to monetary conditions. Although interest rates today are much higher than they were 10 years ago, the right of most policyholders to borrow from t.he companies is pegged by contract at not more than 5 percent. This of course is a valuable right available from no other financial institution, and its value rises the higher interest rates go. The result is that when funds become sufficiently tight in normal chan- nels, a natural consequence of monetary restraint, policyholders resort CHART III BASIC CASH FLOtV aRd ITSJiJf~PON [NJ $ Mill. iiWi TOTAL BASIC CASH FLOW aoc~ __ iO~ / ~ V INCREASE IN LEDGER ASSETS NINIJS POLICY LOANS 500 500 MORTGAGE AMORTIZATION AND PARTIAL PREPAYM~T -~ 0 ___________ ______________ 0 ~5OO ~ 0 SECURITY MATURITIES, SINKING FUNDS R~ ,I AND OTHER CALLS `...i\ 1' `~~` ~ttIItulItIit,Ii-I,IIII-1---1--_--I-- 1957 1960 1965 i%8 PAGENO="0181" 177 to borrowing from the companies on an increasing scale. Apparently the funds are used mostly for business purposes and hence are diverted from the companies but not from the capital market itself-a form of direct investment that has the effect of disintermediating the life insurance business. Because of these developments, little in evidence 20 years ago, the investment operations of the life insurance companies are becoming increasingly responsive to the influence of monetary policy. Changes in cash flow very sOon are reflected in commitment policy. Most of the larger companies commit ahead and rely on their cash flow to meet the eventual takedowns. If the flow falls short of expectations, additional sums can usually be generated from sales of securities or from bank loans, but these are temporary `havens of limited resources. Unless an early recovery in cash generated is confidently expected, commit- ments must be curtailed. This essentially is what the record shows as illustrated in chart IV.' CHART IV 1Like the cash flow statistics, the commitment series includes several new companies beginning in 1967. The commitment and cash flow series do not cover the same companies but they do account for close to the same proportions of the industry's assets. Source: Life Insurance Association of America. UFE ~SURANCE COMPANY CASH FLO~V1 PAGENO="0182" 178 Although responding moderately, as noted above, to the credit re- strictions of 1959-4960 cash flow has been steady and rising during most of the past decade. Month after month policy loans remained in a flat trend, posing no discernible threat to the availability of invest- ment funds. The companies responded tO this apparent growth in cash availabil- ity by stepping up their commitments, selling securities or occasion- ally borrowing from the banks when cash flow ran short, as it. did from time to time for some companies. In fact., supplementary sources of funds such as funds generated by the sale of securities began to be drawn upon more heavily in 1962. The rise probably reflected the sale of both bonds and stocks, the profit on the latter offsetting the loss on the former, and the overall transactions enabling the companies t& raise their average rate of inevstment return. New commitments rose sharply from 1960 when cash flow recovered from the 1959-1960 credit restrictions, until the new restrictions in 1966 again reduced cash flow. Early in 1966 policy loans began to rise as national monetary policy tightened a.nd cash flow came under increasing pressure.. Sales of secu- rities were stepped up to provide additional funds, but now neither the stock market nor the bond market were behaving well and it was soon evident that commitments would have to be curtailed. As policy loans continued to increase, a number of companies entered the banks for supplementary funds and commitments were sharply reduced. Life insurance money beca.me extremely tight; investments in residential mortgages, commercial mortgages and securities all were greatly affected as the companies adjusted their operations to their declining cash flows. To sum up with respect to the response of life insurance companies to the impact of monetary policy, it appears that both the savings they divert from the general economy and the amortization and partial pre- payments on mortgages are persistent and largely unaffected by mone- tary policy. However, the redemption of securities and other repay- ments on mortgages, which account for a large proportion of the cash flow of the industry, were sharply affected by the 1966 changes in credit conditions. Moreover, as interest rates have risen, policyholders in- creasingly have used the life insurance companies as banks of last resort. No doubt many, if not most, of the policy loans in the hands of the banks in 1966 have shifted to the life insurance companies. The poten- tial drain from this source must be less today than it was 2 years ago. Still we must conclude that under the conditions that faced us in 1966 and may be facing us again now, a tight monetary policy very likely will reduce the flow of funds through the life insurance companies and compel them to curtail their commitments. Now let me turn for a moment to guidelines for monetary action and conclude my testimony with a few comments on the relation of fiscal to monetary policy. I can dispose of the guidelines quickly because I am very much in agreement with Professor Chandler's views expressed here a week ago. Every time I wrestle wit.h proposals to stabilize the growth in the money supply, I find myself ending up just about where he did-once you allow all the necessary qualifications to the stabilizing rule you find you have pretty much restored freedom of action to the Board. PAGENO="0183" 179 As to fiscal and monetary policy, I take it that the overall objective of both is to keep total spending, public and private, in balance with the output of goods and services. Monetary policy can hmit total spending but it cannot limit Government spending, which comprises a sizable part of the total. Fiscal policy can limit Government spending, but its effects on private spending may be largely frustrated unless it is backstopped by appropriate monetary policy. I think, therefore, that under most economic conditions fiscal and monetary actions are supplementary, not alternative instruments, and should be used together as parts of a coordinated economic policy. At this time when national economic policy clearly is oriented to- ward the fullest possible production of goods and services, it is par- ticularly important to have sensible and effective fiscal and monetary policy. The substantial inflation we are now experiencing, with all its consequences domestically and on our external balance of payments, can be blamed in large measure on the shortcomings of fiscal policy and the indecisive monetary policy that has resulted. This may not be the right forum for comments on public policy, but I am sure we are all agreed that the inflation must be halted. I think this can be done with the least economic disturbance if the rise in Government expenditures is tempered along with the rise in private expenditures, and this means the coordination of fiscal and monetary policy to achieve a common objective. Chairman PROXMIRE. Thank you very much, Mr. Hart. I think this is the right `forum for comment on public policy. I can- not think of a better one. That is why we asked you here. Our final witness this morning is Mr. Noyes. STATEMENT OP GUY E. NOYES, SENIOR VICE PRESIDENT AND ECON.. OMIST, MORGAN GUARANTY TRUST CO., NEW YORK, N.Y. Mr. Non~is. Mr. Chairman, I could condense the oral presentation of my statement almost to the vanishing point, I think, because the sug- gestion that I have-to the extent that I have one-seems to me to be very closely in line with the sort of procedure you explained in your opening statement as emerging from the hearings yesterday. I might also say before I start, that my personal views are closely in accord with those presented by Mr. Gaines when it comes to the proper framework for analysis of monetary influences. I have focused in my statement on the relationship of changes in monetary policy to changes in the demand deposit component of the money supply, be- cause I thought that would be responsive to the committee's immediate interests. As I understand it, my particular assignment is to say a few words about the response of financial institutions, and particularly commer- cial banks, to changes in monetary policy, and to relate this, to the extent that it is possible, to the degree of precision with which it is possible for the monetary authorities to regulate the rate of growth of the money stock. Before I turn to these specifics, however, it may be useful if I identify myself in terms of broad philosophical-or one might almost say ecclesiastical-affiliation. My early training in economics was not in what has come to be known as the Chicago school, but it was in a school PAGENO="0184" 180 which could hardly be said to deemphasize the importance of changes in the money stock. The chairman of the economics department at the University of Missouri, when I was an undergraduate there, had been a student and protege of Irving Fisher and coauthored with him his classic work on the purchasing power of money. Later when I moved on to do my graduate work at Yale, Professor Fisher had retired from active teaching, but he continued to participate in the informal seminars and his influence continued to be felt. I have never regretted my exposure to this analytical framework which, as you probably know, generated the long-accepted equation of exchange: MV= PT. Nor in my subsequent education, both formal and informal, have I had any occasion to abandon much of what I learned in that earlier period. The longrun relationship between money and prices and between stable economic growth and stable monetary growth is overpoweringly convincing. It is so convincing in fact that there is always a strong temptation to assume away the problems which are really at. the. heart of these hearings. If we assume that the net impact of all economic forces other than monetary policy would be such as to produce an adequate and stable rate of economic expansion, then it is obvious that au intelligently conceived rule administered in more or less automatic fashion by the monetary authority would be most unlikely to upset the patte.rn of stable growth. But it is also most unlikely that discretionary author- ity in the Federal Reserve System would lead to anything other than a stable and adequate rate of monetary expansion in these 1~appy circumstances. It is when the economy is disturbed and distorted by a war, an international payments crisis, a spiraling boom in capital spending, a highly inappropriate fiscal policy, or some similar phenon'ienon, that neither a rule. nor discretionary freedom in the Federal Reserve is likely to produce results that are wholly satisfac- tory to anyone and when differences of view emerge as to which alter- native would minimize the damage-which may be considerable in any case. The probiem that confronts the monetary authorities, and the Congress when it considers the desirability of laying down more rigid guidelines in terms of money or otherwise for the monetary au- thority is that there is no way you can be certain that, in an over- zealous effort to offset other, and perhaps transitory, developments in the economy, flexible monetary management may not contribute itself to instability. On the other hand, if you deny it full flexibility of movement, you cairnot be sure that you will not thereby prevent it from offsetting forces in the economy which would produce serious and long-lived distortions or pre~~euit it from accommodating surges in economic growth that can and should be financed. It is clear that concern for such contingencies has led Congressman Reuss to ll'olose a more complex guideline. And it is hard not to be sympathetic to his effort.. But it is also hardi to write that kindi of a. rulebook. And, as some of the testimony you have alreadly heard in- dicates, even if you accept the idea of a "rulebook," it. is very difficult to get any agreement among so-called experts as to what it should say. PAGENO="0185" 181 My own view is a moderate one. I think the case for a more stable rate of monetary expansion is being well made, by a group of very able and articulate people, inside the Federal Reserve, in the Congress, in the economic profession, and in the private financial community. Its light seems hardly likely to be lost under a barrel. And after all, in 1963, 1964, and early 1965, we had a reasonably stable rate of monetary expansion, in the 3- to 5-percent range, reason- ably stable prices, a steady decline in unemployment, and a good steady increase in real GNP. It was not monetary policy but fiscal policy that started rocking the boat, and the Federal Reserve got pre- cious little thanks for the restrictive moves it made in order to hold the average rate of money supply growth down to 6 perceiit in the last half of 1965. No one ca.n say just how fast and how far interest rates would have moved up in the fall of 1965 if the Federal Reserve pursued policies that held the increase in money to 5 percent instead of 6 percent. But it is a fair guess that the rise would have been sufficient to escalate the Joint Economic Committee's criticism of Fed policy, in its March 1966 report, from harsh to apoplectic. Let me turn now, more specifically, to the response of commercial banks to changes in policy. And to avoid the semantic morass that sometimes develops in these discussions let me include what some would call nonchanges in policy that result in rather drastic changes in money market conditions. By this I mean significant movements up or down in variables like free reserves and interest rates which might result from efforts to avoid major changes in the rate of growth in reserves or the money stock-developments which would be viewed by most of us as changes in policy, but by some as simply adherence to an existing policy defined in terms of money. First, we must at least touch base with the iron law of "total reserves available to support private demand deposits." This is simply total reserves less those reserves utilized to meet the reserve requirements on time and Government deposits, which are, of course, excluded from the narrowly defined money supply. Theoretically, it is possible to measure accurately and currently the magnitude of this figure. And the Federal Reserve can make this figure anything it chooses if it is determined to do so-on a week-to-week, if not a day-to-day, basis. Finally, at least 99 percent of the time, the commercial banks, in the aggregate, must adjust th~ir demand deposit liabilities promptly- within a reserve averaging period-to the net reserves available. The linkage is not absolutely rigid, because there are always some excess reserves in the banking system, but the Federal Reserve knows this and knows how much they are. So, if its sole target is the demand deposit component of the money supply, it can offset changes in the level of excess in a matter of a week or two at most. Pursuing the iron law, we would include that it is not a question of whether banks adjust their demand deposit liabilities promptly to changes in reserve availability, but only how they do it. In short, it is theoretically irrefutable that the Federal Reserve can, within a matter of weeks, force the banking system, and the economy, to accept any moderate change in the money stock it chooses. It is not quite correct to say the Fed can make the money supply level whatever it chooses, because large changes in short periods would PAGENO="0186" 182 create some institutional problems-but no one is talking about large abrupt changes anyway. So this qualification has no practical significance. Perhaps I should not presume to speak for them, but I have always assumed that what people meant when they say "the Federal Reserve cannot control the money supply in the short run" is that it cannot do so as a practical matter-that the result of an effort to hold the rate of expansion stable would create disorderly conditions in financial markets at unacceptably frequent intervals. I have never been altogether comfortable when opponents of "the rule" rest their case too heavily on this argument. It is hard to prove, one way or the other-and in any event it lowers the quality of the dialog to the reductio ad absurdum level. I have discovered nothing in my relatively brief experience as a commercial banker that leads me to question the proposition that, with rare exceptions, the Federal Reserve could, by its policy actions, force the commercial banking system to so manage its assets and liabilities as to produce a reasonably stable rate of growth in the narrowly de- fined money supply in the 3 to 5 percent annual rate range. Such a policy would only rarely produce acute financial market problems and then with ample warning so that modifications could be made. I would go even further and say that from a narrow, self-interest point of view commercial banks would probably benefit from such a policy. It would, after a brief period, considerably simplify the problems of bank asset and liability management, especially if it were accompanied by the removal of all interest rate ceilings-as most advocates of a rule recommend. How does the adjustment mechanism work so far as commercial banks are concerned? In fact, it appears strangely enough to work just about the way the textbooks say it should work. The initial adjust- ment takes the form of transfers-one way or the other-of financial assets between the banks and the nonbank public. In the first instance, the banking system adjusts to lesser reserve availability by selling se- curities from its portfolio to the public and thereby extinguishing demand deposits. Of course, an individual bank may borrow, but. if the Fed holds fast to its reserve target some other bank is forced to sell an asset. In reverse, banks respond to increased reserve availablity by buying securities from the nonbank public and thereby increasing demand deposits. For all practical purposes this happens so fast in either direction one can almost say that there is no lag at all-i or 2 weeks at the most. If you really believe that money is the only thing that matters, you can stop there. The significant change has occurred when some deposi- tor somewhere exchanges his deposit for a Treasury bill and aggregate demand deposits are reduced by an equivalent amount, or vice versa. But most of us-and this certainly includes both bankers and Members of Congress-cannot be quite so Olympian in our attitude. The remander of the adjustment process, and its effect on interest rates, and conditions in credit markets is a matter of serious concern. In order not to extend this statement unduly, let me focus on bank adjustment under one assumption, rather than taking both restrictive and expansionary assumptions. The case which is of most concern PAGENO="0187" 1.83 ~to all of us, especially at the moment, is the one in which bank loan `demand is vigorous and, at existing interest rate levels, this com- ponent of total bank credit alone is tending to expand by more than ~t.he growth being allowed by current monetary policy in the demand deposit component of the money supply. In other words, the adjust- ment process in case of a "squeeze." Initially, as I said, banks respond to a "shortfall" in total reserves by liquidating readily salable investments. On some occasions, a substan- tial increase in loans can be accommodated through this process with no other maj or balance sheet changes or disturbance to financial markets. For example, from 1948 to 1951, total loans increased at an average annual rate of 11 percent, while~ the money supply grew at an average rate of only 2 percent. In this period, banks' U.S. govern- ment security holdings declined at a 3-percent rate. On other occasions banks have accommodated loan demand by mov- ing more aggressively to attract savings and other time deposits. In 1964-65 the money stock went up at a 4.2-percent average rate, while total loans increased at 131/2 -percent rate. On still other occasions, in the squeeze-or crunch if you like-of late 1966, for example, the impact on loan expansion was quick and direct, the rate of loan ex- pansion was brought practically to a halt. It was six-tenths of 1 percent from October to November. I cite this historical experience simply to illustrate the fact that bank response to a lesser rate of monetary expansion than would ac- commodate current loan demand varies. It depends, of course, on the condition banks are in at the outset, on their ability and freedom to attract funds from the market and from other institutions, and on the strength and structure of the band demand that confronts them. In the present circumstances, I think it is fair to say that the adjust- ment process is likely to involve some of all the ingredients in the his- torical examples I have cited. Banks undoubtedly acquired some liquid investments, over and above the bare minimum, during 1967. They can, and undoubtedly will, accommodate some loan demand in excess of the presently permitted rate of monetary expansion by selling liquid investments. They have some ability and freedom to compete more aggressively for time deposits and at least until very recent weeks they have managed to keep total time deposits rising. That they will con- tinue to be able to do this is open to question. Banks are obviously also moving to moderate loan expansion-or at least to produce lower, rate of expansion than would otherwise prevail-by more restrictive lend- ing policies. Clearly, all these things tend to push interest rates up. In order to sell portfolio investments to nonbank investors, banks must offer them at attractive prices-or higher yields. To attract time deposit money they must pay more and to discourage borrowing they must charge more. And to the extent they succeed they will undoubtedly push some bor- rowers into other markets-rather than out of the market completely- and increase credit demand, and rates, in those markets. How these effects permeate financial markets and the economy is another story for another witness. But. perhaps I have said enough to suggest to you why I believe that focusing just on the rate of growth PAGENO="0188" 184 of the money stock, and not taking into account. the variations in the adjustment process that are not. only possible. but likely, in a. particu- lar period, would be a mistake. The amount of interest rate escalation that would flow from any particular rate of money supply expansion is relevant to its impact on the economy. The effect on the structure financial flows is also relevant. Whether banks are or are not able to adjust by "liability manage- ment" or are forced to absorb the full impact on the asset side of their balance sheet makes a tremendous difference in the ripples that flow through the economy from their adjustment to a specified rate of mone- tary expansion. It is easy to be dissatisfied with any existing procedure. Even a hostess with an excellent chef is never satisfied that her dinners are being prepared and served exactly according to her wishes. In the monetary area. the relationship between the Congress and the Federal Reserve is obviously not altogether satisfactory from anyone's point of view. While they may not say so in so many words, I am sure that the Federal Reserve feels they could do a better job if the Congress would just leave them alone and let them do it. The Congress, and especially the individual Congressman, is bound to feel at the same time. that the Fed is not sufficiently responsive to suggestions. I have grave doubts that a "nile book" would correct. this-anymore than the purchase of a cookbook would solve the hostess' problem. There is no evidence that the. Federa.l Reserve is pathologically averse to targets or guidelines. On the contrary, there is ample. evidence in the record that they are experimenting with them almost continu- ously, and as I have said, that there are able people within the System who are continuing to argue effectively for the use of some form of money supply growth rate as a principal operat.ing guide, if not the only one. Leaving it t.o the Federal Reserve System to test. and develop its own rules together with regular and meaningful reports to this com- mittee and the two banking committees on its progress, or the reasons for lack of progress, is probably the best way to move toward more systematic a.nd generally accepted guidelines-and less reliance on vague a.nd admittedly imprecise phrases in monetary policy actions. Chairman PROXMIRE. I am going to have to go down for rollcall in a couple of minutes, and I have some questions I am going to ask Mr. Rumsfeld to ask for me in my absence. But before I go, I would like to say that these are three very excellent papers and we very, very much appreciate them. You have made a. rea.l c.ont.ribution here. I ant very interested to see that although some of you may disagree I think that you have all made substantial arguments in the direction of some kind of effort on the part of Congress to persuade the Federal Reserve Boa.rd t.o adopt policies of using monetary policy in a some- what more moderate way than they have in the past.. I gave the five examples of recessions in which the Fed decreased the money supply, which goes against all conventional wisdom, and I suppose you might find particular rationalizations in each case, but the most conspicuous example right now in my mind is that they have been increasing the money supply in the last year or so, and they have continued todo it in a. very inflationary period. can understand their arguments. They say interest rates would be a lot higher if they did not provide more money, but. one of the PAGENO="0189" 185 reasons interest rates are high is because the expectation is we are going to have further inflation. One of the reasons why the public expects further inflation is that they expect the Fed to pump so much money into the economy. So that if they adopt on a permanent basis a policy of not increasing the the money supply so rapidly when we are in an inflationary period, it seems to me that this might help stem inflation, because expectation and psychological attitudes are so important in inflation itself. Having said that, I am going to ask Representative Rumsfeld if he would like to follow on these questions. I will be back in about 5 minutes. Representative RUMSFELD. First, I would also like to join the chair- man's comment that these papers are most interesting. Possibly one or more of you might like to comment on the chairman's last statement. Mr. GAINES. I agree completely with the proposition that Federal Reserve policy should avoid the extreme swings that have sometimes characterized it in the past. I do not think that the extreme swings, however, as they are reflected in interest rates, could be avoided just by establishing a money supply target or guideline. On the question of interest rates, it seems to me that a good many of the financial difficulties that the country has encountered in recent years have resulted from the wide movements in interest rates. To be specific, Federal Reserve policies in 1966, along with credit demands, resulted in market rates of interest moving above the tra- ditional levels that our economy had had any experience with. The results of this were the dislodgement of huge amounts of relatively hot or interest sensitive money from the savings institutions and the "crunch" in the real estate market that we experienced. Subsequently, the Federal Reserve in the first half of 1967 followed policies that resulted in interest rates that were once again well below the rates available in the savings institutions, so a lot of the hot money flowed back into them. It has since been disintermediated again at the currently prevailing high rates of interest. So long as we have savings institutions, such as savings and loan associations that are not able to adjust their own rates of return on their portfolios quickly to these swings in interest rates, it seems to me that policies that result in wide swings in interest rates that first suck hot money into the institutions and then pull it out create a dangerous kind of situation. I believe that if a set of policies could be developed over a period of time that resulted in a relatively stable level of shorter term interest rates. Then the savings institutions would be able to operate on a sounder basis from 1 year to the next without having to be concerned about vast movements of savings money in and out. This objective cannot be achieved simply by zeroing in on a money supply growth target. It has to be concerned with the broader flow of credit funds through the economy which is not always measured by money supply movements. Representative RUMSFELD. Let me pose some of these questions that the chairman wants our record to include. Take the case of 1967, when the money stock grew by 6.5 percent. What would have been the consequences of strict adherence to a rule of 5-percent maximum growth? Would the outcome have been prefer- able to the actual course of events? PAGENO="0190" 186 Mr. HART. I am trying to work the arithmetic out, but I would think off hand that if we had restricted the growth in demand deposits to 5 percent instead of 6.5 percent, the public would have tried to raise the money in some other fashion, and I suppose this would have brought greater pressure on the whole capital market structure. Representative RUMSFELD. Your judgment then is that it would not have been preferable? Mr. HART. I do not think it would have been preferable right at that point, but I guess I am not too happy about seeing these wide swings, either. I wish there was some way we could reduce the swings, but I am a little troubled as to how you do it. Representative RUMSFELD. It seems to me that the question recog-~ nizes the fact that you are dealing with the lesser of two evils. Mr. HAimT. Somebody who wanted demand deposits would have t~ give them up then, would they not? Representative RtTMSFELD. If the pressure caine in the way which you have described. Mr. HART. Yes. Well, if you have 6.5 percent and you are going to cut it to 5, somebody who wants to hold demand deposits is not going to hold them, because there will be fewer demand deposits. Now, I assume that if you could not have a demand deposit, you would probably want to hold something else close to it. I think this might have caused quite a bit of pressure in the markets. Mr. GAINES. Mr. Rumsfeid, I would like to respond to that if I might. It seems to me it is awfully important to distinguish among types of demand deposits. A growth in demand deposits of any given size that does reflect an increase in liquidity in the economy, an in- crease in the availability of funds that can be spend at the option of the owner of those deposits, is relevant. But in 1967, in my interpreta- tion of what occurred, the largest part of the increase in the money stock, in the demand deposit component of the money stoc.k, repre- sented an increase in compensating balances at the larger commercial banks. This is borne out by the fact of more rapid increase in demand deposits at the larger banks than elsewhere in the economy. Now, these compensating balances were obtained by the banks be- cause the banks were in the driver's seat last year, after the 1966 credit experience. Banks were able to get the 20 percent or so compensating balances that they had been talking to their customers about for a number of years before that. Compensating balances are not truly spendable funds. They do not increase the liquidity of the holder of the balances in the same way that normal growth in money supply would. This was a distinctly different type of increase in money stock. If one could sort out or separate out the compensating balance component of last year's growth in money stock to arrive at an estimate of what the true growth in spendable funds was, I think we would find that the growth in money stock last year was well within the 3- to 5-percent band that the committee is concerned with. Mr. No~s. Do you want me to have a go at that question, too? I do not disagree with anything Mr. Gaines has said; but with all of the benefit of hindsight now, we can say that it might have been desirable to deprive some of these corporations of the liquidity that PAGENO="0191" 187 they were able to accumulate in 1967; because it would have made them somewhat less enthusiastic spenders in the first half of 1968,~ which I gather we all agree is a period in which we would do well to have a little cooler economy than we have had. I think if you want to be more precise, it is probably better not to look at the total year 1967, but break it up a little. The very rapid rate of monetary expansion carried through, shall we say, the summer of 1967, when money stock was continuing to rise at 7- and 8-percent annual rates- Chairman PROXMIRE. Ten percent, wasn't it, during that period? Mr. No~s. It depends upon the period. You can get a period that is 10 percent, you can get a little longer period at 7 or 8 percent. Chairman PROXMIRE. For 6 months, it was? Mr. No~s. Yes. I think with the benefit of hindsight, you can now say it was probably unfortunate; because it did put corporations- through just the process Mr. Gaines has been explaining-in a more liquid position, and therefore in a better position to proceed with high expenditure rates in the subsequent period-that is, the first half of 1968. Now if you look at the monetary policy since November of 1967, you find that the rates of expansion have been, on average, much more moderate. The narrowly defined money supply has increased at about 4.9 percent, a little less than 5 percent, since early November. The rate of increase in time deposits has been about 6.5 percent. Senator PROXMIRE. You see our argument is that it should be 2 percent. Mr. NOYES. Well, 2 percent, in the present circumstances, might create conditions which you might find would be worse than the dis- ease. I do not know that the others on the panel would agree with me on that. Senator PROXMIRE. What this does, of course, is to make it necessary to follow other policies to try and overcome the disintermediation. Obviously it might have a devastating effect on the housing industry, unless you at the same time have the Federal Reserve Board do its best to support the housing industry through buying FNMA obliga- tions and that kind of thing. Mr. Noin~s. You are acutely aware, I am sure- Senator PRoxMnu~. Of course, it also puts pressure on Congress to change its fiscal policies in a hurry. Mr. NOYES. The monetary mechanism does not work with a com- pletely flexible institutional framework; so dramatic changes in the rate of interest, even if they might be desirable in some aggregate sense, can create very severe institutional problems. Mr. GAINES. Mr. Chairman, could I respond to your suggestion? Congressman Reuss in his January statement proposed that the Fed attempt to promote lower rates of interest in the morgage market than would otherwise obtain. I cannot think of a better way to guarantee that there would be an absolutely inadequate supply of mortgage funds, and therefore- Senator PROXMIIiE. Adequate or inadequate? Mr. GAINES. Inadequate. Senator PROxMIRE. Inadequate? PAGENO="0192" 188 Mr. GAINES. Yes, sir; an inadequate supply of mortgage funds and therefore a real crunch in the building industry. Savings and loan associations have very little choice but to lend on residential mortgages. They presumably would continue to channel their money into this field. But the life insurance companies, the mutual savings banks, and the commercial banks with the opportunity to buy 7-percent corporate bonds definitely would not buy ~½- or 634-percent mortgages. Conse- quently, you would dry up the supply of mortgage money if you tried to make this market noncompetitive with other markets, with terrible consequences for building. Senator PROXMIRE. We have done this kind of thing to some extent. We have put differentia.l ceilings on the interest that S. & L.'s pay and banks pay in order to get more money into S. & L.'s and help. We acted on the CD problem-not we, the Federal Reserve Board acted on the CD problem-and as you know, what was happening, money was coming out of savings and loans, going into certificates of de- posit and, therefore, going into industry and out of housing. By remedying that situation, changing the situation, it. did help the S. & L.'s, in spite of the fact the interest rates are higher now than they were in 1966 when S. & L.'s were suffering. I do not. think you can just throw up your hands and say there is nothing you can do. I would agree in the long run you have to adopt fiscal pol~c.ies and monetary policies that make sense. Mr. GAINES. I think, though, that in the allocation of the funds witiun an institution, you have to be concerned with the interest rate relationships on t.'he alternative use they have for those funds. For example, in New York State right now, with its 6-percent usury ceil- ing on mortgages, t.here are for all pract.ica.l purposes no mortgage loans being made.. The consequence, of course, is devastating for the homebuilding industry in the State. Senator PROXMIRE. You would certainly agree you can get into all kinds of trouble with controls if they are only temporary and so forth. You have seen that especially in the international control area. But at the same time, I think this is just a matter of having usury laws which are obviously way out of date, most inappropriate.. I w~ould like to ask each of you gentlemen to respond directly, how- ever, to the proposal we have been trying to develop in the hearings, that we have a 2- to 6-percent area, say, reasonable target. for increase in the monetary supply; and when the Federal Reserve Board varies from that during a quarter, that they come up and tell the Congress through this coniniittee, wily they did SO. Do you think that would be constructive or do you think that per- haps we can get a better target? I takes it, Mr. Gaines, that you feel that maybe we ought to forget about the money supply, and go into bank credit or some other measure that would be more desirable and wiser. Mr. GAINES. Yes; I would think that the Congress might ask the Federal Reserve to report at quarterly intervals or whateve.r on what is happenmng in total credit flows. These flows will be reflected in what happens to money supply, of course. Senator PROXMIRE. We want to do more than just say what is hap- pening in total credit flows. PAGENO="0193" 189 `What I am afraid of is that they will file a report and the committee may have hearings, and that is the end of it. If we set guidelines and it is modified or improved, then we have a target for them to shoot at and we have a basis for focusing our inquiry and we have a basis perhaps for getting greater understanding 011 the part of members of the committee, the Congress and the public of what the Federal Reserve Board is doing and why. I think the main trouble here is a lack of communication and under- standing. This monetary policy can be very complex and very hard for Members of Oongress to understand, and many of us feel that it has been most perverse, many of the `ablest people in the academic area feel that is the case. Mr. GAINES. I agree that it has been perverse on a good many oc- casions and I would have no strong `objection to a money supply target, so long as there was a great deal of flexibility in the interpretation of the ranges of that target, and so long as the Fed had an opportunity to explain why at one time or another it had permitted rates of growth outside those ranges. Senator PROXMIRE. Let me just interrupt to say supposing we had had a situation where in the second quarter of 1967, after the money supply had been increased at the rate of 10 percent, the Federal Re- serve Board had had to come before this committee and explain why, when the President was calling for pretty drastic fiscal action and we were all recognizing inflationary pressures, why, the Federal Reserve Board was indulging in what seemed to be policies that were infla- tionary. Under those circumstances do you think it would have had a good effect on the Federal Reserve Board as well as a very good effect 011 the Congress? Mr. GAINES. I agree with you. You could have asked the question not only in terms of money supply, though, but you could have asked why 90-day Treasury bills were trading at 3.35, what possible justi- fication was there for that given the economic outlook and so on. The difficulty with money supply, I think, is this: Take the entire decade of the 1950s. During that period business corporations were steadily learning how to manage their cash better. If you look at the perfor- inance of the New York and the other big city banks, during that decade, and into the 1960's, you will find that there was no growth in demand deposit totals at all. Their business customers were learning to operate on lower balances, year by year. Senator PROXMIRE. That is fine. Mr. GAINES. Suppose that you had had a 3 to 5 or 2 to 6 percent or some such target rate of money supply growth. That could very well have been too large. Senator PR0xMIRE. Sure. Mr. GAINES. Under the circumstances of the 1950's. Senator PROXMIRE. Then they come up and say why. We ought to change it because there is greater efficiency in the use of money, the velocity is increasing. Mr. GAINES. That is why I said I would be quite agreeable to the idea of targets so long as there is great deal of flexibility in interpreting what was the appropriate target. But again, in 1967 1 interpret the large increase in money supply first to the decided upward shift in the liquidity preference function as a result of the 1966 crunch, and second, to the pressure the banks were putting on their customers to 94-340-68-------13 PAGENO="0194" 190 increase compensating balances, and compensating balances are not usable money from the standpoint of the business depositor. You were out of the room when I made this point. If it. were possible to adjust the figures for last year, as to how much of the. increase in money stock was compensating balance money, rather than truly usable demand deposits, I think you would find that. the rate of growth in money supply was toward the lower end of a 3 to 5 percent range of growth, rather than the 7 percent or whatever it was that actually came out. This is the kind of explanation you could ask of the Federal Re- serve, and I think that they should respond to. Again, you have to have flexibility a.t `both ends of any guidelines that are set. Senator Pnox~rm~. Of course, the flexibility is not the fact. that it would be completely suggestive and there is nothing mandatory `about it. There is no law that prohibits them in anyway but it would require an explanation. Mr. GAINES. Actually, though, Senator, we have moved so far ahead in Our understanding of financial flows, not that we understand them completely today by any means, and in the development of a financial model, the MIT model that the Fed has been working on for some time, I doubt that it is really necessary any longer to use as primitive a measure of Fed performance as money supply. Senator PROXMIRE. I notice that Mr. Hart, in speaking of the in- surance industry, said that they would be bet.ter served, with the mil- lions and millions of people involved, better served by a policy of moderate expansion in the ntoney supply rather than these fluctuations that go up and down. Mr. Noyes said the same thing about the banks, so that these great industrial areas where so many Americans have very deep and big interest, would be better served by this kind of a policy. It seems to me if the Congress is going to influence the Fed to follow that kind of a policy, one way to do is to establish this guideline and then require a justification because they obviously are not follow- ing that kind of a policy now. However, they can rationalize what they are doing: they have fol- lowed a policy especially lately of the widest kinds of fluctuations; sometimes even in periods of recent recessions, reducing the ntoney supply and in a period of inflation increasing it.. As I say, this is something that hurts the banks, hurts the insurance companies, and many people feel hurt.s the whole ecoomy. Mr. Hart, would you like to comment on this? Mr. HART. I guess in a philosophical way I like the idea of some kind of stability here that is according to law rather than according to some man's will. But every time that I wrestle with this thing. as I said in my statement, I find it very difficult to come up with any kind of a rule that seems to me to make very much sense. There are always exceptions, and when you allow for the excep- tions, you seem to get back to about where you are now. However, I do not see anything wrong with asking the Fed to report, say, quarterly to Congress on what they have done, and if you want to gear it around the money supply, it is probably as good as any other single measure. PAGENO="0195" 191 Still I would think bank credit, total bank credit expansion, and the movements therein would be more appropriate than the money supply under current conditions, and I certainly would want to know some- thing about total reserves. In any event, however you do it, I don't see any reason why the Fed should not be called upon at some appropriate interval' to explain what they have done, and why they did it. Senator PROXMIRE. Mr. Noyes? Mr. NOYES. Well, I can comment very briefly, Senator. I think the thing that disturbs some of us about the use of the narrow money supply target is not that it would not work all right as a trigger, but the implication involved that the committee has reached a conClusion that `this is the critical target. We do not feel it is the critical target. While you can use it as a trigger for these reports, we are