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COMPENDIUM ON MONETARY POLICY
GUIDELINES AND
FEDERAL RESERVE STRUCTURE
PURSUANT TO H.R.
11
SUBCOMMITTEE ON DOMESTIC FINANCE
OF THE
COMMITTEE ON BANKING AND CURRENCY
HOUSE OF REPRESENTATIVES
90th Congress, Second Session
D E C E M B E R 1968
Printed for the use of the Committee on Banking and Currency
U.S. GOVERNMENT PRINTING OFFICE
21-570
WASHINGTON : 1968
C O M M I T T E E ON B A N K I N G A N D
CURRENCY
WRIGHT PATMAN, Texas, Chairman
WILLIAM A. BARRETT, Pennsylvania
LEONOR K. SULLIVAN, Missouri
HENRY S. REUSS, Wisconsin
THOMAS L. ASHLEY, Ohio
WILLIAM S. MOOBHEAD, Pennsylvania
ROBERT G. STEPHENS, JR., Georgia
FERNAND J. ST GERMAIN, Rhode Island
HENRY B. GONZALEZ, Texas
JOSEPH G. MINISH, New Jersey
RICHARD T. HANNA, California
TOM S. GETTYS, South Carolina
FRANK ANNUNZIO, Illinois
THOMAS M. REES, California
JONATHAN B. BINGHAM, New York
NICK GALIFIANAKIS, North Carolina
TOM BEVIL, Alabama
LESTER L. WOLFF, New York
CHARLES H. GRIFFIN, Mississippi
WILLIAM B. WIDNALL, New Jersey
PAUL A. FINO, New York
FLORENCE P. DWYER, New Jersey
SEYMOUR HALPERN, New York
W. E. (BILL) BROCK, Tennessee
DEL CLAWSON, California
ALBERT W. JOHNSON, Pennsylvania
J. WILLIAM STANTON, Ohio
CHESTER L. MIZE, Kansas
SHERMAN P. LLOYD, Utah
BENJAMIN B. BLACKBURN, Georgia
GARRY BROWN, Michigan
LAWRENCE G. WILLIAMS, Pennsylvania
CHALMERS P. WYLIE, Ohio
$»ADL NELSON, Clerk and Staff Director
CURTIS A . PRINS, Chief
BE NET D . GELLMAN,
JAMES F . DOHERTY,
ROBERT E . WEINTRAUB,
Investigator
Counsel
Counsel
Economist
ORMAN S. FINK, Minority Staff Member
SUBCOMMITTEE ON DOMESTIC FINANCE
WRIGHT PATMAN, Texas, Chairman
JOSEPH G. MINISH, New Jersey
WILLIAM B. WIDNALL, New Jersey
RICHARD T. HANNA, California
W. E. (BILL) BROCK, Tennessee
TOM S. GETTYS, South Carolina
J. WILLIAM STANTON, Ohio
FRANK ANNUNZIO, Illinois
SHERMAN P. LLOYD, Utah
THOMAS M. REES, California
BENJAMIN B. BLACKBURN, Georgia
NICK GALIFIANAKIS, North Carolina
LESTER L. WOLFF, New York
(II)
LETTER OF TRANSMITTAL
Transmitted herewith for the use of the Subcommittee on Domestic
Finance and other members of the Banking and Currency Committee
and the Congress are the replies received from the Federal Reserve,
the Treasury, the Council of Economic Advisers and 71 academic, bank
and research monetary economists in response to a questionnaire sent
out on July 9, 1968. Respondents were asked to express their opinions
on questions pertaining to H.R. 11, a bill "To make the Federal Reserve
System responsive to the best interests of the people of the United
States and to improve the coordination of monetary, fiscal, and economic policy." (A reproduction of H.R. 11 introduced on January 10,
1967, in the first session of the 90th Congress is found on pages 1-5.)
Questionnaires were sent to the seven members of the Board of
Governors of the Federal Reserve System and the 12 Reserve bank
presidents, the Secretary of the Treasury, the members of the President's Council of Economic Advisers and 125 prominent academic, bank
and research monetary economists; representing all schools of thought
on the fundamental question of how to manage the Nation's money and
credit. Replies are printed verbatim, as they were received, with only
minor editorial changes. In addition, the staff letter of transmittal
which follows contains a question-by-question summary of the replies
and analysis of the response of the Federal Reserve whose 19 highest
officials replied as one man to the questions asked. Neither the staff
analysis nor any of the responses to the questionnaire which follow
herein necessarily represent the views of any member of the subcommittee.
I am sure that all members of the subcommittee join me in expressing
gratitude and appreciation to those who took the time to think about
our questions and submit replies thereby giving us the benefit of their
valuable experience and training.
Reform of our monetary policy system is needed now. Our economy has been in the expansion phase of the business cycle now for
nearly 8 jrears. The expansion, however, has been marred by a minirecession in late 1966 and early 1967 and by inflations of prices and
interest rates first in late 1965 and early 1966 and more recently in
1968. Monetary policy has played an important role in all these movements. Favorable monetary trends contributed substantially, to the
powerful upsurge which has dominated our economic performance
since February 1961, and perverse monetary developments contributed
to the recent short-lived minirecession and low-level inflationary episodes that have flawed this performance. We must realize that continuation of the upswing and minimization of future destabilizing
developments, whether in the direction of recession or inflation, depend
strategically on our achievement in future years of favorable monetary
trends and avoidance of perverse departures from these trends.
(in)
IV
Monetary trends emerge primarily from policy actions of our monetary authorities, that is, the policy making officers of the Federal Reserve System. Nothing can be plainer, therefore, than the need to
structure the Federal Reserve and define its role in the context of the
totality of the Government's economic policies so that we are assured
of monetary trends favorable to stable- economic growth and avoid
destabilizing monetary developments. H.R. 11 was conceived for this
purpose. I believe that this compendium furnishes an indisputable
basis for reform of the Federal Reserve System and amendment of the
Employment Act, essentially as provided for by H.R. 11.
H.R. 11 provides for:
(1) Reducing the number of members of the Federal Reserve Board
to 5 and their term of office to 5 years and making the term of the
Chairman of the Board coterminous with that of the President of the
United States;
(2) Vesting all power to direct open market operations in the
Federal Reserve Board and coordinating such operations with the
economic programs and policies of the President pursuant to the
Employment Act;
(3) Requiring that the President, in submitting his annual economic report pursuant to the Employment Act, shall include, along
with his recommendations on fiscal and debt-management policy,
guidelines concerning monetary policy including the growth of the
money supply as defined by him;
(4^ Retiring Federal Reserve bank stock;
(5) Annual audit of the Federal Reserve Board and banks and
their branches; and
(6) Funds to operate the Federal Reserve System to be appropriated by the Congress of the United States.
Still another reform which the compendium demonstrates we must
adopt is the transfer of all but a small fraction of the Federal Reserve's
portfolio of U.S. Government securities—nowr totaling more than $53
billion—to the Treasury. As long as the Federal Reserve holds these
securities many persons, as the compendium shows, wTill fail to see that
open market purchases of U.S. Government securities increase the
public's financial wealth or net worth, and thereby cause increased
spending and activity in the economy at large. The keystone of the
matter is that open market purchases reduce the public's holdings of
the Federal debt and liability for it by equal amounts, and thus the net
effect is to increase net worth by the amount of currency and reserves
the Federal Reserve uses to pay for its purchases of U.S. Government
securities. What many do not seem to understand is that taxpayers are
liable for U.S. Government securities and the interest thereon only so
long as these securities are held outside the Federal Reserve. When the
Federal Reserve uses the Nation's money and credit to buy U.S. Government securities it retires them just as surely as if the Treasury had
bought them. Taxpayer liability ceases. The law must be changed so
that no one fails to recognize this. Transfer of all but a small fraction
of the Federal Reserve's portfolio to the Treasury and automatic
transfer of all new purchases is urgently needed therefore. With these
transfers there will be no failure to see that open market operations
directly change the public's financial wealth or net worth, and thereby
change spending and economic activity. And seeing this will make it
V
possible at long last- to develop a viable monetary policy—a policy
tuned in to the realities of monetary and economic processes.
In transmitting this compendium to the subcommittee it is my hope
that it will be read and discussed not only by members of the Banking
and Currency Committee but also by the entire Congress and the general public as well.
The questionnaire and analysis which follows was done under the
immediate supervision of Dr. Robert E. Weintraub, professor of economics at the University of California at Santa Barbara.
Sincerely yours,
WRIGHT PATMAN,
Chairman, House Committee on Banking crnd Currency.