reluc- tant to see you adopt it and give it- Senator PROXMIRE. Why isn't it proper to have a stable and regular increase in the money supply within certain limitations? Again, I say if it is not, let them say why. They can always increase it 10 percent or cut the money supply although I do not think we ought to do that, but if they do, let them explain it. Mr. NOYES. I do not object to that, sir. Senator PROXMIRE. I know you don't object to that, but you seem to imply there is something wrong with, say a 2 to 6 percent range. Mr. Non~s. Let me be perfectly clear. I do not really object to it as using it as a basis for the proposed reporting procedure. The thing that troubles me about it is that it seems to give the endorsement of this committee to the narrowly defined money supply as the critical variable, and I do not feel, and I think many of my colleagues do not feel, that this is in fact the critical variable. Senator PRox1~IIRE. This committee has `done this for 2 successive years. We have done it by both the Republicans and Democrats agree- ing, with almost complete unanimity. Congressman Reuss suggested some rather big areas of amendment or modification here, but the com- mittee as a whOle has taken the position that this ought to be regular'. You are saying that perhaps we should not do this. You see- Mr. NOYES. No; I am afraid you have misunderstood me, sir. Senator PROXMIRE. Let me just finish by saying what I am getting at is that I think that Congress has been impotent, very feeble in thi~ whole area of influencing monetary policies. The Federal Reserve Board, rightly or wrongly, has controlled monetary policy completely, and we think they have made some very serious mistakes on the basis of our analysis, not only in the long past, but in the recent, in the very recent past. I think we have a duty, in view of the destructive impact it ha~s had on the economy, of trying to develop some 1nfluence on the Fed that will make their monetary policies more constructive. How can we do it if we do not have a 2 to 6 guideline for monetary growth? Mr. NOYES. Let me be responsive specifically to that. I would be more comfortable if instead of saying a 2 to 6 percent rate of increase in the narrowly defined money supply you said a 7 to 10 Percent in- crease in either total bank credit or the broadly defined money supply. PAGENO="0196" 192 Senator PROXMIRE. Broadly defined money supply? Mr. No~s. To include time deposits. Then I think I would be still more comfortable, and I know Mr. Gaines would be more comfortable, it instea.d of using either of these money supply concepts you said the Federal Reserve should come up and explain why total credit flows have not expanded at a rate equal to the rate of growth expansion in current dollar GNP or something like that. Don't hold me to this precise wording. I am not trying t.o put words in Mr. Gaines' mouth about the precise guideline to use for total credit flows. Maybe he can suggest it, but a total credit. flow guideline as the trigger for their report to you, rather than a narrowly defined money supply guideline, would be preferred. Senator PROXMIRE. At any rate, then, to try and get this, I guess all three of you agree that we should use a better measure t.han money supply. You all also agree that it would be useful for this committee to suggest a guideline in something like this area wit.hout any manda- tory legal action, and then ask the Federal Reserve Board to come up on a quarterly basis when they exceed the units and say why they did and justify it, with the press present so the Congress gets as full an understanding of this as possible, a.nd we ca.n recommend whatever actions seem necessary on the basis of developing an expertise over some years in this whole area. Mr. HART. W~hy can't you ask them, Senator, t.o explain the basic movements in these credit structures ? I mean that is really all you need to ask them, it is not, without tying it into any particular- Senator PROXMIRE. It seems to me we have to have some kind of a trigger, a focus. Mr. HART. You want a measuring stick somewhere ? Senator Puox~rnu~. I think that is right, yes. You see, as I tried to enunciate at the beginning of the hearings this morning, you can make an assumption that this committee has made, that the money supply, other things being equal, ought to keep pace. with the growth in the gross national product c.aused by increased productivity and increase in the work force, and to the extent t.hat this is a growth of 4 percent, the money supply ought to grow at 4 percent. Now, if you have a range between 2 and 6 percent, presumably, there will be a tendency, a proper tendency on the part of the monetary au- thorities, to stabilize the economy by going at the lower end when you have inflationary tendencies and at the higher end when you have recession. There are very great compensating elements here. Obviously, if in the depression of the 1930's instead of decreasing the monetary supply the monetary authorities had insisted on increas- ing it at 6 percent, it would have had a much more desirable effect on the economy than what they did. Obviously, in a period like we are experiencing now, instead of increasing the money supply as they did la.st year by a very big amount, increased it at 2 percent, it would have had a very distinct restraining effect. So that looking at it from the standpoint of taking away the discretion of the Federal Reserve t.o a considerable extent., hoping they `will take it away themselves with t.his kind of guidance, that you will have in the future a better monetary po1icy tl~ati we have had in the past. PAGENO="0197" 193 So many people feel it could not be worse. Mr. HART. But you do not really want to take their discretion away, do you? You are just a little unhappy in the way they have used it. Senator PROXMIRE. We want them to explain it in detail as they have gone off the beam, why they have done so. Mr. HART. That is right, and I think everybody would welcome an explanation. I do not mind the peg point, so to speak. If you want to name 2 to 8 percent it sounds all right to me, but if you convey the implication that somehow this is the right range, and that any de- parture from it is somehow a very exceptional thing, I just wonder what its impact on Board policy would be. Personally, I would rather see a sort of quarterly report., in which the Board explained what it had done on each one of these major variables. I doubt if you could really ask them to explain the total credit flow. Senator PROxMIRE. Yes. Mr. HART. . Because there are a lot of things that I do not suppose they can control or perhaps even explain to you. But you certainly can ask them to explain their own actions. Senator PR0xMIRE. I think, looking at it from the standpoint of a scholar, Mr. Hart, which I am sure you are- Mr. HART. Not a very good one. Senator PRoxMIm~ (continuing). And an expert in this area, I think that that probably would be more satisfactory. Looking at it from the standpoint of a Senator, a Member of Con- gress, I think that something as clear, as simple as the money supply, a focus of that kind and range will get a more desirable dialog begun between the two. Mr. HART. Why can't you tell them, then, that since the long-term growth in the money supply is 4 percent or something like that, more or less like the economy, you would like an explanation when it exceeds this level. Get away from the idea that there is something wrong about exceeding or falling short of this level. Senator PRox~IIRE. rfliey have been wrong in the past. We want to do more than say the long range is this and in the. future we hope to do this. We want to say that our feeling is that whenever you gentle- men have had these drastic fluctuations in the money supply in the past you have almost always been wrong, not. because they have not been right about the conditions at the current time, but. because, as has been documented repeatedly, there are lags between the time they put a policy in effect and the time it has an effect on incomes, gross national product. and so forth. The lag is substantial. Mr. I-TART. As you point out., there hare been periods when there is virtually no growth and they may have been wrong there, so you get it both ways. The proper range, in other words, ma..y be a very wide one for best public policy. Senator PROXMIRE. Let me ask-I am so delighted to have Congress- man Reuss here because lie has contributed so tremendously as a mem- ber of the committee. Mr. GAINES. Mr. Chairman, could I say-- PAGENO="0198" 194 Senator PR0xMIRE. I just want to say he has contributed, as one member of this committee, to this particular concept. I think he initially suggested it., pressed hard for it., and he was also the one who suggested a rather substantial modification in it. I have a couple of more questions before I yield to Congressman Reuss. Mr. Gaines? Mr. GAINES. Just a. very brief comment on something which you said, that the money supply is a. clear and simple guideline. I believe that the three. of us here, and our economist. collegues, generally. would agree that the. Congress should take more direct interest in Federal Reserve policies than it has, and that it is most appropriate to set up some measurement by which you could judge. whether or not the. Fed- era.1 Reserve is behaving properly. Senator PROXMIRE. R.ight. Mr. GAINES. But our concern. I believe, a.t. least. mine, is that. the money supply is not a clear and simple concept.. * As a matter of fact., if I knew exactly what money supply was, I think I would be more inclined to agree with you. Let me cite just one illustration. * Most companies in the United States of any size at all opera.te from day to day in an overdraft position on their checkbooks. They are relying upon the time it takes for checks to clear to maintain the kind of balances that their banks demand of them. Now, there has been much talk of the checkless society in the future where all the computers of the companies and the banks would be linked together, with funds shifted instantaneously. If we were to put that system into effect tomorrow, most of U.S. business would l)e over- drawn immediately and the money supply would be cut in half. Now, with this major uncertainty as to what in the world money supply actually is, and with movement in this direction as something that is conceivable for tile future, what kind of adjustments are von going to have to make in the guidelines for money supply to be the guide that you wish it to be for the Federal Reserve? Senator PROXMIRE. WTe11, my answer to that would be that. it. is true that there are all kinds of changes. Another change was suggested in the efficiency with which demand deposits are. used, and so forth. I think it is necessary to develop some kind of guideline. The rea- son I suggest money supply, that several responsible. economists have suggested this, and it is a concept which is appealingly simple to me because, after all, if the money supply is what the Constitution gives the Congress control over, specific control over, and the interest. rates of course is the price of money, and the. economy does revolve around money and the money supply. I think you can make a very strong case for bank credit and I think that is something that. the. com- mittee ought to consider most carefully, in view of the fact. that you gentlemen have proposedi it and other economists have, also saidi the money supply is not the target we ought to use. Let me just get in a couple more questions and then yieldl to Con- gressinan Re.uss. Mr. Gaines, you said something about the Fedleral Reserve having keyed our interest rates to interest rates abroad, at times in the past, so that we can affect the flow of capital by varying our interest rates, PAGENO="0199" 195 so that if we want an inflow of capital, our interest rates are a little higher, all things considered, than interest rates abroad, a little lower if we can stand an outflow. I asked Mr. Robertson about this, because I was very concerned, and this has been a great concern of our committee. So often at times there have been conflicts between our balance-of-payments position on the one hand, and the needs of our domestic economy. Obviously, we cannot have a situation where we have unemploy- ment, and a kind of need to stimulate the economy on the one hand and an adverse balance-of-payments situation which would suggest that we ought to have monetary restraint and high interest rates. Under these circumstances which do we do? Governor Robertson's position is that we should never govern our monetary policy with respect to international balance of payments, that we should insulate ourselves by using, he suggested, a very com- prehensive equalization tax. Some economists have questioned this aiid said you cannot do it. If you are going to do that, you are going to have to have a floating exchange rate, a flexible exchange rate. That is the only way you can in the long run. My question of you then, do you thing it desirable that you ask the monetary authorities to try and serve these two masters, or do you think you should give priority to the domestic economy and try, in one way or another, to insulate our balance of payments by such a device as interest equalization tax more comprehensively applied? Mr. GAINES. Well, my comments were directed to the future actually rather than what has been the case in the past. If in the future we continue to have the type of aberrations in fiscal policy, and either compensating or complementary aberrations in Fed- eral Reserve policy that lead to the types of economic movements we have had and therefore to the very broad swings in short-term in- terest rates, we just won't be able to permit our money market to be tied intimately to the international monetary market, because rates internationally have not moved over the wide ranges that our own domestic rates have moved over. If, however, your purpose is achieved in the monetary policy area of a more stable year-to-year policy, and if simultaneously we have more responsible fiscal policies in the future than we have had, I think we can foresee a time when the variations in our economic growth rate from one year to the next are likely to be rather minor, and therefore one in which interest rate fluctations properly can be minor from one period to the next. This would be most desirable, of course, from almost any point of view. But one consequence of it would be that we would then become full participants in the huge international money market that has been developed. Our market is now closely linked to the Euro-dollar market, but it tends to be a one-way sort of linkage because of the restraints on credit flows out of this country. We are not in a position at the moment to feed dollars abroad when our rate structure would suggest that. Rates of interest in any given maturity in the Euro-dollar market are almost identical to rates of interest on domestic CD's of the large banks in the United States, after one allows for the added costs of the reserves on these CD's. In other words. the operation of the large PAGENO="0200" 196 banks in this country in the Euro-dollar market has already estab- lished a. very, very close relationship of movement. in these rates. I would think in the future, in the development of the international economy generally, if it is consistent with our own domestic economic needs, it would be very disirable to try to move in this direction of linking our ow-n money market intimately to the international market. Senator PROXMIRE. If we do, what do we do about the domestic economy, in the event we have a situation where the international money market conflicts? Mr. GAINrs. As I say, if we continue to have the types of fiscal and Monetary policies that we have had recently. I am afraid that it w-ill not be possible for use to bring down the walls around our country so as to participate fully in the international market. Chairman PRox:~IIRE. You are ~oin~ farther than that. though. We could have very wise fiscal policies, monetay policies, and just have a situation in which those policies are not as effective as they might be. There were periods in the thirties when our monetary and fiscal policies might have been construed as wise. We ran a big deficit and we had monetary policies during l)art of that time made sense. Sometimes they did not. But we certainly had very low interest rates, extraordinarily low interest rates. I understand the Treasury bills were 1/100 of w-hat. they are now, literally 1/100, not 10 percent but 1/100. Mr. GAINEs. They were actually negative on some occasions. *C1ma~rmamm PROXMIRE. They w-ere. They were actually negative. It still did not do the job. Under those circumstances to do what we did in 1937, to double reserve requirements. because of the interna- tional balance-of-payments situation just does not make sense. Mr. GAINES. Mr. Chairman, I choose to believe, perhaps naively, that the record of our own economic performance, fiscal policy and monetary policy in time period 1961 to 1965 indicated that time millen- mum is not impossible, that w-e do know enough about the way the economy operates to establish policies that will sustain ordierly rates of economic growth indefinitely, with minor dleviatiolls around that growth trend. What I am saying is that I think that the milleirnium of a reces- sion and depression-free economy is decidedly possible. Chairman PROXMIRE. It is very interesting when you said that. because you said that in your statement. It seems to me that this is clear: This mnillinnium arrivedi when the Fed followed a policy of keeping the increase in time money supply about at the level that we are shooting at in our guidlelmes. Mr. GAINES. And it was also a. period in which fiscal policy was not creating impossible problems for the Federal Reserve. Chairman PRox~IIRE. Let me just ask one more question and then I want to turn it over to Congressman Reuss. I will be right back. I would like to ask Mr. Noves if lie wouldi comment. 011 this. I suggest that not only this guidleline with rel)Orts on a guarterly basis, but also, and this would be a matter of law, if we could get. it. through the Congress, a proposal in which the Federal Reserve Board wouid make a monetary report each year, like time President's Economic Report, in which they would set forth time economic conditions and PAGENO="0201" 197 how they expected to meet them, what their program was on the monetary basis, giving us a basis for evaluating what they do in the course of the year, and criticizing what they propose, and not holding them to it necessarily, because of course when the come in, as the President's economic people do, they could say why they are changing the position during the year. At least then we would have them setting forth their own targets, their own reason for following certain policies. Do you think this would be a constructive and useful device or not? Mr. NOTES. I do not see any harm in it, Senator. I think you would probably find that it would suffer from one of the same problems that you find in the President's Economic Report, and that is that no responsible public official is ever inclined to predict disaster, even if he may feel in his bones that there is a little disaster out ahead, and these projections all tend to take on a little "pie in the sky" quality. That is, you tend to get projections of desirable relationships, which one would hope would materialize. Chairman PROXMIRE. In in January of 1968, William McChesney Martin was presenting a report to the people and to the Congress on monetary policies for 1968, would he not have said that we need mone- tary restraint as well as fiscal restraint and we would have spelled out how he expected to- Mr. NoTES. Yes, but he would probably have assumed that the fiscal restraint that he thought was necessary would materialize and have built you a nice model based on the that assumption, which would have looked like a nice, well-balanced 1968. Chairman PR0xMIRE. This would be a very good forum for him to make a pitch for this kind of fiscal policy, it might have had a desirable effect. Mr. No~Es. I said I have no objection to it. I just wouldn't want you to expect too much of it. I think people in any such reports are inclined to project idealized conditions as emerging, rather than perhaps being fully realistic about the problems that confront us. Chairman PH0xMIRE. Right now the monetary policy does not seem to come from anywhere or go anywhere. To some extent the monetary authorities can say they cannot do very much about it. Their con- ditions, fiscal policy conditions or other conditions take it out of their hands. If they were required to do what the President has to do and the Council of Economic Advisers has to do, and what most boards of directors of corporations insist that their officials do for them, set forth a plan for the year and how they intend to go about it, it seems to me that this committee and the Congress would be in a much better position to influence monetary policy. Mr. NoTEs. As I say, I have no objection, but I think you will find that this will not be perhaps quite as productive as you might hope, because of the fact that there is a natural and understandable tendency to assume the best of all worlds in such a project, that is, to assume that all the other right things are done, that peace comes early in Vietnam and that military expenditures can be cut down and so on, so that you get the thing so it fits together with a nice 4 percent real growth trend over the year. PAGENO="0202" 198 And you tend to get the kind of model, to be honest. about it, in the President's Economic Report. It has never, in the time I can remember, said that the country is going to wrack and ruin in the year ahead, because we are doing all the wrong things. It always says there are a few adjustments needed and we are going to make them. Chairman PROXMIRE. The President is elected and he has to look forward to an election perhaps or he has to think with more concern about other people who are up for election much more than the Federal Reserve Board. They are appointed, just one appotntment for 14 years. Under these circumstances, it seems to me they could have more objective critical- Mr. Noi~s. Perhaps. Chairman PRoxMniE. And less political. Mr. Noi-i~s. Perhaps, but again, as I say, as long as you do not. ex- pect too much, I think the presentation of the sort of report you de- scribe is probably a good idea. Chairman PRox~rIRE. Any other observations on that.? I will be right back. Congressman Reuss? Representative REUSS. Thank you. Mr. Chairman. This has been a most useful line of inquiry you have pursued with our witnesses, and a most useful set of hearings. I have read all the papers that have been presented, including the three excellent, papers this morning. I un- fortunately have not been able to get to the hearings until now, but I ant delighted to be able to pursue some of the lines that the Chairman has been pursuing. You three gentlemen and substantially all the other witnesses have said that the monetary policy followed by the Fed ought to be "dis- cretionary", but I do not think that any of you mean by t.hat that it ought to be philosophically chaotic and without any thinking through beforehand by the money managers of what the general guidelines ought `to be. Mr. HART. Oh, no. Representative REuss. By coining out in favor of what is said to be a purely discretionary policy, you are coming out against any arti- ficial oversimplified congressionally legislated mandate, and saying this would not be good, but you are not saying that the Fed should fly by the seat of its pamits or make monetary judgments by reading the entrails of animals. It seems to me actually that the situation is not. unlike the practice of medicine as it existed from the. days of Hippocrates until about 150 years ago, where medical practice was confined mainly to leechi.ng and blood letting, and did more harm than good. It could be that monetary science. is now in the position of medical science several generations ago, and that we are going to have t.o learn as we go. Would you also agree that. by and large the basic record that we. have of monetary management-the published minutes of the Open Market Committee-give us only in the most general terms the ration- a.le of the monetary policy of the Fed, amid panicularly in quantitative terms, it dloes not really tell us very ~nuch? PAGENO="0203" 199 Mr. GAINES. As a matter of fact, Mr. Reuss, for those of us in the private market, whose results are influenced by what the Fed does, we are in the position of having to reacT entrails when we read the statements. Representative REUSS. Yes. I want to return to that point in a minute. I want to pursue that phase of the discussion about which there seems to be some agreement between you and the Chairman just a few minutes ago. It does appear that the purely "money supply, narrowly defined" guideline of the Joint Economic Committee in the last couple of years is oversimplistic, and at least as far as Mr. Gaines is concerned, it tends to concentrate on a result rather than on a cause, that is to say the money supply probably is in large measure the result of the overall credit availability, and hence to define the target in terms of money supply at the very least is picking out one of the less important ele- ments in looking at it. Is that a fair statement of your paper, Mr. Gaines? Mr. GAINES. Yes. Representative REUSS. And actually, both Mr. Hart and Mr. Noyes, in their papers at least, did not violently diverge from your view. Is that fair enough, gentlemen? Mr. NOYES. Yes. As a matter of fact, I indicated in my oral remarks, Congressman, that I really agreed basically with Mr~ Gaines, although I had focused somewhat more narrowly on the money supply, in order to be responsive to the committee's wishes on this occasion. Representative REUSS. About the only thing to be said, I suppose, for the extreme Milton Freedman view of "just lOok at the money supply and nothing else" is that if the money managers do not know what they are doing, there is less capacity for harm, if they do it that way, but really I think we all agree we ought not to necessarily settle for such a regimen. Would it not be possible to do much better than I did in my little essay a couple of months ago to spell out guidelines for Federal Reserve policy? Would it not be possible to refine those draft suggested guideposts to remove from them a couple of points which are probably quite questionable indeed, like the point I had in there on recognizing cost- push inflation, which I think has been pretty well shot down and it is unnecessary to shoot it down again, and by emphasizing a little more clearly than was done, the overall credit aspect of monetary policy. Would it not be possible to construct a set of draft guideposts, and then pro\nide as your last point in the guideposts that whenever the Federal Reserve chances upon a set of circumstances not envisaged by these guideposts, which, due to the ignorance of mortal man, was not possible to put into these guideposts, then it should feel free to diverge from them, but to state clearly the reasons for its divergence, and, to incorporate an idea that was discussed here a moment ago, to report to the Congress and the public every quarter, let's say, on what it had actually done? What about making some progress in that direction? Why is that not useful? Mr. HART. I think it is. PAGENO="0204" 200 Mr. GAINES. Mr. Reuss, I think it wou~d be useful as a first approxi- mation of the sort of measure that you ar~ working toward. It might be useful for the Congress to ask the Federal Reserve. System, in recog- nition of the responsibility the Congress does have in this area, to propose the sore of guidelines, the framework of guidelines within which they would report to the Congress. Representative REUSS. In a. sense that was what I was trying to start in our Economic Report of this year. when I took a stab at. it. in my supplemental views, and sent it to the Fed. You no doubt have read the Fed's comments on it., and also Mr. Mitchell's interesting testimony of yesterday. Many of the Fed's comments a.re well taken. Some points I had in there deserved to be shot down and were. But we still do not know what the Fed's policy is, and it would seem to me, to take up Mr. Gaines' suggestion, t.hat it would be fa.ir enough to ask the Fed, all seven Governors, to come back to us with a com- posite ~batement of what. they think the rules wherein they shall walk should be. Mr. GAINES. Yes. Representative REUSS. With t.he exit clause for unforeseen contin- gencies that I have mentioned. Mr. GAINES. The people in the Fed would be the first ones to deny that they understand fully the exact way the financial flow process in this country works. On the other ha.nd, they have expended a. great deal of excellent talent in their linkage studies and in the development of the MIT model. Representative R.EUSS. The MIT study? Mr. GAINES. Yes. Representative REuss. That is most important. Mr. GAINES. I would think they would a.t. least be able t.o suggest to you the kinds of guidelines in terms of credit flow and credit growth, as related to money supply and the re.st, that would be appropriate, for congressional interest. Representative REUSS. Of it they cannot so respond, if they have to say back to the joint Economic Committee, "Look, gentlemen, very frankly we are in the position that physicians were in in the 18th cen- tury and we do not really know whether our ministrations are helping or hurting the economy," then it would be fair for us to come hack and sa.y, `~Well, this is a. frank admission, a.nd until you do, until the MIT-Fed study is more in hand and those equations are more properly plugged in, why do you not just do like Freedman suggests, more or less, perhaps with a. little wide.r hand?" Would that be a fa.ir rejoinder, if they come in saying. "Look, frankly, we do not know what we are doing"? Mr. GAINES. I think that if the state of knowledge is not yet suf- ficient for them to provide a. more sophistica.ted framework, that. money stock would be an acceptable first approximation. It at least. does get Congress involved in the process. Chairman PR0XMIRE. I would be a little afraid. if the Congressman would yield `at this point, they would come back with a really sophisti- ca.ted combination which they would make sure that. very few outside of maybe Congressman Reuss anti a few others would understand, and they would have a. terrible. `time explaining it to anybody. PAGENO="0205" 201 Mr. HART. I was just going to say, Congressman, I do not think they would come back and tell you that they do not know what they are doing, but if they did, I think I would feel a lot happier if you had a broader set of parameters than just this money-supply concept. Where do you fit CD's into the picture? I do not know. I have often wondered. I would rather see a broader set, including reserve changes, a system tha;t gives a broader purview of the whole credit market. Otherwise, I doubt if their reports are going to mean very much to you. Representative REUSS. I am with you. I wrestled with the angel through the night myself on this one, and if I could have done better, I would. Let me at this point ask, and I will only assign this task to those who volunteer it, would any of you gentlemen be willing to take a crack at evolving a `set of parameter type guideposts that we could keep in our pocket here until such time as the Fed caine back to use with its proposal? I do feel, very frankly, that the essay I attempted a couple of months ago could usefully be edited and expanded to include specifically more reference to total credit than it does. Would anybody be willing to try another essay, just `speaking for himself? Mr. GAINES. I think I speak for all of us whenl say that staff limita- tions, if nothing else, would make it presumptuous for us to try to summarize the work that has been done within the Federal Reserve. More properly, this should come from the Federal Reserve. I am not trying to `beg off on it. Representative REUSS. Perhaps we could come `back at you three after we have received a response from the Fed. Mr. GAINES. Yes. Representative REU5s. Because there is no dou'bt they are doing some of the pioneering work, particularly ir1 conjunction with MIT. Mr. HART. Th'at is right. Representative REIJSS. Let me now raise a subject that is of interest to all you three gentlemen. In saying that the Fed's open-market policy minutes are oftentimes delphic, and give the people in the market like yourselves quite a task of interpretation, you have touched on another important aspect of Federal Reserve communication. \~,That is there to be said, if anything, for the apologia you sometimes hear from the Fed, mostly unofficially, which runs something like this: "We have to be cryptic and delphic, or we will help speculators, and~ counterproductive movements will be set in train." I have never really understood or believed in that apologia. It seems to me that if the Fed agreed on and published some rather clear' parameter-type guideposts, you people who operate in the money market or near the money market could, of course, have a better idea of what the Fed is doing, but that your resulting actions would not necessarily be counter to the public interest. I do not exactly see the Fed's point. Woul~d somebody comment on that? Mr. Nox~s. I have not said anything for a while. I might as well get into the act. PAGENO="0206" 202 I think sometimes System officials put too much weight on this point. Of course, again you can go to extremes, clearly you do not want. the room bugged and have three people in the financial community listen- ing to the bug and not the others. This would create just the problem you suggest. As long as you do not push disclosure too far, secrecy does not make much sense. There is a problem though that I wanted to comment on as you were speaking. I am acutely conscious of it because of my long pe.riod inside the Federal Reserve. You do have to remember that you are talking about 12 people, when you ask, c~WTl~at does the Fed think?" It's just as if you were talking about the much larger number in Congress, and ask, "Why did the Congress do something?" You get into great difficulty summarizing it. The Congress has not refused to act on taxes for any one reason. Each Congressman had his own views and his own reasons for not acting. I have participated in many Federal Reserve meetings, an honest summary of which might go something like this: One man would say, "I think we ought to have a. higher rate of monetary expansion because I am concerned about what is happening in the housing industry, and I think this is a good and sufficient reason. With all of the problems we have in our cities, going to 6 percent mon- etary expansion instead of S in this period is justified on housing grounds alone." And somebody else would say, "Well, I think we ought. to go to 6 percent too, but I am not a bit worried about housing. The thing that concerns me is that if we hold it at 5, we will have disorderly conditions in the money market." You come to the next fellow and he says, "I am a farmer and inter- est rates are already 7 percent and I think any time they are over 6 percent, money is too tight and we ought to ease up so I am for a higher rate of expansion too." Finally you come to still anot.her one, and he says. "Well. I happen to think that I have unusually good foresight, and that the lagged effect of the present policy is going to hit right in the middle of a recession, which I see 6 months ahead. So I am also going to vote for a higher rate." Then you look to the poor secretary down at the end of the table and say, "Now summarize in a few clear, specific words why it was that we went to a 6-percent rate of monetary expansion instead of a 5-percent." Each fellow had his own reasons. It is awfully hard to make a non- monolithic group talk with a single clear voice. Representative REuss. My point was not to kill the piano player, or to fire the secretary. He does the best he can, poor fellow-or poor girl. But my difficulty is the lack of any overall philosophical framework in which the money managers in their triweekly meetings seem to move. Maybe they have one, and it is not revealed, but I certainly do not know. Mr. Nor~s. What I am saying is that much of the time they do not have a single clear specific reason for t.heir action that they all agree upon. When he was a member of the Open Market Committee. Mr. Mal- colm Bryan, then president of the Federal Reserve Bank of Atlanta, used to have a. measure of total reserve growth, which he spoke about PAGENO="0207" 203 at every meeting and he often explained his vote specifically in terms of this indicator of Federal Reserve policy. But you could not say that the Federal Reserve policy was being directed to obtain a specific rate of total reserve growth. This was just Mr. Bryan's indicator, which he liked and in which he often found sufficient reason for his contribution to the total vote. Representative REUSS. Of course I think Congress and the public has the right to know the inputs into this process. If, for instance, there is a man aboard the ship today who is apply- ing this-and this is one-twelfth of the voting power-we ought to know it. We also ought to know what the agreement or lack of agreement there is on the part of members of the Open Market Committee. Mr. No~s. I understand; and I am very sympathetic. Representative REUSS. If, and I am purely guessing, three of them follow a "look at the money supply" view, three of them follow a "look at interest rates" view, and six of them follow a "look at credit" view, and they factor it out on a 6-3-3 basis; we ought to know that, and we do not. Until we do, Congress has delegated the constitutional power to coin money and regulate the value thereof, without giving the slightest guidelines to the coiners of money and regulators of the value thereof. Mr. GAINES. Mr. Reuss, I think one reason why any statement from the Federal Reserve has the impact that it `does is because there are so few intelligible statements. We have all become accustomed to reading these entrails, taking each comma seriously when we see the minutes of the Open Market Committee. Obviously, something more can be done. Initially it might have an upsetting effect, but once we got accustomed to them speaking more openly, I think we would not react too badly. However, it would be absolutely impossible and I think irresponsible to go the full way in making available to the public or to the Congress the detailed minutes of each meeting. For example, Mr. Coombs from the New York Fed, in reporting on the foreign exchange market, has to say things he does not want to get outside of that room. Representative REUSS. Let me interrupt and say I completely agree with you. All that I was talking about was a set of self-governing ordinances to be adopted by the Fed, and subject to change in the light of current further learning, so that we put them through the same intellectual drill that we are putting ourselves through, and also so that the public, and particularly the concerned public, can know what the rules of the game are. Mr. HART. I would agree. I think that if there are times when the votes of the Board members and the Open Market Committee are as widely diversified as Jack has just suggested in his example, we certain ought to know it. Mr. Noi~s. But you will recall the the outcome of my imaginary vote was 4 to 0. Everybody wanted to increase the money supply growth rate from five to six. But they `had a different reason, which each felt was the most important reason for it. I was purposely show- ing there was no divergence at all in the outcome, each person felt the really important reason for doing it was different. Chairman Pnoxi~rniE. May I interrupt at this point? PAGENO="0208" 204 You know the committees of Congress have the same problem. We have committee reports we have to make, and we are as diverse as the members of the Federal Reserve Board, perhaps more so, we come from differeitt parts of the country. We have different viewpoints. \Ve represent different parties and different ideological approaches within the parties and yet we do have majority and minority reports and very often they are unanimous, and we find tha.t the staff of course in most cases will write the report, and members of the committee will try to subscribe to it. If they have a difference that is very important., they might state that as a minority view Mr. NOYES. That is very close to what the Federal Reserve policy record is now. Chairman Pnox~rimt. This would be very useful. I do not. imow if that is what Congressman Reuss had in mind, but it seems to me if they could get together on a statement to which they could all subscribe expressing their philosophy and t.heir reasons, and free of course to put in the minority view, to indicate if something is extraordinarily important and the reason that they subscribe to the increase or de- crease, this would be very usefuL What I am saying is that it is not at all really difficult. Human beings have to do this all the time, the Supreme Court and so on. It can be done and it seems to me extraordinarily useful to us. Mr. NOYES. It is done in the policy record, but the language gets so fussy that you `do not like it and I do not like it., and I guess nobody likes it. Representative REUSS. During your absence, Mr. Chairman, I have had a fine opportunity to explore on a. "where do we. go from here basis" with the members of the panel, and the consensus seems to be that this committee ntight well usefully go on front here by asking the Fed' to articulate wha.t its guideposts are in as quantitative terms as possible, and indicating whether the.re are any disagreements among the inem~bers of the Board of Governors and the ntentbers of the Open Market Committee over that articulation, and that we then examine it and perhaps on trial basis and with quarterly reports see how it. is working in application. Whatever articulation there is would have an open end exit clause, so that. if new factors came into play, the Fed could do what. it thought ha.d to be done. Chairman PRox~rInE. I think that. is very good. That is along the line that I was suggesting before. WTe suggest stepping in because you have to get into the water in some way or another, get. the. money supply, the range, let them comment on it., refine. and improve it.. and as long as it is done in a way that will increase our understanding rather than obscure it. Thank you very, very much, gentlemen. I do want to say I welconte all of you. Mr. Noyes happens to work for a company for which I worked. Mr. NoYEs. I am aware of that. Chairman PROXMIRE. I was a J. P. Morgan associate and was paid the magnificent salary of $25 a week. Mr. NOYES. It has gone up since then. PAGENO="0209" 205 Chairman PROXMIRE. I am glad to hear that. I came to them with two degrees, one from Yale and one from Harvard, and I was worth $25 a week to them. I hope you are doing better. I am sure you are. Mr. No~s. The people who come to them with the credentials you have are, I can assure you. Chairman PR0XMIRE. Before we adjourn, I have some comments to go along with additional materials to be included in the record. Since Prof. Milton Friedman's name has been mentioned so frequently during these hearings, I think it appropriate to note that we invited him to appear at these hearings but were unable to work out mutual satisfactory timing. I would like, however, to include in the record Professor Friedman's presidential address delivered to the 80th Annual Meeting of the American Economic Association last winter which is entitled "The Role of Monetary Policy." I think this will add a great deal to our record as a recent restatement of his position. Useful also, I believe, would be an article from the bulletin of the Federal Reserve Bank of New York of March 1968 entitled "Lags in Monetary and Fiscal Policy" by Mark H. Willes. I would like to include in the record a recent address by Prof. Robert Weintraub Also included, of course, are the materials supplied to the Joint Economic Committee by the Federal Reserve System which served as background materials for these hearings. 94-340-68-------14 PAGENO="0210" THE ROLE OF MONETARY POLICY5 By Milton Friedthan55 There is wide agreement about the major goals of economic policy: high employment, stable prices, and rapid growth. There is less agreement that these goals are mutually compatible or, among those who regard them as incompatible. about the terms at which they can and should be substituted for one another. There is least agreement about the role that various instruments of policy can and should play in achieving the several goals. My topic for tonight is the role of one such instrument-monetary policy. What can it contribute? And how should it be conducted to contribute the most? Opinion on these questions has fluctuated widely. In the first flush of enthusiasm about the newly created Federal Reserve System, many observers attributed the relative stability of the 1920s to the System's capacity for fine tuning-to apply an apt modern term. It came to be widely believed that a new era had arrived in which business cycles had been rendered obsolete by advances in monetary technology. This opinion was shared by economist and layman ~1,ike, though, of course, there were some dissonant voices. The Great Contraction destroyed this naive attitude. Opinion swung to the other extreme. Monetary policy was a string. You could pull on it to stop inflation but you could not push on it to halt recession. You could lead a horse to water hut you could not make him drink. Such theory by aphorism was soon replaced by Keynes rigorous and sophisticated analysis. Keynes offered simultaneously an explanation for the presumed impotence of monetary policy to stem the depression, a nonmonetary interpretation of the de- pression, and an alternative to monetary policy for meeting the depression and lii's offering was avidly accepted. If liquidity preference is absolute or nearly so- as Keynes believed likely in times of heavy unemployment-interest rates cannot be lowered by monetary measures. If investment and consumption are little affected by interest rates-as Hansen and many of Keynes' other American disciples came to believe-lower interest rates, even if they could be achieved. would do little good. Monetary policy is twice damned. The contraction, set in train, on this view, by a collapse of investment or by a shortage of investment opportunities or by stubborn thriftiness, could not, it was argued. have been stopped by monetary measures. But there was available an alternative-fiscal policy. Government spending could make up for insufficient private investment. Tax reductions could undermine stubborn thriftiness. The w-ide acceptance of these views in the economics profession meant that for some two decades monetary policy was believed by all but a few reactionary souls to have been rendered obsolete by new economic knowledge. Money did not matter. Its only role was the minor one of keeping interest rates low, in order to hold down interest payments in the government budget, contribute to the "euthanasia of `the rentier," and maybe, stimulate investment a bit to assist government spend- ing in maintaining a high level of aggregate demand. These views produced a widespread adoption of cheap money policies after the war. And they received a rude shock when `these policies failed in country after country, when central bank after central bank was forced to give up the pretense that it could indefinitely keep "the" rate of interest at a low level. In this country. the public denouncement came with the Federal Reserve-Treasury Accord in 1951. although the policy of pegging government bond prices was not formally aban- doned until 1953. Inflation, stimulated by cheap money policies, not the widely heralded postwar depression, turned out to be the order of the day. The result was the beginning of a revival of belief in the potency of monetary policy. tPresidentlal address delivered at the Eightieth Annual Meeting of the American Eco- nomic Association, Washington, D.C., December 29, 1967. ~I am indebted for helpful criticisms of earlier drafts to Armen Alchian, Gary Becker, Martin Bronfenbrenner, Arthur F. Burns, Phillip Cagan, David D. Friedman, Lawrence Harris, Harry G. Johnson, Homer Jones, Jerry Jordan, David Meiselman. Allan H. Meltzer. Theodore W. Schultz, Anna J. Schwartz, Herbert Stein, George J. Stigler, and James Tobin. (206) PAGENO="0211" 207 This revival was strongly fostered among economists by the theoretical devel- opments initiated by Haberler but named for Pigou that pointed out a channel- namely, changes in wealth-whereby changes in the real quantity of money can affect aggregate demand even if they do not alter interest rates. These theoretical developments did not undermine Keynes' argument against the potency of ortho- dox monetary measures when liquidity preference is absolute since under such circumstances the usual monetary operations involve simply substituting money for other assets without changing total wealth. But they did show how changes in the quantity of money produced in other ways could affect total spending even under such circumstances. And, more fundamentally, they did undermine Keynes' key theoretical proposition, namely, that even in a world of flexible prices, a position of equilibrium at full employment might not exist. Henceforth, unem- ployment had again to be explained by rigidities or imperfections, not as the natural outcome of a fully operative market process. The revival of belief in the potency of monetary policy was fostered also by a re-evaluation of the role money played from 1929 to 1933. Keynes and most other economists of the time believed that the Great Contraction in the United States occurred despite aggressive expansionary policies by the monetary authorities- that they did their best but their best was not good enough.1 Recent studies have demonstrated that the facts are precisely the reverse: the U.S. monetary authori- ties followed highly deflationary policies. The quantity of money in the United States fell by one-third in the course of the contraction. And it fell not because there were no w-illing borrowers-not because the horse would not drink. It fell because the Federal Reserve Sysitem forced or permitted a sharp reduction in the monetary base, because it failed to exercise the responsibilities assigned to it in the Federal Reserve Act to provide liquidity to the banking system. The Great Contraction is tragic testimony to the power of monetary policy-not, as Keynes and so many of his contemporaries believed, evidence of its impotence. Jn the United States the revival of belief in the potency of monetary policy was strengthened also by increasing disillusionment with fiscal policy, not so much with its potential to affect aggregate demand as with the practical and political feasibility of so using it. Expenditures turned out to respond sluggishly and with long lags to attempts to adjust them to the course of economic activity, so empha- sis shifted to taxes. But here political factors entered with a vengeance to prevent prompt adjustment to presumed need, as has been so graphically illustrated in the months since I wrote the first draft of this talk. "Fine tuning" is a marvel- ously evocative phrase in this electronic age, but it has little resemblance to what is possible in practice-not, I might add, an unmixed evil. It is hard to realize how radical has been the change in professional opinion on the role of money. Hardly an economist today accepts views that were the com- mon coin some two decades ago. Let me cite a few examples. In a talk published in 1945, E. A. Goldenweiser, then Director of the Research Division of the Federal Reserve Board, described the primary objective of mone- tary policy as being to "maintain the value of Government bonds. . . . This country" he wrote, "will have to adjust to a 21/2 percent interest rate as the return on safe, long-time money, because the time has come when returns on pioneering capital can no longer be unlimited as they were in the past" [4, p. 117]. In a book on Financing American Prosperity, edited by Paul Homan and Fritz l%iachlup and published in 1945, Alvin Hansen devotes nine pages of text to the "savings-investment problem" without finding any need to use the words "interest rate" or any close facsimile thereto [5, pp. 218-27]. In his contribution to this volume, Fritz Machiup wrote, "Questions regarding the rate of interest, in par- ticular regarding its variation or its stability, may not be among the most vital problems of the postwar economy, but they are certainly among the perplexing ones" [5, p. 466]. In his contribution, John H. Williams-not only professor at Harvard but also a long-time adviser to the New York Federal Reserve Bank- wrote, "I can see no prospect of revival of a general monetary control in the postwar period" [5, p. 383]. Another of the volumes dealing with postwar policy that appeared at this time, Planning and Paying for Full Employment, was edited by Abba P. Lerner and Frank D. Graham [6] and had contributors of all shades of professional opin- ion-from Henry Simons and Frank Graham to Abba Lerner and Hans Neisser. Yet Albert Halasi, in his excellent summary of the papers, was able to say, 1 In [2J, I have argued that Henry Simons shared this view with Keynes and that It accounts for the policy changes that he recommended. PAGENO="0212" 208 "Our contributors do not discuss the question of money supply. . . . The con- tributors make no special mention of credit policy to remedy actual depressions. Inflation . . . might be fought more effectively by raising interest rates. But . . . other anti-inflationary measures . . . are preferable" [6 pp. 23-24]. A ~nrvey of Coittemporary Economics, edited by Howard Ellis and pub- lished in 1948, was an "official" attempt to codify the state of economic thought of the time. In his contribution, Arthur Smithies wrote, "In the field of com- pensatory action, I believe fiscal policy must shoulder most of the load. Its chief rival, monetary policy, seems to be disqualified on institutional grounds. This country appears to be committed to something like the present low level of in- terest rates on a long-term basis" [1, p. 208]. These quotations suggest the flavor of professional thought some two decades ago. If you wish to go further in t.his bumbling inquiry, I recommend that you compare the sectons on money-when you can find them-in the Principles texts of the early postwar years, with the lengthy sections in the current crop even, or especially, when the early and recent Principles are different editions of the same work. The pendulum has swung far since then, if not all the way to the position of the late 1920s, at least much closer to that position than to the position of 1945. There are of course many differences between then and now, less in the potency attributed to monetary policy than in the roles assigned to it and the criteria by which the profession believes monetary policy should be guided. Then, the chief roles assigned monetary policy were to promote price stability and to preserve the gold standard; the chief criteria of monetary policy were the state of the "money market," the extent of "speculation" and the movement of gold. Today, primacy is assigned to the promotion of full employment, with the pre- vention of inflation a continuing but definitely secondary objective. And there is major disagreement about criteria of policy, varying from emphasis on money market conditions, interest rates, and the quantity of money to the belief that the state of employment itself should be the proximate criterion of policy. I stress nonetheless the similarity between the views that prevailed in the late `twenties and those that prevail today because I fear that, now as then, the pendulum may u-eli have swung too far, that. now as then, we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and, as a result, in danger of preventing it from making the contribution that it is capable of making. Unaccustomed as I am to denigrating the importance of money, I therefore shall, as my first task, stress what monetary policy cannot do. I shall then try to outline what it can do and how it can best make its contribution, in the present state of our knowledge-or ignorance. I. WHAT MOxETARY POLICY CANNOT DO From the infinite world of negation, I have selected two limitations of mone- tary policy to discuss: (1) It cannot peg interest rates for more than very limited periods; (2) It cannot peg the rate of unemployment for more than very limited periods. I select these because the contrary has been or is widely be- lieved, because they correspond to the two main unattainable tasks that are at all likely to be assigned to monetary policy, and because essentially the same theoretical analysis covers both. Pegging of Interest Rates History has already persuaded many of you about the first limitation. As noted earlier, the failure of cheap money policies was a major source of the re- action against simpleminded Keynesianism. In the United States, this reaction- involved w-idespread recognition that the wartime and postwar pegging of bond prices was a mistake, that the abandonment of this policy u-as a desirable and inevitable step, and that it had none of the disturbing and disastrous con- sequences that were so freely predicted at the time. The limitation derives from a much misunderstood feature of the relation be- tween money and interest rates. Let the Fed set out to keep interest rates down. How will it try to do so? By buying securities, This raises their prices and lowers their yields. In the process, it also increases the quantity of reserves available to banks, hence the amount of bank credit, and, ultimately the total quantity of money. That is why central bankers in particular, and the financial community more broadly, generally believe that an increase in the quantity of money tends PAGENO="0213" 209 to lower interest rates. Academic economists accept the same conclusion, but for different reasons. They see, in their mind's eye, a negatively sloping liquidity preference schedule. How can people be induced to hold a larger quantity of money? Only by bidding down interest rates. Both are right, up to a point. The initial impact of increasing the quantity of money at a faster rate than it has been increasing is to make interest rates lower for a time than they would otherwise have been. But this is only the beginning of the process not the end. The more rapid rate of monetary growth will stimulate spending, both through the impact on investment of lower market interest rates and through the impact on other spending and thereby relative prices of higher cash balances than are desired. But one man's spending is another man's income. Rising income will raise the liquidity preference schedule and the demand for loans; it may also raise prices, which would reduce the real quantity of money. These three effects will reverse the initial downward pressure on interest rates fairly promptly, say, in something less than a year. Together they will tend, after a somewhat longer interval, say, a year or two, to return interest rates to the level they would otherwise have had. Indeed, given the tendency for the economy to overreact, they are highly likely to raise interest rates temporarily beyond that level, setting in motion a cyclical adjustment process. A fourth effect, when and if it becomes operative, will go even farther, and definitely mean that a higher rate of monetary expansion will correspond to a higher, not lower, level of interest rates than would otherwise have prevailed. Let the higher rate of monetary growth produce rising prices, and let the public come to expect that prices will continue to rise. Borrowers will then be willing to pay and lenders will then demand higher interest rates-as Irving Fisher pointed out decades ago. This price expectation effect is slow to develop and also slow to disappear. Fisher estimated that it took several decades for a full adjustment and more recent work is consistent with his estimates. These subsequent effects explain why every attempt to keep interest rates at a low level has forced the monetary authority to engage in successively larger and larger open market purchases. They explain why, historically, high and rising nominal interest rates have been associated with rapid growth in the quantity of money, as in Brazil or Chile or in the United States in recent years, and why low and falltng interest rates have been associated with slow growth in the quantity of money, as in Switzerland now or in the United States from 1929 to 1933. As an empirical matter, low interest rates are a sign that monetary policy has been tight-in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy-in the sense that the quantity of money has grown rapidly. The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted. Paradoxically, the monetary authority could assure low nominal rates of inter- est-but to do so it would have to start out in what seems like the opposite direc- tion, by engaging in a deflationary monetary policy. Similarly, it could assure high nominal interest rates by engaging in an inflationary policy and accepting a temporary movement in interest rates in the opposite direction. These considerations not only explain why monetary policy cannot peg interest rates: they also explain why interest rates are such a misleading indicator of whether monetary policy is "tight" or "easy." For that, it is far better to look at the rate of change of the quantity of money.2 Employment as a Criterion of Policy The second limitation I wish to discuss goes more against the grain of current thinking. Monetary growth, it is widely held, will tend to stimulate employment; monetary contraction, to retard employment. Why, then, cannot the monetary authority adopt a target for employment or unemployment-say, 3 percent unemployment; be tight when unemployment is less than the target; be easy when unemployment is higher than the target; and in this way peg unemploy- inent at, say, 3 percent? The reason it cannot is precisely the same as for interest rates-the difference between the immediate and the delayed consequences of such a policy. 2 This is partly an empirical not theoretical judgment. In principle, "tightness" or "ease" depends on the rate of change of the quantity of money supplied compared to the rate of change of the quantity demanded excluding effects on demand from monetary policy itself. However, empirically demand is highly stable, if we exclude the effect of monetary policy, so it is generally sufficient to look at suppy alone. PAGENO="0214" 210 Thanks to Wicksell, we are all acquainted with the concept of a "natural" rate of interest and the possibility of a discrepancy between the "natural" and the "market" rate. The preceding analysis of interest rates can be translated fairly directly into Wicksellian terms. The monetary authority can make the market rate less than the natural rate only by inflation. It can make the market rate higher than the natural rate only by deflation. We have added only one wrinkle to Wicksell-the Irving Fisher distinction between the nominal and the real rate of interest. Let the monetary authority keep the nominal market rate for a time below the natural rate by inflation. That in turn will raise the nominal natural rate itself, once anticipations of inflation become widespread, thus requiring still more rapid inflation to hold down the market rate. Similarly. because of the Fisher effect, it will require not merely deflation but more and more rapid deflation to hold the market rate above the initial "natural" rate. This analysis has its close counterpart in the employment market. At any moment of time, there is some level of unemployment which has the property that it is consistent with equilibrium in the structure of real wage rates. At that level of unemployment, real wage rates are tending on the average to rise at a "normal" secular rate, i.e., at a rate that can be indefinitely maintained so long as capital formation, technological improvements. etc.. remain on their long- run trends. A lower level of unemployment is an indication that there is an excess demand for labor that will produce upward pressure on real wage rates. A higher level of unemployment is an indication that there is an excess supply of labor that will produce downward pressure on real wage rates. The "natural rate of unemployment," in other words, is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is im. bedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor avail- abilities, the costs of mobility, and so on.3 You will recognize the close similarity between this statement and the cele- brated Phillips Curve. The similarity is no coincidental. Phillips' analysis of the relation between unemployment and wage change is deservedly celebrated as an important and original contribution. But, unfortunately. it contains a basic defect-the failure to distinguish between nominal wages and real wages-just as Wicksell's analysis failed to distinguish between nominal, interest rates and real interest rates. Implicity, Phillips wrote his article for a world in which everyone anticipated that nominal prices would be stable and in which that anticipation remained unshaken and immutable whatever happened to actual prices and wages. Suppose, by contrast, that everyone anticipates that prices will rise at a rate of more 75 per cent a year-as, for example, Brazillians did a few years ago. Then wages must rise at that rate simply to keep real wages unchanged. An excess supply of labor w-ill be reflected in a less rapid rise in nominal wages than in anticipated prices.4 not in an absolute decline in wages. When Brazil embarked on a policy to bring down tile rate of price rise, and suc- ceeded in bringing the price rise down to about 4.5 per cent a year. there was a sharp initial rise in unemployment because under the influence of earlier antici- pations, wages kept rising at a pace that was higher than the new rate of price rise, though lower than earlier. This is the result experienced, and to be expected. of all attempts to reduce the rate of inflation below that widely anticipated.5 It is perhaps worth noting that this "natural" rate need not correspond to equality between the number unemployed and the number of job vacancies. For any given structure of the labor market, there will be some equilibrium relation between these two magnitudes. but there is no reason why it should be one of equality. Strictly speaking, the rise in nominal wages will be less rapid than the rise in antici- pated nominal wages to make allowances for any secular changes in real wages. 5'Stated in terms of the rate of change of nominal wages, the Phillips Curve can be expected to be reasonably stable and well defined for any period for which the arerage rate.of change of prices, and hence the anticipated rate. has been relatively stable. Fr.r such periods, nominal wages and "real" wages move together. Curves computed for differ- ent periods or different countries for each of which this condition has been satisfied will differ in level, the level of the curve depending on what the average rate of price change was. The higher the average rate of price change, the higher will tend to be the level of the curve. For periods or countries for which the rate of change of prices varies consider- ably, the Phillips Curve will not be well defined. My impression is that these statements accord reasonably well with the experience of the economists who have explored empirical Phillips Curve. Restate Phillips' analysis In terms of the rate of change of real wages-and even more precisely, anticipated real wages-and it all falls into place. That Is why students of empirical Phillips Curves have found that it helps to include the rate of change of the price level as an independent variable, PAGENO="0215" 211 To avoid misunderstanding, let me emphasize that by using the term "natural" rate of unemployment, I do not mean to suggest that it is immutable and unchangeable. On the contrary, many of the market characteristics that determine its level are man-made and policy-made. In the United States, for example, legal minimum wage rates, the Walsh-Healy and Davis-Bacon Acts, and the strength of labor unions all make the natural rate of unemployment higher that it would otherwise be. Improvements in employment exchanges, in availability of infor- mation about job vacancies and labor supply, and so on, would tend to lower the natural rate of unemployment. I use the term "natural" for the same reason Wicksell did-to try to separate the real forces from monetary forces. Let us assume that the monetary authority tries to peg the "market" rate of unemloyment at a level below the "natural" rate. For definiteness, suppose that it takes 3 per cent as the target rate and that the "natural" tate is higher than 3 per cent. Suppose also that we start out at a time when prices have been stable and when unemployment is higher than 3 per cent. Accordingly, the authority increases the rate of monetary growth. This will be expansionary. By making nominal cash balances higher than people desire, it will tend initially to lower interest rates and in this and other ways to stimulate spending. Income and spending will start to rise. To begin with, much or most of the rise in income will take the form of an increase in output and employment rather than in price. People have been expecting prices to be stable, and prices and wages have been set for some time in the future on that basis. It takes time for people to adjust to a new state of demand. Producers will tend to react to the initial expansion in aggregate demOnd by increasing output, employees by working longer hours, and the unemployed, by taking jobs now offered at former nominal wages. This much is pretty standard doctrine. But it describes only the initial effects. Because selling prices of products typically respond to an unanticipated rise in nominal demand faster than prices of factors of production, real wages received have gone down-ithrough real wages anticipated by employees went up, since employees implicitly evaluated the wages offered at the earlier price level. Indeed, the simultaneous fall cx post in real wages to employers and rise cx ante in real wages tO employees is what enabled employment to increase. But the decline cx post in real wages will soon come to affect anticipations. Employees will start to, reckon on rising prices Of the things they buy and to demand higher nominal wages for the future. "Market" unemployment is below the "natural" level. There is an excess demand for labor so real wages will tend to rise toward their initial level. Even though the higher rate of monetary growth continues, the rise in real wages will reverse the decline in unemployment, and then lead to a rise, which will tend to return unemployment to its former level. In order to keep unemploy- ment at its target level of 3 per cent, the monetary authority would have to raise monetary growth still more. As in the interest rate case, the "market" rate can be kept below the "natural" rate only by inflation. And, as in the interest rate case, too, only by accelerating inflation. Conversely, let the monetary authority choose a target rate of unemployment that is above the natural rate, and they will be led to produce a deflation, and an accelerating deflation at that. What if the monetary authority chose the "natural" rate-either of interest or unemployment-as its target? One problem is that it cannot know what the "natural" rate is. Unfortunately, we have as yet devised no method to estimate accurately and readily the natural rate of either interest or unemployment. And the "natural" rate will itself change from time to time. But the basic problem is that even if the monetary authority knew the "natural" rate, and attempted to peg the market rate at that level, it would not be led to a determine policy. The "market" rate will vary from the natural rate for all sorts of reasons other than monetary policy. If the monetary authority responds to these variations, it will set in train longer term effects that will make any monetary growth path it follows ultimately consistent with the rule of policy. The actual course of mone- tary growth will be analogous to a random walk, buffeted this way and that by the forces that produce temporary departures of the market rate from the natural rate. To state this conclusion differently, there is always, a temporary trade-off between inflation and unemployment; there is no permanent trade-off. The tem- porary trade-off comes not from inflation per Se, but from unanticipated inflation, which generally means, from a rising rate of inflation. The widespread belief that there is a permanent trade-off is a sophisticated version of the confusion between PAGENO="0216" 212 "high" and "rising" that we all recognize in simpler forms. A rising rate of infla- tion may reduce unemployment, a high rate will not. But how long, you will say, is "temporary"? For interest rates, we have some systematic evidence on how long each of the several effects takes to work itself out. For unemployment, we do not. I can at most venture a personal judgment, based on some examination of the historical evidence, that the initial effects of a higher and unanticipated rate of inflation last for something like two to five years; that this initial effect then begins to be reversed; and that a full adjustment to the new rate of inflation takes about as long for employment as for interest rates, say, a couple of decades. For both interest rates and employment, let me add a qualifica- tion. These estimates are for changes in the rate of inflation of the order of magnitude that has been experienced in the United States. For much more sizable changes, such as those experienced in South American countries, the whole ~tdjustment process is greatly speeded up. To state the general conclusion still differently, the monetary authority controls nominal quantities-directly, the quantity of its own liabilities. In principle, it can use this control to peg a nominal quantity-an exchange rate, the price level, the nominal level of national income, the quantity of money by one or another definition-or to peg the rate of change in a nominal quantity-the rate of in- flation or deflation, the rate of growth or decline in nominal national income, the rate of growth of the quantity of money. It cannot use its control over nominal quantities to peg a real quantity-the real rate of interest, the rate of unemploy- ment, the level of real national income, the real quantity of money, the rate of growth of real national income, or the rate of growth of the real quantity of money. II. WHAT MONETARY POLICY CAN DO Monetary policy cannot peg these real magnitudes at predetermined levels. But monetary policy can and does have important effects on these real magnitudes. The one is in no way inconsistent with the other. My own stiidies of monetary history have made me extremely sympathetic to the oft-quoted, much reviled, and as widely misunderstood, comment by John Stuart Mill. "There cannot. . . ," he wrote, "be intrinsically a more insignificant thing, in the economy of society, than money; except in the character of a con- trivance for sparing time and labour. It is a machine for doing quickly and com- modiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and inde- pendent influence of its own when it gets out of order" [7, p. 488]. True, money is only a machine, but it is an extraordinarily efficient machine. Without it, we could not have begun to attain the astounding growth in output and level of living we have experienced in the past two centuries-any more than we could have done so without those other marvelous machines that dot our countryside and enable us, for the most part, simply to do more efficiently what could be done without them at much greater cost in labor. But money has one feature that these other machines do not share. Because it is so pervasive, when it gets out of order, it throws a monkey wrench into the operation of all other machines. The Great Contraction is the most dramatic example but not the only one. Every other major contraction in this country has been either produced by monetary disorder or greatly exacerbated by monetary disorder. Every major inflation has been produced by monetary expansion- mostly to meet the overriding demands of war which have forced the creation of money to supplement explicit taxation. The first and important lesson that history teaches about what monetary policy can do-and it is a lesson of the most profound importance-is that mone- tary policy can prevent money itself from being a major source of economic disturbance. This sounds like a negative proposition: avoid major mistakes. In part it is. The Great Contraction might not have occurred at all, and if it had. it would have been far less severe, if the monetary authority had avoided mis- takes, or if the monetary arrangements had been those of an earlier time when there was no central authority with the power to make the kinds of mistakes that the Federal Reserve System made. The past few years, to come closer to home. w-ould have been steadier and more productive of economic well-being if the Foderal Reserve had avoided drastic and erratic changes of direction, first ex- panding the money supply at an unduly rapid pace. then, in early I9@~, stepping on the brake too hard, then, at the end of 1966. reversing itself and resuming ex- pansion until at least November. 1967, at a more rapid pace than can long be maintained without appreciable inflation. PAGENO="0217" 213 Even if the proposition that monetary policy can prevent money itself from being a major source of economic disturbance were a wholly negative proposition, it would be none the less important for that. As it happens, however, it is not a wholly negative proposition. The monetary machine has gottea out of order even when there has been no central authority with anything like the power now possessed by the Fed. In the United States, the 1907 episode and earlier banking panics are examples of how the monetary machine can get out of order largely on its own. There is therefore a positive and important task for the monetary authority-to suggest improvements in the machine that will reduce the chances that it will get out of order, and to use its own powers so as to keep the machine in good working order. A second thing monetary policy can do is provide a stable background for the economy-keep the machine well oiled, to continue Mill's analogy. Accomplishing the first task will contribute to this objective, but there is more to it than that. Our economic system will work best when producers and consumers, employers and employees, can proceed with full confidence that the average level of prices will behave in a known way in the futre-preferably that it will be highly stable. Under any conceivable institutional arrangements, and certainly under those that now prevail in the United States, there is only a limited amount of flexibility in prices and wages. We need to conserve this flexibility to achieve changes in relative prices and wages that are required to adjust to dynamic changes in tastes and technology. We should not dissipate it simply to achieve changes in the absolute level of prices that serve no economic function. In an earlier era, the gold standard was relied on to provide confidence in future monetary stability. In its heyday it served that function reasonably well. It clearly no longer does, since there is scarcely a country in the world that is prepared to let the gold standard reign unchecked-and there are persuasive reasons why countries should not do so. The monetary authority could operate as a surrogate for the gold standard, if it pegged exchange rates and did so ex- clusively by altering the quantity of money in response to balance of payment flows without "sterilizing" surpluses or deficits and without resorting to open or concealed exchange control or to changes in tariffs and quotas. But again, though many central bankers talk this way, few are in fact willing to follow this course-and again there are persuasive reasons why they should not do so. Such a policy would submit each country to the vagaries not of an impersonal and automatic gold standard but of the policies-deliberate or accidental-of other monetary authorities. In today's world, if monetary policy is to provide a stable background for the economy it must do so by deliberately employing its powers to that end. I shall come later to how it can do so. Finally, monetary policy can contribute to offsetting major disturbances in the economic system arising from other sources. If there is an independent secular exhilaration-as the postwar expansion was described by the proponents of secular stagnation-monetary policy can in principle help to hold it in check by a slower rate of monetary growth than would otherwise be desirable. If, as now, an explosive federal budget threatens unprecedented deficits, monetary policy can hold any inflationary dangers in check by a slower rate of monetary growth than would otherwise be desirable. This will temporarily mean higher in- terest rates than would otherwise prevail-to enable the government to borrow the sums needed to finance the deficit-but by preventing the speeding up of in- flation, it may well mean both lower prices and lower nominal interest rates for the long pull. If the end of a substantial war offers the country an opportunity to shift resources from wartime to peace time production, monetary policy can ease the transition by a higher rate of monetary growth than would otherwise be desirable-though experience is not very encouraging that it can do so without going too far. I have put this point last, and stated it in qualified terms-as referring to major disturbances-because I belive that the potentiality of monetary policy in offsetting other forces making for instability is far fore limited than is com- monly believed. We simply do not know enough to be able to recognize minor disturbance when they occur or to be able to predict either what their effects will be with any precision or what monetary policy is required to offset their effects. We do not know enough to be able to achieve stated objectives by delicate, or even fairly coarse, changes in the mix of monetary and fiscal policy. In this area particularly the best is likely to be the enemy of the good. Experience sug- gests that the path of wisdom is to use monetary policy explicitly to offset other disturbances only when they offer a "clear and present danger." PAGENO="0218" 214 III. HOW SHOULD MONETARY POLICY BE CONDUCTED? How should monetary policy be conducted to make the contribution to our goals that it is capable of making? This is clearly not the occasion for presenting a detailed "Program for Monetary Stability"-to use the title of a book in which I tried to do so [3]. I shall restrict myself here to two major requirements for monetary policy that follow directly from the preceding discussion. The first requirement is that the monetary authority should guide itself by magnitudes that it can control, not by ones that it cannot control. If as au- thority has often done, it takes interest rates or the current unemployment per- centage as the immediate criterion of policy, it will be like a space vehicle that has taken a fix on the wrong star. No matter how sensitive and sophisticated its guiding apparatus, the space vehicle will go astray. And so will the monetary authority. Of the various alternative magnitudes that it can control, the most appealing guides for policy are exchange rates, the price level as defined by some index, and the quantity of a monetary total-currency plus adjusted demand de- posits, or this total plus commercial bank time deposits, or a still broader total. For the United States in particular, exchange rates are an undesirable guide. It might be worth requiring the bulk of the economy to adjust to the tiny per- centage consisting of foreign trade if that would guarantee freedom from mone- *tary irresponsibility-as it might under a real gold standard. But it is hardly worth doing so simply to adapt to the average of whatever policies monetary authorities in the rest of the world adopt. Far better to let the market, through floating exchange rates, adjust to world conditions the 5 per cent or so of our resources devoted to international trade while reserving monetary policy to promote the effective use of the 95 per cent. Of the three guides listed, the price level is clearly the most important in its own right. Other things the same, it would be much the best of the alternatives- as so many distinguished economists have urged in the past. But other things are not the same. The link between the policy actions of the monetary authority and the price level, while unquestionably present, is more indirect than the link between the policy actions of the authority and any of the several monetary totals. Moreover, monetary action takes a longer time to affect the price level than to affect the monetary totals and both the time lag and the magnitude of effect vary with circumstances. As a result, we cannot predict at all accurately just what effect a particular monetary action will have on the price level and, equally important, just when it will have that effect. Attempting to control di- rectly the price level is therefore likely to make monetary policy itself a source of economic disturbance because of false stops and starts. Perhaps. as our under- standing of monetary phenomena advances, the situation will change. But at the present stage of our understanding, the long way around seems the surer w-ay to our objective. Accordingly, I believe that a monetary total is the best currently available immediate guide or criterion for monetary policy-and I believe that it matters much less which particular total is chosen than that one be chosen. A second requirement for monetary policy is that the monetary authority avoid sharp swings in policy. In the past, monetary authorities have on occasion moved in the wrong direction-as in the episode of the Great Contraction that I have stressed. More frequently, they have moved in the right direction, albeit often too late, but have erred by moving too far. Too late and too much has been the general practice. For example, in early 1966, it was the right policy for the Federal Reserve to move in a less expansionary direction-though it should have done so at least a year earlier. But u-hen it moved, it went too far, producing the sharpest change in the rate of monetary growth of the postwar era. Again, having gone too far, it was the right policy for the Fed to reverse course at the end of 1966. But again it went too far, not only restoring but exceeding the earlier excessive rate of monetary growth. And this episode is no exception. Time and again this has been the course followed-as in 1919 and 1920, in 1937 and 1938, in 1953 and 1954, in 1959 and 1960. The reason for the propensity to overreact seems clear: the failure of monetary authorities to allow for the delay betw-een their actions and the subsequent effects on the economy. They tend to determine their actions by today~s conditions-but their actions will affect the economy only six or nine or twelve or fifteen months later. Hence they feel impelled to step on the brake, or the accelerator, as the case may be, too hard. PAGENO="0219" 215 My own prescription is still that the monetary authority go all the way in avoiding such swings by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total. The precise rate of growth, like the precise monetary total, is less important than the adoption of some stated and known rate. I myself have argued for a rate that would on the average achieve rough stability in the level of prices of final products, which I have estimated would call for something like a 3 to 5 per cent per year rate of growth in cur- rency plus all commercial bank deposits or a slightly lower rate of growth in currency plus demand deposits only.° But it would be better to have a fixed rate that would on the average produce moderate inflation or moderate deflation, provided it was steady, than to suffer the wide and erratic perturbations we have experienced. Short of the adoption of such a publicly stated policy of a steady rate of monetary growth, it would constitute a major improvement if the monetary authority followed the self-denying ordinance of avoiding wide swings. It is a matter of record that periods of relative stability in the rate of monetary growth have also been periods of relative stability in economic activity, both in the United States and other countries. Periods of wide swings in the rate of monetary growth have also been periods of wide swings in economic activity. By setting itself a steady course and keeping to it, the monetary authority could make a major contribution to promoting economic stability. By making that course one of steady but moderate growth in the quantity of money, it would make a major contribution to avoidance of either inflation or deflation of prices. Other forces would still affect the economy, require change and adjustment, and disturb the even tenor of our ways. But steady monetary growth would provide a monetary climate favorable to the effective operation of those basic forces of enterprise, ingenuity, invention, hard work, and thrift that are the true springs of economic growth. That is the most that we can ask from monetary policy at our present stage of knowledge. But that much-and it is a great deal-is clearly within our reach. REFERENCES 1. H. S. ELLIS, ed., A Survey of' Contemporary Economics. Philadelphia 1948. 2. MILToN FRIEDMAN, "The Monetary Theory and Policy of Henry Simons," Jour. Law and Econ., Oct. 1967, 10, 1-13. 3. , A Program for Monetary Stability. New York 1959. 4. E. A. GOLDENWEISER, "Postwar Problems and Policies," Fed. Res. Bull., Feb. 1945, 31, 112-21. 5. P. T. ROMAN AND FRITZ MACHLUP, ed., Financing American Prosperity. New York 1945. 6. A. P. LERNER AND F. P. GRAHAM, ed., Planning and Paying for Full Employ- ment. Princeton 1946. 7. J. S. MILL, Principles of Political Economy, Bk. III, Ashley ed. New York 1929. 