CONTENTS
Page
Statement of Respondents:
Letter of transmittal
Text of H.R. 11
Summary and analysis
Gov. William McC. Martin, Chairman, for the members of the Board of
Governors and the Reserve bank presidents of the Federal Reserve
System
Honorable Henry H. Fowler, Secretary of the Treasury
Members of the Council of Economic Advisers—Dr. Arthur Okun (Chairman), Dr. Merton J. Peck, Dr. Warren Smith
Dr. E. Sherman Adams, First National City Bank
Prof. Carl T. Arlt, University of Illinois
Prof. Joseph Aschheim, George Washington University
Prof. George L. Bach, Stanford University
Prof. Martin Bronfenbrenner, Carnegie-Mellon University
Prof. Karl Brunner, Ohio State University
Prof. Meyer L. Burstein, Warwick University and Aspen, Colo
Prof. Phillip Cagan, Columbia University
Dr. Gregory C. Chow, Thomas J. Watson Research Center, I B M
Prof. Carl F. Christ, Johns Hopkins University
Prof. Jacob Cohen, University of Pittsburgh
Prof. Robert L. Crouch, University of California, Santa Barbara
Prof. John M. Culbertson, University of Wisconsin
Prof. Paul Davidson, Rutgers University
Prof. William G. Dewald, Ohio State University
Prof. James S. Earley, University of California, Riverside
Prof. Otto Eckstein, Harvard University
Prof. David I. Fand, Wayne State University
Prof. William Fellner, Yale University
Prof. Leo Fishman, West Virginia University
Prof. William J. Frazer, Jr., University of Florida
Prof. Milton Friedman, University of Chicago
Prof. Gary Fromm, The Brookings Institution
Dr. Tilford C. Gaines, Manufacturers Hanover Trust Co
Prof. William I. Greenwald, CCNY
Prof. Herschel I. Grossman, Brown University
Prof. Seymour E. Harris, Emeritus, Harvard University and University of
California, San Diego
Prof. Lowell Harriss, Columbia University
Dr. E. C. Harwood, American Institute for Economic Research
Dr. Gabriel Hauge, Manufacturers Hanover Trust Co
Prof. Thomas M. Havrilesky, University of Maryland
Prof. Donald D. Hester, University of Wisconsin
Dr. Walter E. Hoadley, Bank of America
Prof. George Horwich, Purdue University
Prof. William R . Hosek, University of New Hampshire
Prof. Dudley W. Johnson, University of Washington, Seattle
Prof. Edward J. Kane, Boston College
Prof. Norman F. Keiser, San Jose State College
Prof. Raymond P. Kent, Notre Dame University
Dr. Leon H. Keyserling, Washington, D.C
Prof. Henry A. Latane, University of North Carolina
Prof. Axel Leijonhufvud, UCLA
Dr. Michael E. Levy, The National Industrial Conference Board
Prof. Dudley G. Luckett, Iowa State University
Prof. George Macesich, Florida State University
(VII)
III
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7
29
55
70
85
87
91
94
98
100
104
106
106
109
1^5
119
127
130
142
147
151
154
158
160
166
203
227
227
235
236
242
250
264
272
273
283
291
293
304
313
338
344
356
364
408
409
421
431
437
VIII
Dr. Carl H. Madden, Chamber of Commerce of the United States
Prof. Thomas Mayer, University of California, Davis
Prof. Paul W. McCracken, University of Michigan
Prof. Stephen L. McDonald, University of Texas
Prof. Jacques Melitz, Tulane University
Prof. Allan H. Meltzer, Carnegie-Mellon University
Prof. Hyman P. Minsky, Washington University, St. Louis
Prof. George R . Morrison, University of California, San Diego
Prof. Walter A. Morton, University of Wisconsin
Dr. Guy E. Noyes, Morgan Guaranty Trust Co
Prof. Boris P. Pesek, University of Wisconsin
Prof. Howard N. Ross, CUNY, Bernard M. Baruch College
Prof. Robert H. Scott, University of Washington, Seattle
Dr. Beryl Sprenkel, Harris Trust and Savings Bank
Prof. Roland Stucki, University of Utah
Prof. Ronald L. Teigen, University of Michigan
Prof. Earl A. Thompson, UCLA
Prof. Richard S. Thorn, University of Pittsburgh
Jerry Voorhis, Cooperative Foundation & National Association of Housing
Cooperatives, Chicago, 111
Dr. Charls E. Walker, American Bankers Association
Staff Report on, "The Federal Reserve System After 50 Years," parts II
and IV
Prof. Henry C. Wallich, Yale University
Dr. Clark Warburton, McLean, Va
Prof. Sydney Weintraub, University of Pennsylvania
Prof. C. R. Whittlesey, Emeritus, University of Pennsylvania
Dr. Frazar B. Wilde, Chairman Emeritus, Connecticut General Life Insurance Co
Dr. Leland Yeager, University of Virginia
Page
457
460
472
474
479
488
491
493
501
502
508
520
526
534
546
548
553
559
573
574
593
630
634
644
648
650
651
TEXT OF H.R. 11
[H.R. 11, 90th Cong., first sess.],
A BILL To make the Federal Reserve System responsive to the best interests of the
people of the United States and to improve the coordination of monetary, fiscal, and
economic policy
It provides f o r :
( a ) Retiring Federal Reserve bank stock;
(b) Coordinating Federal Reserve bank policies and programs with those of
the President of the United States in keeping with the provisions of the Employment Act of 1946;
( c ) Reducing the number and term of office of members of the Federal Reserve
Board;
(d) Making the term of Chairman of the Board coterminous with that of the
President of the United States;
(e) An audit for each fiscal year of the Federal Reserve Board and the Federal
Reserve banks and their branches by the Comptroller General of the United
States;
( f ) Funds to operate the Federal Reserve System to be appropriated by the
Congress of the United States.
Be it enacted "by the Senate and House of Representatives of the United States
of America in Congress assembled,
RETIREMENT OF FEDERAL RESERVE BANK STOCK
1. ( a ) The last sentence of the first paragraph of section 2 of the
Federal Reserve Act (12 U . S . C . 222) is amended by changing "subscribing and
paying for stock" to read "obtaining a certificate of membership".
(b) The last sentence of the third paragraph of such section 2 (12 U.S.C. 282)
is amended by changing "subscribe to the capital stock of such Federal reserve
bank in a sum equal to 6 per centum of the paid-up capital and surplus of such
bank, one-sixth of the subscription to be payable on call of the organization committee or of the Board of Governors of the Federal Reserve System, one-sixth
within three months and one-sixth within six months thereafter, and the
remainder of the subscription, or any part thereof, shall be subject to call when
deemed necessary by the Board of Governors of the Federal Reserve System, said
payments to be in gold or gold certificates." to read "obtaining a certificate of
membership pursuant to the provisions of this Act."
(c) The fourth paragraph of such section 2 (12 U.S.C. 502) is repealed.
(d) The paragraphs which, prior to the repeal made by subsection (c) of this
section, were the eighth, ninth, tenth, eleventh, and twelfth paragraphs of such
section 2 (12 U.S.C. 283-286) are repealed,
(e) The first sentence of the last paragraph of such section 2 (12 U.S.C. 281)
is repealed.
SEC. 2. (a) The last sentence of the first paragraph of section 4 of the Federal
Reserve Act is amended by changing "a subscription to the capital stock o f " to
read "an application for a certificate of membership in".
(b) The second paragraph of such section is amended (1) by changing "when
the minimum amount of capital stock prescribed by this Act for the organization
of any Federal reserve bank shall have been subscribed and allotted," to read
"when the organization committee shall deem that a sufficient proportion of eligible banks have applied for membership in a Federal Reserve bank in process of
organization,", (2) by striking "the amount of capital stock and the number of
shares into which the same is divided,", (3) by changing "subscribed to the capital stock o f " to read "applied for membership in", (4) by striking "and the number of shares subscribed by each", and (5) by changing "subscribed or may
thereafter subscribe to the capital stock o f " to read "applied or may thereafter
apply for membership in".
SECTION
(1)
10
(c) The subparagraph numbered "Eighth" of the fourth paragraph of such
section 4 (12 U.S.C. 341) is amended by striking "stock".
(d) The tenth paragraph of such section 4 is amended by changing "stockholding" to read "member".
(e) The second sentence of the twelfth paragraph of such section 4 is amended
by changing "subscriptions to the capital stock" to read "applications for
membership".
SEC. 3. Section 5 of the Federal Reserve Act (12 U.S.C. 287) is amended to read:
"CERTIFICATES OF MEMBERSHIP
"SEC. 5. (a) The Federal Reserve banks shall have no capital stock.
" ( b ) A bank applying for membership in the Federal Reserve System at any
time after the date of enactment of this subsection shall submit such application,
in accordance with the regulations of the Federal Reserve Board, to the Federal
Reserve bank of its district. Such application shall be accompanied by a membership fee of $10, which shall not be refundable unless such application is disapproved or withdrawn before approval.
" ( c ) Upon the approval of an application submitted pursuant to subsection (b)
of this section, the Federal Reserve bank shall issue to the applicant a certificate
attesting the membership of the applicant in such Federal Reserve bank and in
the Federal Reserve System.
" ( d ) Wiheni a member bank voluntarily liquidates, it shall surrender its certificate of membership and cease to be a member of the Federal Reserve bank
of its district and of the Federal Reserve System."
SEC. 4. (a) The first paragraph (12 U.S.C. 288, first paragraph) of section 6
of the Federal Reserve Act is repealed.
(b) The second sentence of the paragraph which, prior to the repeal made by
subsection (a) of this section, was the second paragraph (12 U.S.C. 288, second
paragraph) of such section 6, is amended to read: "The certificate of membership
held by said national bank shall be surrendered to the Federal Reserve bank of
its district, and said national bank shall cease to be a member of such Federal
Reserve bank and of the Federal Reserve System."
SEC. 5. (a) The first paragraph (12 U.S.C. 289) of section 7 of the Federal
Reserve Act is amended by striking "the stockholders shall be entitled to receive
an annual dividend of 6 per centum on the paid-in capital stock, which dividend
shall be cumulative. After the aforesaid dividend claims have been fully met,".
(b) The second sentence of the second paragraph (12 U.S.C. 290) of such
section 7 is amended by striking "dividend requirements as hereinbefore provided, and the par value of the stock.".
(c)' The third paragraph (12 U S.C. 531) of such section 7 is amended by
striking "capital stock and".
SEC. 6. (a) The first paragraph (12 U.S.C. 321, first paragraph) of section 9
of the Federal Reserve Act is amended (1) by changing, in the first sentence,
"the right to subscribe to the stock o f " to read "membership in", (2) by striking
the second and third sentences, and (3) by changing, in the last sentence, "stockholder" to read "member".
(b) The first sentence of the second paragraph (12 U.S.C. 321, second paragraph) of such section 9 is amended by changing "Federal reserve bank stock
owned by the national bank shall be canceled and paid for as provided in section
5 of this Act." to read "membership of such national bank shall be extinguished
and the certificate of membership canceled as provided in section 5 of this Act."
(c) The first sentence of the third paragraph (12 U.S.C. 321, third paragraph)
of such section 9 is amended (1) by changing "stockholder" to read "member", and
(2) by changing "stock" to read "membership".
(d) The fifth paragraph (12 U.S.C. 323) of such section 9 is repealed.
(e) The first sentence of the paragraph which, prior to the repeal made by
subsection (d) of this section, was the ninth paragraph (12 U.S.C. 327) of such
section 9, is amended by striking out "stock" and inserting in lieu thereof
"certificate of membership".
(f) The paragraph which, prior to the repeal made by subsection (d) of this
section, was the tenth paragraph (12 U.S.C. 328) of such section 9, is amended (1)
by changing, in the first sentence thereof, "all of its holdings of capital stock"
to read "its certificate of membership", (2) by striking the second proviso of
the first sentence thereof, (3) by changing, in the last sentence thereof, "stock
3
holdings" to read "certificate of membership", and (4) by striking, in the last
sentence thereof, "a refund of its cash paid subscription with interest at the rate*
of one-half of 1 per centum per month from date of last dividend, if earned,,
the amount refunded in no event to exceed the book value of the stock at that
time, and shall likewise be entitled to".
(g) The paragraph which, prior to the repeal made by subsection (d) of this;
section, was the sixteenth paragraph (12 U.S.C. 333) of such section 9, isamended (1) by striking, in the first sentence thereof,
except that any such;
savings bank shall subscribe for capital stock of the Federal reserve bank in an
amount equal to six-tenths of 1 per centum of its total deposit liabilities as shown
by the most recent report of examination of such savings bank preceding its
admission to membership", (2) by striking all of the remaining sentences of
such paragraph except the last sentence thereof, and (3) by striking, in the last
sentence of such paragraph, ", except as otherwise hereinbefore provided with
respect to capital stock".
(h) The paragraph which, prior to the repeal made by subsection (d) of this
section, was the twenty-second paragraph (12 U.S.C. 337) of such section 9, is
amended (1) by changing, in the third sentence thereof, "stock" to read "certificate of membership", and (2) by changing, in the last sentence thereof, "stock"
to read "certificates of membership".