8lnan as yet unpublished article on "The Optimum Quantity of Money," I conclude that a still lower rate of growth, something like 2 per cent for the broader definition, might be better yet in order to eliminate or reduce the difference between private and total costs of adding to real balances. PAGENO="0220" LAGS IN MONETARY AND FISCAL POLICY°~ By Mark H. Willes Current debate about a tax increase reflects a fundamental problem in the timing of changes in monetary and fiscal policy. In essence, the short-run ob- jective of these policies is to moderate swings in the economy, stimulating when the economy is slack and restraining when it is taut. But a change In policy may not affect economic conditions immediately. In this case, policy-makers must anticipate economic changes and take action on the basis of expected future con- ditions. Effective policymaking requires knowledge of the causes and lengths of the lags of monetary and fiscal policy. WHY POLICY EFFECTS LAG Lags of monetary and fiscal policy can be traced to several causes. as shown in Figure 1. Recognition lag. It takes time to recognize that the economy has changed in such a way as to require a change in policy. Assume, for example, that a business delcine should be offset by an easing of policy. Although such a decline actually begins at point t0 in Figure 1, it will be some time before reports evidencing the decline will be received by various Government agencies. More time will pass while these reports are aggregated and analyzed. Most analysts will not be con- tent with one piece of information; they will w-ant supporting evidence from several economic series over some period of time before they will be ready to conclude that they are confronting a general decline in business rather than simply a transient fluctuation in one statistic. Time elapsing between the start of the decline (t0) and when this decline is recognized (t1) has been dubbed by economists as the recognition lag. Action lag. Once the need for a policy change is recognized, it takes decision- makers time to alter policy. This lag is shown in Figure 1 as the period between points ti and t2. Action lags can be caused by several things. First, not all those with policy responsibilities may be convinced of the need for change; this may delay action. Second, it may take time to work out details of the change and to go through the administrative exercises necessary to implement them. Finally, there might be political or other economic objectives which lead to policymakers to put off any policy change. For example, a change in monetary policy might be delayed if such action would hamper a current or prospective Treasury financing operation. Or, an easing of policy to stimulate business might be put off because it would conflict with a desire to protect the balance of payments. Responsiveness to more than one objective need not always extend the length of the action lag, however. It could cause policymakers to change policy before they recognized a general movement in business, thus producing a nega tire action lag. This could happen, for example, if a decline in the money supply or an in- crease in unemployment led to an easing in monetary policy even though a down- turn in general business conditions was not yet evident. Inside lag. The sum of the recognition and action lags, called the inside lag, does not, therefore, depend solely on the ability of poilcymakers to recognize and respond to some economic change. Its length depends also upon what is used as a based for measurement and how this base relates to changes in other conditions that also influence policy decisions. The inside lags are influenced by policy trade- offs and priorities as well as speed of data collection and analysis. administrative procedures. and other commonly recognized factors. Outside lags. After policy is changed, it takes time for the effects of the change to work their way through the economy and alter spending. This outside lag is shown as the space between points t2 and ti in Figure 1. *From March 1968, Business Review, Federal Reserve Bank of Philadelphia. (216) PAGENO="0221" 217 SCHEMATIC OF THE LAGS OF MONETARY AND FISCAL POLiCY TOTAL LAG r r~ INSIDE LAG ~ OUTSIDE LAG A RECOGNITION LAG ACTION LAG RECOGNITIC)N OF CHANGE IN INCOME DUE TO NEED FOR ACTiON NEED FOR ACTION CHANGE IN POLICY CHANGE IN POLICY I ~ V3 t1 t3 TIME Causes of outside lags are difficult to anlayze because they involve complex aspects of the way the economy works. Economists have incomplete knowledge of all the relationships involved. Some of the main factors can be discussed in a general way, however. The outside lag associated with income tax changes, for example, depends on the time required to alter the disposable income of indi- viduals and corporations and their spending. Adjustments by corporations prob- ably tend to be more sluggish than those by individuals. Corporate cash positions generally are not affected so quickly as are those of individuals, corporate planning and spending tend to be longer, and so on. These differences between individuals and corporations likely diminish as corporate tax payment schedules are accelerated. Changes in Government expenditure policies may influence the pace of eco- nomic activity quickly. In some cases, placement or cancellation of orders for goods can cause changes in production and income before any actual alteration in Government spending takes place. Even without this, release of additional funds to an ongoing project often will stimulate spending immediately, while a cutback in actual expenditures generally will have immediate depressing effects on na- tional income. Similarly, changes in transfer payments (like unemployment ben- efits) or purchase of services usually will cause an almost immediate alteration in disposable income and spending. On the other hand, newly appropriated funds for projects involving considerable planning or organization may begin to find their way into the spending stream only after some months. Similarly, reduced appropriations may not produce an immediate cut in spending if unused previous appropriations exist. The link between changes in monetary policy and spending is not so direct as in the case of fiscal policy. Emonomists are still debating exactly what the chan- nels are. Some think monetary policy is linked to the real sectors of the economy primarily through interest rates. An increase in rates inhibits investment and perhaps consumption and thereby causes a reduction in the rate of growth of in- come. Other economists view the monetary mechanism as involving primarily the quantity rather than the cost of money. As individuals and corporations adjust to changes in their actual and desired holdings of money, they change their expenditures on goods and services, thus altering the level of national income. Still other economists focus on availability of credit, arguing that a change in monetary conditions alters banks' willingness to lend. Bank lending behavior, in turn, influences the amount of investment and consumption expenditures that can be financed and therefore the level of income. The first step in each these theories is the response of banks to changes in rnoaetary policy. Banks may or may not adjust quickly to changes in monetary policy depending on their current reserve position, loan demand, interest rate PAGENO="0222" 218 expectations, and so on. The longer banks delay in making adjustments. the longer the outside lags of monetary policy. Proponents of interest-rate theories acknowledge that interest costs are often only a small fraction of the cost of a good or service, so a change in the rate may exert little influence on many spending decisions. Even in those cases where interest costs do matter, it may take time for them to affect aggregate spending. Some projects may already be under w-ay. The cost of curtailing them may be greater than the cost of continuing under more expensive financing conditions. On the other side, it takes time to plan and carry out investment and other projects. A decline in interest costs may lead to increased spending, but only after a long start-up period. Changes in the quantity of money also may affect spending totals only after a lag. Alterations in spending may be more closely associated with long-run than short-run changes in the money supply. In the short run, individuals and businesses may try to use their existing money balances more or less intensively, thereby avoiding the need to make significant spending adjustments. HOW LONG ARE THE LAGS? On the basis of what economists know about how the economy works, they have attempted to get some idea of how long these lags are. Iiaside lags. The Federal Reserve generally has been able to recognize cyclical changes in economic activity within three months of their occurrence [8].' Since there is no reason to believe that analysts in the executive and legislative branches of the Government are not equally good in recognizing shifts in the economy, this suggests that the recognition lag for monetary and fiscal policy is probably about three months. In the postwar period, the action lag of monetary policy as measured in re- lation to cyclical turning points usually has been zero. At times, however, it has been negative as the monetary authorities responded to factors that preceded cyclical declines in the economy [8]. In monetary policy, the decisionmaking group is relatively small and homo- geneous. It can and does act quickly. In contrast, fiscal policy decisions are made by Congress and the President. The larger number of people involved increases the likelihood of diversity of opinion and objectives, slowing down the decision- making process. In addition, the administrative machinery is complex. As a result, while fiscal policy decisions have at times been made in less than a month, on some occasions many months have passed before agreement has been reached on a course of action. The fate of the 1960 tax increase proposal is a case in point. More than a year has passed since the President first suggested the increase, and it has been over seven months since the 10 iercent surcharge proposal went before Congress. Lags in planning and appropriations have alsn meant delays in making changes in Government expenditures. Consequently, while it is difficult to make precise statements about the actio~i lags of fiscal policy, it is clear that many months can pass before a policy change is made. This compares with the zero or negative action lags of monetary policy and goes far to explain the preference of many for the use of monetary rather than fiscal policy for stabilizing the economy in the short run. Outside lags.2 Outside lags of fiscal policy are often relatively short. Changes in personal income taxes generally produce significant changes in disposable income and consumption spending within a month or two [1]. Changes in cor- porate tax rates take longer to have an effect. One study has suggested three or four months [1]. Similarly, if action is taken directly on Government expen- ditures, income can be affected within a few months. A broad range of expendi- ture and income tax policies, therefore, can have a significant effect on national income within a period of one to three months. This is one estimate of the range of outside lags of fiscal policy. For monetary policy the situation is more complicated. As noted earlier, esti- mates of outside lags depend partly on what is viewed as the most important short-run link between monetai'y policy and the real sectors of the economy. `Numbers in brackets refer to references listed at the end of this article, The discus ion might eem to 1mph th t the out ide 1 g i ome di c e une re ml Action is taken and the impacts are registered on the economy at some single POifli in tue future. Actually, it is more likely that the effects of a given policy change will be distributed over a period of time. A iignifieant proportion of these effects may be clustered within a short interval but then perhaps not. Generally the term `outside lag' is used to denote the time It takes for a policy change to have a "significant" effect (often difficult to define) on the economy, or the time it takes for a policy change to have its peak effect. PAGENO="0223" 219 The one element common to most theories of the relationship between mone- tary policy and economic activity is the process of adjustment by banks. Recent evidence suggests that banks make adjustments to monetary changes quickly-within a month ortwo [2] [5] [7]. This type of evidence leads those who focus on credit availability to conclude that changes in monetary policy are quickly felt by bank borrowers and depositors and that income changes follow shortly thereafter. Actions of the monetary authorities and banks produce changes in the money supply. Quantity theorists start with this change in money supply to measure what they consider the most significant part of the outside la.g of monetary policy. The best-known study of this lag found that changes in income lagged changes in the quantity of money by an average of about fourteen months using one type of formulation, and by about five months using another method of comparison [3]. Other studies obtained similar results.3 Most investigators have used a change in interest rates as the starting point to measure the major component of the outside lag of monetary policy. Their estimates vary widely, but the minimum lag found has been about three months with many estimates ranging up to eighteen months and more.4 There is little concentration of estimates at any point in the three- to eighteen-month range, so that on the surface an estimate of almost any length within this range seems equally likely. LAGS AND PUBLIC POLICY Table 1 presents a range of estiniates for the various components of the lags of monetary and fiscal policy suggested in the previous section. While these ranges are not all-inclusive, they do include the thinking and findings of most economists. Tab~ I RANGE OF ESTIMATES OF THE AVERAGE LAGS OF MONETARY AND FISCAL POLICY (In months) Inside Lags Outside Lags Total Lags Recognition Lags (1) Action Lags (2) (3) (4) Monetary Policy 3 0 1~20 4~23 Fiscal Policy. 3 i~15 1~3 5~2i Table 1 suggests several conclusions which have important implications for public policy: 1. Estimates of the lags of monetary and fiscal policy differ widely. 2. Monetary and fiscal authorities are doing a relatively good job in recognizing changes in the economy. 3. Monetary authorities generally act promptly but the effects of action may take considerable time to be felt. 4. Fiscal authorities often act slowly but the effects are usually felt fairly quickly. See {6J for a summary of some of these studies. For summaries of some of these studies see [4]. PAGENO="0224" 220 inasmuch as changes in policy-especially monetary policy-take time to be effective, it is necessary to anticipate. Given the objective of trying to reduce fluctuations in economic activity, monetary and fiscal policy should have a stimu- lative effect when the economy is declining and a restraining effect when it is increasing, if outside lags are very long, a change of policy initiated at the beginning of a change in the economy may not begin to have any substantial effect until the need is past. Instead, it may have its greatest effect when the direction of the economy has reversed and the opposite policy is called for. In such case, changes in monetary and fiscal policy would aggravate fluctua- tions in the economy. The shorter the outside lags, the less likely is a distortion of this kind and the more effective are the policies in reducing undesired fluctuations in economic activity. Policy changes, therefore, sometimes need to be out of step with current fluctuations in the economy, coming before the need arises so that their effects will be felt at the appropriate time. This puts a premium on business forecasting. Good forecasts, by "recognizing" a change before it occurs, in effect make the recognition lag negative and greatly improve the timing of monetary and fiscal policy by compensating for the other lags. If the outside or action lags are very long, good forecasting is essential for monetary and fiscal policy to be effective in helping the nation achieve its economic objectives. Even if the outside or action lags are not long, good fore- casting can contribute significantly to the timeliness of policy actions. Another way to reduce the over-all lags of monetary policy is to reduce the action lag. For fiscal policy there is considerable room for movement. Most proposals involve giving the President authority to make changes in taxes or expenditures without waiting for the full process of Congressional review and determination. There may be ways to speed up Congressional action as well. The length of the outside lags of monetary and fiscal policy is determined by responses to policy changes of many individuals and businesses. It is not known whether or not anything can be done about this reaction time. Perhaps research will reveal possibilities of influencing the outside lags of monetary and fiscal policy by changing the types or mix of tools employed. Some economists. convinced that the lags of monetary and fiscal policy are long, have suggested that the Government get out of the stabilization business. They advocate replacing current reliance on discretionary policies with a set of rules that w-ould hold the monetary and fiscal environment stable rather than try to have it counter short-run fluctuations in economic activity. This would not reduce cyclical fluctuations but, it is argued. would keep them from being aggravated by well-intentioned but inappropriate Government policies. Many economists do not go thiS far. They think the lags are at the short- rather than the long-end of the ranges given in Table 1 or they are confident that lags can be reduced. They see discretionary monetary and fiscal policy helping in a significant and positive way to reduce undesired fluctuations in the economy. Much has been done toward understanding lags and in dealing with them. but much more remains. One thing is certain. Policy decisions and actions must be made and interpreted with the problem of lags clearly in mind. Policymakers and the public must look to the future if they are to obtain the conditions they desire in the present. TEcHNIcAL APPENDIX_MEASLTREMEXT OF THE LAGs Measurement of lags of monetary and fiscal policy is difficult. Notions of the exact nature of the lags are not completely developed and the methodological and statistical problem~ involved are formidable. These factors account. at least in nart. for a wide divergence of opinions and estimates of the lenuth of the lass. In.eide lags. Conceptually. measurement of the inside lazs is fairly straizht- forward but in practice is often complicated by lack of suitable data GErl c~iffi- culties in interpreting available data. What IS required is an indication of wiwn those with policy respon~ihilities receanize chanrea in the economy and when they dleclde to chnnae policy. Since these lags Eenerally relcte to Tlnannounr~ iwlrment~ end intentions of policymakers. currently avnil~N~ tiw~ ~ries not do. The~e series may well be influenced by other factors and give a leading impression of the length of the recognition and action lars. PAGENO="0225" 221 Consequei~t1y, in [8] the official minutes and staff memoranda of the Federal Open Market Committee for the years 1952-1960 were used to see how long it took the monetary authorities to recognize cyclical turning point in general economic activity (NBER reference dates were used as a benchmark) It was assumed that this would be a good indication of the length of time it takes the monetary authorities to recognize significant changes in any target economic variable. These records, reflecting policy decisions as well as statements on the economic outlook of policymakers, were also used to measure the action lag of monetary policy. Comparable data are not available for the fiscal authorities, so an assump- tion was made that the recognition lag was the same for fiscal as for monetary policy. Also, no formal attempt was made to estimate the action lag of fiscal poi- icy. The record of explicit attempts to take counter-cyclical fiscal action, espe- cially on the tax side, is relatively short. This makes it difficult to say anything definite about the action lag of fiscal policy. Experiences of the 1962 and 1967 tax proposals suggest that the action lag may easily be a year or more. On the other hand, some excise tax legislation, the speed-up or slow-down of some Gov- ernment procurements and expenditures, and other fiscal measures have been handled by the Congress or the President relatively quickly. In short, the nature of political a'nd legislative processes gives little meaning to the idea of an aver- age action lag for fiscal policy. A range raither than a point estimate gives a bet- ter indication of the length of this lag, and experience may be too limited to set a definite upper bound on this range. Outside lags. Measurement of outside lags of monetary and fiscal policy is plagued by conëeptulai as well as methodological and statistical problems. It was iioted in the accompanying article that the outside lag is not a discrete phenom- enon. Rather, the effects of a policy change are distributed over a number of subsequent periods. Economic theory provides little help in deducing the precise shape of this distribution. It may well vary from one economic sector to another, and different policy actions might result in different distributions as w-eli. Some investigators assume a policy change has limited immediate effects on the economy but that these effects build up as time passes, reach a peak in some future time period and then subside. Others assume that a policy change has its greatest. effect initially, and that these effects then become smaller in each sub- sequent period. Still other assumptions are possible. Depending on the asslimp- tion used and the statistical formulations employed, the shape of lag dis- tributions can vary widely. Since the term "outside lag" is generally interpreted as meaning the time it takes for a policy action to achieve a certain percentage of its total effcts, or to reach its peak effect, these different distributions can im- ply greatly different estimates of the outside lags of monetary and fiscal policy. Numerous statistical formulations and techniques are used to try to estimate the distributed lags associated with policy changes. In [2], an adjustment co- efficint for banks that can be converted into a lag distribution is estimated by correlating (in a multiple regression) changes in excess reserves (dependent variable) with the stock of excess reserves at the beginning of each period (inde- pendent variable). In [7], the distributed lag in bank adjustments is estimated by regressing deposit changes (dependent variable) against current and lagged changes in unborrowed reserves (independent van ables). Coefficients of the independent variables describe the lag structure. Lag distributions describing relationships between changes in interest rates or income and various types of expenditures have been estimated by the use of a variety of functional forms and statistical methods. Generally they involve in- cluding as independent variables in a multiple regression equation lagged observa- tions of the dependent variable (e.g., plant and equipment expenditures) or lagged observations of the independent variable (e.g., interest rates or income). The re- sulting coefficients *and lag distribution depend significantly on the functional form used, the constraints imposed on the coefficients, and the statistical esti- mating procedures followed. These factors account in part for the different esti- mates of the outside lag of monetary policy recorded in [4]. The results for fiscal policy contained in [1] reflect similar considerations. Those who focus on the quantity of money as the main link between monetary policy and the economy generally do not actually estimate the shape of the entire lag distribution. Instead, they compare turning points in income with turning points in the money stock to see how long the former lags the latter [3], or they correlate lagged changes in the money stock with income or changes in income [6]. The assuniptioim is that these procedures yield an estimate of the w-eighted 94-340-68------15 PAGENO="0226" 222 average interval between action and effects. The entire lag distribution is com- pressed into one number. Economists are not agreed on the best way to estimate the outside lags of mon- etary and fiscal policy. Much progress has been made in recent years but much is yet to be learned. A real concern of many, especially in the case of monetary policy, is that in spite of the sophisticated techniques used, we have still been unable ito icolate the effects of policy changes from all of the other things which influence the pace of economic activity. This separation is essential if the lags are to be measured correctly. REFERENCES 1. Ando, Albert and E. Cary Brown, "Lags in Fiscal Policy," Stab flizat ion Poli- cies, Prentice-Hall, Inc., 1963, pp. 7-13. 97-163. 2. Bryan. William R. "Bank Adjustments to Monetary Policy: Alternative Esti- mates of the Lag," American Economic Review, September 1967, pp. 855-64. 3. Friedman, Milton, "The Lag in the Effect of Monetary Policy," Journal of Political Economy, October 1961, pp. 447-66. 4. Hamburger, Michael J. "The Impact of Monetary Variables: A Selected Sur- vey of the Recent Empirical Literature," Staff Economic Study ~Vumber 34, Board of Governors of the Federal Reserve System, July 1967. 5. Horwich, George, "Elements of Timing and Response in the Balance Sheet of Banking, 1953-55," Journal of Finance, May 1957, pp. 238-55. 6. Mayer, Thomas, "The Lag in Effect of Monetary Policy: Some Criticisms." Western Economic Journal, September 1967, pp. 324-42. 7. Rangarajan, C. and Alan K. Severn, "The Response of Banks to Changes in Aggregate Reserves," Journal of Finance, December 1965, pp. 651-64. 8. Wiles, Mark H., "The Inside Lags of Monetary Policy: 1952-1960." Journal of Finance, December 1967, pp. 591-93. PAGENO="0227" CURRENT MONETARY POLICY: A CRiTICAL APPRAISAL By ROBERT WEINTRATJR° I asked this question on a final exam in a Money and Banking course many years ago. Assume that you are Chairman William McChesney Martin of the FRB. What policies do you recommend that the Fed pursue to stop a burgeoning inflation? This was the last of a long hard series of questions and one student wrote, "I've had enough trouble with this exam without assuming I'm someone I'm not." Period! I won't tell you what grade I gave this fellow for that answer. To do so would tell you more about me than I'm sure you want to know. What you want to know, I think, is how I think the question I asked on that exam should be answered. What I think about using monetary policy to combat inflation is, in any case, the central theme of my talk. To begin with we can have no doubt whatever that Chairman Martin is con- cerned right now in April, 1968 with the problem of burgeoning inflation. He said so Friday a week ago. I quote, "The nation is in the midst of the worst financial crisis since 1931." And, he continued, "In 1931 the problem was defla- tion, today it is inflation and equally intolerable." Before coming to grips with the policy question of what the Fed should do to stop inflation I want to answer two preliminary questions. The first of these is whether Chairman Martin's present concern with inflation is relevant and real- istic. This is a fair question for two reasons. First, and I say this with all due respect. MeChesney Martin sometimes chases ghosts. I'm sure you all remember that four years ago at Columbia he saw the ghost of 1929 lurking in a dozen "disquieting similarities." The spectre he raised then didn't scare me and it shouldn't have scared anyone. It simply didn't exist. The second reason this question is a fair one is that Martin's concern with inflation is not new. Back in 1959 he told the Senate Finance Committee that the Federal Reserve is "al- ways fighting inflation." The list of such citations could be greatly multiplied, for in the seventeen years since Martin became the ranking officer of our mone- tary authority-i.e., the Fed, the primary objective of U.S. monetary policy has been the avoidance of inflation. Viewed in the perspective of our monetary history in these seventeen years this concern with inflation has been excessive. Between 1951 and 1968 th OPI rose only by 28.5 per cent, and nearly half of the total rise occurred in five years, in 1956, `57 and `58 and 1966 and 1967. For the WPI the record shows the total rise was only 10 per cent between 19~5l and 1968. Moreover, the record was one of complete stability except for 1956, `57 and `58 and the last two years. Clearly inflation has not always been a major problem in the seventeen years that MeChesney Martin has been Chairman of the FRB. Nonetheless, particularly during the first decade of Martin's stewardship "tight-money" policies were pursued relentlessly to combat inflation and at times the costs exceeded the benefits. Because the fight against inflation, however noble, involves the risk of deflation. If carried too far, tight money policies end in recession. Since 1951 the pursuit of tight-money ended in recession three times. We suffered recessions in the wake of tight-money policies first between July, 1953 and August, 1954, second between July, 1957 and April, 1958 and third between May, 1960 and February, 1961. Add also that tight money caused what has been termed a "mini-recession" in the latter part of 1966 and first half of 1967. (Some equate tight money with high and increasing interest rates, others with little or no growth in the money stock. The recession episodes cited followed periods when money was tight whether defined in terms of interest rates or money supply.) *TJniversjty of California at Santa Barbara. Address before the California Bankers Association, Group Seven, Santa Barbara, Calif., Apr. 27, 1968. (223) PAGENO="0228" 224 Of course the fact that the use of monetary policy to combat inflation can bring on recession doesn't mean we should not use or even hesitate to use mone- tary measures to fight inflation when rising prices are a `clear and present" danger. It simply means that we must do so judiciously. Everyone can agree to this, for to say we must use monetary policy judiciously means different things to different men. Sooner or later, if we are to say anything substantive, we must define exactly what we mean as an operating procedure by a judicious monetary policy. I'll get to this definition later if you don't mind. For now it suffices to say a judicious monetary policy necessarily requires that the Fed is not fooled by events into believing it is doing something when it is doing nothing. This is a larger order than it may appear at first glance as we will later see. But now let us answer the question under discussion. Is Chairman Martins present concern with inflation relevant and realistic? It is. Today inflation definitely is a clear and present danger. Witness, for example. that in the first quarter of this year the CPI rose at annual rate of 4 per cent. We have to look back to the first six months of the Korean War to find U.S. prices rising this rapidly. There can be no doubt then that Chairman Martins concern with hula- tion is both relevant and real. My second preliminary question is what is causing this inflation we now are experiencing. In the abstract context of economic theory the proximate causes of inflation are (1) private expenditures by householders and businesses, and (2) Government purchases of goods and services. "Let's". as Al Smith said, "look at the record." First let's look at the components of private spending: consumption and in- vestment. In percentage terms consumption increased by 5.6 per cent in 1963. 7.0 per cent in 1964, 8.0 per cent in 1965, 7.6 per cent in 1966. and at an annual rate of 5.5 per cent in both the first and second halves of 1967. Since the current rate of increase of consumption is about what it was back in 1963 and 1964- years marked by a remarkable degree of price s~biity-consumption spending would not appear to be a major element in the inflation we now are experienc- ing. But it will prove to be a strong future force for inflation if it should again grow at the 7.5-8.0 per cent rate that obtained in 1965 and 1966. Let's look now at investment spending, including both investment in structures and equipment and inventory changes. This expenditures item has been a major inflationary factor in recent mowihs. In 1963 investment spending increased by 4.9 per cent. In 1964 it rose by 7.9 per cent. in 19115 by 14.3 per cent. and in 1966 by 9.9 per cent. In the first half of 1967 investment fell at the annual rate of 19.2 per cent. The bulk of the fall reflected a decline in the growth of business investories. This decline was the principal symptom of the mini-recession we suffered early last year. But partly ~ecause of renewed investment in inventories total investment increased rapidly in the second half of 1967 and acted to pre- vent the small business downswing of early 1967 from becoming a full-scale recession episode. At the same time, however, the rise in total investment in the second half of 1967, which for the record was at an annual rate of 16.2 per cent, has put considerable current upward pressure on prices. Let me last call your attention to government purchases of goods and services, including state and local spending as well as federal purchases. In 1963 govern- ment spending rose by 4.6 per cent, in 1964 by 5.0 per cent. in 1965 by 6.0 per cent and again in 1966 ~y 6.0 per cent. In the first half of 1967 the rise in this item was at the whopping annual rate of 16.1 per cent. In the second half of 1967 the rate of increase in government purchases of goods and services dropped to an annual rate of 8.3 per cent. Today it is very nearly axiomatic in economics that increases in government spending act to increase national income in nominal terms and hence, as a coi~ollary, prices when employment is full or nearly full and the growth of output constrained. Since employment was nearly full in 1967 the rise in government spending early that year put enormous inflationary pres- sure on the economy and though this pressure was reduced in the second half of 1967 it was still strong by historical standards. In summary, trends in government spending and private investment are currently strongly inflationary. Fortunately however, government spending ap- pears now to be rising at a rate the economy can absorb without substantial inflation, that is, at less than 10 per cent per year. But unfortunately private investment now is burgeoning at a rate that portends sizbstantial future inflation. This item, recall, rose in the second half of 1967 at an annual rate of 16.2 per cent. And lastly, there is consumption. This item increased only moderately in 1967, by 5.5 per cent. It has not yet contributed substantially to the current inflation. But it may do so before the year is out. Indeed proponents of the 10 per PAGENO="0229" 225 cent surtax believe consumption spending will rise s'u~bstantially and greatly aggravate the current inflation unless Congress passes the surtax. But where does monetary policy fit into the picture? The answer is that mon- etary developments affect consumption and investment spending. But this is a purely formal answer. We want to identify the links that relate monetary policy to consumption and investment, a.nd also we want to identify the role monetary policy has played in the current inflation. ITow `does monetary policy affect consumption and investment? A ful'lhlown answer to this question requires at least a full year of study. Moreover, we do nbt know all of the details of the transmission process. But the main elements of the chain of causation are known and can be set forth in a few minutes. Let me take the time to do so by sketching the adjustments of the economy to a policy of monetary expansion. Monetary expansion is a two-pronged policy. One prong is defined by decreases in interest rates and the other by increases in the nation's money stock. The interest rate effects of monetary expansion are well-known. To illustrate, with a 5 per cent interest rate a corporation can raise $100 million ~y selling (for simplicity) a default free bond with a coupon yield in perpetuity of $5 million per year. At 4 per cent $100 `million can be ruised by selling a default free bond with a coupon yield of $4 million per year in perpetuity. O1'ea'rly, corporations are more likely to invest in a $100 million project when their future annual interest obligations are $4 million than when they are $5 million. Thus decreases in interest rates act to increhse investment. By the same line of reasoning decreases in interest rates `also `tend to increase consumption. For consumers buy durable go'ods and, for example, a 1 per cent interest rate reduction reduces the cost of financing a $5,000 consumption loan `by $50 per year where (for simplicity) interest is computed and paid annually on the initial loan for the full term of the loan `and the principal is paid in full at the end of the term. Money supply increases, the second prong of monetary expansion, affect con- sumption an'd investment because the public cannot be forced to hold larger money balances, than it desires to hold in view of its total wealth and the struc- ture of returns to different assets including money. If the nominal stoc'k of money therefore increases, or, in the context of a growing economy, grow's more rapidly than warranted jy the growth of the na'tio'n's wealth and the structure of yields, the public will try to reach the desired level of cash balances by reordering its spending patterns. Households will increa~se their spending on consumers' goods. Pi~oducers, who demand and hold the overwhelming bulk of the economy's money balances, finding that they have excess working capital, will increase inventories and other new investment commitments such as new orders for consumers' goods and plant aitd equipment expenditures. In summary, monetary policy affects consumption `and investment, and thereby prices, via intervention of interes't rates and money jmlances. We turn now to assessing the role played by monetary policy in the current inflation. Th'is is not an easy task. For we a~rrive `at one conclusion if we look at interest rate trends and another if we judge the thrust of mbnetary policy by changes in the money stock. The trend of `interest rates has been up, up and up and almost without pause since the last trough in `bus'iness activity back in February, 1961. T'o illustrate the trend, in February, 1901 the daily average of yields on 91 day Treasury bills was 2.42 percent and the daily `average of yields on Treasury bonds maturing or callable in 10 `or `more years was 3.81 per cent. In January, 1903 the same variables were respectively 2.91 per cent and 3.89 per cent. In Janu- ary, 1905 they were 3.83 per cent and 4.15 per cent. In J'anuary, 1960 they were 4.58 `per cent and 4.43 per cent. In January, 1907 they were 4.72 per cent and 4.40 per cent. In January, 1968 they were 4.99 per cent and 5.18 per cent. And last week the bill rate was 5.46 per cent and the long term rate was 5.27 per cent. Recalling that economic `theory asserts that investment `and purchases of consumer durables are stimulated by low and falling interest rates, the trend of interest rates in recent years makes one w-onder whether th'ere is something w-rong with that part of our t:heory that links monetary policy to investment `an'd consumption (and thereby to prices) via in'tervention of interest rates. In fact there is something wrong with `that part of our model. It is incom- plete. It ignores the feedback effects `of money supply changes. Increases in the quantity of money `have far reaching repercussions on the economy's real varia- bles and there is feedback from these variables to interest rates. Initially, in- 04-340 O-68----16 PAGENO="0230" 226 creases in the money stock cause interest rates on financial assets and credit instruments to fall. But this effect is ephemeral. It is short-lived precisely because lower interest rates impel increases in investment and consumption spending. For as employment and economic activity expand, product prices and the dollar returns to capital, that is present and expected profits, also rise. Product prices rise directly because of the increases in spending. Profits rise because capital resources are used more intensively and the goods produced with these resources sell at higher prices. (If this troubles you think of what happens to land rents in the wake of population increases.) In turn, because of the rise in prices and profits it now- pays to sell financial assets and buy consumer and capital goods. In the final analysis, as a consequence there is a tendency for interest rates on financial assets and credit instruments to rise w-ith monetary growth and economic expansion. As Milton Friedman has put it, "monetary growth will also make for higher interests rates, as changed price expectations overcome the liquidity effects of rapid monetary growth." This is an extremely important point. It can~t be overemphasized. It means w-e cannot judge the thrust of monetary policy by looking at interest rate trends. On the one `hand, increases in interest rates may mean that money is "tight"; for the initial impact of a policy of monetary restraint on interest rates is to raise `them. On the other, increuses in interest rates may mean that we are in the midst of a boom with product prices and yields on real capital rising because of feedback from monetary expansion and the public, accordingly, selling financial assets and credit instruments (and hereby bidding up their yieds) so they can obtain funds to buy the higher-price consumer goods and higher-yield capital goods. Thus interest rate trends are an unreliable indi- cator of the thrust of monetary policy. We can however, without any hesitation or doubt whatever, judge the thrust of monetary policy by what is happening to the money stock. If it is rising rapidly policy is expansionary, no ifs. ands or buts. More on this in a moment. Now, let's look at the behavior of our money stock. The facts show- that the nation's money stock has expanded very rapidly recently w-hether defined inclusive or exclusive of time deposits in commercial banks. I prefer to use the narrow- conventional defiait?ion w-hich equates money with circulating media, that is, the usage that defines money as a social good. Back in February, 1961 the public's holdings of ciu-rency and demand deposits (seasonally ad- justed) added lip to $141.6 billion. In January, 1963 the total was 8148.0 billion. The money stock had increased at annual rate of 1.6 per cent in these twenty- three months. In January, 1965 the quantity of money was S160.0 billion. Betiveen 1963 and 1965 it had increased at an annual rate of 4.0 per cent. In January, 1966 the money `stock was $168.4 billion; it had risen by 5.2 per cent in 1965. In January, 1967 the money stock w-as $169.6 billion; it had in- creased only 0.7 per cent from a year earlier and in fact had fallen after June, 1906. In January, 1968 the quantity of money w-as $182.4 billion: It had risen by 7.5 per cent in 1967. For the record, in the second half of 1961 the annual rate of increase was only 5.1 per cent and so far this year the money stock has risen at an annual rate of 5.5 per cent reaching $184.1 billion in mid-April. Manifestly, money supply policy n-as strongly expansionary in 1967 and there is at most scant evidence that it is now- being nioderated. Recalling the theoretical link betw-een money supply and consumption and investment spend- ing it is difficult not to conclude, and totally reasonable to conclude, that a major underlying cause or root of the current inflation is monetary policy as specified by grow-tb of money stock. We have come full circle, back to our original and central question. What should the Fed now- do to slow-, if not halt, the current burgeoning inflation? Hopefully, the answ-er is now self-evident. To be succinct, the answer is: Moderate the growth of the conventionally defined money stock. To elaborate upon this dictum: This, then is the essence of a judicious monetary policy, if not for all seasons at least for this one. First, the Fed must stop trying to dampen spending via intervention of higher interest rates, which is its traditional operating procedure in inflation. It must stop using this tactic because we cannot readily distinguish betw-een interest rate increases that result from its policy act:ions `and those that feedback from increases in economic activity and in present and expected prices and profits. In periods of economic expansion. interest rates, as w-e have seen, tend to be pulled up by rising prices and profits, and hence in such periods the Fed can be fooled into thinking it is tightening money when in fact it is doing nothing. if its target is higher interests. The PAGENO="0231" 227 appropriate target of monetary policy in inflationary periods is moderate monetary growth. Unlike in the case of interest rates, there is no chance that the Fed will think it is doing something when it is doing nothing if this is its target. This is because the natural tendency in inflationary periods is for accelerated, not moderated monetary growth. (Monetary growth accelerates in such periods because banks use their reserves more intensively when in- terest rates rise and, as we have observed, interest rates tend to rise in periods of business expansion and inflation.) Because monetary growth will moderate in inflationary periods only if the Fed acts to moderate it, the stock of money is a reliable target of monetary policy. It also is a pliable target because the Fed can closely regulate the supply of money balances. Actions taken to decrease monetary growth will tend to do exacty that in the final analysis as well as in the short run. Second, officers of the Federal Reserve and especially Chairman Martin should stop blaming loose fiscal practices for the current inflation. There can be no doubt that the money supply changes of 167 greatly aggrevated, if they did not give birth to the current inflation. "People who live in glass houses," warns an old adage, "should not throw bricks." L~st, `the Fed should moderate the growth of the conventionally defined money stock, currency plus demand deposits. I do not know precisely what the growth rate now should be. But such foreknowledge is not required, because monetary growth now `should `be whatever it takes to achieve the sort of price stability we had in 1903 and 1964 when the OPT increased only 1.5 per cent per year and the WPI was almost completely stable. Perhaps the current ra'te of monetary growth~-5.5 per cent~will achieve this `stability. If not, it would be judicious and prudent as well to try 5.0 per cent, `and if this does not work, 4.5 per cent, etc. The important things are `to decelerate the growth of the money stock until `the inflation is ended