(i) The last paragraph (12 U.S.C. 338) of such section 9 is amended by changing, in the last sentence thereof, "stock" to read "certificates of membership".
SEC. 7. The amendments made by the first six sections of this Act shall take
effect on the thirty-first day after the date of enactment of this Act
SEC. 8. (a) Not later than thirty-one days after the date of enactment of this
Act, each holder of stock in any Federal Reserve bank shall surrender such stock
to such bank, which shall, as of the thirty-first day after the date of enactment
of this Act, cancel and retire the same and pay or credit to such former holder
the par value thereof, plus interest at the rate of one-half of one per centum per
month from the date of the last dividend, less a membership fee of $10, which
shall not be refundable.
(b) Upon the cancellation and retirement of Federal Reserve bank stock as
provided in subsection (a) of this section, each Federal Reserve bank shall issue
to each such former holder thereof a certificate attesting its membership in such
Federal Reserve bank and in the Federal Reserve System.
SEC. 9. The eleventh paragraph of section 9 of the Federal Reserve Act is
amended to read:
"Any applying bank shall be eligible for membership if it is an insured bank
as defined in subsection (h) of section 3 of the Federal Deposit Insurance Act.
The capital stock of a State member bank shall not be reduced except with the
prior consent of the Federal Reserve Board."
COORDINATION OF MONETARY POLICIES AND PROGRAMS
SEC. 10. (a) Section 12A of the Federal Reserve Act (12 U.S.C. 263) is amended
to read:
"SECTION
12A.
OPEN MARKET OPERATIONS
" ( a ) No Federal Reserve bank shall engage or decline to engage in openmarket operations under section 14 of this Act except in accordance with the
direction of and regulations adopted by the Board. The Board shall consider,
adopt, and transmit to the several Federal Reserve banks regulations relating
to the open-market transactions of such banks.
" ( b ) All purchases and sales by Federal Reserve banks of paper described
in section 14 of this Act as eligible for open-market operations, as well as all
other actions and policies of the Federal Reserve banks and the Board in the
field of monetary affairs, shall be conducted in accordance with the programs
and policies of the President pursuant to the Employment Act of 1946 and other
provisions of law.
" ( c ) The Board shall submit a quarterly report to the Congress stating, in
comprehensive detail, its past and prospective actions and policies under this
section and otherwise with respect to monetary affairs, and indicating specifically how such actions and policies facilitate the economic program of the
President."
4
ABOLITION OF FEDERAL OPEN MARKET COMMITTEE
(b) The Federal Open Market Committee is abolished.
FEDERAL RESERVE BOARD MEMBERSHIP AND TENURE
SEC. 11. (a) The first and second paragraphs ( 1 2 U . S . C . 2 4 1 and 2 4 2 ) of section
10 of the Federal Reserve Act are amended to read as follows:
"The Federal Reserve Board (hereinafter referred to as the 'Board') shall be
composed of five members appointed by the President by and with the advice and
consent of the Senate. Each member shall be appointed for a term expiring on
June 30 of one of the first five calendar years succeeding the year in which he is
appointed, as designated by the President at the time of nomination, subject to
the limitation that not more than one member of the Board may have a term
scheduled to expire within the same calendar year. The members of the Board
shall devote their entire time to the business of the Board.
"The members of the Board shall be ineligible during the time they are in office
and for two years thereafter to hold any office, position, or employment in any
member bank, except that this restriction shall not apply to a member who has
served the full term for which he was appointed. The President shall designate
one member as Chairman, to serve as such until the expiration of his term of
office as a member, or until the President shall designate another member to
serve as Chairman, whichever is earlier. The Chairman of the Board, subject
to its supervision, shall be its active executive officer. The Chairman may designate one member as Vice Chairman, who shall have power to act in the temporary absence or disability of the Chairman, or in the event of the death, resignation, or permanent incapacity of the Chairman, to act as Chairman pending
appointment of his successor. Each member of the Board shall within fifteen days
after notice of appointment make and subscribe the oath of office. Upon the expiration of their terms of office, members of the Board shall continue to serve until
their successors are appointed and have qualified."
(b) The Board of Governors of the Federal Reserve System established under
authority of the Federal Reserve Act as in effect prior to the effective date of
the amendment made by subsection (a) of this section is abolished. Each member of the Board of Governors of the Federal Reserve System in office immediately prior to the taking effect of such amendment shall be paid one year's
salary at his then current rate.
( c ) On and after the effective date of the amendment made by subsection ( a )
of this section, any reference (other than the reference in subsection (b) of this
section) to the Board of Governors of the Federal Reserve System in any law,
rule, or regulation of the United States or any department or agency thereof
shall be deemed a reference to the Federal Reserve Board.
AUDIT
OF FEDERAL
RESERVE
SYSTEM
BY
COMPTROLLER
GENERAL
SEC. 12. (a) The Comptroller General shall make, under such rules and regulations as he shall prescribe, an audit for each fiscal year of the Federal Reserve
Board and the Federal Reserve banks and their branches.
(b) In making the audit required by subsection ( a ) , representatives of the
General Accounting Office shall have access to all books, accounts, financial records, rep>rts, files, and all other papers, things, or property belonging to or in
use by the entities being audited, including reports of examinations of member
banks, and they shall be afforded full facilities for verifying transactions with
balances or securities held by depositaries, fiscal agents, and custodians of such
entities.
5
( c ) The Comptroller General shall, at the end of six months after the end of
the year, or as soon thereafter as may be practicable, make a report to the Congress on the results of the audit required by subsection ( a ) , and he shall make
any special or preliminary reports he deems desirable for the information of the
Congress. A copy of each report made under this subsection shall be sent to the
President of the United States, the Federal Reserve Board and the Federal
Reserve banks. In addition to other matters, the report shall include such comments and recommendations as the Comptroller General may deem advisable,
including recommendations for attaining a more economical and efficient administration of the entities audited, and the report shall specifically show any program,
financial transaction, or undertaking observed in the course of the audit which
in the opinion of the Comptroller General has been carried on without authority
of law.
(d) The Comptroller General is authorized to employ such personnel and to
obtain such temporary and intermittent services as may be necessary to carry
out the audit required by subsection ( a ) , at such rates as he may determine,
without regard to the civil service and classification laws, and without regard
to section 15 of the Act of August 2,1946, as amended (5 U.S.C. 55a).
RECEIPTS AND EXPENDITURES OF FEDERAL RESERVE SYSTEM
SEC. 13. Section 7 of the Federal Reserve Act is amended by inserting immediately after the section heading the following new paragraph:
"The full amount of all interest, discounts, assessments, and fees received
by Federal Reserve banks shall be paid or credited by such banks to the Secretary
of the Treasury and covered into the Treasury as miscellaneous receipts. The
expenses of such banks may be paid only from such funds as may be specifically
authorized or appropriated for that purposes."
SEC. 14. (a) The third paragraph (12 U . S . C . 243) of section 10 of the Federal
Reserve Act is amended to read :
"There are hereby authorized to be appropriated such sums as may be necessary to pay the expenses of the Federal Reserve Board and the salaries of its
members and employees. Subject to the availability of appropriations, the Board
may maintain, enlarge, or remodel its office building in the District of Columbia
and shall have sole control of such building and space therein."
(b) The fourth paragraph (12 U.S.C. 244) of section 10 of the Federal Reserve
Act is amended by striking the third sentence.
EFFECTIVE DATE I ACCOUNTING PERIOD
SEC. 15. Sections 13 and 14 of this Act shall take effect on the first day of the
first fiscal year which begins after the date of enactment of this Act. During the
period between the date of enactment of this Act and the effective date of such
sections, the several Federal Reserve banks and the Federal Reserve Board shall
take such steps as may be necessary to change their accounting period from the
calendar year to the fiscal year and otherwise to bring their accounting practices
and procedures into conformity with those employed by other agencies of the
United States operated with appropriated funds.
AMENDMENT OF EMPLOYMENT ACT OF 1946
SEC. 16. Subsection (a) of section 3 of the Employment Act of 1946 (15 U.S.C.
1022(a)) is amended by adding the following new sentence at the end thereof:
"Such program shall include the President's recommendations on fiscal and debt
management policy and guidelines concerning monetary policy, domestic and foreign, including the growth of the money supply as defined by him."
COMPENDIUM ON MONETARY POLICY GUIDELINES AND FEDERAL RESERVE STRUCTURE
Staff Report for the Subcommittee on Domestic Finance of the
Committee on Banking and Currency
S U M M A R Y AND ANALYSIS
D E A R M R . C H A I R M A N : Replies to the questionnaire have been received
from the Federal Reserve, the Secretary of the Treasury, the Council
of Economic Advisers, and 71 academic, bank, and research monetary
economists in response to your letter of inquiry on H.R. 11 of July 9,
1968. These replies are transmitted herewith along with a summary of
the responses and an analysis of the reply of the Federal Reserve.
I . VIEWS ON COORDINATING MONETARY AND FISCAL POLICIES
The first two questions of the questionnaire concerned the matter
of coordinating fiscal, debt management, and monetary policies. Specifically, respondents were asked:
1. Do you believe that a program coordinating fiscal, debt management, and monetary policies should be set forth at the beginning of
each year for the purpose of achieving the goals of the Employment
Act, or alternatively, should we treat monetary crndfiscalpolicies as
independent, mutually exclusive stabilization policies f
If you believe a program should be specified, do you believe that
the President should be responsible for drawing up this program, or
alternatively, should such responsibility be dispersed between the
Federal Reserve System and agencies responsible to the President?
1. Summary of respondents' views
By more than a 3-to-2 majority respondents favored the principle of
requiring the President to present annually an economic program coordinating fiscal, debt management, and monetary policies. Moreover,
only half of the dissenting respondents—comprising only about onefifth of all respondents—favored the system now in force. Under this
regime, monetary policy in no way is constrained or even guided by an
economic program or monetary rule but rather is used flexibly for purposes of cushioning unexpected shocks and reversing emerging undesired economic trends, and fiscal policy is used only by way of trying to
correct major disequilibriums. The other half of the dissenting group—
also comprising one-fifth of all respondents—opposed discretionary
management of our money and credit whether orchestrated, as now, by
the Federal Reserve authorities with reference to the fiscal policy extant, or as provided for in H.R. 11, by the President together with
his fiscal and debt management policies. Respondents in this group
(7)
8
regarded fiscal policy as too slow and cumbersome for use as a stabilization tool, and were not sanguine about discretionary monetary management. They therefore favored the development of a clearly defined
monetary strategy or rule. Thus, if respondents are divided by their
views on the present system of uncoordinated discretionary monetary
management, we find they are opposed by a nearly 4-to-l majority.
For readers' convenience, table I lists respondents by their broad
views on questions 1 and 2. Respondents are classified by whether they
(1) oppose the present schema wherein the monetary authorities have
full discretion and act independently of the fiscal authorities and, if
so, favor (a) requiring the President annually to present a program
coordinating monetary and fiscal policies, though on a provisional
basis, or (6) constraining the use of discretion in monetary management by adopting some clearly defined strategy or rule, or (2) favor
the present system. Of course the finer points of respondents' views
on these complex questions are not captured by our category titles,
and therefore some respondents' views may be misinterpreted in
table I. We hope not. In any case respondents' views should be read in
full.
TABLE I.—TABULATION OF VIEWS ON COORDINATING MONETARY AND FISCAL POLICIES
Respondents' views
Opposed to the present regime wherein the Federal Resdrve is neither guided
by a program coordinating monetary; and fiscal! policies on a provisional
basis, nor constrained by a monetary rule
Favor a coordinated program
Favor a rule *
Chairman Okun
Arlt
Bach 2
Burstein *
Chow 2
Cohen
Davidson
Dewald
Earley
Fand
Fishman
Frazera
Gaines
Greenwald*
Harris, S.
Harriss, L.
Hauge
Havrilesky 2
Hoadley
Horwich
Hosek2
Johnson 2
Keiser
Kent
Keyserling2
Leijonhufvud 2
Luckett 2
Mayer2
McCracken
McDonald
Morrison 2
Morton
Noyes
Scott
Sprenkel 2
Stucki2
Thompson?
Thorn
Voorhis2
Warburton2
Weintraub
Yeager2
Aschheim
Bronfenbrenner
Brunner
Cagan
Christ
Crouch
Culbertson
Friedman
Grossman
Harwood
Melitz
Meltzer
Pesek
In favor of the present regime
Governor Martin
Secretary Fowler
Adams
Eckstein
Hester
Kane
Madden
Minsky
Ross
Teigen
Walker
Wallich
Whittlesey
Wilde
1 Dr. Harwood proposed adopting a full-bodied gold money. The others in this group favored a percent per annum
monetary growth rule, or at least constraining the Fed to focus on money supply.
2 However, also favor constraining Federal Reserve actions by imposing a clearly defined money supply strategy or
alternatively, a monetary growth rule valid for the year.
9
A large number of the 3-to-2 majority favoring coordination of
stabilization policies as provided by H.R. 11 based their support on the
assumption that fiscal and monetary policies are substitutable one for
the other, and therefore, unless they are coordinated, sometimes will
work at cross purposes and other times to compound disequilibriums in
the economy at large.1 The validity of this assumption is undeniable
if fiscal and monetary actions are distributed through the future in
similar time patterns, with repercussions from both policies occurring
in the current quarter and the bulk of all effects occurring within 9
months or a year. Under this regime, it would be irresponsible not to
coordinate monetary andfiscalpolicies.
But the case for coordinating also is strong if the lags between
actions and effects—the so-called impact or outside lags—differ
for monetary and fiscal actions. If the outside lag of monetary policy is
shorter than that of fiscal policy, the success of current fiscal actions
will depend significantly on future monetary policy. Under this
regimefiscalpolicy cannot be programed rationally to achieve the goals
of the Employment Act without some idea of future monetary actions.
Clearly, in this case, if fiscal policy is used for stabilization purposes,
those who present the program for current fiscal policy must also
present at least a general near-future monetary policy program. The
alternative to doing this is our present system in which, as was noted
above, fiscal policy is used only to correct major disequilibriums and
discretionary authority characterizes monetary management. Discussion of this alternative is resumed later in analyzing the Federal
Reserve's views on coordinating monetary and fiscal policies.
Conversely, if the outside lag of monetary policy is longer than that
of fiscal policy, monetary policy cannot be programed rationally even
from day to day without knowledge of futurefiscalpolicy. The alternative to coordination in this case is to establish a neutral monetary
strategy to endure regardless of the economic winds. Discussion of this
alternative also is resumed later.
Respondents who favored coordinating monetary and fiscal policies
recognized that any annual economic program presented in January
had to be both general and provisional to permit adapting to undesired
changes in economic trends. To this there can be no disagreement. To
remove anty doubt that may exist about the intent of H.R. 11 in this
respect it is recommended that section 10(b) be amended, as was
suggested by Mr. Keyserling, to read that open-market operations
"shall be conductedfoisofaras feasible in accordance with the programs
and policies of the President pursuant to the Employment Act of 1946
and other provisions of law." [Emphasis supplied.]
It also is noteworthy that several of the respondents who favored
the principle of requiring the President to coordinate macroeconomic
policies urged that our action options for coordinating monetary and
fiscal policies be widened by delegating limited power to change tax
rates to the President. This idea, however meritorious, takes us afield
from the committee's jurisdiction and the immediate subject at hand.
ll The danger of monetary and fiscal policies working at cross-purposes often has been
recognized. For example, in 1964, many feared that the Federal Reserve would cancel the
stimulus of the taix cut by tightening money. 'The danger, under the present system that
monetary policy will compound an undesired thrust from fiscal policy has not been so
widely recognized. But it exists. To illustrate, in the first half of this year, 1968. monetary
policy was extremely expansionary in respect to the growth of the money supply (conventionally defined) and thereby compounded the inflationary thrust of the fiscal policy then
extant. IThe Federal Reserve authorities apparently decided the 1968 inflation had to be
tackled by fiscal policy, and failed to reverse their inflationary policy.
21-750—68
2
10
Also, many respondents who favored requiring that the President
coordinate monetary and fiscal policies as provided by H.R. 11
stipulated that this requirement should be coupled with a statutory
directive instructing the Federal Reserve to regulate the money supply
to achieve maximum employment and price level stability. It is important to recognize that this suggestion is similar to the recommendation to develop a clearly defined monetary strategy or rule which
was made by half of the respondents who opposed requiring the
President to make recommendations concerning monetary policy
along with his recommendations on fiscal and debt management
policies. The similarity of these views indicates that coordination can
be carried out in the context of a clearly defined monetary strategy.
To further pursue this matter, some respondents argued that there is
little advantage to coordinating monetary and fiscal policies inasmuch
as neither the President and his advisers nor the Federal Reserve authorities have yet bothered to acquire adequate knowledge of how
monetary policy affects economic activity. Instead of discretionary coordination we now need, in the view of these respondents, a clearly defined strategy or rule for the conduct of monetary policy. The staff
shares this group's concern for developing an appropriate strategy
for monetary policy, and also joins with them in deploring the fact
that the Federal Reserve authorities have neglected to develop a
validated theory of how monetary policy works. However, we believe
that the development of a clearly defined monetary strategy is not
inconsistent with coordination. In support of this belief we note again
that many of the respondents who favored coordination also wanted
a statutory instruction to regulate the money supply to achieve maximum employment and price-level stability. In this regard, H.R. 11
directs the President to specify guidelines for the growth of the
money supply along with his other stabilization recommendations. In
other words, the operational assumption for monetary policy of H.R.
11 is that the quantity of money is the crucial variable by which Federal Reserve actions are transmitted to the economy in the large. Thus,
it is the clear intent of H.R. 11 that the President's program for
achieving the goals of the Employment Act be centered on a money
supply growth strategy. In the later review of respondents' views on
monetary policy guidelines we will see that the overwhelming majority
of respondents, including many who favor that the President coordinate monetary and fiscal policies, favor the development and specification of a money supply growth strategy.
The second group of respondents who were opposed to coordination,
comprising once again about one-fifth of all respondents, held the
view that the monetary authorities must retain virtually unlimited
freedom to take whatever actions they deem wise. The Federal Reserve
was among those respondents favoring the fullest use of discretionary
authority in monetary management. The argument of this group is
analyzed below in considering the Federal Reserve's views on coordinating monetary and fiscal policies.
2. The Federal Reserve's views on coordinating monetary and fiscal
policies
In replying to the two questions on coordination the Federal Reserve
concluded that for purposes of achieving full employment, price-level
stability and balance-of-payments equilibrium, there is a natural
11
division of labor and responsibility between monetary policy and
fiscal- and debt-management policies (hereafter simply fiscal policy).
In reaching this conclusion the Federal Reserve observed that "major
changes in the intensity of fiscal stimulation or restraint are not everyday occurrences," and therefore fiscal policy is not well suited for adjusting the economy to minor swings in business activity and reacting
to unexpected events in the short run. Rather, the Federal Reserve's
view is that fiscal policy is the appropriate tool for countering gross
maladjustments in the macroeconomy, for example, mass unemployment and rapid inflation. But, concerning monetary policy on the other
hand, the Federal Reserve's view is that it "is well suited to rapid and
marginal response to the emerging requirements of the economy. It is
continually under review and subject to gradual, flexible and even
reversible adjustments. It is the very essence of monetary policy that
it can respond to the unexpected developments and that it can adjust
for divergencies between unfolding economic events and projections."
Assuming the validity of this argument "it would seem," as the
Federal Reserve asserted, "most unwise to commit monetary policy
in advance. * * * To do so would rob it of the very flexibility and
adaptability that constitute the unique contribution of monetary policy to the economic stabilization instruments at the Government's
disposal." Rather, given this argument, optimal stabilization policy
requires that fiscal policy be set at the beginning of each year and
that monetary policy be used flexibly within the year to adjust to
changing business and international conditions. Responsibility should
be divided accordingly—fiscal policy with the President and monetary policy with the Federal Reserve. It is asserted that, "This division of responsibilities in the field of economic policy is one of the
desirable checks and balances in our system of government."
The Federal Reserve's argument, however, is not persuasive. To
begin with it calls for operational procedures which are the antithesis
of democratic procedures. For, if we accept the premise that monetary policy is "unique"—the only flexible instrument at the Government's disposal for achieving economic stabilization, then it is just
plain wrong that control of monetary policy should be vested in
authorities (Federal Reserve officers) wTho are only remotely responsible to the people. The details of the structure of the Federal Reserve
are discussed later. Here our only concern is that if the premise is
accepted that the economic state of the union rests so strategically
on the satisfactory use of monetary policy, then surely, under our
form of government, the President must control or at least guide the
monetary authorities in their use of the only flexible instrument we
have for achieving economic stabilization. Furthermore, the operational procedures called for by the Federal Reserve's argument contravene the requirements of existing law. For it is impossible for the
President to discharge the responsibilities assigned him by the Employment Act of 1946 if he cannot guide the use of the only effective
tool at the Government's disposal for achieving "Maximum employment, output and purchasing power."