and not to overreact but to decelerate gently so as to avoid recession. I am not `however hopeful that `this will `be d'one except by some "happy" accident. It would be naive and romantic to think the Fed which `ha's `traditionally tried to influence `total economic `activity via intervention of money market and credit variables will now voluntarily decide to aim its actions at controlling the money stock in a judicious and prudent way. But it should. PAGENO="0232" 228 Background materials on "Standards for Guiding Monetary Action" The following section I of "Supplementary Views of Representative Reuss" is excerpted from the "1968 Joint Economic Report, Report of the Joint Economic Committee, Congress of the United States, on the January 1968 Economic Report of the President, together with State- ment of Committee Agreement, Minority and Other Views," March 19, 1968 (5. Rept. 1016). PAGENO="0233" 229 SUPPLEMENTARY VIEWS OF REPRESENTATIVE REUSS While I join with my colle~gues in the Joint Economic Committee report, I take this opportunity to present some additional views of my own: I. MONETARY POLICY-TH/E JOINT ECONOMIC COMMITTEE VERSUS THE FEDERAL RESERVE SYSTEM In recent years, dialog between the Joint Economic Committee, in its annual reports, and the Federal Reserve System, in the minutes of the Open Market Committee, might as well have been conducted in Urdu on the one side and Swahili on the other. The Joint Economic Committee, in its 1967 Report, urged upon the Fed "the policy of moderate and relatively stable increases in the money supply, avoiding the disrupting effects of wide swings in the rate of increase or decrease * * * generally within a range of 3 to 5 percent per year." Our "advice" is obviously not being fo]lowed. For the period April 1966 to January 1967, the money supply (narrowly defined as de- mand deposits in banks, and currency outside banks) actually declined, at a rate of 0.2 percent. From January 1967 to January 1968, it increased at a rate of 7.3 percent. To find a period when the money supply increase was within the suggested range, one has to look at the period November 1967 to February 1968, when it increased at the rate of 3.5 percent. Obviously, the Fed had more on its mind than the money supply narrowly defined. Perhaps the Fed has some cause for complaint. It was not told, for example, why time deposits in banks, or deposits in savings and loan associations, mutual savings banks, and credit unions, were not included in its purview. It was not told what, if any, attention was to be paid to levels of interest rates, production, em- ployment, prices, and bank reserves; to the timing of Treasury bor- rowings; to the balance of pliyinents; to the housing industry. Equally, the Joint Economic Committee has trouble making head or tail out of what the Fed is doing from the published minutes of the Open Market Committee. For example, from January 1967 to August 1967, the Fed increased the money supply at a rate of 9 percent. Yet at its meeting of July 18, 1967-at a time when the administration was stepping up its warning of inflationary pressures-the Fed declined to tighten up on its expansionary creation of money supply. The minutes of the July 18, 1967, Open Market Committee meeting give the follow- ing rationale for this action: In the course of the Committee's discussion, considerable concern was expressed about the recent, high rates of growth of bank credit and the money supply, particularly in view of the prospects for more rapid economic expansion later in the year. It was generally agreed, however, that the Treasury's PAGENO="0234" 230 forthcoming financing militated against seeking a change in money market conditions at present. Moreover, even al)art from the Treasury financing, most members felt that it would be premature to seek firmer money market conditions at a time when resumption of expansion in overall economic activity was in a fairly early stage; and some also referred in this connection to the growing expectations that the adminis- tration would press for measures of fiscal restraint. In addi- tion, some members expressed concern about the possibihty that any significant further increases in market interest rates might reduce the flows of funds into mortgates and slow the recovery underway in residential construction activity. Was the Fed continuing to create money at the rate of 9 percent- in the face of the Joint Economic Committee's 3 to 5 percent "ad- vice"-because of Treasury borrowing, the level of production, expectations about future tax increases, worries about residential construction, or what? What weight was assigned to these factors? We are not told. Obviously, the Joint Economic Committee and the Fed are not talking the same language. In an effort to get the parties to the dialog to talk the same language,. the following guidelines for Federal Reserve monetary action are suggested as a basis for discussion: The Federal Reserve System, through open-market operations, reserve requirements, and discount policy, shall endeavor to accommodate a growing full-employment gross national product by expanding the money supply (narrowly defined to include commercial bank demand deposits and currency outside banks) by 3 to 5 percent yearly, with the following qualifications: 1. The target figure should be adjusted up or down from the above band from time to time to reflect the extent to which time deposits in commercial banks, and in savings and loan assoications, mutual savings banks, and credit unions, substitute for the narrowly defined money supply; 2. The target figure should be on the higher side of the band in periods of less than full use of resources, on the lower side in periods of full use of resources; 3. The target figure should be exceeded when resources are under- employed and simultaneously businesses are making exceptionally heav~j demands on credit, not for cv~rrent business expenditures, but for addi- tional liquidity in anticipation of future needs or to replenish unexpected liquidity losses; 4. The target figure should be exceeded to the extent necessary to reflect the increase in dollar gross national product estimated to be attributable to cost-push inflation; 5. The target figure need be sought only over periods, such as 3-month. periods, sufficient to allow the Federal Reserve System to accommodate large Treasury borrowings, with the averaging out to occur over the remainder of the period; 6. Balance-of-payments considerations should affect monetary policy only through varying the maturity of the Federal Reserve Systems's port- folio, so as to achieve to the extent possible appropriate interest differ- entials as between long-term and short-term securities; PAGENO="0235" 231 7. The consequences of monetary policy for the homebuilding ind'wstry sho'uld be taken into account by including Federal National Mortgage Association and Federal Home Loan Bank Board securities in the Federal Reserve System's portfolio in meaningful amounts, and by lengthening its portfolio, whenever homebuilding finance is unduly retarded by overall monetary stringency. I have transmitted this proposed guideline to the Fed for its com- ments. The Fed obviously does not agree with the Joint Economic *Committee's "advice." Perhaps the advice has been too tersely stated, with insufficient regard for, other factors than the money supply, narrowly defined. The above proposed guidelines are designed to elicit precisely what the Federal Reserve regards as proper monetary criteria. Perhaps the resulting exchange can enable both parties to make their future dialog more meaningful. * * * * * * * PAGENO="0236" 232 Letter to Chairman Martin from John R. Stark: CONGRESS OF THE UNITED STATES, JOINT EcoNoMIc COMMITTEE, March 15, 1968. Hon. WILLIAM MCCHESNEY MARTIN Chairman of the Board of Governors of the Federal Reserve System, Washington, D.C. DEAR MR. CHAIRMAN: Representative Henry Reuss, a member of the Joint Economic Committee, has asked me to transmit to you a proposed guideline for monetary policy. This guideline appears on page 45 of the enclosed Report of the Joint Economic Committee, in separate views set forth by Mr. Reuss. He is requesting the comments of the Federal Reserve Board on his guideline (atrn page 46, second paragraph). I have transmitted this proposed guideline to the Fed for its comments. The Fed obviously does not agree with the Joint Economic Committee's "advice." Perhaps the advice has been too tersely stated, with insufficient regard for other factors than the money supply, narrowly defined. The above pro- posed guidelines are designed to elicit precisely what the Federal Reserve regards as proper monetary criteria. Per- haps the resulting exchange can enable both parties to make their future dialog more meaningful." It would be appreciated if you wifi let me have the Board's comments when it is convenient. Sincerely, JOHN R. STARK, Executive Director. Letter to Representative Reuss from Chairman Martin: BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, Washington, April 19, 1968. Hon. HENRY S. REUSS, Joint Economic Committee, New Senate Of/ice Building, Washington, D~C. DEAR Mn. REUSS: This is in response to your request, transmitted to us on March 18 by the executive director of the Joint Economic Committee, for comments on the guidelines for monetary policy set forth in your supplementary views in the Committee's recent report on the Economic Report of the President. We have asked our staff to analyze the proposed guidelines, and I am enclosing a memorandum they have prepared that discusses the guidelines and their implications for monetary policy, together with two articles published in the Federal Reserve Bulletin referred to in the memorandum. Since your PAGENO="0237" 233 proposal raises a number of fundamental issues regarding the part the Federal Reserve System plays in economic stabilization, you may also be interested in the other materials I am enclosing, which include remarks by Governor Maisel on the relation between money and income, an article on the same subject by a member of the staff of the Federal Reserve Bank of New York, and a copy of a letter to Representative Clawson concerning Federal Reserve purchases of Federal Home Loan Bank obligations. I have a great deal of sympathy for the feelings that must have prompted your remarks about Urdu and Swahili. Part of the trouble lies in the lack of exact knowledge on anyone's part about how mone- tary policy affects the economy. And all of us are plagued by the fact that the same words-even though spoken in English by Americans reasonably practiced in the art of communication-all too often mean different things to different people. But we must keep at our efforts to communicate, and I hope the enclosed materials will make some contribution to mutual understanding. Sincerely yours, WM. McC. MARTIN, Jr., Chairman. [MEMORANDUM] To: Board of Governors. From: Division of Research and Statistics, Division of International Finance. Subject: Comments on Mr. Reuss' guidelines for monetary policy. In the Report of the Joint Economic Committee on the January 196S Economic Report of the President, Representative Reuss sets forth as a basis for discussion some guidelines for Federal Reserve monetary policy. These guidelines specify that the Federal Reserve should expand the money supply by 3 to 5 per cent annually, with certain qualifications. This memorandum discusses the character of the guidelines proposed by Mr. Reuss and their implications for monetary policy. The assumption implicit in Mr Reuss' proposal appears to be that a growth rate of 3 to 5 per cent in the money stock constitutes a long-run "norm". The proposal does recognize that short-run deviations from this norm would, from time to time, be appropriate, but these deviations would have to be justified by reference to specific factors listed. In commenting on this proposal, it may be useful to begin by considering the appropriateness of a 3 to 5 per cent growth rate in money over the longer run, and then to turn to the specific considerations that would justify short-run deviations in the growth of money balances. The issue of how much growth in money the economy needs over the long run to promote orderly economic growth is one of the central problems faced by monetary policy. Experience indicates that the Federal Reserve should be chary of rules that seek to SJ)eCify, once and for all, what growth of money over the long-run is appropriate. In an economy as dynamic as ours, factors affecting the amount of money the public may wish to hold change over time. The experience of the I)eriod since World War II is illustrative. Throughout this period, the public has been adding to its money holdings at a slower pace than the growth of GNP, and at a sub- PAGENO="0238" 234 stantially slower pace than the rates of accumulation of many other financial assets. Excess liquid asset holdings carried forward from the end of World War II were only partly responsible for the economi- zation of money balances that occurred. To a larger extent, the slow growth of the public's demand for money reflected the development of new techniques of cash management by corporations that per- mitted economies in transactions balances. Additionally, the increas- ing attractiveness of such liquid assets as time and savings deposits also moderated the public's desired additions to money holdings, especially during the past decade. A fuller discussion of how such factors as these influenced the monetary needs of the economy during the postwar years was contained in an article prepared by the Staff entitled "Monetary Policy and Economic Activity: A Postwar Review," published in the May 1967 issue of the Federal Reserve Bulletin. Because these factors reduced the public's demand for money, growth in the money stock over the past twenty years at an average annual rate of less than 2~ per cent has financed an average annual increase of over 6 per cent in GNP in current dollars, and an average annual increase of almost 4 per cent in real GNP. Growth in the money stock over this period at a 4 per cent rate-the middle of the target range cited in Mr. Reuss' guidelines-would have produced a money stock at the end of 1967 more than 35 per cent above the actual figure. Surely, the amount of price inflation we would have suffered over these past two decades would have been much greater if monetary policy had been guided by the view that approximately a 4 per cent growth rate constitutes a reasonable longer-run target. The postwar period is not, in this respect, an isolated case. We can look forward at the present time to the prospect of major changes in the public's use of money growing out of technological advances in bank- ing that could greatly reduce the use of che~ks within the next decade or two. Just how these developments might alter the growth rate of money consistent with full employment and stable prices we cannot be sure. It does seem, however, that fixing any specific long-nm growth target for the money supply might require suppressing technological advance in our payments system, or alternatively of running the risk of supplying excessive or inadequate amounts of money to accom- modate the needs of a growing economy. Flexibility in monetary policy decisions is essential not only to problems of short-run economic stabilization, but also to permit adaptation to the evolving structure of financial markets and to changes in public demands for money. As noted earlier, the guidelines proposed by Mr. Reuss do suggest that short-run deviations in the rate of monetary expansion would be desirable. One of the specific factors mentioned in this regard is the desirability of increasing the rate of monetary expansion to the extent necessary to reflect the increase in GNP attributable to cost-push inflation. Acceptance of such a principle would be very likely to convert monetary policy from a tool for stabilizing the economy into a vehicle of inflation. Increases in costs are not unrelated to aggregate demands for goods and services, as these demands are reflected in markets for labor, for raw materials, for intermediate products, and for capital instru- ments. Price increases for these resources-which constitute cost increases for their users-are thus not independent of monetary policy, PAGENO="0239" 235 even though the relation between monetary policy and such prices is indirect. Assuring owners of these resources that, in the aggregate, they were free to press for whatever rates of remuneartion they might choose, without fear of the discipline of restraining stabilization poli- cies, would open the door to a never-ending round of cost-price increases. Even if the establishment of this principle were desirable, however, it could not be made operational. Rates of price advance cannot be decomposed into cost-push and demand-pull elements, except arbi- trarily. Businesses do not alter prices in response to cost changes, irrespective of the state of current demand. Neither do pricing policies respond to changes in demand, irrespective of costs. The performance of prices during 1967 attests to the intermingling of demand and supply effects in price behavior. Unit costs in manu- facturing were rising quite early in the year. But with aggregate demands sluggish in the first half, these cost pressures did not result in a significant advance in industrial commodity prices until after midyear. It was not until demands for goods and services picked up in the second half of 1967 that increases in unit costs that businesses had incurred earlier-and were still incurring-began to be passed through to higher prices. The experience of 1967 indicates that cost- push pressures can be contained by limitations on aggregate demands, and conversely that over-exuberant demand facilitates transmission of cost pressures into rising prices. Mr. Reuss' guidelines suggest also that temporary deviations in the target growth rate of money should be permitted to accommodate large Treasury borrowings. Since this is the only explicit recognition in his proposal of the relation between fiscal policy and monetary policy, the impression might be gained that monetary and fiscal policies should be determined largely independently of one another. Such a view would depend on an extreme position with regard to the determinants of money income and t.he causes of economic instability. A small group of monetary economists does, in fact, argue that the effect of fiscal policy on money incomes and prices is insignificant- that "money only" matters. In our view, fiscal policy plays a critical role in the determination of incomes, spending, and financial flows, and must, therefore, be an important consideration in deciding what rate of monetary expansion should be permitted by monetary policy over both the long and short run. Fiscal decisions must be taken into account in monetary policy in a more significant manner than merely by providing temporary accommodation for unusually large Treasury financing needs. Mr. Reuss' guidelines suggest, in addition, that short-run deviations in the growth rate of the money supply may be appropriate when they reflect variations in the public's demand for money. Thus, his pro- posals allow for changes in the target rate of monetary expansion to the extent, that growth in time and savings deposits and shares sub- stitutes for growth in money holdings, and to the degree that business liquidity requirements rise in periods of resource slack for reasons not associated with current expenditure plans. It may be useful to state the general principle that underlies these two qualifications. It is that the growth rate of the money stock should be altered in response to changes in the demand for money that are not associated with changes in the public's plans to spend PAGENO="0240" 236 for goods and services. This principle seems entirely valid; problems arise, however, in trying to determine just how much the target rate of monetary expansion should be allowed to vary in accordance with it. The year just completed provides a good example of the difficulties involved. During 1967 the money stock rose by 6~ percent. the largest increase of any postwar year. Yet it seems clear that some part of this increase should be attributed to a shift in business demands for liquidity of the kind that could be classified as a relevant "quali- fication" under Mr. Reuss' suggested guidelines. Business long-term credit demands-especially during the last half-were huge. These credit demands apparently were not associated with current business expenditures, but were designed to effect a significant rebuilding in corporate liquidity. Available information, however, is much too sketchy to indicate what portion of the $11 billion increase in money holdings in 1967 can be attributed to this factor. Furthermore, it must. he recognized that additions to money holdings to satisfy liquidity preference could at some future time be a source of funds to finance inflationary pres- sures, if these desires for more liquidity proved to be reversible. Thus, while it is clear that the end use of current financing activities must be considered in formulating policy, this principle is difficult to incorporate with precision in any guide to policy. Similar kinds of difficulties are encountered when we consider how target rates of money should be adjusted to take into account the growth of time deposits at commercial banks and of deposits and shares at nonbank savings institutions. This question has been of 1)articular importance in the past decade, as commerical banks have become more aggressive in bidding for time deposits and in offering new' types of instruments for the public to hold, and as nonbank savings institutions have increasingly become caught up in monetary processes. The difficulties in this area arise from the fact that we do not have empirical information that indicates the degree to which growth in these money substitutes, or "near-moneys" as they have often been called, provides a satisfactory alternate to growth in money balances in meeting the economy's needs for liquid assets and credit. It is for this reason that some monetary economists have tried to take into account these changing public preferences for financial assets by broadening the basis on which judgments on the course of monetary policy are made-to include not just the behavior of quantities of financial assets other than money, but also the prices and yields of financial assets. Thus, if shifts in public preferences between money and other financial assets alter the significance of a given growth rate of money, perhaps a better interl)retation of policy can he gained by bringing into the analysis additional evidence that might hell) in judging whether the growth of money and credit is too rapid or too slow. Some of the considerations involved in this extension of monetary analysis were dealt with in the article in the May 1967 Bulletin mentioned earlier. Also, an article entitled "Time Deposits and Financial Flows" that appeared in the December 1966 Federal Reserve Bulletin dealt with the pronounced effects in financial markets that have resulted from the increased competition for time deposits in recent years. PAGENO="0241" 237 We turn now from these more detailed issues relating to establish- ment of target rates of monetary expansion to discuss Mr. Reuss' suggestion as to how balance of payments considerations should affect monetary policy. He proposes that balance of payments problems should be taken into account in the formulation of monetary policy only to the extent of altering the maturity distribution of the System's portfolio. This prol)osal might be appropriate in a period in which domestic prices were stable or declining and considerable slack existed in the use of our labor and capital resources. Under those circumstances, domestic economic developments could not be held accountable for a less than optimum international current account surplus. Consequently an effort to encourage more favorable international capital flows by altering the differential between long and short-term interest rates would be about all monetary policy could properly undertake in the interests of international payments equilibrium. This was, in effect, a basic ingredient of the policy pursued in the early years of the 1960's, before domestic economic overheating and inflation became the serious problems they are today. But it would be inappropriate to try to establish a separation of domestic and international stabilization policies applicable at all times and under all circumstances. When both domestic and balance of payments considerations point in the same policy direction, this reinforcement quite properly influences the intensity with which cur- rent policies are 1)ursued. Currently, for example, we are in the pro- cess of seeking solutions for the most serious balance of payments and international financial problems this country has encountered in several decades. Our domestic economic and financial policies cannot ignore the existence of these problems. The Federal Reserve has supported the selective measures taken to restrict outflows of capital. But it cannot enjoy the luxury of supposing that the problems of external equilibrium that still remain are someone else's responsi- bility. The stakes at issue are simply too serious. Balance of payments equilibrium deserves a place among the goals of central bank policy-not merely for its own sake, but for what it contributes to economic and social welfare both here and abroad. The lessons of the past weeks and months indicate deafly that failure to restore equilibrium in our payments accounts could lead to very serious disturbances in the international monetary system, and there- fore in the world economy. Finally, we turn to Mr. Reuss' suggestion for taking into account the effects of monetary policy on homebuilding by Federal Reserve open-market operations in the obligations of FNMA and the Federal Home Loan Banks "in meaningful amounts," and by lengthening the maturity of the System's portfolio of Treasury securities. The results which would ensue from Federal Reserve open-market operations in FNMA and FHLB issues would depend importantly on the scale of transactions contemplated. For purposes of the discussion here, we interpret his suggestion to imply System purchases in amounts suf- ficient to effect a Percel)tible reduction in borrowing costs to these agencies, relative to other market interest rates, but with these in- stitutions still relying ~)redOminantly on the money and capital markets as the principal source for their funds. PAGENO="0242" 238 Under those conditions, entrance of the Federal Reserve on the buy side of the market for FNMA and FHLB issues could be ex- pected to have only a. minor effect on the costs of borrowing by these agencies. Since the overall posture of monetary policy must be dictated by economic conditions, purchases of these agency issues would have to be compensated for by equivalent sales of direct Treasury debt from the System's portfolio. Consequently, interest rates on average would be affected little. There might be some tend- ency for rates on agency issues to decline relative to other market rates, but rates would tend to rise on the Treasury securities that were sold in order to effect open-market purchases in these agency issues. The reduced costs of borrowing by these agencies would thus tend to be offset by higher borrowing costs on other Federal obliga- tions. Moreoever, the relative decline in rates on these agency issues would likely be small, inasmuch as there is an abundant supply of other Federal securities of comparable maturity to attract invest- ment funds, and investors substitute freely between types of short- term debt as yield spreads change. The differential in yield between agency issues and comparable issues of direct Treasury debt reflects principally the market's evaluation of certain technical factors relating to the size, maturity, ease of marketability, and extent of Federal backing of agency issues. Such differentials can be narrowed by development of a broad private market acceptance, which could be forestalled by more active System intervention in what is, as yet, a relatively small market. A viable and broad private market for these issues would be more likely to develop over the longer-run if demand and supply forces were allowed to work with minimal direct System support. The proposal to lengthen the maturity of the System's portfolio, the other part of Mr. Reuss' suggestion for dealing with potential problems of housing finance, seems unlikely to be of material benefit to homebuilding during a period of monetary restraint. Indeed, such maturity switches might even result in an additional constriction of mortgage fund availability. Maturity lengthening in the System's portfolio would, to some degree, reduce rates on long-term market securities relative to those on short-term instruments. This would encourage some institutional investors to acquire fewer long-term market securities and more mortgages. But at the same time, the increase in short-term rates would probably reduce the inflow of deposits and shares at nonbank thrift institutions, and this would tend to restrict funds to the mortgage market. This channel of in- fluence stemming from lengt~~ing of maturities in the System's portfolio might well be the mbi'e significant channel affecting mort- gage fund availability. There is still reason to be concerned that policies of monetary restraint may fall more heavily on housing than on other activities, so long as artificial rigidities and imperfections in the structure of housing finance are maintained. Measures designed to remove the impediments to a more stable flow of funds to residential construction would help to spread the burden of restraint more uniformly, and offer the greatest promise of avoiding unnecessarily sharp contrac- tions in homebuilding. PAGENO="0243" 239 Members of the staff of the Board of Gov- ernors of the Federal Reserve System made a Staff Presentation in audio-visual form to the "Symposium on Money, Interest Rates, and Economic Activity," which was held in Washington, D.C., in April 1967, under the sponsorship of the American Bankers As- sociation. The materials used on that occa- sion-with such modifications of charts and text as are necessary for printing in the BULLETIN-are shown below. The original presentation was made by Daniel H. Brill, Senior Adviser to the Board; Robert C. Holland and Robert Solo-* mon. Advisers to the Board; and Albert R. Koch, Deputy Director of the Division of Research and Statistics. Graphics were de- signed under the supervision of Mack Rowe. The task on which we are setting out-a review of monetary policy over the entire postwar period-borders on the impossible. Just to read off the list of topics suggested to us for possible coverage would take most of our allotted time. Therefore, we will have to be highly selective. We will spend some time discussing post- war developments in financial markets, since it is through these markets that policy actions are communicated to the rest of the economy. But we must spend time, too, on nonfinancial developments, since they de- termine the stance of policy and reflect how fully the ultimate goals of policy are real- ized. And we will consider the international as well as the domestic aspects of policy actions. For the selection of developments in these areas on which to focus, and for the inter- pretation of events, let me first exonerate our principals. This is purely a staff view of the lessons of the postwar years; it is not in any way an official history of the period. PAGENO="0244" 240 In most respects the postwar period has been satisfying in terms of over-all eco- nomic performance. Real gross national product and industrial output have risen substantially, and the effects of growth have been reflected in the expansion of employ- ment and real wages. These developments provided the context in which monetary de- cisions were made over the postwar period. It is appropriate, therefore, to begin our discussion with a more detailed review of the performance of the real economy. NONFINANCIAL DEVELOPMENTS One of the most pervasive stimulants to postwar growth was the expansion in popu- lation and the large increase in demands for goods and services that it generated. The im- pact spread from housing, to schools, and to community facilities-sectors where outlays are relatively insensitive to short-run changes in income. Some of these outlays, however, are quite responsive to variations in credit conditions. The new-born of 20 years ago are reaching marriageable age, and a large wave of family formation is now in the offing. But with the birth rate declining, the an- nual percentage increase in population has slowed markedly since the middle 1950's. This slowing could have advantages, since earlier high birth rates have aggravated ur- ban congestion, intensified pressure on edu- cational facilities, and increased the burdens of Government. These pressures would be eased somewhat by a slower growth in popu- lation, but economic expansion would then have to depend more on invention and tech- nical progress. Research and development expenditures have been an important factor in technical progress and increased productivity-the basic ingredients of higher standards of liv- PAGENO="0245" 241 Tt~C{t~OLOGV /~D EDUC1~TIO~ lOeO leOS ~IlIIoni 0 CT EL 20 10 e BUSItcIESS FIXED I~VESE11 r~tleec~ls `50 `55 .-- - ing. Expenditures for research and develop- ment, supported in part by Federal financ- ing, have risen dramatically since 1950. With technology changing rapidly, business investment decisions may have become less dependent on short-run prospects for sales and profits. Investment in human capital-repre- sented here by the rise in college enroll- ment-also has yielded striking returns. The effects of increased knowledge, accord- ing to one estimate, may account for as much as half of our growth in total real output. With population, skills, and technology all advancing rapidly, the upward course of business fixed investment has proceeded with few interruptions. Earlier in the post- war period the rate of increase was rela- tively modest, despite large replacement needs, but investment advanced rapidly from 1955 through 1957. The slowdown in outlays after 1957 created fears that invest- ment opportunities were becoming satu- rated. But growth in demands and stimula- tive tax and credit policies resulted in an acceleration after 1961. As a share of gross national product, expenditures for business fixed investment are not especially large-varying between 9 and 11 per cent-but they are strategic in terms of maintaining high resource use and economic growth. Providing a financial cli- mate conducive to a high, but sustainable, rate of fixed investment clearly must remain a central objective of monetary policy. Although the growth rates of business in- vestment and of GNP have been large over the past 20 years, cyclical downturns have been costly. In each of the four postwar re- cessions, indicated by the vertical shading in the chart, the utilization rate of manufactur- ing capacity declined, and profits were re- duced substantially. Share of GOP Rate~ 94-340 0 - 68 - 17 PAGENO="0246" 242 PNDIJSThH~L P~'CT~J~ `~ ~ i 13 Unemployment during these recessions rose sharply-to a high of over 7 per cent during the recession of 1957-58. But there were also periods between recessions when the unemployment rate was too high, and capacity use was too low. Our problems of resource slack in the late 1950's and the early 1960's resulted from inadequate longer-run growth as well as from recession- ary declines. It is some comfort that the duration and amplitude of recessions have been reduced relative to the prewar period. Measured by the decline in industrial production, the four postwar recessions ranged in magnitude from 7 to 14 per cent. By contrast, de- clines of the 1920's and 1930's were much deeper and were generally longer. The cur- rent expansion since 1960 has been es- pecially encouraging, with industrial output rising over 40 per cent between 1961 and 1966. Like compound interest, the cumu- lative return from steady growth is surpris- ingly large. With recessions relatively short and mild, the postwar years have been free of the major price deflations of earlier periods in our economic history. Postwar periods of inflation have been episodic-usually war- induced. Wholesale prices rose sharply after World War II ended and during the early stages of the Korean conflict. The rise in 1956-57, by contrast, reflected mainly a peacetime investment boom with rising unit labor costs. After 1957, wholesale prices were stable for about 7 years, as unit labor costs leveled off, but then the pressures of Vietnam, superimposed on expanding pri- vate demands, touched off new price in- creases. The recent price rise, however, has been milder than those of earlier inflationary periods. In the early postwar years consumer PAGENO="0247" IIOUI2LY EARIIUI6S P000UCTIVITY ~ ~. UflIT LACOft COSTS prices moved more or less in line with wholesale prices. After 1958, however, the two series began to diverge. The rise in con- sumer prices since then has reflected in large part increased costs of services. An important factor moderating cost- price pressures over the postwar period has been the diminishing rate of increase in hourly earnings in manufacturing (including fringe benefits). The bars in the accom- panying chart represent average annual rates of increase from one cycle peak to the next. In each successive cycle, the increase has been smaller. Meanwhile, productivity gains have continued to be rapid-averag- ing between 3 and 4 per cent per year. Unit labor costs, consequently, have increased progressively less, and between 1960 and 1966, showed virtually no rise. In the last year of the recent period, how- ever, the pattern changed dramatically. Hourly earnings rose more rapidly-in the context of rising consumer prices, higher profits, and a tight labor market. And with gains in productivity slowing, unit labor costs rose significantly. -~ - - S Avoiding inflation and recession depends on fiscal as well as on monetary policy. Deficits and surpluses in the Federal budget, as measured in the national income ac- counts, have contributed importantly to cyclical stability. The budget has moved to- ward deficit during recessions and back to- ward surplus during expansions. In the most recent expansion the swing toward surplus was cut short by tax reduc- tions, which played a significant role in pro- longing economic growth. But when the expanded defense effort began in mid-1965, the rapid escalation of expenditures pre- vented the movement toward budget surplus that we needed to help maintain price sta- bility. *~e~sgo um~$I cbui.. ser teeS `~5.'53 53.57 ~57.'n `c3.e3 ~5-'C3 4 243 ~ ~ t~~3 flfl~r,_ n ~EDERI~L E~UDGET IA 5*515 PAGENO="0248" 244 Increased spending for the war in Vietnam was the principal source of the rise in total Federal purchases last year. Indeed, the postwar growth and fluctuations in Federal purchases have been dominated by defense requirements. Growing pressures for nondefense gov- ernment services, however, have generated substantial increases in other types of gov- ernmental spending. Thus, State and local government purchases have nearly doubled as a percentage of GNP in the past two decades, and these outlays now about equal Federal purchases. Federal transfer pay- ments, which rose slowly in the first postwar decade, began accelerating thereafter-re- flecting marked increases in social security benefits and in other social welfare pro- grams. These growing government expenditures can be traced, in part, to new demands created by the postwar change in popula- tion. Half of the postwar increase has been in the number of youngsters under 18 years of age. Educating this group has absorbed more than a third of State and local gov- ernment spending and an increasing propor- tion of Federal outlays. And the large in- crease in the oldest age group has brought with it a sharp rise in government transfer payments. The massive migration into suburbia has also had a major influence on economic de- velopments. Surburban growth has required huge amounts of public and private funds to build the necessary social infrastructure. Though central cities have grown also, they have lost many higher-income families. Left with a deteriorating tax base and growing urban problems, the cities have had to seek outside help in meeting rising costs. Rising demands for services are evident, too, in the pattern of consumer outlays. PAGENO="0249" 245 Consumers are allocating a larger portion of their outlays to better housing and to in- creased education and medical care, and a smaller portion to such basic nondurable goods as food and clothing. Durable goods expenditures continue to fluctuate cyclically, but over the longer run the proportion of consumers' spending on durable goods has changed little. Growth of government and private spend- ing for services and the rapid increase in productivity in the output of goods, have profoundly affected the structure of employ- ment. Service employment, including per- sons engaged in trade and in private and public services, has increased almost unin- terruptedly. Employment in the goods-pro- ducing industries, although recovering somewhat in recent years, is only a little higher now than in 1953. Farm employ- ment, meanwhile, has declined steadily. With a higher proportion of our work force in the more stable service sectors, cyclical unemployment problems may be- come less severe. But with slow growth of jobs in output of goods, and with increasing demands for highly trained workers, unem- ployment problems of a different kind have developed. Last year, for example, the overall un- employment rate declined, and quickly re- duced the pool of trained and experienced workers. Among adult men the unemploy- ment rate was nearly as low as during the Korean war. But for the increasing number of teenage jobseekers, the unemployment rate has remained exceptionally high. Simi- larly, the rate for nonwhite workers has shown little improvement, and it remains more than double the figure for white work- ers. Inadequate skills and inexperience are clearly major occupational handicaps in the labor market. For white-collar and skilled PAGENO="0250" 246 workers, unemployment rates last year were below 3 per cent, but for those without skills the rates were much higher. Structural unemployment problems can- not be solved by aggregate monetary and fiscal policies alone. But with the social costs of unemployment extraordinarily high, the need to maintain a strong and growing econ- omy has become more urgent. Let us now turn to the position of the United States in the world economy. BALANCE OF PAYMENTS It was in 1958-9 years ago-that ero- sion of the U.S. international reserve posi- tion, and the payments imbalance from which it stems, began to be a serious prob- lem for the United States. The problem has proved persistent. Total U.S. reserve assets -consisting of gold, convertible currencies, and our reserve position in the International Monetary Fund-have declined by about $10 billion since 1957, and U.S. liabilities to foreign official institutions have increased by about $7 billion. In order to arrest this deterioration it is necessary to achieve a better matching be- tween our net exports of goods and services, on the one hand, and our expenditures abroad for aid, military purposes, and for- eign investment, on the other. Foreign economic aid in the first 5 post- war years averaged over $5 billion a year, with heavy outflows to Europe. At that time, with urgent demands and severe shortages of capacity abroad, any flow of dollars from the United States pulled U.S. exports with it. Since 1952, net aid to Europe has been very small-even negative in years when large advance repayments of debts were be- ing made. Aid to other countries continued to show a rising trend through 1962 but has since leveled off. PAGENO="0251" 247 Although foreign economic aid is larger now than it was in the mid-1950's, it is a smaller proportion of GNP-about one-half of 1 per cent. Most aid is now tied to U.S. exports. In some cases this aid-tying avoids a burden on our balance of payments, but in others the tied-aid exports replace sales that might have been made for cash. U.S. military expenditures abroad reached a peak in 1958 of about $3.5 billion. Since then, expenditures in Europe, and also in Canada, have declined. But those in other areas have risen abruptly since 1964 because of Vietnam, and the total for all areas reached a new high last year. Sales of mili- tary equipment (not shown here) have helped to offset expenditures, and net mili- tary spending abroad remained somewhat lower last year than in 1958. While military expenditures were gradu- ally declining from 1958 to 1964, corporate direct investmçnt abroad was increasing rapidly. Before 1958, direct investments were mainly in Canada and in the petroleum industry elsewhere. These bulged during the Suez crisis of 1956-57. Since 1958, flows to manufacturing affiliates in Europe have also been strongly on the rise. Last year, growth in the total outflow for direct invest- ment was checked in response to the Com- merce Department's voluntary program. Income receipts from past investments have also had a strong upward trend and have exceeded outflows of new capital. But in recent years this excess has shrunk. Net outflows of U.S. private capital other than direct investment have had a strong growth trend since the early 1 950's. These flows were cut back sharply in 1965 and re- mained low last year under the influence of the interest equalization tax (JET), the vol- untary credit restraint programs, and the tightness in U.S. financial markets. The JET PAGENO="0252" Selected Payments 0 Surplus on Cdx. & Sore. ~LL~TiJLL~~ - z~c1 c~.no r:-u c.c~ )VEE~ttLL ALt~[~C~ r.