Second, as a matter of economics and logic the Federal Reserve's
argument is not persuasive. It rests on the fact tha/t, under present
institutional arrangements, monetary policy can be changed more rapidly than fiscal policy. But there is nothing sacred about these arrange-
12
ments. If the Congress so desires it can give the President clearly defined limited powers to change tax rates, a course of action many persons have recommended. This would make fiscal policy just as well
suited as monetary policy "to rapid and marginal response * * * and
subject to gradual, flexible, and even reversible adjustments." Moreover, if the so-called "impact" or "outside lag" between actions of the
Federal Reserve and changes in employment, production, and purchasing power is longer than the outside lag for fiscal policy, then effective
economic stabilization strategy would in fact require using fiscal policy
counter-cyclically, not monetary policy. That is, under this structure of
outside lags the Federal Reserve's argument should be turned around.
Fiscal policy should be used flexibly and monetary policy changed
only infrequently and within clearly prescribed limits, if at all.
The Federal Reserve, of course, must live in the world as it is, not in
some theoretically ideal world. And, in the world as it is, there are
constraints on changing fiscal policy promptly but none on changing
monetary policy promptly. However, this does not mean that monetary policy should be used flexibly—only that it can be. In fact, for
the world as it is, many economists argue that the degree of monetary
stimulation should be kept relatively constant over time because we
lack both foresight about future economic trends and knowledge about
the outside lag for monetary policy, which are required if we are to
benefit from changes in the degree of monetary stimulation. The Federal Reserve does not claim ability to forecast. Indeed the Federal Reserve's reply asserts that "the possibility of error in forecasting * * *
remains disturbingly high." Nor does the Federal Reserve claim knowledge of the outside lag for monetary policy. The System's reply does
not cover this important subject in any substantive detail. Thus it is
curious that the Federal Reserve argues against limiting "the flexibility and adaptability that constitute the unique contribution of monetary policy to the economic stabilization instruments at the Government's disposal." For, clearly, given both the primitive state of the art
of economic forecasting and our lack of knowledge on the outside lag
for monetary policy, using monetary policy flexibly involves awesome
risks as well as a high potential for serving well the public interest.
For example, today a trend to recession may be forseen and monetary
policy eased to prevent it. But by the time today's action takes effect
the problem may be inflation and we will wish that the monetary authorities had tightened when they eased. But, if the impact lag is short
or no other change occurs, today's shift to monetary ease will work
effectively, preventing the predicted recession without contributing to
inflation.
Because the flexible use of monetary policy involves risks as well as
potential benefits it is imperative to safeguard against monetary policy
being used unwisely while at the same time not eliminating its potential for good. This is the purpose of the provision in H.R. 11 requiring
the President to set guidelines for monetary policy at the beginning of
the year along with his recommendations on fiscal and debt management policy. The guidelines would serve as a warning against unduly
frequent or large changes in the degree of monetary stimulation or restraint without interfering with the "rapid and marginal response"
the Federal Reserve argues monetary policy is well suited to. The case
for such guidelines appears indisputable.
13
I I . VIEWS ON MONETARY POLICY GUIDELINES
Question 3 concerned the nature of details of Presidential guidelines
on monetary policy. Specifically, respondents were asked:
A. Should monetary policy be used to try to achieve the goals of
the Employimnt Act via intervention of money supply (defined as
desired) as provided in H.R. 11, or alternatively should H.R. 11 be
amended to make some other variable or variables the immediate
target of monetary policy; for example, interest rates, bank credit,
liquidity, high-powered or base-money, total bank reserves, excess
reserves, and free reserves? * * * It ivould be most helpful if, in providing the reasons for yowr choice, you list the actions the Federal
Reserve should take to control the target variable (or variables) and
also explain the link between your recommended target of monetary
policy and the goals of the economy as defined by the Employment Act.
B. Should the guidelines of monetary policy be specified in terms
of some index of past, present, or future economic activity, or alternatively in terms of the target variable's value or growth?
C. For only those persons who recommend that some index of
economic activity be used to guide the monetary authorities in controlling the target variable: Should we use a leading (forward looking), lagging (backward looking) or coincident indicator of economic
activity?
D. For only those persons who recommend that the guidelines be
put in terms of the target variable's value or growth: Should the same
guidelines be used each year into the foreseeable future, or alternatively\ should new guidelines be issued at the beginning of each year
conditioned on expected private investment, Government spending,
taxes, et cetera?
E. For only those persons icho recommend that the guidelines be
put in terms of the target variable's value or growth and who also
recommend that the same guidelines be used year after year into the
foreseeable future: What band of values or range of growth do you
recommend?
F. For all those persons recommending that the guidelines be put
in terms of the target variable's value or growth, * * * Under what
circumstances, if any, should the monetary authorities be permitted
during the year to adjust the target variable so that it exceeds or falls
short of the band of values or range of growth defined by the guidelines issued at the beginning of the year?
1. Summary of respondents'' vietvs
By a more than 2 to 1 majority, respondents favored making
the growth of the money supply or its cognate, base money, the target
of monetary policy. The larger part of the minority was eclectic in
its approach to the kinds and means of monetary management.
Respondents in the majority group differed in respect to the details
of managing the growth of the money supply. To begin with a few
of these respondents wanted to use base money, defined as bank reserves plus publicly held currency and coin, as the target variable.
But the overwhelming number in the majority urged that policy
focus on some money supply measure. On this question the staff concurs with the larger number of these respondents who believe it would
14
be more productive to use a money supply measure than to use base
money as the target of monetary policy. Base money affects economic
activity largely by changing the money supply and the correspondence
between changes in base money and money supply is not a constant.
At different times a given change in, say, the conventional money
supply requires different input of base money. Thus, though the Federal Reserve controls money supply largely by changing base money,
money supply is the appropriate vehicle for transmitting monetary
policy actions to the economy in the large.
Second, there were differences about the most useful definition of
money. These differences centered on whether to include time deposits
in commercial banks or to count as money only publicly held demand
deposits and currency and coin. But no one argued that this question
is crucial. In fact, many of the respondents in the money supply group
did not specify which measure to use and many others indicated that
either one might be used. The staff agrees that this matter is not
crucial.
Last, there were differences about how to specify the guidelines for
money supply growth. Roughly half of the group favored specifying
a target percentage change in money supply for 6 months to a year
ahead in terms of the economy's expected or actual performance. A
fairly popular plan of this type, advanced by several respondents,
requires the President to specify every January the estimated change
in money supply that is needed to enable us to achieve our full employment real gross national product in the year ahead without generating inflation. Under this plan the Federal Reserve would be allowed to vary the growth of the money supply around the target
growth rate. The President would set the limits, say plus or minus 2
percentage points, around his target percent per annum growth rate.
Other plans of this type which were advanced by respondents would require the monetary authorities to generate whatever money supply
growth it takes (1) to keep the rate of unemployment under some desired maximum, say 4 percent, or (2) to prevent the price level from
rising faster than some minimum rate, say 3 percent per year for the
The other half of the many respondents urging adoption of a
money supply target recommended that the Congress or the President
set guidelines for money supply growth in terms of a band or range of
percent per annum values. The major argument for this strategy is
that it would mute the development of economic disequilibriums because of mistakes in monetary management. The most popular bands of
values recommended were 3 to 5 and 2 to 6 percent per annum.
Several respondents among those urging the specification of a percent per year range for money supply growth suggested that the President also set a target growth rate within the guideline range every
6 months or year. This could be done using econometric techniques,
if desired. The Federal Reserve would be allowed to use discretion
to regulate the growth of the money supply around the target rate
but not enough to violate the guideline range.
A few respondents here recommended setting a quasi-permanent
relatively-narrow band of values for monetary growth and instructing
the Federal Reserve to stay within this range. The range would be
15
adjusted outward only if it was proved to be clearly inappropriate by
a persistent inflationary trend or persistent unemployment. But others
wanted the range reviewed each year. Still another strategy that was
suggested called for specifying a fairly broad range of allowable
money supply growth and using triggers to collapse the range. Thus,
the maximum allowable range of money supply growth might be set
as zero to 10 percent per year. And the Federal Reserve would be directed to reduce the upper limit to, say, 8 percent when the CPI advances more rapidly than 2 percent per year and by 1 additional percentage point for every additional point of inflation. In the same way
the lower limit of allowable money supply growth would be set at, say,
2 percent per year when the rate of unemployment reached 3 percent
and raised one point for every point rise in unemployment. Last,
some suggested trying to hit an interest rate target subject to the
constraint that monetary growth stay within a specified range.
The staff sees no need at this time to choose among the various
strategies recommended by respondents for setting monetary policy
guidelines. Rather, the conclusion that should be drawn from this listing of possible montary policy strategies is that issuing guidelines for
money supply growth, as provided for by H.R. 11, keeps the door open
for fruitful innovations in monetary policy while at the same time protecting against major errors in monetary management.
As was earlier noted, the major alternative to adopting a money
supply target for monetary policy which was advanced by respondents
calls for eclectism in monetary management. The eclectic approach
to monetary policy is discussed next in analyzing the Federal Reserve's
views on monetary guidelines, for the System was a strong advocate of
this approach.
2. The Federal Reserve's views on monetary policy
The Federal Reserve's reply to this series of questions is in a sense
a nonreply. The Federal Reserve's view is that it is necessary to be eclectic in managing the Nation's money and credit. Neither the kind nor
even the means of management can be specified. For, as asserted by the
Federal Reserve, "monetary policy cannot be formulated solely in
terms of any single financial variable or any single class of variables."
Rather the kind of monetary management, and the means of manage-,
ment, must be adapted to the particular requirements of each new
crisis, new situation, new day. For each particular crisis, situation,
day, in the Federal Reserve's view, "incoming information on both financial quantities and financial prices must be assimilaited and interpreted. Movements in financial quantities—such as total bank reserves,
the money stock, commercial bank time deposits—and claims against
nonbank intermediaries—on the one hand, together with indications
of cost and availability of credit—including interest rates and nonprice terms of credit—on the other, must be evaluated jointly to assess
what effects monetary policy currently is having * * *."
To justify its eclectism the Federal Reserve argued that, "The effects that stem from any given monetary policy depend fundamentally
on private reactions to the policy, and these are not static. They change
over time * * *." Thus, beginning in the 1950's, "the monetary authorities have had increasingly to take into consideration the effects of
changes in policy on a broad range of financial assets * * *. In par-
16
ticular, monetary policy decisions have had to take into account the
potential effect of variations in time deposit growth * * *. [Also] we
cannot afford to exclude the major nonbank thrift institutions from
consideration in formulating monetary policy * * *. Still another
complexity arising in the late 1950's and continuing throughout the
1960's has been the serious imbalance in the U.S. balance of payments."
Distilled to its essence, the Federal Reserve's reply here argues that
because there nearly always is something undesirable happening (e.g.,
an outflow of funds from nonbank thrift institutions, imbalance in our
external payments, etc.), and also because there are many possible
target variables or vehicles for transmitting monetary actions to the
macroeconomy (e.g., money supply, interest rates, etc.), the monetary
authorities must be allowed to "play it by ear"—to use a familiar
analogy. The plea should be denied. To say that something undesirable
nearly always happens and that there are many possible monetary
policy targets is no substitute for the difficult theoretical analysis and
hard empirical research that would have led the Federal Reserve to
provide a validated or at least verifiable theory of how their actions
affect employment, production, and prices.