~ns~ tv:. cl (:!`~s 46-40 ~~~HL1 50-53 62-06 50-61 2 2 ~r SEflVICFIS t~"~e cC r:~. lion l,Ciiitxry Exports ~rts~~ I I I I~ I I I and the voluntary programs are still exerting substantial effects this year. In the accompanying chart, we have added up, for successive periods, the selected aid, military, and investment payments just discussed. The steady increase since the early 1950's is evident. Meanwhile, the U.S. export surplus on goods and services has also been on a rising trend since the early 1950's. But net receipts on goods and services have not been large enough to match the total payments on aid and on military and investment accounts. Thus, the overall balance of payments- shown in the accompanying chart on the of- ficial reserve transactions basis-has been in deficit since the early 1950's. At first, these deficits were regarded as desirable, since postwar reconstruction required some build- ing up of the gold and dollar reserves of foreign countries. But by the time the world- wide boom of the mid-1950s came to an end, the dollar shortage was clearly over, and substantial U.S. payments deficits were no longer welcome. Just at that time, the rate of deficit increased sharply-to an average of about $2.5 billion a year in 1958-61. The new problem was to reduce these deficits. Since the early 1960's, the rate of deficit has been cut by nearly half. But it remains too large, and the accompanying erosion of the U.S. reserve position is a serious problem. While limitations on capital outflow can contribute to the solution of this problem, heavy reliance must also be placed on a long-run improvement in the surplus of exports over imports of goods and services. Since the early 1950's, exports of goods and services, including investment income re- ceipts, have been growing at about the same rate as imports. These more or less parallel movements have given the net balance on these transactions an increasing trend, 248 * F~ET TF~Rt1AT'L TF~At~SI~CTIOIiS * t~.ns~T ;,xru~ns. tIIII:~u of d:T!:,: PAGENO="0253" 249 which, on a ratio scale, shows up as a steady gap. There have been wide fluctuations, mostly of a cyclical character, in the goods and services balance. Fluctuations in demand in this country cause short-run variations in the growth of U.S. imports. Over the long run, merchandise imports have grown roughly in line with GNP. But they have declined more rapidly than GNP in reces- sions, shown in the chart by the shading. And they have risen much more sharply than GNP during boom periods, as in 1965- 66, when domestic pressures on capacity be- came intense. Similarly, exports fluctuate in response to cyclical developments abroad. Cycles in Europe, Canada, and Japan directly affect shipments to those countries. And shipments to nonindustrial countries tend also to re- flect, with a lag, the fluctuations of demand in foreign industrial countries and in the United States. Longer-run trends of both exports and imports are influenced by our competitive position in world markets. During the boom of the mid-1950's, prices in this country rose sharply, especially for producers' equip- ment. The price advance here for those products outpaced that in Europe, which is exemplified in the chart by Germany. Eu- rope's better price performance in the 1950's was the result, in part, of a more rapid ad- vance in productivity. Thus, sharply rising wages in Europe kept consumer prices mov- ing up as fast as ours in the 1950's while Europe's industrial and export prices lagged ours. Our international competitive position may have been at its weakest in the years from 1958 to 1960. Thereafter, relative price stability in the United States-at least until last year-has been helping us to re- GOOfiS & SERVICES .1 dennis. ratIo $ non ftiitary 45 20 10 I I I I I I I I I too' snot, rnub~ Producers' Equipment ~ Consumer Goods & Services :~,~ormseY~.~. 130 120 110 Ito 135 120 110 `so gain some of the ground lost. PAGENO="0254" 250 But the balance of payments problem is still with us. To correct it, we must en- large our surplus on goods and services or hold down capital outflows or both, and we must do these things in a way that is con- sistent with other objectives-in particular, the maintenance of a vigorous and healthy domestic and world economy. Our balance of payments problem- represented by a persistent deficit-has as its counterpart a persistent surplus in con- tinental Western Europe. Better equilibrium in world payments requires corrective action by Europe-action to reduce surpluses there -as well as corrective action here. What contribution can monetary policy make to improvement in our payments posi- tion? Its main contribution is to help pre- vent price inflation and the sort of deteriora- tion in our competitive position that oc- curred in the late 1950's. This means try- ing to prevent the build-up of excess demand pressures, such as we experienced in 1965- 66. Although monetary policy also has some capacity for affecting capital ~flows, that capacity is limited if monetary policy is to perform its domestic tasks adequately. It is the influence on prices and costs that matters most for the longer-run balanct of payments position. The presentation will continue with a review of developments in domestic financ- ial markets over the postwar period. FINANCIAL DEVELOPMENTS Postwar economic growth has been sup- ported by a rapid increase in private debt. Measured here to include the debt of non- financial businesses, individuals, and State and local governments, private debt has risen much faster than GNP. While length- ening of maturities has moderated the debt burden, the fragmentary evidence available PAGENO="0255" 251 ~TES Pet cut suggests that a larger share of current in- come is now being absorbed by debt service. The need for maintaining a stable growth in income to sustain repayment abilities of borrowers has thus become more critical. Federal debt-net of holdings by the Federal sector-dropped sharply relative to GNP in the early postwar years. In dollar amounts, net Federal debt reached its trough in 1951, but the increase since then has been slow, and the ratio to GNP has fallen fur- ther. However, with private debt rising rapidly, the ratio of total debt to GNP began to show an upward trend early in the 1950's, and the rise continued until recently. In the process the financial markets had to absorb an abundance of new securities. Debt expansion has brought with it ris- ing interest rates on all types of borrowing. For long-term rates on both Government and private securities (the latter repre- sen~ed in the chart by the FHA mortgage rate), recessionary declines were short, and rates subsequently climbed to new peaks -and to the highest levels in four decades during 1966. F Three-month bill rates, characteristically more volatile, experienced much wider cyclical swings and rose more during the entire period than did long-term yields. While the secular rise in yields reflects mainly the strength in domestic investment and borrowing, other developments also played a role. International capital markets have become more closely interrelated, and capital needs in other countries increasingly impinge on U.S. financial markets. The pace of borrowing by individuals and businesses has been irregular. These fluctua- tions reflect principally the course of busi- ness investment in fixed capital and inven- tories, and purchases by individuals of homes and durable goods. Since these expenditures PAGENO="0256" S (DC) (D~ CD~ ~ S. ~ 0 S CD 0 tIQ CD ~ CD ~ ~< ~. ~ 00~. C.~i _____ S. ~ CD CD0 a 0 I S PAGENO="0257" 253 GNP, reflect dramatic postwar shifts in the structure of financial asset holdings, espe- cially those of consumers. In 1946, their holdings of debt securities exceeded their money balances and also their savings accounts at banks and nonbank intermedi- aries. By 1966, however, consumers had built up their savings accounts to twice their holdings of debt securities and to more than three times their holdings of money. The total volume of savings accounts by this time was huge-roughly $300 billion- and financial institutions were bidding ag- gressively for these funds. The competitive positions of banks and nonbank intermediaries in the market for consumer savings accounts have changed markedly in the postwar period. Over the first decade the interest rates offered by commercial banks were less attractive than those paid by other institutions, and the banks' share of the total stock in this market declined. By the mid-1950's, bank appetites to com- pete for savings accounts had become whetted by the need for new sources of loanable funds. When Regulation 0 ceilings were lifted, banks raised interest rates on deposits, and they began to hold their own in this market. During 1965 and 1966, competition intensified further, and banks -for the first time in the postwar period -gained headway in the competition for consumer savings accounts. In the corporate sector management of liquid assets also has influenced the level and structure of financial asset holdings. The ratio of total liquid assets to current liabilities has trended downward-reflecting strong interest rate incentives to limit money holdings and the development and spread of innovations in corporate cash management. Corporate money balances, consequently, 1946 1966 CONSUMER HOLDINGS CONSUMER SAVINGS ACCOUNTS Pat cant if total lionbenk Fin. Instit, $0 Commercial Banks ~ Psr `50 55 $5 `$5 BillIons of d to Securities ~ Time Dep. 20 :.: Money `5$ `$4 `$5 CORPORATE LIQUIDITY PAGENO="0258" SHARE OF FUNDS SUPPLIED Pir rut 45 ~immsrcisi 1~11 I~25 47.51 $201 57.11 02.15 ft ~ 47.51 52.55 57.51 12.55 02 - $osfle. Public ~ I - i i~:: 254 grew slowly over the first 15 postwar years -more slowly than sales or current liabili- ties. Large banks became concerned about the sluggish growth of the accounts of their large customers, and in 1961 they introduced negotiable CD's to recapture a larger share of corporate liquid funds. Corporate time deposits then mushroomed, but money holdings declined. However, corporate investment in short- term securities also appears to have been reduced by this increased commitment to CD's. Thus, corporate security holdings have not increased materially since 1960, even though their total liquid assets have grown by one-fifth. - For banks, attraction of time and savings deposits from consumers, businesses, and others has significantly improved their posi- tion as suppliers of funds. In the first 5 postwar years banks supplied less than one- fifth of total funds raised; by 1962-65, on the other hand, their share had risen to over one-third. This rising bank share was partly at the expense of nonbank financial institutions, whose share of funds supplied has dimin- ished gradually over the past decade. But the principal offset was the reduction in funds supplied' directly to borrowers by the nonfinancial public, through their purchases of market securities. The funds attracted by banks and non- bank intermediaries through competition in rates and other terms have proved to be highly interest-sensitive. In 1966, market interest rates rose sharply-and by more than the rates on deposit-type claims, whose yields were constrained by both institutional and regulatory factors. Consequently, the nonfinancial public acquired more market securities and fewer deposit-type claims, and the shares of funds supplied by banks and PAGENO="0259" 255 TIME DEPOSITS Pit cut Ra*1z pilits YIELD SPREAD + T. SEP.- 3-5 YR. EAT. nonbank institutions declined during the year. Last year's experience was foreshadowed by earlier fluctuations in the growth rate of time deposits at commercial banks. These variations appear to be mainly the result of changes in relative yields. The bottom panel of the accompanying chart shows the yield spread, in basis points, between the rate on 3- to 5-year Governments-a representative market security-and the average effective rate paid on time and savings accounts. Time deposits became relatively more at- tractive when the yield spread moved up, and in those periods time deposit growth generally accelerated. When yields.on time deposits became relatively less attractive, their growth usually slowed. Movements in these two series have not been perfectly cor- related, to be sure, but they have been quite similar. With holders of financial assets becoming more interest-sensitive, nonbank institutions have been increasingly influenced by the effects of monetary policy. Thus, the growth rate of nonbank savings accounts began to recede late in 1964, when competition from banks intensified. In last year's taut financial markets, with rates on market securities and banks' time deposits rising, net inflows to nonbank institutions dropped markedly, and then increased sharply in the fourth quarter when market rates began to fall. The impact of monetary restraint also spread to insurance companies, where policy loans rose sharply, reducing the volume of funds available for investment in corporate securities and mortgages. The more aggressive competition develop- ing in financial markets over the postwar years, together with the decline in liquidity of financial institutions, has created an en- vironment requiring a higher order of man- PAGENO="0260" 256 agement, both at banks and at nonbank fi- nancial institutions. At the central bank, these developments also call for increased capability on the part of policy-makers to recognize, and to adapt to, policy impacts that are not only becoming more prompt but also more pervasive. In conclusion, let us discuss the implica- tions of our analysis for the formulation of policy. CONCLUSION Recognizing that there is still much to be learned about stabilization policy, we can all take some pride in the performance of the economy in the postwar period to date. Ii~i- dustrial output has more than doubled since 1947. In long-run perspective, the four re- cessions appear as brief hesitations in the general advance. Though production has turned down recently, the rapid and pro- longed expansion since 1960 suggests that we may have learned something about main- taining steady growth. But even a casual look at broad economic indicators reveals unsolved problems. For example, the unsatisfactory price rec- ord reflects mainly sudden bursts of demand, the effects of which are seldom reversed. For prices, what goes up usually does not come down. The stability of wholesale prices be- tween the periods of strong surge indicates what can be accomplished if balanced and orderly expansion is maintained. Improvement in our record of prices is needed in part because of the effect of infla- tion on our balance of payments. Interna- tional payments disequilibrium has been a problem for nearly a decade. In recent years we have made some progress in reducing the disequilibrium by improving our competitive position and by using such measures as re- straints on capital flows. But a problem still PAGENO="0261" 257 CAPACITY USE ~KEMP~OYMENT Per ceet ~ J~~~J~Ient Rate~ ~ ~ c ~ I ~ t~i~ U4TEREST RATES Percent remains, and our policy goals-both domes- tic and international-could be jeopardized if we do not show more progress in moving toward equilibrium. Furthermore, any pride we might take in the overall economic performance of the postwar years is diluted when we consider the amount of lost production and idle re- sources whether associated with short post- war recessions or longer periods of slack in resource use. The cost of recessions is high, given our pressing social needs. To reduce further the extent and duration of these recessions, we must learn more about the underlying causes of economic fluctuations and how to forecast their occur- rence. It is well known that the effects of monetary policy on the economy are not instantaneous. Since the lags are variable and sometimes substantial, poor forecasting can result in poor policy decisions. Granting that the forecasting art is still primitive, the solution, it seems to us, lies in improving the art, rather than abdicating to arbitrary rules the responsibility for stabilization policy. One area in which improvements are needed is in the understanding of interac- tions between monetary policy and financial variables. Those developments we can ob- serve-such as changes in interest rates- usually represent both the effects of policy and the public's responses to a host of other influences. Rising interest rates, for example, may stem from either restrictive monetary policies or from rising demands for credit. Moreover, interest rates are only one of the many terms in the complex equation that determines credit flows. Terms other than price, and the availability of loan funds to borrowers, can change drastically in ways that interest rates fail to indicate. But since changes in interest rates and the associated variations in prices of financial assets are the 94-340 0 - 68 - 18 PAGENO="0262" 258 i~i E~i ~ ~cr~L~:, Per cut lr:reess - 1065 1060 5 1 5 2 mtsi flosorvoc ,L~onoy Stock Tins Doposito 10 0 0snk Credit C j iS ~ ~J ~i~te - UPflSICI :. `54.57 leclOslit `57.55 uXPAI15l~ `50-00 utCC5$IO~ `00-01 -~-. UHhlI ~:. JilL *:~_£L JHUIL m ~, ... ~ common thread that links the financial mar- kets, their behavior is vital in any assessment of monetary policy. Because of the difficulties in interpreting interest rate movements, some economists advocate judging the posture of monetary policy by one or more measures of monetary growth. There are times when a variety of quantity measures display parallel move- ments, as those shown here did between 1965 and 1966. Then, the direction of pol- icy, at least, is clear, although the degree of restraint or ease may not be. The more serious problems arise when there is a need for finer judgments on the course and intensity of policy. Here, for ex- ample, we show the annual rates of change in total bank reserves over recent periods of expansion and recession (as defined by the National Bureau of Economic Re- search). It appears from the total reserve measure that Federal Reserve policy was contracycical: reserves rose more rapidly during recessions than during expansions. But growth of the money stock during these periods suggests a different conclusion: the money stock has sometimes risen more rapidly during expansions than in interven- ing periods of recession. It is perhaps tempt- ing to interpret this as evidence of misguided policy action. But the money stock is deter- mined by the public's demand for money interacting with monetary policy; this de- mand is influenced by income, interest rates, expectations, and other factors. Thus, changes in the money stock must be inter- preted in light of changes in other financial and nonfinancial variables that accompany them. In contrast to the changes in money, growth in bank credit over these economic cycles was contracydical: largest during re- cessions and smallest in periods of expan- PAGENO="0263" Money & Time Dep. Nonbank Say. Accts. - Assail rats .1 Iscisass, billions at dollars Res. Construction 259 sion. To an important degree, these fluctua- tions in bank credit reflected changes in the growth rate of time deposits. The public switched between market securities and time deposits, as monetary policies-interacting with credit demands-altered the yield spread between these classes of assets. It would seem, therefore, that no single aggre- gate banking measure tells the whole policy story. Moreover, the problems of interpreting monetary measures are magnified when the effects of policy spread more pervasively outside the banking system. During the 1950's, the effects of monetary restraint were confined mainly to a relatively narrow range of financial assets. Restrictive policies during the 1958-59 expansion, for example, reduced the growth of money and time de- posits substantially, but the growth rate of nonbank savings accounts changed little. Last year, restrictive policies once again reduced the growth rate of money and time deposits. But with market rates on securities rising rapidly, and with commercial banks bidding more aggressively for available funds, net inflows of funds to nonbank sav- ings institutions also fell abruptly before recovering late in the year. As monetary restraint spread to nonbank financial institutions, there were marked ef- fects on the structure of private expendi- tures. Though the money stock rose consid- erably during the first half of last year, the mortgage market came under pressure fairly quickly, and housing starts and residential construction declined sharply. While purchases of consumer durable goods leveled off last year, and new capital appropriations of manufacturers declined after the second quarter, it seems evident that these developments were less closely related to financial restraint than was the 30 20 10 196566 EXPENDITURES 1110 APPROPRIATIONS 61111mm *f dollars Consumer Durabies 20 25 20 PAGENO="0264" 260 decline in residential construction. Not all sectors were affected equally by monetary policy during the year. These structural ef- fects raise important questions of equity and social priority, and it is necessary to take them into account in deciding when, how much, and what kind of policy actions are appropriate. With monetary restraint extended to a wider range of financial assets and institu- tions, and with an uneven impact of restraint on spending, an assessment of monetary policy from the changes in any single varia- ble goes further astray. Sophisticated mone- tary analysis does not-and need not-rest its case on the behavior of free reserves, or the money stock, or bank credit, or interest rates, or any other single factor. Recogni- tion of the need to comprehend the inter- dependency among financial variables, and between financial and nonfinancial varia- bles, underlies much of contemporary mone- tary research, and the Board's staff is devot- ing a large share of its resources to that quest. It is clear that determination and interpretation of policy require a weighing of the movements in all these variables to- gether and jointly assessing their meaning for the ultimate targets of monetary and fiscal policy-that is, employment, produc- tion, and prices. For in the long run, the test of the success or failure of stabilization policies depends not on the growth of the money stock, nor on the level of interest rates, nor the size of the Federal deficit, but on the extent to which monetary and fiscal policies together fulfill the potential for real economic growth that our resources make possible. PAGENO="0265" TIME DEPOSITS AND FINANCIAL FLOWS REPRINTED FROM FEDERAL RESERVE BULLETIN FOR DECEMBER 1966 (261) PAGENO="0266" CHART 1 262 NFLOWS of time and savings deposits at commercial banks have declined sharply in 1966, especially since mid-August. This decline contribUted to a reduction in the availability of bank credit to borrowers. The 1966 slowdown followed several years of very high rates of inflows of time and savings deposits at commercial banks. This success in attracting time and savings deposits since 1957- and especially in the period from 1962 through 1965-had a sig- nificant influence on the role of commercial banks in the financial system. Commercial banks as a group became not only suppliers of money, but also one of the dominant issuers of nonmonev liquid assets. By the end of 1964 their interest-bearing deposits exceeded private demand balances for the first time in history; 10 years earlier time and savings deposits at banks had been less than one-half as large as private demand deposits. With this greater inflow of time deposits, total bank deposits grew at an accelerated rate, and banks showed a marked increase in their share of the total funds supplied in credit markets. Th~thposit GROWTH stows since ~th stnmrter `66 The larger time deposit inflow at banks in the first half of the 1960's was accompanied by substantial readjustments in the size and composition of financial flows throughout the economy. The public-consumers, businesses, and State and local governments -placed a greater share of its financial asset acquisitions in bank time deposits rather than in other interest-bearing assets and at the same time increased its rate of acquisition of total financial assets relative to income. Banks. meanwhile, expanded their share t5 It P1 Data are for ati cornmercjat banks. Data for tSfb are ar seasonatty adjusted annuat rates. PAGENO="0267" of funds supplied in the markets for State and local government bonds and real estate mortgages. In the business sector, firms issued fewer securities and relied more on issues of mortgages and on loans from banks to finance their expenditures. With the decline in inflows of time deposits in 1966, these tendencies were reversed. Banks reduced their acquisitions of securities. Their sales and runoffs of U.S. Government securities were large all year, and since midyear many also liquidated municipal bonds. Furthermore, they became increasingly reluctant to make additional loans. As a result a larger share of credit demand was met in money and capital markets at rising yields. The greater interest of banks in competing for time and savings deposits in the last 10 years emerged from earlier postwar de- velopments. In the first decade after World War II bank deposits did not expand so fast as the over-all economy. This slower expansion reflected in part the excess liquidity left over from wartime finance and the recurrent need to temper inflation by restrictive monetary policy actions that curbed the expansion in bank reserves and deposits. At the same time, nonbank financial institutions were recording high growth rates as their deposits and shares gained increasingly widespread acceptance among consumers. As a result, commer- cial banks lost their competitive position in the market for con- sumer savings. Concurrently, businesses were diversifying their liquid asset portfolios-nonfinancial businesses, attracted by rising yields, turned more and more to market instruments as a repository for liquid funds, and their deposits at banks showed little growth. With the growth of deposits limited, banks in the first postwar d5~cade drew heavily on their previous accumulations of liquid assets to finance loan expansion. While banks had been expected gradually to liquidate part of their huge holdings of Government securities acquired during the war, the persistent erosion of liquid- ity due to loan expansion and liquid asset sales led banks to try to find additional sources of funds to finance customers' loan de- mands. Banks were thus coming under pressure to compete more aggressively for time and savings deposits. The increase in Regulation 0 ceilings at the beginning of 1957 gave banks added leeway to compete for these deposits, and the growth rate of time deposits began to accelerate soon thereafter. In the period from 1957 through 1961 time deposits at banks 263 TIME DEPOSIT GROWTH PERCENTAGE INCREASE, 1946-56 Bank dnposits 38 GNP 101 Nonbank deposits 172 Bank deposits are total deposits at commerciat banks; nonbank deposits inctade savings and to an assns., mu- taat savings banks, and credit anions. PAGENO="0268" 264 grew at about twice the rate of the first postwar decade. Con- sumers were the major source of these increased inflows-ac- counting for about two-thirds of the additional growth of total time and savings deposits during this period. Four increases in Regulation Q ceiling rates in the period from 1962 through 1965 permitted banks to continue to attract deposits from consumers. But the decision of large banks in early 1961 to issue large-denomination negotiable certificates of deposit (CD's) to nonfinancial businesses broadened th~ area of bank competition for funds and signaled the beginning of more inten- sive efforts to attract deposits. Time deposit inflows accelerated to an average annual rate of 15 per cent over the 1962-65 period. Acquisitions by consumers - accounted for about one-half of the increased inflow, a smaller proportion than in the previous 5 years. On the other hand, ex- panded purchases by nonfinancial corporations accounted for almost one-third of the additional inflow, as compared with about one-fourth in the 1957-61 period. Large banks obtained more than one-third of their time deposit inflows from negotiable CD's in 1962-65 and accounted for most of the growth in total time deposits at all banks. But banks in all size groups, located all over the country, had accelerated time and savings deposit inflows in this period. With a vast increase in their time deposits, banks expanded sharply the amount of funds supplied to credit markets in the form of loans and investments. Annual growth rates of bank credit, which averaged about 4 per cent in the first 10 years after World War TI, accelerated to an average of nearly 9 per cent in the period 1962-65. The share of bank credit in the total supply of funds to nonfinancial borrowers rose correspondingly. In the 1962-65 period of accelerated time deposit growth, bank credit accounted for more than one-third of the total, compared with only about one-fifth in the first postwar decade. PUBLIC FINANCIAL . ASSET PORTFOLIOS The larger inflows of time deposits at banks altered the per- centage distribution of financial asset acquisitions of the public -with time deposits gaining at the expense of other financial assets. In the period from 1957 through 1961 the increased share of financial asset purchases by the public that were allocated to time deposits was accompanied mainly by a relative decline in the public's accumulation of money, as Chart 2 indicates. The pro- portion devoted to acquisitions of market securities did decline PAGENO="0269" 265 slightly, but that going to nonbank institutions increased as these institutions competed aggressively to maintain their relative posi- lion in the market for individual savings. From 1962 through 1965, however, the further rise in the share devoted to time deposits was accompanied by a relative increase in the money component of the public's financial asset acquisitions, even though corporations were reducing substantially the proportion of their liquid assets held as money balances. For the nonfinancial public as a whole, the rise in its time deposit share ACQUISITIONS of financial assets by public change dramatically CHART 2 ~ MONEY TIME DEPOSITS SAVINGS SHARES CREDIT MARKET INSTRUMENTS Li 1* ANNUAL AVERAGE Flow of funds data. Savings shares are claims on sasings and loan assns., mutual savings banks, and credit unions. Credit market instruments include all funds supplied directly to credit markets by the private domestic nonfinancial sector. reflected a sharp decline in its share of funds directed toward other interest-bearing financial assets. Most of the displacement of interest-bearing assets by time deposits during this period came at the expense of market securities, but the continued growth of these deposits also began to bite into the portion taken by non- bank intermediaries. Total financial asset flows. Bank time deposit expansion during the early 1960's also was accompanied by a sharp rise in the rate at which the public acquired total financial assets. Av~rage annual accumulations of money, time deposits, other savings de- PAGENO="0270" 266 posits and shares, and market securities totaled just over S20 billion in the period from 1957 through 1961, but rose to more than $40 billion from 1962 through 1965. This growth in private financial asset flows was relatively larger than the increased flow of private income. Thus, in the consumer sector, the share of income allocated to financial assets totaled 5.1 per cent in the period from 1957 through 1961, but rose to 7.2 per cent from 1962 through 1965. Some of this greater allocation of consumer income to financial assets reflected a smaller share of income used for purchasing consumer durable goods and housing. But most of it was asso- ciated with a much higher level of borrowing, especially in the mortgage market. Thus, in the period from 1957 through 1961 average annual mortgage borrowing by consumers amounted to 61 per cent of their expenditures for new housing. From 1962 through 1965 mortgage borrowing rose to 81 per cent of consumer expendi- tures on housing. Generally easy conditions in the mortgage mar- ket in the later period encouraged a high turnover rate of existing houses and a withdrawal of owners' equity from the housing market. And with returns on time deposits and other liquid assets quite generous, consumers found it relatively inexpensive to retain liquid assets while borrowing to finance outlays for housing or for other goods and services. Relative yields. The accelerated inflow of time deposits at com- mercial banks over the past 10 years thus appears to have reflected a complex series of shifts in the volume and structure of financial asset acquisitions by the public. In these shifts changes in relative yields on financial assets and in the availability of credit played a dominant role. Rates paid by commercial banks on time deposits rose relative to rates on other financial assets available for pur- chase by the public, and the public was encouraged to acquire more time deposits and less of other financial assets. At the same time, the abundant availability of mortgage credit on relatively easy terms encouraged the public to borrow more in relation to its expenditures. As a result, total financial asset acquisitions also rose relative to income and spending. The role of changes in relative yields on financial assets as a factor in time deposit growth is illustrated in Chart 3. The top panel shows changes in the annual growth rate of time deposits. The bottori panel, plotted on a reversed scale, shows the number of basis points by which the yield on 3- to 5-year Government PAGENO="0271" 267 bonds exceeds the average effective rate paid on time and savings deposits. The higher the yield-spread line, the more attractive time deposits become; the lower the line, the less attractive they become. Changes in the yield spread between time deposits and market securities may arise from changes in offering rates by banks or, alternatively, from wide cyclical movements in market rates on securities. A good example of the response of time deposit growth to cyclical variations in market rates is provided by the 1958 to 1960 period, when rates paid by banks on time deposits changed TIME DEPOSITS expand as relative yield increases CHART 3 _______________ TIME DEPOSITS ~ t: YIELD SPREAD 100 Time deposits at alt commercial banks. Effective rate on time deposits is ratio ctf interest patd on deposits during year to average eve! of time deposits during year. Figures for 0966 are for first half; effective rate on time deposits for the first half of 0966 is estimated. slowly. In 1959 rate spreads moved substantially against time deposits, as interest rates on market securities rose to what were then record postwar levels, and time deposit growth showed a steep decline from the 1958 highs. Then in 1960 market rates dropped, and time deposit growth turned up again. It is clear that these cyclical swings in time deposit growth were affected by monetary policy. Federal Reserve open market opera- tions were influencing market interest rates and were inducing the public to switch between time deposits and market securities. Policy actions that changed the availability of bank credit were thus influencing time deposit growth as well as the growth of demand balances and the money stock. PAGENO="0272" 268 Growth in time deposits has also been spurred by favorable yield spreads caused by changes in offering rates by banks rather than by cyclical movements in market rates. Thus, the continued favorable yield spread for time deposits in the period from 1960 through 1965 reflected higher offering rates on time deposits- permitted by higher ceiling rates under Regulation Q-rather than declining market rates. Moreover, as indicated in the table, EFFECTIVE RATES PAID AT FINANCIAL INSTITUTIONS (Per cent per annum) ~ Type of institution 1952-56 1962-65 1957-61 Average effective rate at: Commercial banks 1.33 Savings and loan associations 2.94 Mutual savings banks 2.52 2.38 3.71 3.24 3.40 4.28 4.00 Spread above commercial bank rate: Savings and loan associations 1.61 Mutual savings banks 1.19 1.33 .86 .88 .60 Nope-Effective rates are ratios of total interest or dividends paid during the year to average deposit, or shares during year. Data are for ati insured institutions. higher offering rates also made bank time deposits more attractive relative to deposits and shares at other financial institutions. In some localities during 1965 and 1966 the rates being offered by banks on specific kinds of time deposits exceeded those paid by local nonbank competitors. The continued favorable yield spread permitted banks to attract greater inflows of funds and thereby to enlarge their contribution to financing economic expansion through acquisitions of loans and investments. This accelerated inflow of time deposits during the 1960's influenced borrowing and lending patterns and in- terest rates throughout the economy as commercial banks sought assets with higher rates of return to cover the additional cost of time deposits. BANK'S SHARE For example, banks stepped up their purchases of mortgages in New mortgages: ~ the period from 1962 through 1965; the proportion of funds sup- ~ plied to that market was almost twice the annual average for 1957 1962.65 19.4 through 1961. With banks, as well as nonbank institutions, bid- State and local ~~ood issues: 21 8 ding aggressively for mortgages, total mortgage borrowing by con- 1957:61 32.7 sumers and businesses showed a large expansion. 1962.65 ~ In the market for municipal securities the structural shift in Based on flow of funds data. Per. sources of finance was even more striking. Commercial banks jndtrlted. averages for the pertod have long been important in the municipal bond market; during PAGENO="0273" 269 the period 1952-56 they supplied about one-fifth of the net funds raised. As time deposit inflows rose after the 1957 change in the Regulation 0 ceiling, banks increased their share of total funds supplied to this market. But the sharpest jump in bank purchases occurred in the early 1960's, when large banks began to issue negotiable CD's in volume and banks accounted for almost three- fourths of the total supply of funds in the market for municipal securities. Businesses, like consumers, increased their total borrowings in the period from 1962 through 1965-to an annual average of about $22 billion compared with an average of about $12 billion in the previous 5 years. While most of the increased borrowing reflected more capital spending, businesses expanded their bor- rowing by more than the rise in their net investment in fixed capital and inventories. The most striking aspect of the change in business external financing was its structure. On average, the volume of stock and bond financing was smaller in the period from 1962 through 1965 than in either of the two earlier periods shown in Chart 4, even though total external financing was much larger. Businesses BUSINESS BORROWING in 1962-65 changes composition CHART 4 ~ TOTAL 2G ANNUAL AVERAGES Flow of funds d a for nonfinanc al corporations PAGENO="0274" 270 apparently found credit available on easy terms at banks and in the mortgage market, and they relied relatively little on security financing. The abundance of mortgage credit at low cost encour- aged a marked expansion in the volume of multifamily and com- mercial construction and an attendant rise in mortgage borrowing by businesses during this period. These changes in the structure of financial flows-increased bank purchases of long-term assets, large demand for mortgages by financial institutions, and reduced financing by businesses in the open market-influenced the structure of interest rates during the expansion of economic activity in the period from 1961 LONG-TERM interest rates stable during most of the `60's CHART 5 ~ CtYERCIAI PtPES Rates are enonthty averages. through 1965. Unlike developments in earlier expansion periods, long-term interest rates-represented in Chart 5 by the new-issue yield on high-grade corporate bonds-were on the whole stable or declining from early 1961 until the spring of 1965. On the other hand, yields on short-term instruments-represented by the rate on 4- to 6-month commercial paper-began to drift upward early in the expansion, but at a pace that was considerably slower than in earlier periods of economic expansion. With a gradual rise in short-term rates, there emerged a pattern of rate relationships be- tween long- and short-term securities that was somewhat different from that of earlier expansions. Thus, during the first 2 years of the current expansion, long- PAGENO="0275" 271 DEVELOPMENTS IN 1966 NONBANK DEPOSITS Per cent increase 1963 11.9 1964 10.9 1965 8.0 1966 (Jan..Sept.) 3.1 Flow of funds data for saving; and loan assns. and mutual savings banks. Data for 1966 are at a seasonally adjusted annual rate. term rates were trending downward, while short-term rates were rising. And it was not until the spring of 1965, when commercial paper rates had risen to a level near rates on corporate new issues, that long-term borrowing costs showed any significant rise. In previous expansions long-term rates had risen earlier, along with short-term rates. The relative stability of long-term rates contrib- uted to expansion in the domestic economy, whereas the rising short-term rate helped to ameliorate short-term capital outflows. In mid-i 965 interest rates began to rise throughout the maturity spectrum because of the mounting credit demands associated with the more rapid pace of economic activity that accompanied the increase in defense expenditures. Interest rates accelerated even faster in 1966, as monetary restraint reinforced the pressures on rates caused by heavy demands for credit. By the early autumn market yields on all classes of debt instruments had risen far above earlier postwar peaks. The changing relationship between market rates and the rates paid by banks on time and savings deposits reduced the relative attractiveness of bank deposits, and the expansion in time deposits began to slow down. Deposit flows. During the first 8 months of 1966 the deceleration in time deposit inflows of banks was relatively moderate. Yields on market securities showed substantial increases, but banks took advantage of the higher rate ceilings on time deposits established in December 1965 to maintain their competitive position. Despite large outflows of passbook savings-on which ceiling rates were not increased-total interest-bearing deposits of banks rose at an annual rate of more than 11 per cent in the period from the end of 1965 through August of 1966, compared with an average of 15 per cent for the 4 years 1962 through 1965. The increasing competition from banks and the market, how- ever, led to a sharp reduction in inflows of funds to nonbank intermediaries. Inflows had already slackened in 1965, but in the first three quarters of 1966 the combined inflow to savings and loan associations and mutual savings banks declined to an annual rate of just above 3 per cent. Several developments tended to retard the inflow of bank time deposits after mid-1966. The Board of Governors in July reduced the maximum rate that member banks may pay on time deposits on which the holder has more than one maturity option. Also in July, and again in September, reserve requirements on those time deposits-other than savings accounts-in excess of $5 million at PAGENO="0276" 272 individual member banks were raised, first from 4 to 5 per cent, and then to 6 per cent. Finally, in late September, pursuant to new legislative authority, the Board of Governors reduced the maximum rate member banks may pay on time deposits with denominations of less than $100,000 from 5½ per cent to 5 per cent. This action-taken simultaneously with restrictions by the Federal Deposit Insurance Corporation on maximum rates paid by mutual savings banks and by the Federal Home Loan Bank Board on maximum rates paid by member savings and loan asso- ciations-aimed to reduce the competitive escalation of rates among financial institutions. While these regulatory changes made it more difficult and costly for banks to attract time deposits, increasing market yields were also working in the same direction. Since mid-1966 most short-term market yields have exceeded the new 5 per cent ceiling on.time deposits in denominations of less than $100,000, and many were above the 5½ per cent ceiling on larger negotiable CD's during much of the late summer and autumn. With the resultant reduction in the relative attractiveness of bank time deposits, MARKET YIELDS rise above Regulation 0 celings in late summer of `66 CHART 6 ~ EGULATION 0 CEILINGS PRIME COMM. PAPER TREASURY BILLS: 90-BAY 30-DAY Bill rates are for offering side of market and have been converted to an investment basis (differs from discount-basis rate in that it gives the return on the amount invested rather than on the face amount of the bill at maturity and expresses this return in terms of a 365-day rather than a 360-day year; the investment yield corrects a d ownssard bias of the discount- basis yield). Latest week shown December 9. ttNtMtNAtIt~S tF SttO,tOO CR MtRt D(NOMINAtIORS DC LESS tItAN StOtOtC I I I l PAGENO="0277" 273 inflows to commercial banks dropped to an annual rate of less than 1 per cent from August through November. In October seasonally adjusted time deposits at banks declined for the first time since early 1960. These developments, by reducing the ability of banks to extend loans, had the effect of reinforcing monetary restraint in the economy. Much of the reduction in time deposit inflows since late sum- mer has occurred at the larger banks. These banks-which deal with highly interest-sensitive depositors and are the largest issuers of negotiable CD's-had an outflow of $3.0 billion of negotiable CD's from mid-August through November. The largest of these banks offset part of the outflow through increased borrowing from foreign branches; such borrowing increased by $1.2 billion from August through November. After mid-October, runoffs of negotiable CD's slowed con- siderably, as yields on very short-term market instruments-such as 30-day Treasury bills-declined enough to permit banks to attract funds in limited volume by selling short-term CD's. These sales, however, resulted in a sharply declining average maturity of outstanding CD's-accelerating the trend that had begun at midyear. In addition to outflows of negotiable CD's, large banks in October and November began to face slower growth-and in some cases outflows-of other types of time deposits, in par- ticular of consumer-type certificates. It is probable that this development reflected both the rollback in rate ceilings on smaller- denomination time deposits in late September and the movement of some funds by the public to longer-term market instruments in search of assured high yields for a longer period. The pressure on large banks-particularly that generated by runoffs of negotiable CD's-reinforced the effort of the Federal Reserve to reduce the expansion of business loans by banks. Dur- ing most of 1966 inflationary pressures were receiving impetus from the expansion in business capital outlays, and in the first 7 months of the year bank loans to nonfinancial businesses expanded at a seasonally adjusted annual rate in excess of 20 per cent- more than in 1965-despite some reduction in the availability of bank reserves at the initiative of the Federal Reserve. Lower time deposit inflows since late summer-and CD runoffs-reduced the ability of banks to make such loans. In addition, on September 1 the presidents of the Federal Reserve Banks wrote to all member banks calling upon them to rely more on curtailment of business 94-340 0 - 68 - 19 PAGENO="0278" 274 loans in adjusting to liquidity pressures and permitting them more extended use of Federal Reserve discount facilities when needed to accomplish such adjustments. In the 4 months ended in November, business loans expanded at a rate of less than 7 per cent. Credit flows. Reductions in deposit inflows at banks and non- bank financial institutions have produced a major shift in the sources of funds supplied for the financing of economic expansion. The share of total funds supplied by commercial banks fell from nearly 40 per cent in 1965 to an average of just over 20 per cent for the first three quarters of 1966. In the third quarter the com- mercial banking system supplied only about 7 per cent of total funds raised by nonfinancial borrowers. The share supplied by PUBLIC increases its share of total funds supplied in `66 CHART 7 ~ NONBAHO INTERMEOIARIES ::::::: :~: Flow of funds data. Denominator of each ratio is totat funds raised. Numerators as fottows: Bank loans and inves:rtreots, nonbank depositary institutions' acquisitions of credit market instruments, and domestic nonfinancial public's ccl purchases of credit market instruments. 