Manifestly, the Federal Reserve's eclectic views on the nature of
monetary policy guidelines in no way whatever casts doubt on the
usefulness of requiring the President to specify monetary guidelines
for the Federal Reserve "including the growth of the money supply
as defined by him," as provided by H.R. 11.
The staff's view is that the purposes of the Employment Act, which
we conceive as the minimization of both unemployment and inflation,
will be served by the President's setting money supply guidelines, as
provided by H.R. 11. In principle, changes in money supply that
originate in open market operations change spending and economic
activity by changing the size and composition of the public's nominal or financial wealth. When the Federal Reserve buys U.S. Government securities on the open market the public's assets are unchanged
since increases in holdings of base-money are offset by decreases in
holdings of securities but taxpayers' liabilities fall by the amount of
Federal debt retired and hence there is a rise in net worth. In turn,
the rise in net worth acts directly to increase consumption and investment. Added stimulus is provided because increases in money supply
necessarily change the composition of financial wealth. As a result
the return to holding money falls relative to other returns and spending on the whole spectrum of assets (real and financial) and on
goods increases as the public attempts to realign returns. Moreover,
there is at least a prima facie empirical case tht perverse changes
in money supply have contributed substantially to past episodes of
inflation and recession.
Guidelines will impel, but not compel, the Federal Reserve to
dampen and perhaps even prevent sharp destabilizing changes in
money supply in future years. As was observed earlier, the overwhelming number of persons responding to the committee's questions
share this view.
The staff sees no technical problem in using money supply as the
target variable of monetary policy. In this connection the staff recognizes that money supply tends to fall in recessions and rise in periods
17
of economic expansion. But this does not disqualify money supply
from being used as the target variable of monetary policy. The Federal
Reserve has ample powers to overwhelm cyclical movements of money
supply and make monetary growth whatever it desires from quarter to
quarter though not day to day. Thus, the fact that money supply has
a procyclical component in no way disqualifies it from being used as
the target variable. Indeed, this property makes money supply especially well suited to serve as the target variable of monetary policy.
For, because money supply has a procyclical component, the Federal
Reserve cannot be deceived into thinking it has tightened (or eased)
when it has not if money supply is used as the target variable. In expansion periods when the natural tendency is for monetary growth
to accelerate the goal of policy is to decelerate the growth of the
money stock, and only such restraint can be regarded as proof that
monetary policy has been tightened successfully. Conversely, in recessions when the money stock tends to fall, the goal of policy is to increase monetary growth, and only this acceleration can be regarded as
proof that monetary policy has been eased sufficiently. Thus, money
supply is a technically usable as well as a potentially useful vehicle
for transmitting monetary actions to the macroeconomy.2
One final remark is in order here. The Federal Reserve, having asserted that "monetary policy cannot be formulated in terms of any
single financial variable or any single class of variables," did not, of
course, reply to the questions (3.B), (3.C), (3.D), (3.E), and (3.F)
concerning guideline details. But clearly the setting of money supply
guidelines, as provided by H.R. 11, will involve consideration of (3.B)
whether the growth of the money stock should be tied to some index
of economic activity, or alternatively, whether percentage per annum growth guidelines should be specified without regard to the behavior of economic indexes, and (3.C), if the former, what index, or
(3.D)? (3.E), and (3.F) if the latter, whether the growth rate should
be reviewed annually, what band or range of percentage growth rates
should be specified and what circumstances, if any, should trigger
violations of the guidelines. H.R. 11, wisely in the opinion of the
staff, leaves these details to the President. Hopefully, the replies of
many of the respondents to questions (3.B), (3.C), (3.D), (3.E), and
(3.F), which were summarized in the preceding section and are
printed as received in the text of this report, will throw light on how
they should be worked out.
For readers' convenience table 2 lists respondents bv their broad
views on question 3. Respondents are classified by whether thev favored
(1) a money supply target, (2) an interest rate or bank credit target,
or (3) the eclectic approach to monetary management. The staff recommends reading respondents' replies to question 3 to capture the full
flavor of their views.
2 Our objection to using interest rates as the target variable may now be noted. It is
that, though interest rates undeniably help to transmit monetary actions to the macroeconomy, movements of interest rates may provide misleading information about the
thrust of monetary policy. In expansions when the aim of monetary policy is to tighten
money and credit we can be deceived into believing policy was tight when it wasn t
because in such periods interest rates tend to rise because of increases in credit demand.
In the same way, in recessions we might believe that policy was easy when it wasn t
because interest rates tend to fall in such periods as a result of decreases in credit demand.
18
TABLE I I . — T A B U L A T I O N OF VIEWS ON MONETARY POLICY TARGETS
Respondents' targets
Money supply, more specifically, percent per annum growth of the
money stock, or a money supply
cognate
The rate of interest or credit
flows or both
Chairman Okun i
Adams
Cohen
Gaines
Hauge
Horwich
Scott
Arlt
Aschheim 3
Bach
Bronfenbrenner
Brunner
Cagan
Chow
Christ
Crouch
Culbertson
Davidson
Dewald
Fand
Fellner
Fishman
Frazer
Friedman
Greenwald
Grossman 3
Harris, S. 3
Harriss, L.
Havrilesky
Hosek
Johnson
Keiser 3
Kent
Keyserling 3
Latang 3
Leijonhufvud
Levy 3
Luckett
Mayer
McCracken 3
McDonald
Melitz
Meltzer
Morrison
Morton 3
Pesek
Sprenkel
Stucki
Thompson
Thorn
Voorhis
Wallich 3
Warburton
Weintraub
Yeager
Eclectic
Governor Martin
Secretary Fowler
Burstein
Earley
Eckstein
Hester
Hoadley
Kane
Madden
Minsky
Noyes
Ross
Teigen 1
Walker 2
Wilde
Whittlesey
» Subject, however, to not using free reserves as the target and requiring that the rate of growth of the money stock
be greater than zero.
2 Favors, however, that the Federal Reserve explain monetary growth outside the 2 to 6 percent per year range.
3
Supplemented by or in association with interest rates or bank credit or both.
I I I . VIEWS ON DEBT M A N A G E M E N T
Question 4 concerned debt management policy. Specifically, respondents were asked:
Given the goals of the Employment Act, what can debt management do to help their implementation?
1. Summary of respondents' views
Roughly 25 percent of all respondents did not comment on this question.
In principle, debt management can influence aggregate demand by
shortening maturities in recessions, which would increase the public's
liquidity and thereby propensities to consume and invest, and conversely, increasing the maturity of the debt in inflations to decrease liquidity and hence spending. But only about 15 percent of all respondents recommended pursuing this strategy aggressively. At the
other extreme about 40 percent of all respondents opposed changing
19
the maturity of the debt—shortening it in recessions and lengthening
it in inflations—by way of attempting to offset cyclical movements in
economic activity. Some persons in this group favored rather managing the debt to minimize the carrying cost even though this entails
procyclical changes in the public's liquidity. The argument underlying
this view is that the Federal debt is too small a part of total financial
wealth and too narrowly held to be able to affect the public's liquidity
by altering its age-mix, and hence debt management is not a useful
stabilization tool. Under this assumption it is eminently sensible to
adopt a policy that minimizes carrying costs. But the majority in the
group of respondents who opposed using debt management for stabilization purposes did not recommend using it to minimize carrying
costs. Rather they favored adopting a passive strategy, one of keeping
the maturity-composition of the debt relatively constant and thus not
interfering with the stabilization effects of monetary and fiscal policies. It w^ould appear that this group, though not believing that the
public's liquidity and/or propensities to spend and invest could be
changed by altering the age-mix of the Federal debt, did not want to
risk affecting aggregate demand procyclically by altering the age-mix
to minimize carrying costs—i.e., by lengthening the maturity of the
publicly held debt in recessions and shortening it in inflations.
Roughly 20 percent of all respondents, including the Federal Reserve, viewed debt management as having "some" or "limited" potential
for influencing economic trends via intervention of liquidity and the
propensities to consume and invest. They recognized, however, that
the usefulness of debt management as a stabilization tool is constrained
both by the purely housekeeping requirement of holding down carrying costs and the fact that holdings of Federal debt comprise only a
small part of a small part of the public's total financial wealth. Some
of the respondents in this group observed that because of the housekeeping goal there was some danger that debt management would be
destabilizing. They recommended, therefore, that at minimum the debt
not be managed to minimize carrying costs over the cycle.
This viewpoint is discussed further immediately below in presenting
the Federal Reserve's views on debt management. Here it is noted only
that, with respect to policy, 60 percent of all respondents and 75 percent
of those who commented on debt management would appear to agree
that the important contribution debt managers can make to economic
stability is simply not to interfere with other stabilization policies.
This majority consists of the respondents who stated that debt management has no potential as a stabilization policy yet recommended
keeping the age-mix of the debt constant, and those respondents who
concluded that debt management would be destabilizing if used to
minimize carrying costs and recommended that it definitely not be used
for this purpose.
2. The Federal Reserved views on debt management
On this matter the Federal Reserve replied that, "Shifts in the
maturity composition of the Federal debt * * * alter the liquidity of
the debt and/or term structure of interest rates. [Thereby] they will
have some impact on financial flows and private spending * * *."
[Emphasis supplied.] However, the Federal Reserve, correctly we
think, concluded that, regardless of the potential for influencing "financial flows and private spending" by changing the age-mix of the
Federal debt, the role that debt management can play as a stabiliza-
20
tion tool is clearly circumscribed. As the Federal Reserve's reply
noted, it is limited because technical and housekeeping considerations
make debt lengthening "most feasible in periods of declining interest
rates * * * [but] when interest rate declines are associated with an
undesirable slackening of economic activity, the economic goals of the
country may indicate the desirability of keeping debt lengthening to
moderate dimensions so as to encourage investors to lend more to finance
capital outlays of private sectors of the economy." In the same way
from the standpoint of housekeeping considerations it is most feasible
to shorten the debt in periods of rising interest rates. But just as interest rate declines are symptomatic of recessions so rising interest rates
are a symptom of inflation, and manifestly, it would be unwise to add
to the public's liquidity by debt-shortening operations during inflationary periods.
H.R. 11 neither specifies nor suggests debt management targets. Respondents were questioned about the potential benefits from debt
management policies to determine whether H.R. 11 should be amended
to require the President to make recommendations on the term structure of interest rates or the age-mix of the publicly held Federal debt.
No substantial reason has been developed for such an amendment.
IV. VIEWS ON POLICY
INSTRUMENTS
Question 5 explored several aspects of the use of policy instruments.
Specifically, respondents were asked:
5.A Do you see any merit in using open-market operations for defensive purposes or should they be used only to facilitate achievement
of the Presidents economic program and the goals of the Employment Act?
5.B Do you believe that monetary policy can be effectively and efficiently implemented solely by open-market operations?
5.0 For what purposes, if any, should (a) rediscounting, (b)
changes in reserve requirements, and (c) regulation Q be used?
5.D Do you see any merit m requiring the Federal Reserve Board to
make detailed quarterly reports to the Congress on past and prospective actions and policies?
5.E What costs and benefits would accrue if representatives of the
Congress, the Treasury, and the CEA were observers at Open Market
Committee meetings?
1. Summary of respondents' views
One-fourth of all respondents did not comment on the merits of using open-market operations for so-called defensive purposes. Those
who did approved defensive open-market transactions by a nearly 4to-1 margin. Many respondents pointed out in support of their view that
defensive transactions to absorb certain transient influences are essential in order to closely control the rate of growth of the money supply.
Monetary growth can be influenced perversely at any point in time by
sudden, unexpected, and ephemeral changes in such elements as U.S.
gold holdings, the public's preferences for currency and time deposits
and banks' desires to hold excess reserves. But open-market operations can be used to prevent these influences from modifying significantly desired money supply growth. Clearly, in the limited sense of
maintaining desired money supply growth against perverse influences
defensive open-market operations have merit. Respondents who opposed defensive operations, however, would not appear to have had
this meaning in mind. Rather, their opposition is to using open-mar-
21
ket operations to assist Treasury financing operations and otherwise
maintain order in the money market. The staff agrees both that openmarket operations should not be used for such purposes and must be
used to maintain desired money supply growth in the face of perverse
transient influences.
A fourth of all respondents also failed to comment on questions 5.B
and 5.C. Of the remainder, half stated that monetary policy can be
effectively and efficiently implemented solely by open-market operations. But many in this group recommended nevertheless retaining
some of the other currently used tools of monetary policy, especially
rediscounting, for such special purposes as providing a sure source
of short-term funds to banks.
The other half of respondents commenting on questions 5.B and
5.C concluded that monetary policy would be less effectively and efficiently implemented by using only open-market operations than by
using, in addition, some of the other policy instruments now being
used. However, even among this group there was strong sentiment for
rescinding regulation Q.
The staff believes that questions concerning monetary policy instruments or tools are a secondary matter compared to the questions of
monetary and fiscal policy coordination, the target and guideline
specification for monetary policy, and the structure of the Federal Reserve. These latter are the subjects of H.R. 11. Respondents were questioned about instruments to determine whether there was reason for
amending H.R. 11 to modify the currently used kit of monetary policy
instruments. But substantial argument was not developed for amending the bill to modify the Federal Reserve's existing powers to set
rediscount rates and rediscount eligible paper, change reserve requirements, and regulate interest paid on time deposits. On the other hand
the bill might be amended to assure that these powers, as open market
powers, are used insofar as feasible to implement the President's economic program pursuant to the Employment Act. However, in view
of the heavy sentiment against regulation Q, the committee might
want to take up the question of reevaluating regulation Q separately.
Roughly one-sixth of all respondents did not comment on the merits
of requiring the Federal Reserve to make detailed reports on its actions
to the Congress. Respondents who commented on this question favored
the reporting requirement by a nearly 4-to-l majority. Some, however,
wanted any report confined to past actions. Others recommended that
the report be limited to explaining money supply growth. Another recommendation called for full discussion of proposed changes in regulations covering rediscounting, reserve requirements, and commercial
banking activities.
One-third of all respondents did not comment on the costs and benefits of having administration observers at OMC meetings. Those who
commented were opposed to the idea by more than a 5-to-l majority.
2. The Federal Reserve*s views
Concerning the usefulness of defensive open-market operations, the
Federal Reserve replied that "if the financial markets are to respond
as intended to national policy action, the [money and credit] mechanism must be protected from short-run swings in such factors as the
public's demand for currency, the speed of check collections, international currency flows, or the size of Treasury balances held at Federal Reserve banks." Because all the factors listed affect money supply
growth the staff has no quarrel with this view. As was earlier noted, in
22
the limited sense of offsetting undesired autonomous influences on
money supply growth defensive open-market operations are an essential part of monetary policy.
It is gratifying that the Federal Reserve did not attempt to also
justify using open-market operations to maintain order in the money
market. It makes little or no sense to use open-market operations to
insulate money-market variables—and thereby players—against the
economic winds of the da j .
On the questions pertaining to the instruments of monetary policy,
the Federal Reserve argued that monetary policy can be more effectively implemented by using rediscounting, reserve requirement
changes, and changes in regulation Q along with open-market operations than by open-market operations alone. The Federal Reserve's
argument that changes in reserve requirements have advantages over
market operations in special circumstances that "require a massive and
immediate tightening or easing of bank reserve positions" is especially
compelling. The Korean war inflation was quickly and substantially
damped by increasing reserve requirements in January 1951. More important, now might be another time when an upward revision of
reserve requirements would be an effective way of decelerating
inflation.
But the System's argument on regulation Q is not persuasive. The
Federal Reserve would retain regulation Q to protect "thrift institutions" whose "earning power is limited by their necessarily heavy
commitment in long-term assets * * * [which commitment] has limited the ability of these institutions to meet the competition of rising
open market rates." The staff shares the Federal Reserve's concern for
thrift institutions. But, if desired, these institutions and the mortgage
and other markets they serve can be protected in periods of disintermediation by Federal Reserve purchases of the obligations of Federal
home loan banks and its members, the Federal National Mortgage
Association and other agencies.
Concerning the merits of monetary policy reports, the Federal Reserve argued that "it could be seriously misleading to the public for the
Federal Reserve to present, at the beginning of a quarter, a detailed
prospectus of future actions and policies when in fact the actual policies adopted would depend so heavily on the extent to which domestic
and foreign developments within the quarter alter the System's assessment of future monetary and credit needs."
The Federal Reserve is not, of course, opposed to reporting to the
Congress about its past actions. It does so now. The staff believes, however, that there is merit in providing a projection of the money stock
and of the broad actions that will be taken to achieve this target along
with the explanation of past money supply growth in the Fed's quarterly reports to the Congress. Such requirement will impel development of validated theory on money supply and of the relationships of
employment and prices to money supply. Few persons care to make
wrong forecasts.
To pursue this matter, it is vital that the reports be substantive. On
this the Federal Reserve's response indicates that its future reports
will be as meaningless as its past and current ones have been. The
Federal Reserve stated that "such reports, to be useful, should include
an analysis of all major monetary and financial developments of the
preceding calendar quarter." [Emphasis supplied.]
We see no advantage in covering the spectrum of major monetary
and financial developments. Rather, to obtain maximum benefits from
23
monetary policy reports they must focus on the behavior of the money
supply. Specifically, they must explain both the proximate causes of
money supply growth in the preceding quarter or 6 months and how
the observed growth has or will implement the President's economic
program and the goals of the Employment Act. The educational
value—to the Federal Reserve authorities—of having to prepare and
discuss such reports will be large. The System, therefore, should not
be permitted in reporting to the Congress to substitute extensive descriptions of monetary and financial developments for meaningful,
empirically verifiable, statements about the policy of the immediate
past.
The Federal Reserve was opposed to having administration observers at meetings concerned with open market policy. The System argued
that this would restrict "full and frank" discussion. H.R. 11 does not
now call for administration observers at these meetings. And, in view
of the fact that H.R. 11 requires the President to make monetary
policy recommendations, including guidelines on money supply
growth, the staff sees no need for amending H.R. 11 to provide for
such observers, especially inasmuch as their presence might inhibit
discussion.
For reader's convenience, table 3 lists respondents' votes, "yes" or
"no," on questions 5.D. and 5.E. Respondents' views, especially on
5.D., should be read in full.
V. VIEWS ON T H E FEDERAL RESERVE^ STRUCTURE
H.R. 11 provides for the following structural changes in the Federal
Reserve System :
1. Retiring Federal Reserve bank stock;
2. Reducing the number of members of the Federal Reserve
Board to five and their terms of office to no longer than 5 years;
3. Making the term of the Chairman of the Board coterminous
with that of the President of the United States;
4. An audit for each fiscal year of the Federal Reserve Board
and the Federal Reserve banks and their branches by the
Comptroller General of the United States; and
5. Funds to operate the Federal Reserve System to be appropriated by the Congress of the United States.
Respondents were asked:
Please comment freely on these several provisions. In particular, it
would be most helpful if you would indicate any risks involved in
adopting these provisions and discuss whether their adoption would
facilitate the grand aim of H.R. 11 j which is to provide for coordination by the President of monetary and fiscal policies.
By heavy majorities respondents favored all provisions except No. 5.
Respondents' votes on these matters, including the Federal Reserve's
votes, are recorded in table 4.
In addition, H.R. 11 provides for the vesting of all open market powers in the five-man Federal Reserve Board. Respondents were not
asked to comment on this provision directly, though many recognized
that any surviving open market committee would have to be drastically reduced in size if the Board were reduced to five members.
Among those who commented, some respondents favored doing away
entirely with Reserve bank representation in formulating open market
policy but others favored retaining some representation.
24
TABLE I I I . — T A B U L A T I O N OF VOTES ON QUESTIONS 5 . 0 AND 5.E
Respondents' votes
On the desirability of reporting past and prospective
policies and actions
For
Governor M a r t i n 1
Secretary Fowler 1
Chairman O k u n 1
Arlt1
Aschheim
Bach 1
Brunner
Cagan 2
Cohen
Crouch 2
Culbertson 2
Dewald
Ear ley
Fand
Fishman 3
Frazer
Friedman
Fro mm
Gaines 1
Harris, S.
Harriss, L.
Hauge1
Havrilesky
Horwich
Hosek 1
Johnson
Kane
Keiser
Kent 2
Keyserling
Luckett 1
Madden *
McDonald
Meltzer
Minsky 1
Morrison 3
Noyes 1
Ross
Sprenkel
Stucki
Thorn
Voorhis
Walker »
Warburton
Weintraub 1
Whittlesey
Yeager 2
Against
Burstein
Chow
Davidson
Hester
Hoadley
Leijonhufvud
Melitz
Morton
Pesek
Scott
Teigen
WaOich
On the desirability of having observers at
OMC meetings
For
Davidson
Ear ley
Havrilesky
Keiser
Keyserling
Melitz
Warburton
Against
Governor Martin
Secretary Fowler
Chairman Okun
Aschheim
Bach
Burstein
Cagan
Chow
Crouch
Culbertson
Dewald
Fand
Frazer
Gaines
Greenwlad
Harris, S.