1966 data at seasosally adjusted nonbank intermediaries also has shown a sharp decline. A much larger share of total funds has been supplied, therefore, by the nonfinancial public through direct purchases of market securities. The increasing share of total credit supplied directly through markets has been characteristic of earlier periods of monetary restraint. In 1966, however, higher alternative yields-on bank deposits and market instruments-have cut more into the public's purchases of claims on nonbank institutions than at any other time in the postwar period. In the first three quarters of 1966 consumers allocated to nonbank depositary institutions a postwar low of less than 20 per cent of their total accumulation of money, all deposits and shares, and market securities. In previous periods of restraint, this ratio had never declined below 40 per cent. The declining share of total credit supplied to the public by nonbank institutions has resulted in a dramatic cutback in the availability of new residential mortgage financing. Most prospec- PAGENO="0279" 275 tive mortgage borrowers have only limited borrowing alternatives in securities markets. Since many nonbank financial institutions tend to specialize in residential mortgages, the supply of financing for-and the volume of expenditures on-housing has declined sharply as 1966 has progressed. Other borrowers-particularly some businesses-who find it difficult to obtain bank credit are able to shift their borrowing to money and capital markets. But such financing is an imperfect substitute for bank loans because of the greater inflexibility, higher interest rates, and transactions costs, as well as the institutional lags, associated with issuance of new stocks and bonds. As in earlier periods of restraint, market financing was made even more costly by the competition of increased liquidation of bank holdings of securities, and in 1966 demands of the Federal Government for funds added to the congestion in some markets. Still other borrowers who find it difficult to obtain bank credit have only limited alternative sources of financing because they are too small to issue open market paper and securities effectively. Institutional investors in 1966 reduced their financing of firms through private placements, as prior commitments and other drains limited their availability of funds. Trade credit has been relied on heavily by many businesses, but its usefulness is limited largely to inventory financing. Most other sources of financing for these borrowers are quite costly. Thus, the diversion of funds from claims on banks and other financial institutions by rising market yields has had a pronounced effect on credit markets. The greater cost and limited substituta- bility of market financing for credit obtained at financial institu- tions, and the institutional and structural obstacles to a smooth transfer of credit from one type of lender to another, have re- duced the total borrowing of the nonfinancial public. Despite the increase in the public's purchases of credit market instruments, businesses, consumers, and State and local governments in the third quarter of 1966 are estimated to have borrowed from all sources at a seasonally adjusted annual rate of about $60 billion, down 20 per cent from the second-quarter rate; borrowing by nonfinancial businesses was down by almost 40 per cent. While much of the quarter-to-quarter decline in the total funds raised by these sectors reflected increased financing needs in the second quarter because of accelerated tax payments, the rate of total borrowing in the third quarter by each of these sectors dropped below its 1965 rate.. PAGENO="0280" PAGENO="0281" )R RELEASE ~iday, February 16, 1968 )proximately 4 P.M., EST MONEY AND INCOME Remarks of SHERMAN J. MAISEL Member Board of Governors of the Federal Reserve System at the Faculty and Graduate Students Colloquium sponsored by the Graduate Economics Club Yale University New Haven, Connecticut February 16, 1968 (277) PAGENO="0282" 278 MONEY AND INCOME Few things fascinate mankind as much as money. And one thing that seems almost invariably true is that, at least from the standpoint of the individual, the supply of money is seldom as plentiful as the supply of theories about it. Since even a simple theory may give significant insights into the workings of the economy and of the monetary system, it has been beneficial to have so many. I hope we will never cease to have new theories nortire of examining the old ones along with the new. In the course of these examinations, however, we ought to ren~ember the warning given every beginning student of economics: stay on guard against oversimplification, especially when it is proposed that a theory be used as the basis for determining a policy that is to be applied in practice. For purposes of. study, in furtherance of the understanding of particular processes, oversimplification may be positively helpful--as when we assume "all other things remain unchanged," even though in fact they do not. For policy purposes, however, particular theories may have marked deficiencies. They may apply only in the long run, and not at all in the short. They may describe mainly underlying tendencies and touch upon only a segment of reality. When used for policy proposals without these factors being taken into account, they may lead to prescriptions that would do r~ore harm than good. PAGENO="0283" 279 Economic history is full of theories that have attempted to prove that if the supply of money or credit could be made to behave in accordance with certain simple criteria, nearly all economic problems would be solved. Since scarcely anything could be more attractive or convenient, it is not surprising that the perennial search for such single, simple solutions is still in progress--and perhaps in full cry, to judge by the samples carried daily in the press of simplistic monetary proposals or policies advocated by some of our most eminent professional economists, by generally well- informed political leaders, and by well-trained financial writers. Today I would like to discuss some of the reasons why I think that theories that accept or overemphasize (in my judgment) the money supply as the major determinant of income would serve poorly as the basis for formulating monetary policy, in contrast to those that stress the need to consider the interactions of non-monetary together with all monetary causes of shifts in income and spending. For ease of exposition, I will use the terms "money supply theory" or "money supply only" for propositions that put most stress on changes in the money supply as the prime determinant of economic activity, and "money- income-expenditure" theory for those which stress the need to look at a broader list of variables. (While I have gone over the literature carefully and have tried to be representative in statements of views, an individual believer in either theo~y may well objectthat his views are not fairly represented. Almost an~ibody Who has written in either area could almost PAGENO="0284" 280 certainly come up with past statements that would enable him to disavow the theories as they are presented here.) Briefly I feel the analysis leads me at least to conclude that while important contributions have been made to show that "money does matter," this is far from the conclusion and it leads to entirely different policy prescriptions from claims that "only money matters." The belief that control of the money supply would be the most efficient type of governmental economic policy is not supported by either the facts or theory. It pays too little attention to the basic non-monetary causes of instability and to changes in the demand for liquidity. Because our economic system is complex, we need complex theories to analyze it. We must take into account changes in demand whether they come from government spending, from psychological factors, from endogenous cycles, from the money supply, from shifts in liquidity preferences or innumerable other forces. By considering a large number of variables which alter income, employment, and prices, we can explain and predict what is happening to the economy. Based on this knowledge, a flexible monetary and fiscal policy can be more efficient than a single variable policy in reducing the amount of instability and increasing the growth rate of the economy. PAGENO="0285" 281 Velocity and Interest Rates Before taking up some rather faulty assumptions upon which the money supply theory seems to me to rest, I'd like to absolve the theory of one such assumption that is, however, embraced in the associated policy prescription of a constant growth in the money supply. That is the assumption of a stable link between money and income. Stress is placed in the pre- scription not the theory on the stable long-run relationship between income and changes in money. Price and interest impacts on money demand under normal circumstances are said to be slight. While the velocity of money admittedly fluctuates in the short run, emphasis is on its stability over the long run. It is this assumption that allows the relationship to be turned on its head. Money can be thought of as the tail which wags the dog. Money is exogenously determined by the Federal Reserve System. To make the public willing to hold the money stock, income must adjust to the level of money. This leads to the concept that if money grows at a constant rate, income will also grow at a constant rate. Discretionary monetary policy should be replaced by one based on a more or less constant growth in the money supply. The theory itself points out that the demand for money depends upon interest rates as well as upon income. As a result, adjustments to changes in either the supply of money or the desire to spend can occur by alterations in interest rates and in the velocity of money. The demand for money changes with interest rates. A change in the supply of money may alter interest rates, not income. PAGENO="0286" 282 Thus, the direct causal link between money and income is broken. An excess of money over the demand for it may cause people to buy bonds in place of, or in addition to, corrmodities. A rise in the demand for goods may ~ raise interest rates. A given supply of money may not halt the expansion of demand from non-monetary sources. It may support a higher income level by turning over more rapidly. It is, of course, true that there is a way in which changes in bond prices and in velocities may affect spending. An excess of roney holdings may be passed on through successive portfolios via shifts in yields on assets. People-and institutions see short-L~riii gains in selling bonds at high prices. As one does so after another, the outcome eventually will be more spending, but how much more cannot be foreseen. How high a degree of leverage the money stock can.exert on income, particularly in any short or intermediate period, is questionable. - While avoiding this error of which they are at times accused, the "money supply only" theories do seem to me to neglect, ignore, or dismiss as insignificant a number of other~highly important points. Non-Monetary Causes of Spending Shifts One is the effect on the economy of changes in spending caused by wars, changes in the size and composition of the population, alterations in technology, government programs, the expected return on capital, and shifts in exports. The impact on income may become cumulative through operation of the multiplier-acceleration process as well as through the PAGENO="0287" 283 effects produced by changes in expectations. Progress and growth can lead, and have led, to destabilizing movements in demand. Furthermore, there is no obvious force in the economy which would prevent these movements from becoming explosive in either direction. Monetary factors may, of course, interact with these other changes. If there are changes in the rate or level of spending, and the money supply cannot adjust, changes will be produced in interest rates, bond prices, and wealth. These changes will react in turn upon future expenditures. Those who stress non-monetary causes of instability believe that purely monetary reactions arising from a stable money supply will be too slow, and perhaps too weak, to offset the instability arising from non-monetary causes. Velocities will shift; interest rates alter; desires for liquidity will change. Because monetary influences are felt with a lag, immediate market reactions to non-monetary d~velopments Ldfl increase rather than offset instability. Market Imperfections May Raise the Costs of Monetary Movements Another matter the money-supply theory appears to neglect (or assume away) is the problem of sectoral adjustments to monetary changes. It is well established that monetary changes have a differing impact on sectors of the economy. Yet the theory assumes that shifts in demand as a result of changes in interest rates or in the availability of credit will either be smooth or not excessively inefficient. In contrast, the money- income-expenditure approach points out the degree to which laws, rules, PAGENO="0288" 284 regulations, market institutions, and market imperfections influence income, and to the extremely uneven adjustments to which these factors may lead. These uneven adjustments may in turn bring about unexpected results with heavy costs. In constructing a theory simply to aid in understanding, as I noted at the outset, it may be proper to disregard the legal and institu-~ tional structure of the economy in order to study basic tendencies. In formulating policy, however, the economy's true reactions cannot be treated so cavalierly. Analysis for policy must consider the channels through which economic forces move. Policies do not sail the smooth seas of theoretical assumptions. They must steer their course among the rocks and shoals of laws and institutions. Money supply theorists assume perfection in the working of credit markets, though perfection is as rare in markets as in life. The imperfections that characterize markets in practice serve in fact to reallocate credit with seriously destabilizing results. If each sector of the economy had equal access to all capital markets--as it does not--everything would work through the price mechanism and allocational goals would be well served. If markets were truly impersonal--as they are not--those with the projects promising the best return would be the ones to get the credit. But the truth is that forces other than prices play major roles in the market place. PAGENO="0289" 285 When credit is tight (loanable funds are scarce in relation to demand in the economy), this becomes glaringly *apparent. For example, there is really little in a long-standing customer relationship to tell a bank that a prime depositor has a particularly meritorious project. Yet, at times of credit stringency, he is given credit on favorable terr~~s while other applicants with excellent projects are rationed out of the market for considerations that are perfectly logical to the bank. If markets functioned with perfect economic efficiency, this would not happen. For the economy in general, the most important effect of high interest rates has been to restrict the flow of funds to the housing market as the bond market has attracted funds that in other times were deposited in mortgage lending institutions (due to legal interest rate constraints and the slow turnover of assets at these institutions). Because real resources move slowly, this failure of credit to flow to its most efficient point constitutes an important stabilization problem. It is difficult to move labor geographically or to retrain a pli~mber to be an engineer. Also, unions can halt entry of new labor into the market just as monopoly and oligopoly halt entry of new businesses. Given this lack of real factor mobility, a temporary shift of credit may cause structural unemployment. It also may in the case of housing lead to an inflationary rise in rents and the cost of living if the supply of residences lags demand. It may be true that the resources would move given enough time. But the length of time required is much longer than is practical for the business cycle, and the reallocation is neither perfect PAGENO="0290" 286 nor cheaply accomplished. Nobody suggesting specific policy proposals today can responsibly ignore these imperfections. Fiscal Policy Is not Insignificant Also ignored, neglected, or downplayed by faithful adherents to the money supply theory is the extremely significant role the governments expenditures and its deficit may play in determining the course of economic and financial developments. The exoansion in expenditures caused by the war in Viet Nam has had major impacts on our economy in recent years. Wars can cause major changes in income irrespective of how they are financed. But the ease and efficiency with which resources are shifted to the war effort is not independent of tax policy and how the war debt is financed. To prove that a money creation rule could take the place of fiscal and debt management policy, one must show that by maintaining a constant growth in the money supply changes in other policies would be reduced to insignificance. But most economists agree that the opposite is true. Tax and debt policy can create a more efficient system of trans- ferring resources. The level of demand is not dependent entirely on the money supply and independent of the method of financing. Financing through borrowing rather than through taxing may cause significant structural changes. Most experience indicates that the level of production and the amount of resources available for the ~iar can be influenced by fiscal and debt policy. Who pays for the war and how income is redistributed also would be different under a system which used money supply as the key policy variable. PAGENO="0291" 287 In order to ignore the question of whether goods and services are purchased by the government or private spenders, one must assume that borrowing to reallocate resources is an efficient way of reallocating them. In addition, aggregate demand must not increase. If the government spends the proceeds of its bond issue on real resources while only part of the funds come from household demand for real resources the latter is not. true. If funds are raised by taxes, the person taxed has his wealth reduced. The reduced wealth makes it difficult for the taxpayer to borrow to augment his income. It appears that a person who turns in more money in taxes reduces his consumption by more than one who turns in this same additional amount to pay for a bond. A change in income or wealth produced by governmental expenditures may alter spending even if the supply of money is unchanged. Since the pattern of government demand differs so much from that of household demand, an increase in governmental expenditures requires a major shift of resources. When the government borrows heavily to payfor its expenditures, bond rates may be pushed up enough to cause major alterations in the. flow of funds. Some users of credit may get more, while others are fully supplied. In general, the lack of mobility of factors of production limits the effectiveness of high interest rates in reallocating resources. The impediments to accomplishment of such shifts in terms of rigidities, bottlenecks, etc. are significant and cannot be ignored. A tax program may be far more efficient in freeing the type of resources required and in insuring that no large quantities of resources lack demand. PAGENO="0292" 288 Shifts in the Demand for Money As economists we recognize that market equilibria can be altered by a shift in either supply or demand. For stability to result from a constant supply, demand must not shift. This, however, doesn't appear to be the case of the demand for money and credit. Desires for liquidity have shifted rapidly. We have just experienced such a major shift. In addition, expectations about future profits also may move rapidly. Unless we can raise the cost of capital relative to expectations about future profits, we cannot slow the boom without causing grave structural disorders. There are situations in which expectations are even destabilizing for the system. An expected price inflation feeds itself by encouraging people to buy goods and to draw down money balances. This sort of expecta- tion may not be amenable to a rule about the rate of growth of money. Some expectations about returns on capital may be stabilizing after awhile, but there is little guarantee that the short-run problem will be costless. A sharp reduction in expected return on capital may cause major disruptions. For stability, the use of fiscal policy or discretionary monetary policy may be quite necessary in such a situation. Similarly, if expected returns promise to outpace the cost of capital, especially as in a situation where business firms are particularly liquid, fiscal policy or discretionary monetary policy may be needed to dampen the elements giving rise to those expectations. In neither case should the money supply con- tinue to expand at a constant rate. For it to do so would in the former case not make it easy enough for people to borrow; in the latter case it would make it too easy. PAGENO="0293" 289 What Is Meant by the Supply of Money? The concept of the money supply is far more complex than it sometimes appears. Major differences in policy suggestions may follow from how the `money supply" is defined. There are at least four different versions of what the money supply is. While the movements of the money supply in all four versions are related, the growth rates of the respective "supplies" may differ greatly over periods of a quarter or even a year. Whether or not these differences are significant and which versions of the money supply should be considered as a primary index for policy depends upon one's complete theory. Sometimes money supply theorists talk as if currency in circu- lation and private demand deposits were all that mattered. At other times, they add private time deposits to get a larger version of the money supply. Movements of these two "money supplies" differ considerably. Because the government's cash balance is large and it rises and falls rapidly as the government takes in receipts and pays its bills, time and demand deposits also grow at a rate different from total commercial bank deposits. The behavior of total deposits of corrrnercial banks in turn may differ con- siderably from those of savings banks and savings and loan associations. Although some slippage exists, the total most directly affected by Federal Reserve operations is that of commercial bank deposits. Yet the total that seems to fit most theories best is total deposits of all institutions. Moreover, even with a constant level of deposits, 94-340 0 - 68 - 20 PAGENO="0294" 290 significant effects may result from alterations in the equal but opposite side of the balance sheet--loans and investments. There are many cases where the person to whom bank credit is loaned will influence the total amount of spending. To find these effects, we must look at bank loans and assets as well as the money supply. A policy that recommends strict control of a particular monetary total must properly define the total to be controlled. The recommendation could apply to anything from free reserves to all financial assets. To be operational, two characteristics must prevail. First, the target total must be under the control of the Federal Reserve. Second, the relationship between the targeted variable and spending must be clearly defined. A choice then depends on both practice and theory. The one thing that the Federal Reserve can control precisely is the volume of bonds in its portfolio. Although total non-borrowed reserves --those made available through purchases of government securities in the open market--are also within the reach of the Federal Reserve fairly con- stantly, the money supply, in contrast, is the result of interactions of the banks, the public, and the Federal Reserve. In general, the further you get from a definition of the targeted variable in terms of open market operations the more difficult it becomes to determine how Federal Reserve policy will affect it. Depending on the definitidn of money used, the total supply of it may be affected by public substitution between demand and time deposits, by shifts from public to private deposits, and by switches to bank deposits from other financial assets. PAGENO="0295" 291 If control over the total money supply is all that is needed, as the money supply theorists suppose it to be, the composition of the total must be of no consequence. But if the total alone is important, there must be some unifying purpose in holding all the assets included in the total. If time deposits are included, the motive cannot be trans- actions. It must have to do with liquidity or some other measure. If the measure were broadened so that all interest rate effects were internalized, the relationship to income might be more stable. But broadening theory to such a measure is to eliminate the control of the Federal Reserve. Statistical Studies At times over-exuberant believers in the money supply theory seem to be stating that there is little use quibbling over the theory because the facts have been proved statistically, and that there is an empirical if not necessarily a theoretically valid law justifying the policy of constant growth of money supply. When we examine all the many studies in this sphere and the relevant debates, it becomes clear that no such certainty exists. We face, of course, the typical problem of drawing conclusions about an extremely complex system from partial statistics. Looking at post-Korean data, we can correlate about half of quarterly changes in the GNP with changes in various definitions of the money stock. (Total member bank deposits or credit seem to do best.) The models giving such correlations contain lagged distributions for three to five quarters. PAGENO="0296" 292 Similarly, we find sets of expenditure variables which give equivalent results. In each case, we must still look to other factors to account for the majority of changes that have occurred. This can be done with m~ore complete models such as have been constructed at the Federal Reserve based upon the money-expenditure-income theories. Our problem is not merely that of looking at a bottle that is half empty and also half full. The problem is a good deal more complex. In each case, we can by theoretical reasoning improve or dissipate the initial statistical results. Most of the models used in such tests tend to be too simple. As an example, some published studies have argued at length over the use of claimed misuse of the concepts of "turning points" to attempt to prove either theory. - A comparison of turning points in no way does justice to a model in which various factors other than money affect GNP. This is particularly true when monetary policy is expected to offset part of the expansionary force of autonomous expenditures or of a runaway in expected return on capital. The effectiveness of policy depends on the relative strengths of the two opposing forces, not on the point in time when policy changes. If a strong expansionary policy action were to be coupled with a weak downward movement in other forces, one would expect the policy's effect would be more swiftly felt than if the other forces were moving down rapidly. The necessary ceteris p~tbus conditions are not represented in sonie of the statistical work. PAGENO="0297" 293 The fact that eminent scholars can draw different conclusions from similar data is, of course, not surprising. We are dealing with extremely complex matters. There are innumerable ways of specifying the basic models as well as of fitting data. No one can or should be convinced purely by past statistical results. One must be convinced by the underlying theories and by the ability to use the concepts in arriving at useful predictions and policy judgments. Concl usion My conclusion fromthis analysis is that a flexible package of policies based on forecasting should not be replaced by a single policy. As economists we must continue to examine theories new and old, but we ought not, without greater cause than we have yet been shown, abandon the system of analysis which looks at numerous variables and considers as relevant for policy the entire broad structure of our economy. Jt seems to me, on the evidence to date, that no policy based only on the control of the money supply will suffice. While impor~ant contributions have been made to economic research to show that "money does matter" in determining the course of the economy, that is a far different thing from claiming that "only money matters," and the policy prescription to which it leads is entirely different. Policy based on a broader, more complete analysis should in my opinion lead the economy to more success in achieving the goals set for it. PAGENO="0298" 294 Our problem in trying to use the various instruments of monetary policy to help steer the course of the economy to its goals--maximum employment and steady economic growth with relatively stable prices--is comparable to that of a bus driver trying to get to the top of a mountain. If the road were completely straight with a constant slope, it might make sense for him to lock his steering wheel in place and hold his accelerator at a fixed level. If, however, the mountain curves and changes its slope rather frequently, nothing could be more disastrous than an attempt by the driver to lock his steering gear in place and apply a constant flow of gasoline. He would be far more likely to reach his goal by using his steering wheel, his brakes, and his accelerator to help adjust to the variations in his road. In like vein, it seems to me that the American economy is too dynamic to achieve stability from a single policy rule such as `hold the growth of the money supply constant." PAGENO="0299" 295 The Rolle of? the ~kfiIo~ey ~npplly ~ ~ns~e~ Cydlle~ By RICHARD G. DAVIS'~' Most, if not quite all, economists are agreed that the behavior of the quantity of money makes a significant difference in the behavior of the economy-with "money" usually defined to include currency in circulation plus private demand deposits, but sometimes to include com- mercial bank time deposits as well.' Most economists, for example, setting out to forecast next year's gross national product under the assumption that the money supply would grow by 4 per cent, would probably want to revise their figures if they were to change this assump- tion to a 2 per cent decrease. In the past five to ten years, however, there has come into increasing prominence a group of economists who would like to go considerably beyond the simple assertion that the behavior of money is a significant factor influ- encing the behavior of the economy. It is not easy to characterize with any precision the views of this group of economists. As is perhaps to be expected where com- plex issues are involved, their statements about the impor- tance of monetary behavior in determining the course of business activity encompass a variety of individual posi- tions, positions which may themselves be undergoing change. Moreover these positions are rarely stated in quantitative terms. More frequently, the importance of money as a determinant of business conditions will be characterized as "by far the major factor", "the most fin- portant factor", "a primary factor", and by similar qualita- tive phrases inescapably open to various interpretations. Of course a~ one moves from the stronger phrases to the weaker, one comes closer and closer to the view that money is simply "a significant factor", at which point it be- comes virtually impossible to distinguish their views from those of the great majority of professional opinions. In order to bring a few of the issues into sharper focus, this article will take a look at some evidence for the "money supply" view of business fluctuations in one of its more extreme forms. Without necessarily implying that all the following positions are held precisely as stated by any single economist, an extreme form of the money supply * Assistant Vice President, Research and Statistics, Federal Reserve Bank of New York. ~~ore rarely, other types of liquid assets such as mutual say- ings bank deposits are also included in the definition of money. PAGENO="0300" 296 vieW can perhaps be characterized somewhat as follows: The behavior of the rate of change of the money supply is the overriding determinant of fluctuations in business ac- tivity. Government spending, taxing policies, fluctuations in the rate of technological innovation, and similar matters have a relatively small or even negligible influence on the short-run course of business activity. Hence, to the extent that it can control the money supply, a central bank, such as the Federal Reserve System, can control ups and downs in business activity. The influence of money on business operates with a long lag, however, and the tithing of the influence is highly variable and unpredictable. Thus attempts to moderate fluctuations in business activity by varying the rate of growth of the money supply are likely to have an uncertain effect after an uncertain lag. They may even backfire, producing the very instability they are designed to cure. Consequently, the best policy for a central bank to follow is to maintain a steady rate of growth in the money supply, year in and year out, at a rate which corresponds roughly to the growth in the economy's productive capacity. The implications of these views are obviously both highly important and strongly at variance with widely held beliefs. Thus they deny the direct importance of fiscal policy (except perhaps in so far as it may influence monetary policy), while they attribute to monetary policy a virtually determining role as regards business fluctua- tions. At the same time, they deny the usefulness of dis- cretionary, countercyclical monetary policy. The issues involved are highly complex and cannot possibly be ade- quately treated in their entirety in a single article.2 The present article, therefore, confines itself to examining the historical relationship between monetary cycles and cycles in general business. The article concludes that the relation- ship between these two kinds of cycles does not, in fact, provide any real support for the view that the behavior of money is the predoiftinant determinant of fluctuations in business activity. Moreover, the historical relationship between cycles in money and in business cannot be used to demonstrate that monetary policy is, in its effects, so long delayed and so uncertain as to be an unsatisfactory countercycical weapon. The first section shows how proponents of the money supply view have measured cycles in money and exam- 2 Among the many interesting and relevant issues not discussed are .the advantages and disadvantages of the money supply ~s an immediate target of monetary policy or as an indicator of the effects of policy, the proper definition of the money supply, and the nature and stability of the demand for money. PAGENO="0301" 297 ines the persistent tendency of turning points in monetary cycles, so measured, to lead turning points in general business activity. It argues that these leads do not neces- sarily paint to a predominant causal influence of money on business. A second section suggests that the cyclical relationship of money and business activity may be as much a reflection of a reverse influence of business on money as it is of a direct causal influence running from money to business. A third section indicates why, for some periods at least, the tendency for cycles in money to lead cycles in business may reflect nothing more than the im- pact on money of a countercyclical monetary policy. Next, the relative amplitudes of monetary contractions and their associated business contractions are examined. Again it is argued that these relative amplitudes fail to provide any clear evidence for a predominant causal influence of money. A fifth section examines the timing of turning points in money and in business for evidence that the in- fluence of money operates with so long and variable a lag as to make countercyclical monetary policy ineffective. A final section suggests that there may well be better ways to evaluate the causal influence of money on business than through the examination of past cyclical patterns. CYCLES fl~ 1~O~EY AIW CYCLES fiN EUSIINLISS ACTOVflTY As already implied, proponents of the money supply school have argued that the historical relationship between cycles in money and cycles in general business activity provides major support for their views on the causal importance of money in the business cycle. For the most part, these economists have delineated cycles in the money supply in terms of peaks and troughs in the percentage rate of change of money (usually including time deposits), while cycles in business have been defined in terms of peaks and troughs in the level of business activity as marked off, for instance, by the so-called "reference cycles" of the National Bureau of Economic Research (NBER) .~ ~ See, for example, Milton Friedman and Anna J. Schwartz, "Money and Business Cycles", Review of Economics and Statistics (February 1963, supplement), pages 34-38. While the procedure of these economists in comparing percentage rates of growth of money with levels of business activity can certainly be defended, it is by no means obvious that this is the most appropriate ap- proach, and there are many possible alternatives. Thus, for ex- ample, cycles in the rate of growth of money could be compared with cycles in the rate of growth, rather than the level, of business activity. For some purposes the choice among these alternatives makes a considerable difference, as is noted later in connection with measuring the length of the lags of business-cycle turning points relative to turning points in the monetary cycle. PAGENO="0302" 298 They have argued that virtually without exception every cycle in the level of business activity over the past century of United States experience can be associated with a cycle in the rate of growth of the money supply. The exceptions that are observed occurred during and just after World War 11-although the events of 1966-67 may also be interpreted as an exception, since an apparent cyclical decline in monetary growth was not followed by a reces- sion but only by a very brief slowdown in the rate of business expansion.4 The money supply school also finds that cycles in business activity have lagged behind the corresponding cycles in the rate of growth of the money supply, with business peaks and troughs thus following peaks and troughs in the rate of monetary change. While the evidence supporting these generalizations is derived from about a century of United States data, the nature of the measurements and some of the problems of interpretation can be illustrated from the postwar experience represented in Chart I. The chart shows monthly percentage changes in the money supply, defined here to include currency in the hands of the public plus commercial bank private demand and time deposits, on a seasonally adjusted daily average basis.5 The shaded areas represent periods of business recession as determined by the NBER. The first point to note is the highly erratic nature of month-to-month movements in the rate of change of the money supply. Indeed, the reader might be excused if he found it difficult to see any clear-cut cyclical pattern in the chart. The erratic nature of the money series, which partly reflects short-run shifts of deposits between Trea- sury and private accounts, does make the precise dating of peaks and troughs in the money series somewhat arbi- trary. This introduces a corresponding degree of arbitrari- ~ Granting the difficulties of dating specific cycleturning points for series as erratic as the rate of growth of the money supply, a peak (for the definition of money that includes time deposits) seems to have occurred in October 1965, with a trough in October 1966. While there was a slowdown in the rate of growth of busi- ness activity in the first half of 1967, there was clearly no business cycle peak corresponding to the peak in the money series. Indeed, the current dollar value of GNP moved ahead in the first two quarters of 1967, although at a reduced rate. The 1965-66 decline in the rate of growth in the money supply was relatively short (twelve months). In amplitude it was clearly among the milder declines, but it was nevertheless still nearly twice as steep as the mildest of past contractions in the rate of monetary growth (No- vember 1951 to September 1953). In any case, the 1965-66 de- cline does appear to represent a specific cycle contraction for the rate of monetary change under the standard NBER definition. See Arthur F. Burns and Wesley C. Mitchell, Measuring Business Cycles (National Bureau of Economic Research, 1946), pages 55-66. 5While, as noted, many analysts would prefer to define the money supply to exclude commercial bank time deposits, such an exclusion would not materially affect the general picture, at least not for the period illustrated by the chart. PAGENO="0303" 299 0* 2 `0 t 1/) I- Id)! OE I- 1/) ~ 0~ >- C 1/) ~ >2 z~ z~ (flE .2. E z PAGENO="0304" 300 ness in measuring timing relationships relative to turning points in business activity. Waiving this difficulty, how- ever, peaks and troughs in the money series as dated in one well-known study of the problem are marked on the chart for the 1947-60 period.6 As can be seen, each mone- tary peak occurs during the expansion phase of the busi- ness cycle and thus leads the peak in business. Similarly, there is a monetary trough marked during three of the four postwar recessions acknowledged by the NBER. A fourth monetary trough, however, in February 1960 occurs somewhat before the onset of recession three months later. The leads of the peaks in the money series with respect to the subsequent peaks in business activity are, it should be emphasized, quite variable, ranging from twenty months to twenty-nine months for the period covered in the chart and from six months to twenty-nine months for the entire 1870 to 1961 period. The corresponding range of leads of money troughs relative to subsequent troughs in business cycles varies from three months to twelve months for the charted period and up to twenty- two months for the longer period. The significance, if any, of these leads in assessing the importance of cycles in money in causing cycles in busi- ness is highly problematical. Firstly, chronological leads do not, of course, necessarily imply causation. It is per- fectly possible, for example, to construct models of the economy in which money has no influence on business but which generate a consistent lead of peaks and troughs in the rate of growth of the money supply relative to peaks and troughs in general business activity.7 Secondly, the ex- treme variability of the length of the leads would seem to suggest, if anything, the existence of factors other than money that can also exert an important influence on the timing of business peaks and troughs. Certainly even if a peak or trough in the rate of growth of the money supply could be identified around the time it occurred, this would be of very little, if any, help in predicting the timing of a subsequent peak or trough in business activity. Thirdly, there is a real question as to whether anything at all can be inferred from the historical record about the influence of money on business if, as is argued in the next section, 6 The dates used are essentially those presented in Milton Fried- man and Anna J. Schwartz, op. cit., page 37, Table I. Minor modifications of the Friedman-Schwartz dates have been made when these seemed obviously dictated by revisions in the data subsequent to publication of their work. ~ See James Tobin~ "Money and Income: Post Hoc Propter Hoc?", to be published. PAGENO="0305" 301 there is an important reverse influence exerted by the business cycle on the monetary cycle itself. THE flNFLUENCE OF BUSINESS ON MONEY Although the persistent tendency of cycles in monetary growth rates to lead business activity does not, as noted, necessarily imply a predominant causal influence of money on business, this tendency has nevertheless seemed to the money ilipply economists to be highly suggestive of such an influence. Certainly the consistency with which these leads show up in cycle after cycle is rather striking and does suggest that cycles in money and cycles in business are related by some mechanism, however loose and un- reliable. Nevertheless, it is important to recognize that this mechanism need not consist entirely or even mainly of a causal influence of money on business. It might, in- stead, reflect principally a causal influence of business on money, or it could reflect a complex relationship of mutual interaction. As noted earlier, virtually all economists be- lieve that there is, in fact, at least some causal influence of money on business, and it may be that this influence alone is enough to explain the existence of some degree of consistency, albeit a loose one, in the timing relationships of peaks and troughs in business and money. However, the existence of a powerful reverse influence of the business cycle itself on the monetary cycle would have important implications. By helping to explain the timing relation- ships of the money and business cycles, the existence of such an influence would certainly tend to question severely any presumption that these timing relationships are them- selves evidence for money as the predominant cause of business cycles. There are, in fact, a number of important ways in which changing business conditions can affect, and apparently have affected, the rate of growth of the money supply over the 100 years or so covered by the available data. First, the state of business influences decisions by the monetary authorities to supply reserves and to take other actions likely to affect the money supply-as is discussed in detail in the next section. Business conditions can also have a direct impact on the money supply, however. For example, they may affect the balance of payments and the size of gold imports or exports. These gold movements, in turn, may affect the size of the monetary base-the sum of cur- rency in the hands of the public and reserves in the banking system. Various official policies have tended to reduce or PAGENO="0306" 302 offset this particular influence of business on money, but at least prior to the creation of the Federal Reserve System it may have been of considerable significance. Second, business conditions may influence the money stock through an influence on the volume of member bank borrowings at the Federal Reserve. While the size of such borrowings is, of course, importantly conditioned by the terms under which loans to member banks are made, in- cluding the level of the discount rate, it may also be significantly affected by the strength of loan demand and by the yields that banks can obtain on earning assets. These matters, in turn, are clearly related in part to the state of business activity. A third influence of business on money operates through the effects of business on the ratio of the public's holdings of coin and currency to its holdings of bank de- posits. A rise in this ratio, for example, tends to drain reserves from banks as the public withdraws coin and currency. Since one dollar of reserves supports several dollars of deposits, the loss of reserves leads to a multiple contraction of deposits which depresses the total money supply by more than it is increased through the rise in the public's holdings of cash. While no one is very sure as to just what determines the cyclical pattern of the cur- rency ratio, a pattern does seem to exist which in some way reflects shifts in the composition of payments over the business cycle as well as, in the historically important case of banking panics, fluctuations in the public's confidence in the banks themselves.8 A final avenue of influence of business on money is through the influence of business conditions on the ratio of bank excess reserves to deposits. When the ratio of excess reserves to deposits is relatively high, other things equal, the money supply will be relatively low since banks will not be fully utilizing the deposit-creating potential of the supply of reserves available to them. Business condi- tions can affect the reserve ratio in various ways. Thus they can influence bank desires to hold excess reserves through variations in the strength of current and prospec- tive loan demand, through variations in the yields on the earning assets of banks, and through variations in banker expectations. When business is rising, loan demand is apt to be strengthening, yields on earning assets are apt to be 8 It might be noted that while the Federal Reserve has for many years routinely offset the reserve effects of short-term movements in coin and currency, such as occur around holidays, for example, the ratio of coin and currency in the hands of the public to deposits has apparently continued to show some mild fluctuations of a cyclical nature. PAGENO="0307" 303 rising, and banker confidence in the future is likely to be increasing. Thus excess reserves are apt to decline, with the reserve ratio rising and thereby exerting an upward influence on the money supply. The influence of business on money-acting through its influence on the growth of the monetary base, the cur- rency ratio, and the excess reserve ratio-is extremely complex and is not necessarily stable over time. The cyclical behavior of the monetary base and the cur- rency and reserve ratios have in fact varied from cycle to cycle. Moreover the relative importance of these three factors in influencing the cyclical behavior of money has varied over the near 100-year period for which data are available. In part, these variations have reflected the ef- fects of the creation and evolution of the Federal Reserve System. A detailed examination of the behavior of the monetary base, the currency and reserve ratios, and the role of business conditions in fixing their cyclical patterns is beyond the scope of this article. Recently, however, a very thorough analysis of the problem has been done for the NBER by Professor Philip Cagan of Columbia Uni- versity. He finds that "although the cyclical behavior of the three determinants [of the money stock] is not easy to interpret, it seems safe to conclude that most of their short-run variations are closely related to cyclical fluctua- tions in economic activity. . . . Such effects provide a plausible explanation of recurring cycles in the money stock whether or not the reverse effect occurred."9 The fact that the business cycle itself has an important role in determining the course of the monetary cycle se- riously undermines the argument that the timing relation- ships of monetary cycles and business cycles point to a dominant influence of money on business. By the same token, ample room is left for the possibility that many other factors, such as fiscal policy, fluctuations in business investment demand, including those related to changes in technology, fluctuation in exports, and replacement cycles in consumer durable godds, may also exert important in- dependent influences on the course of business activity. MONETARY POLIICY AND THE CYCLIICAL DEHAV~OR OF MONEY One important, though perhaps indirect, influence of business on money requires special mention, namely the 9Phillip Cagan, Determinants and Effects of Changes in the Stock of Money, 1875-1960 (National Bureau of Economic Research, 1965), page 261. PAGENO="0308" 304 influence it exerts via monetary policy. The relevance of monetary policy to the behavior of monetary growth dur- ing the business cycle was perhaps especially clear during the period beginning around 1952 and extending to the very early 1960's. In this period, policy was more or less able to concentrate on the requirements of stabilizing the business cycle relatively (but not entirely) unimpeded by considerations of war finance, the balance of payments, and possible strains on particular sectors of the capital markets. The ultimate aim of stabilizing the business cycle is, of course, to prevent or moderate recessions and to forestall or limit inflation and structural imbalances during periods of advance. The tools available to the Federal Reserve, however, such as open market operations and discount rate policy, influence employment and the price level only through complex and indirect routes. Hence, in the short run, policy must be formulated in terms of variables which respond more directly to the influence of the System. Some possibilities include, in addition to the rate of growth of the money supply, the growth of bank credit, conditions in the money market and the behavior of short-term interest rates, and the marginal reserve position of banks as measured, for example, by the level of free re- serves or of member bank borrowings from the Federal Reserve. It is clear that the money supply need not always be the immediate objective of monetary policy, and indeed it was not by any means always such during the 1950's. Given this fact, the behavior of the rate of growth of the money supply during the period cannot be assumed to be simply and directly the result of monetary policy decisions alone. Nevertheless, it is clear that the current and prospective behavior of business strongly influenced monetary policy decisions, given the primary aim of moderating the cycle, and that these decisions, in turn, influenced the behavior of the rate of growth of the money supply. Thus, for example, as recoveries proceeded and threatened to gen- erate inflationary pressures, monetary policy tightened to counteract these pressures. Regardless of what particular variable the System sought to control-whether the money supply itself, conditions in the money market, or bank mar- ginal reserve positions-the movement of any of these vari- ables in the direction of tightening would, taken by itself, tend to exert a slowing influence on the rate of monetary expansion. In this way, the firming of monetary policy in the presence of cumulating expansionary forces would no doubt help to explain the tendency of the rate of monetary PAGENO="0309" 305 growth to peak out well in advance of peaks in the busi- ness cycle. Similarly, the easing of policy to counteract a developing recession would help to produce an upturn in the rate of monetary growth in advance of troughs in busi- ness activity. In addition to the feedback from business conditions to policy decisions and thence from policy to the money supply, there are circumstances in which developments in the economy can react on the money supply even with monetary policy unchanged. Consider, for example, a situation in which the focus of policy is on maintaining an unchanged money market "tone"-a phrase that has been interpreted to imply, among other things, some rough stabilization of the average level of certain short-term in- terest rates such as the rate on Federal funds. Now a speedup in the rate of growth in economic activity would ordinarily accelerate the growtn of demand for bank credit and deposits. This, in turn, would normally result in up- ward pressure on the money market and on money market interest rates. Maintaining the stability in money market tone called for by such a policy would require, however, under the assumed circ~imstances, supplying more reserves to the banks in order to offset the upward pressures on money market rates. Thus, with unchanged policy, an acceleration in the rate of business expansion could gen- erate an acceleration in the rate of growth of reserves, and thence in the money supply. Similarly, a tapering-off in the rate of business expansion could, in these circum- stances, generate a tapering-off in the rate of monetary expansion well before an absolute peak in business activ- ity occurred. It should be emphasized that unchanged monetary policy could be perfectly consistent with counter- cyclical objectives under these conditions if the slowdown (or speedup) in the rate of business advance either were expected to be temporary or were regarded as a healthy development. The reaction of monetary policy to changing business conditions and the reaction of the money supply to mone- tary policy undoubtedly help explain the tendency of peaks and troughs in the rate of growth of the money supply to precede peaks and troughs in the level of eco- nomic activity during this period. The resulting monetary leads, however, cannot then be interpreted as demonstrat- ing a dependence of cycles in business on cycles in mone- tary growth. These leads would very likely have existed even if the influence of money on business were altogether negligible. 94-340 0 - 68 - 21 PAGENO="0310" 306 SEVERITY OF CYCLICAL MOVEMENTS Apart from matters of cyclical timing, some proponents of the money supply school have also regarded the rela- tionship between the severity of cyclical movements in money and the severity of associated cyclical movements in business as suggesting a predominant causal role for money. They argue, perhaps with some plausibility, that, if the behavior of money were the predominant deter- minant of business fluctuations, the relative sizes of cyclical movements in business and roughly contemporaneous cyclical movements in money should be highly correlated. For example, the severity of a cyclical decline in the rate of growth of the money supply should be closely related to the severity of the associated business recession or depression. The evidence for such a correlation, however, is actually rather mixed. Cyclical contractions in the monetary growth rate can be measured by computing the decline in the rate of mone- tary growth from its peak value to its trough value.10 On the basis of these computations, monetary contractions can be ranked in order of severity. Similarly, the severity of business contractions can be ranked by choosing some index of business activity and computing its decline dur- ing each business contraction recognized and dated by the NBER. If the resulting rankings of monetary contrac- tions are compared with the rankings of their associated business declines for eighteen nonwar business contrac- tions from 1882 to 1961, the size of monetary and business contractions proves to be moderately highly correlated.11 It turns out, however, that this correlation depends entirely on the experience of especially severe cyclical contractions. Among the eighteen business con- tractions experienced during the period, six are generally recognized as having been particularly deep. They include three pre-Worid War I episodes and the contractions of 1920-21, 1929-33, and 1937-38. In the latter three de- clines, the Federal Reserve Board's industrial production index fell by 32 per cent, 52 per cent, and 32 per cent, respectively, compared with a decline of only 18 per cent for the next largest contraction covered by the production index (1923-24). 10 Generally, three-month averages centered on the specific cycle turning point months have been used to reduce the weight given to especially sharp changes in the peak and trough months them- selves. 11 The Spearman rank correlation, for which satisfactory signifi- cance tests apparently do not exist when medium-sized samples (10 (ri <20) ~re liwOlved, is .70. The Kendall rank correlation coefficient, adjusted for ties, is .53 and is significant at the 1 per cent level. Rankings of business contractions are based on the Moore index. See Friedman and Schwartz, op. cit., Table 3, page 39. PAGENO="0311" 307 These six most severe contractions were in fact asso- ciated with the six most severe cyclical declines in the rate of growth of the money supply, though the rankings within the six do not correspond exactly. As was argued earlier, business conditions themselves exert a reverse influence on the money supply, and it seems probable that partic- ularly severe business declines may tend to accentuate the accompanying monetary contractions. Thus, for exam- ple, the wholesale default of loans and sharp drops in the value of securities that accompanied the 1929-33 depres- sion helped lay the groundwork for the widespread bank failures of that period. These failures were in part caused by, but also further encouraged, large withdrawals of cur- rency from the banking system by a frightened public. By contracting the reserve base of the banking system, in turn, these withdrawals resulted in multiple contractions of the deposit component of the money supply. Developments of this type help to explain the associa- tion of major monetary contractions with major depres- sions but do not seem `to account fully for it.12 Thus it may be that catastrophic monetary developments are in fact a pre-condition for catastrophic declines in business activ- ity. In any case, for more moderate cyclical movements, the association between the severity of monetary contrac- tions and the severity of business contractions breaks down completely. There is virtually no correlation whatever be- tween the relative rankings of the twelve nonmajor con- tractions in the 1882-1961 period and the rankings of the associated declines in the rate of monetary growth.13 Certainly this finding does not support the theory that changes in the rate of monetary growth are of predominant importance in determining business activity. MEASURING LAGS UN THE INFLUENCE OF MONEY ON BUSINESS Despite their belief in the crucial role of the money supply in determining the cyclical course of business activ- ity, some members of the money supply school neverthe- less argue, as suggested at the beginning of this article, that discretionary monetary policy is a clumsy and even danger- ous countercydical weapon. The starting point for this view is again the fact that peaks and troughs in the level 12 See Phillip Cagan, op. cit., pages 262-68. 13 The Kendall coefficient for the twelve nonmajor contractions is a statistically insignificant .03, while the corresponding Spear- man coefficient is .01. PAGENO="0312" 308 of business activity tend to lag behind peaks and troughs in the rate of change of the money supply-in particular the fact that these lags have tended to be quite long on average and highly variable from one cycle to another. Thus long average lags of about sixteen months for peaks and twelve months for troughs have suggested to these economists that the impact of monetary policy is correspondingly delayed, with actions taken to moderate a boom, for example, having their primary impact during the subsequent recession when precisely the opposite in- fluence is needed. Moreover, the great variability from cycle to cycle of the lags as measured by the money supply school has suggested that the timing of the impact of monetary policy is similarly variable and unpredictable. For this reason, they argue, it will be impossible for the monetary authorities to gauge when their policy actions will take effect and therefore whether these actions will turn out to have been appropriate. It is true, of course, that monetary policy affects the economy with a lag. The full effects of open market pur- chases on bank deposits and credit, for example, require time to work themselves out. More important, additional time must elapse before businessmen and consumers ad- just their spending plans to the resulting changes in the financial environment. For this reason, the pattern of spending at any given time will to some degree reflect the influence of financial conditions as they existed several months or quarters earlier. Hence it is certainly possible, for example, that some of the effects of a restrictive mone- tary policy could continue to be felt during a recession even though the current posture of monetary policy were quite expansionary. The fact that such lags do exist, however, shows only that monetary policy cannot be expected to produce imme- diate results. Like fiscal policy, its effectiveness depends in part on the ability to anticipate business trends so that policy actions taken today will be appropriate to tomorrow's conditions. Of course the longer the lags in the effects of policy prove to be, the further out in time must such anticipations be carried and the greater is the risk that policy actions will prove to be inappropriate. Moreover, if the lengths of the lags are highly variable and thus perhaps unpredictable, the risks of inappropriate policy decisions are obviously inbreased and the need for continuous adjustments in policy is apt to arise. The timing of cycles in money and cycles in business, however, provides absolutely no basis for believing that the lags in the effects of monetary policy are so long or PAGENO="0313" Chart II -5 Per cent CHANGES IN GROSS NATIONAL PRODUCT AND IN MONEY SUPPLY PLUS TIME DEPOSITS Quarter.to.quarter percentage changes; campound annual rates 28.3 Per cent 20 15 -10 0 1947 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 Note: Percentage chnngns are bnsed on seasonally odjustnd data. Sources: BoardotGcoernorsotthe Federal ReserveSystem;UnitedStatesDepartmentotCommerce. -10 PAGENO="0314" 310 so variable as to vitiate the effectiveness of a counter- cyclical policy. First, there are many reasons for doubting that the lag in the effects of monetary policy should be measured by comparing the timing relationships between cyclical turns in money and in business. It has been argued, for example, that other variables more directly under the control of policy makers, such as member bank nonborrowed reserves, or variables more clearly related to business decisions, such as interest rates, must also be taken into account. Yet, even if the behavior of the money supply be accepted as the indicator of policy, there are many alternative ways in which "the lag" between monetary and business behavior can be measured, and it makes a great deal of difference which measure is used. If, for example, the rate of change in the money supply is replaced by deviations in the level of the money supply from its long- run trend, the average lag between monetary peaks so measured and peaks in general business apparently shrinks from the sixteen months previously cited to a mere five months.14 Alternatively, it can be plausibly argued that the appropriate measure is the lag between the rate of change in the money supply, and the rate of change, rather than the level, of some measure of business activity such as gross national product (GNP) or industrial pro- duction. When peaks and troughs for money and business are compared on this basis, the lead of money over busi- ness appears to be quite short.15 The near simultaneity, in most cases, of peaks and troughs in the rates of change of the money supply and of GNP during the post-World War II period can be seen in Chart II. To be sure, move- ments in the two series are quite irregular, so that the deci- sion on whether to treat a particular date as a turning point is sometimes rather arbitrary. Nevertheless, the lead of peaks and troughs in the rate of growth of money over peaks and troughs in the rate of growth of GNP appears to average about one quarter or less.16 14 This estimate is presented by Milton Friedman in "The Lag Effect in Monetary Policy", Journal of Political Economy, Octo- ber 1961, page 456. 15 See John Kareken and Robert Solow, "Lags in Monetary Policy", Stabilization Policies (Commission on Money and Credit, 1963), pages 21-24. 16 When quarterly dollar changes in the money supply are cor- related with quarterly dollar changes in GNP experimenting with various lags, the highest correlation is achieved with GNP lagged two quarters behind money. (For the 1947-IT to 1967-ifi period the R2 is .34.) The correlation with a one quarter lag is almost exactly as high, however (R2 = .33). When percentage changes in the two series are used~instead, the correlation virtually disappears, no matter what lag is used~ PAGENO="0315" 311 The point of these various comparisons is not to prove. that the lag in monetary policy is necessarily either very long or very short, but rather to illustrate how hard it is to settle the matter through the kind of evidence that has been offered by the money supply school. Similar difficul- ties, as well as others, beset attempts to measure the variability of the lag in the influence of money on business by comparisons of cyclical peaks and troughs in the two. However the turning points are measured, the resulting estimates may seriously overstate the true variability of the lag in the influence of money on business. The reason is that observed differences from cycle to cycle in the timing of turning points in money relative to turning points in business are bound to reflect a number of factors over and beyond any variability in the influence of money on business.17 These "other" sources of variability include purely statistical matters such as errors in the data and the arbitrariness involved in assigning precise dates to turning points in money and in business. More funda- mentally, the fact that there ~xists a reverse influence of business on money, an influence that is probably, uneven from one cycle to the next, imparts a potentially serious source of variability to the observed lags. Moreover, if there are important influences on the general level of busi- ness activity other than the behavior of money, these factors would also increase the variability of the observed timing relationships between turning points in money and in business. Taking all these possibilities into account, it seems fair to say that whatever the true variability in the impact of money on business, its size is overstated when it is measured in terms of the variability of the lags in cyclical turning points. WAYS UN WUUECH MONEY MAY UNFLUENCE ~USUN ESS If there is a broad conclusion to be drawn from a study of the historical pattern of relationships between cycles in money and cycles in business, it is that there are distinct limits to what can be learned about the influence of money on business from this kind of statistical analysis. Perhaps this should not be surprising. During the business cycle many factors of potential importance to the subsequent behavior of business activity undergo more or less con- 17 Other sources of variability are discussed in some detail by Thomas Mayer in "The Lag in the Effect of Monetary Policy: Some Criticisms", Western Economic Journal (September 1967), pages 335-42. PAGENO="0316" 312 tinuous change. At the same time the business cycle itself feeds back on the behavior of these factors. Hence it is extremely difficult to isolate the importance of any single factor, such as the behavior of money, and post hoc, propter hoc reasoning becomes especially dangerous. In these circumstances there appears to be no substitute for a detailed, and hopefully quantitative, examination of the ways in which changes in the money supply might work through the economy ultimately to affect the various com- ponents of aggregate demand. Some brief and tentative sketches aside, the proponents of the monetary school have not attempted such an analysis. The possible ways in which an increase, for example, in the money supply might stimulate aggregate demand can be separated into what are sometimes called "income effects", "wealth effects", and "substitution effects". In- come effects exist when the same developments that pro- duce an increase in the quantity of money also add di- rectly to current income. Examples would be increases in bank reserves and deposits resulting from domestically mined gold or an export surplus. Similarly, a wealth effect occurs when a process increasing the money supply also increases the net worth of the private sector of the econ- omy. A Treasury deficit financed by a rundown of Trea- sury deposit balances might be regarded as an example of such a process, since the resulting buildup of private de- posits would represent an increase in private wealth. Far more important than the income or wealth effects in the present-day United States economy are substitution effects such as result when the Federal Reserve engages in open market operations and banks expand loans and investments.18 When the Federal Reserve buys Govern- ment securities from the nonbank public, the public of course acquires deposits and gives up the securities. There is no direct change in the public's net worth position,19 or in its income; rather there is a substitution of money for securities in the public's balance sheet. The same is true when the banks expand the money supply by buying se- curities from the nonbank public: the public substitutes money for securities, but neither its wealth nor its income 18 These substitution effects are sometimes also known as "port- folio balance" or "liquidity" effects. 19 This statement has to be modified to the extent that the Fed- eral Reserve's buying activity bids up the market value of the public's holdings of GOvernment securities. The significance of this wealth effect is probably minimal and is further limited in its consequences by the tendency of many holders to value Govern- ments at Qriginal purchase price or at par rather than at current market value. PAGENO="0317" 313 is directly changed by the transaction. Similarly, when banks expand deposits by making loans, the monetary assets of the borrowers rise, but their liabilities to the banking system rise by an equal amount and their net worth and income are unchanged. Since these substitution effects associated with open market operations and with the expansion of bank de- posits are by far the most important operations by which the money supply is changed, it seems especially relevant to study the ways in which these effects may influence economic activity. The main avenues appear to be through changes in interest rates on the various types of assets and changes in the availability of credit. When the Federal Reserve or the commercial banks buy securities from the - nonbank public in exchange for deposits, funds are made available for the public to purchase, in turn, a wide va- riety of private securities such as mortgages, corporate bonds, or bankers' acceptances.2° The increased demand for these securities tends to push rates on them down. And with borrowing costs down, business firms may be induced to expand outlays on plant and equipment or inventory while consumers may increase spending on new homes. In most cases, the effects of lower interest rates on capital spending probably stem from the fact that external financ- ing has become cheaper. In some cases, however, lower market yields on outstanding government and private securities might induce business holders to sell such assets in order to purchase higher yielding capital goods and thus, in effect, to make direct substitution of physical capital for financial assets in their "portfolios". Finally, lower interest rates on securities may reduce consumer incentives to acquire and hold financial assets while tempt- ing them to make more use of consumer credit, thereby reducing saving out of current income and increasing con- 20 The newly created deposits may of course in principle be used immediately to buy goods rather than financial assets, thus tending directly to stimulate business activity. Even in this case, however, the effects of the money-creatir~g operations work through and, depend upon reactions to interest rates. When the Federal Reserve or the commercial banks enter the market to buy securities, their bids add to total market demand, making market prices for securities higher (and yields lower) than they otherwise would have been. Indeed it is these relatively higher prices (lower yields) that induce the nonbank public to give up securities in exchange for deposits. If the deposits are in fact immediately used to purchase goods, then the process can be regarded as one in which lower market interest rates on securities stemming from bids by the Federal Reserve or the commercial banks have induced the public to give up securities in exchange for goods. The extent to which such switching will occur obviously depends upon the sensitivity to interest rates of business and consumer demands for goods. PAGENO="0318" 314 sumption purchases.21 With regard to bank lending, open market purchases of Government securities increase bank reserves and may ease the terms on which banks are willing to make loans. Changes in lending terms other than interest rates, which include repayment procedures, compensating balance re- quirements, and the maximum amount a bank is willing to lend to a borrower of given credit standing, are often bracketed as changes in "credit availability". Such changes are regarded by many analysts as being more important influences on many types of spending than are changes in interest rates. Moreover, changes in credit availability re- lated in part to changes in the money supply are not con- fined to lending by commercial banks, as was dramati- cally illustrated in 1966 with regard to nonbank mortgage lenders. In any case, an increased availability of funds permits and encourages potential borrowers to increase their loan liabilities, thereby providing funds which can be used to build up financial assets (perhaps mainly money market instruments) or to purchase physical assets in the form of business capital goods, inventories, or consumer durables. Stepped-up purchases of financial assets add to downward pressures on interest rates, stimulating spend- ing through the processes already described, while addi- tional demand for physical assets stimulates business activity directly. Studies of the influence of changes in interest rates and the availability of credit on spending in the various sectors of the economy have appeared with increasing frequency in the post-World War II period, especially within the past few years. Some of these studies have taken the form 21 While there is little general agreement that such direct effects on consumption are important, a recent study of the problem has in fact found a significant influence of interest rates on consumer de- mand for automobiles and other durables. (See Michael J. Ham- burger, "Interest Rates and the Demand for Consumer Durable Goods", American Economic Review, December 1967.) In general, proponents of the monetary school feel that analyses of the role of interest rates in consumer demand undertaken to date have ne- glected to take into account certain important factors. In particular, they think that the most relevant interest rates may not be the ones usually studied, namely the rates on financial instruments, but rather the interest rates "implicit" in the prices of the durable goods them- selves-i.e., where the value of the services yielded by a consumer durable, such as an auto or a washing machine, is treated as analogous to the coupon or dividend yielded by a bond or stock. The obvious difficulties of defining and measuring the value of such services have probably been responsible for the notable dearth of research into this possibility, however, and the issue must be regarded as completely unsettled. PAGENO="0319" 315 of interviews of businessmen and consumers with regard to the influence of credit cost and availability conditions on their spending decisions. Other studies have employed modern statistical and computer technology in an attempt to extract such information from data on past behavior.22 With regard to spending on housing, there has been gen- eral agreement that the cost and availability of credit are highly important. A number of studies have also found varying degrees of influence on business spending for plant and equipment and for inventories as well as on consumer spending for durable goods such as autos and appliances. All these studies, however, have also found factors other than cost and availability of credit to be highly important. Moreover, a large degree of disagree- ment exists with regard to the exaôt quantitative impor- tance of the financial factors. Given the serious technical problems that surround these studies, major areas of disagreement are virtually certain to exist for some time to come. Nevertheless, studies of the type referred to here appear to offer the hope at least that firmly grounded and widely accepted conclusions on the importance of money in the business cycle may ulti- mately be reached. Of particular interest are large-scale econometric models which attempt to provide quantitative estimates of the timing and magnitude of the effects of central bank actions on the money supply and other finan- cial magnitudes and the subsequent effects, in turn, of these variables on each of the various major components of aggregate demand. One such model is currently `under construction by members of the Federal Reserve Board staff in cooperation with members of the Economics De- partment of the Massachusetts Institute of Technology.23 Granting the major technical problems still unresolved, projects of this kind appear promising as a means of eventually tracking down the importance of money in ex- plicit, quantitative terms. 22 For a summary of some of these studies, see Michael J. Ham- burger, "The Impact of Monetary Variables: A Selected Survey of the Recent Empirical Literature" (Federal Reserve Bank of New York, July 1967). Copies of this paper are available on request from Publications Services, Division of Administrative Services, Board of Governors of the Federal Reserve System, Washington, D.C. 20551. 23 preliminary results of this work are discussed in "The Fed~ral Reserve-MIT Econometric Model" by Frank deLeeuw and Edward Gramlich, Federal Reserve Bulletin (January 1968), pages 9-40. PAGENO="0320" 316 HOARD OF GOVERNORO OF TN 0 FEDERAL RESERVE SYSTEM WASHINGTON. 0.0. 5055! March 7, 1968. The Honorable Del Clawson, House of Representatives, Washington, D. C. 20515. Dear Mr. Clawson: - This is in reply to your request for coent on a proposal by Mr. Preston Martin, Savings and Loan Coissioner of the State cf California, for possible Federal Reserve "backstopping" of the con- solidated obligations of the Federal Home Loan Bank System. As you will recall, he requests the Federal Reserve to commit itself to buy FHL Bank obligations-- either directly or in the secondary market-- as a means of cushioning the impact of monetary policy on the savings and loan industry and housing during periods of "very severe" credit restraint. At the outset it should be noted that Federal Reserve purchases of FHL Bank obligations directly from the FHLB System are not authorized under present law. Section l4(b)(2) of the Federal Reserve Act (12 U.S.C. 355), which was added to the law by the Act of September 21, 1966, provides that the Federal Reserve Banks may "buy and sell in the open market, under the direction and regulations of the Federal Open Market Coom~ittee, any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States." Altho~igh the Reserve Banks are also authorized by section 14(b) of the Act to purchase certain obligations of the United States directly from the Treasury, this authority does not extend to all agency issues but only to those which are fully guaranteed as to principal and interest by the United States. Moreover, since existing law already authorizes the Secretary of the Treasury to lend up to $1 billion directly to the F~B System, a similar authorization to the Federal Reserve would be simply additive. While the 1966 act does authorize the Federal Reserve to purchase F}U. Bank obligations in the open market, such buying is not really a feasible means of supporting the savings and loan industry. To have a significant influence on flows of funds to the FHLB System at times of severe credit squeeze, such Federal Reserve acquisitions would have to be very large and concentrated within a few months. PAGENO="0321" 317 Because the market in FHL Bank debt is still relatively small, at least when compared to the market for U. S. Government securities, purchases on such a large scale would quickly force other buyers out of the market leaving the Federal Reserve the dominant market force. Federal Reserve preemption of the buy side of the secondary market would, of course, tend to reduce interest yields on FBI Bank issues, at least temporarily. But it has generally been our view that financial markets are benefitted most over the long run if basic forces of supply and demand are allowed to work themselves out in the market- place independent of direct Federal Reserve support. Since the Treasury- Federal Reserve accord in the early 1950's, all of our open market operationshave been conducted with this view in mind. Otherwise, uncertainties are engendered in the minds of investors and dealers whether pegged interest rates or general monetary objectives will be given first priority. Such uncertainties in turn create arbitrary price fluctuations which retard the market's development. The market for FHL Bank debt and agency securities in general has already grown considerably in depth and breadth in recent years, a~d the Federal Reserve would not wish to inhibit further improvement. sequently, I believe Federal Reserve transactions in the secondary market for agency securities should be undertaken only to the extent they contribute to the market's long run development. With this objective in mind, the Federal Reserve began in late 1966 to make repurchase agreements with dealers in agency securities. Since then, nearly $1 billion of such transactions have been made, about half of which have been in the obliga- tions of housing agencies. More generally, any undertaking to finance the FEL Banks through Federal Reserve buying of FHL Bank debt would have to be accomplished within the constraints of general monetary policy--which in the circum- stances assumed would be strongly anti-inflationary. Federal Reserve experience with the pegging of interest rates during and after World War II showed that efforts to hold any given interest rate at artificially low levels cause the Federal Reserve to become "an engine of inflation." If Federal Reserve purchases were to be made on the scale required without releasing substantially more reserves to the banking system than would be consistent with general monetary policy, the Federal Reserve would have to make partly offsetting sales of U. S. Government securities. And over the longer run ~ additions of FBI Bank obligations to the Federal Reserve security portfolio would represent substitutions for U. S. Government securities. PAGENO="0322" 318 Thus, while Federal Reserve purchases would tend, other things being equal, to depress interest rates on FHL Bank obligations, Federal Reserve sales (or foregone purchases) would at the same time put upward pressure on yields of short-term Treasury issues. At best, a Federal Reserve buying program of this type would simply help to keep spreads between yields on short-term Treasury and FHL Bank issues from widening as much as they usually would in the assumed circumstances of generally rising short-term rates and expanding FHL Bank offerings. In short, Federal Reserve buying of FHL Bank debt--even if undertaken directly, as well as in the open market--would probably not be very effective in insulating the Home Loan Bank System from high interest costs at times of severe credit squeeze. Since large-scale - buying of FlU. Bank debt would also present problems of market domination, as already noted, and create important technical difficulties for day-to- day management of the Federal Reserve open market portfolio, it is not at all clear that such a policy would on balance produce a net sociai benefit. The Board of Governors does, of course, recognize that occasions may arise when FIlL Banks should be provided with otherwise unavailable funds for lending to S and L's faced with a severe liquidity crisis. Emergency arrangements were made during the 1966 credit squeeze for Federal Reserve Banks to serve as lenders of last resort in such situations through their discount operation. Similar arrangements would again be made should similar circumstances develop in the future. But in the last analysis continued efforts to produce fundamental institutional reforms are likely to be most effective in ameliorating the severity of pressures on mortgage and housing markets during periods of tight money. since 1966, both Government and industry groups have been actively studying and promoting a number of such proposals for institutional reform. I believe these efforts should continue to be actively encouraged. I hope that these comments will be helpful to you in responding to Commissioner Martin. Sincerely yours, Wm. McC. Martin, Jr. (Whereupon, at 12:15 p.m., the committee adjourned.) 0