Hauge
Hester
Hoadley
Horwich
Hosek
Johnson
Kent
Leijonhufvud
Madden
Mayer
McDonald
Morrison
Morton
Noyes
Pesek
Ross
Scott
Sprenkel
Stucki
Teigen
Walker
Wallich
Weintraub
Wilde
1 Confined, however, to past actions.
2
Reporting, however, not essential if guidelines are issued; serve to check conformity with guidelines.
Explain only (past) variations in monetary growth.
3
Putting aside consideration of the requirement that funds to operate the Fed be appropriated by Congress, we consider below the
other structural provisions of H.R. 11. The case for the bill's other
provisions would appear indisputable. To begin with rigorous analysis
and hard empirical work can play no role in monetary policy as long
as open market policy is set by general agreement of 19 men. Federal
Reserve policy is eclectic in the kinds, means, and timing of monetary
atcions because it is a consensus policy that is reached by softening and
blending the opinions of all participants at open market committee
meetings. In this connection, we note how few dissents there are to
OMC decisions, a fact which supports that the aim of the OMC
decision process is not to produce a socially optimal policy but rather
to conceal differences of opinion. If monetary policy ever is to be based
on validated theory the Federal Reserve's decisionmaking machinery
will have to be overhauled. H.R. 11 provides necessary and sufficient
streamlining by vesting all open market powers in a five-man Board
of Governors.
25
Second, the Federal Reserve's many ties to the commercial banking business and to the New York money market tend inevitably to
produce in our monetary authorities a limited and ofttimes dangerously deceptive view of what is in the national interest and how best
to achieve these goals. Commercial bank members of the Fed elect
two-thirds of their Reserve bank's directors and not surprisingly there
is a strong banking orientation among those chosen to direct the affairs
of the Reserve banks and select their presidents—men who now serve
on the Federal Open Market Committee. In addition, the Federal Reserve serves and supervises commercial banks in a variety of ways
from clearing checks to rediscounting eligible paper. Also, the Federal
Reserve is the largest transactor in Government securities doing business on a day-to-day basis. Inescapably Federal Reserve authorities
obtain a substantial proportion of their information and feel about the
economy's trends and problems from members of the banking community and transactors in the money market. More important, they
get an exaggerated notion of the remedial effects of using monetary
policy to solve the problems encountered by loan and other bank officers, bank examiners, and money market technicians and transactors.
This is an intellectual form of myopia: viz, that the problems of the
banking business and money market are problems the monetary authority must solve and to which they must furthermore give the highest priority. It is not a sound working hypothesis for the exercise
of monetary policy.
The principal operating mistake deriving from the Federal Reserve's ties to commercial banking and the money market is that too
much attention is given to interest rates, free reserves, and other money
market and credit variables, and too little is paid to the money supply.
The money supply has behaved erratically because the growth of M
has emerged as a byproduct of the Federal Reserve's emphasis on
credit variables and especially interest rates. In the 1953-60 period
low monetary growth often was consistent with the Federal Reserve's
interest rate targets in this period. At times in the years after 1953
the achieved low monetary growth doubtless was desired; for example,
in the second half of 1956. But at other times; for example, in the fall
and winter of 1957-58, it was not.
More recently rapid monetary growth has been consistent with the
Federal Reserve's interest rate and other credit targets. Because interest rates have been high and free reserves low by historical standards the Federal Reserve has been deceived lately (mid-1967 to mid1968) into thinking it has been following a tight money policy. But
in fact the thrust of policy judged by changes in money supply has
been aggressively expansionary, and inflation of both prices and interest rates has resulted.
A change in the priority target of monetary policy definitely is in
order. But it is naive and romantic to believe that under present
structural arrangements the Federal Reserve authorities will make
money supply their target the variable for transmitting its actions
to the economy at large and achieving the goals of the Employment
Act. We cannot expect money to be the target of monetary policy as
long as the Federal Reserve's ties to the banking business remain in
force. Further, we cannot expect appropriate coordination of monetary
and fiscal policies as long as the members of the Board of Governors,
by reason of their 14-year terms and the lack of effective appoint21-570—68
3
26
ment control by the incumbent President^ have no financial or political
incentive to correct their mistakes and misconceptions. The restructuring provisions of H.R. 11 do not guarantee a sensible and sound monetary policy but unless they are adopted, sensible and sound monetary
developments will emerge only as happy accidents. The national
interests can be more rationally implemented.
TABLE IV.—TABULATION OF VIEWS ON THE STRUCTURE OF THE FEDERAL RESERVE SYSTEM
Respondents' votes
Retiring the capital stock
For
Chairman Okun
Arlt
Aschheim
Cohen
Crouch
Davidson
Dewald
Earley
Fand
Fish man
Frazer
Friedman
Gaines
Hauge
Havrilesky
Hester
Horwich
Hosek
Johnson
Kane
Keiser
Kent
Keyserling
Leijonhufvud
Macesich
Madden
Mayer
Melitz
Meltzer
Morrison
Morton
Pesek
Ross
Scott
Teigen
Thorn
Voorhis
Wallich
Warburton
Weintraub
Whittlesey
Yeager
Decreasing the number of Governors
and their t e r m s 1
Against
Governor Martin
Secretary Fowler
Adams
Bach
Fellner
Hoadley
McCracken
McDonald
Noyes
Sprenkel
Walker
See footnotes at end of table.
For
Secretary Fowler
Chairman Okun
Aschheim
Bach
Brunner
Burstein
Chow
Cohen
Crouch
Dewald
Earley
Eckstein
Fand
Fishman
Frazer
Friedman
Harris, S.
Havrilesky
Hosek
Johnson
Kane
Keiser
Kent
Keyserling
Leijonhufvud
Mayer
McCracken
Melitz
Meltzer
Morrison
Ross
Stucki
Teigen
Thorn
Voorhis
Wallich
Warburton
Weintraub
Whittlesey
Wilde
Yeager
Against
Governor Martin
Adams
Arlt
Fellner
Gaines
Hauge
Hester
Hoadley
Horwich
Madden
McDonald
Minsky
Morton
Noyes
Pesek
Scott
Sprenkel
Walker
Making the term of the FRB Chairman
coterminus with that of the President
For
Governor Martin
Secretary Fowler
Chairman Okun
Adams
Arlt
Aschheim
Bach
Brunner
Chow
Cohen
Crouch
Davidson
Dewald
Earley
Eckstein
Fand
Fishman
Friedman
Gaines
Harris, S.
Hauge
Havrilesky
Hester
Johnson
Kane
Keiser
Kent
Keyserling
Leijonhufvud
Mayer
McCracken
McDonald
Melitz
Meltzer
Minsky
Morrison
Ross
Scott
Stucki
Teigen
Voorhis
Walker
Wallich
Warburton
Weintraub
Whittelsey
Yeager
Against
Burstein
Fellner
Hoadley
Horwich
Madden
Morton
Noyes
Pesek
Sprenkel
Thorn
27
TABLE IV.—TABULATION
OF VIEWS
ON THE STRUCTURE OF THE
FEDERAL RESERVE
SYSTEM—Continued
Respondents' votes
Auditing Federal Reserve spending
For
Aschheim
Chow
Cohen
Crouch
Dewald
Fand
Fishman
Frazer
Friedman
Gaines
Greenwald
Harris, S.
Hauge
Havnlesky
Hosek
Johnson
Keiser
Keyserling
Leijonhufvud
McCracken
McDonald
Melitz
Meltzer
Morrison
Stuck!
Teigen
Voorhis
Warburton
Weintraub
Wilde
Yeager
Against
Governor Martin
Secretary Fowler
Chairmau Okun
Adams
Arlt
Bach
Brunner
Burstein
Earley
Hester
Hoadley
Kent
Madden
Mayer
Minsky
Morton
Noyes
Pesek
Ross
Scott
Sprenkel
Thorn
Walker
Wallich
Whittlesey
Providing that funds to operate the Federal Reserve
be appropriated by Congress
For
Chow
Cohen
Crouch
Davidson
Dewald
Fand
Fishman
Friedman
Harris, S.
Hosek
Keiser
Keyserling
Leijonhufvud
Melitz
Meltzer
Morrison
Morton
Voorhis
Yeager
Against
Governor Martin
Secretary Fowler
Chairman Okun
Adams
Arlt
Aschheim
Bach
Brunner
Burstein
Earley
Frazer
Gaines
Greenwald
Hauge
Havrilesky
Hester
Hoadley
Horwich
Johnson
Kent
Madden
Mayer
McCracken
McDonald
Minsky
Noyes
Pesek
Ross
Scott
Sprenkel
Stucki
Teigen
Thorn
Walker
Walhch
Warburton
Weintraub
Whittlesey
Wilde
'Not necessarily exactly as provided by H.R. 11. We note here also that some respondents expressed their own ideas
on restructuring the Federal Reserve System. Brofenbrenner stated that the restructuring proposals of H.R. 11 were
"matters of subsidiary importance. I should, instead be interested in procedures for identifying and disciplining members of the Board of Governors, or subsidiary staff members, responsible for egregious and continued breaches of the
proposed monetary rule." (Brofenbrenner proposed that monetary growth be calculated each year, based on expected
labor force, output and velocity changes, and that exchange rates be competitively determined.) Grossman was against
Federal Reserve independence but did not specify structural changes or comment on the provisions of H.R. 11. Luckett
favored making the Secretary of the Treasury ana Chairman of the CEA voting members of the Federal Reserve Board.
Last, several respondents observed that the restructuring details in H.R. 11 would be unnecessary if there was a clearly
defined monetary growth strategy which the Federal Reserve was instructed to follow, including Culbertson, Friedman,
Leijonhufvud, and Yeager.
REPLY OF HON. WILLIAM McC. MARTIN, CHAIRMAN,
BOARD OF GOVERNORS OF THE FEDERAL RESERVE
SYSTEM, FOR THE MEMBERS OF THE BOARD OF GOVERNORS AND THE RESERVE BANK PRESIDNTS OF
THE FEDERAL RESERVE SYSTEM
BOARD OF GOVERNORS
OP THE FEDERAL RESERVE SYSTEM,
Washington, September 9,1968.
H o n . WRIGHT PATMAN,
Chairman, Committee on BamJc and Currency,
House of Representatives, Washington, D.C.
DEAR MR. CHAIRMAN : Each of the members of the Board of Governors and
each of the presidents of the Reserve banks has received your letter of July
1968 regarding plans of the Subcommittee on Domestic Finance to hold hearings on H.R. 11 later this year, and requesting views by September 1 on certain
questions pertaining to monetary policy guidelines and open-market operations,
some aspects of the structure of the Federal Reserve System, and recent monetary developments.
The members of the Board and the Reserve bank presidents have each considered your questions. As you know, most of these issues have been raised on
previous occasions and have been carefully reviewed within the System. The
members of the Board and Reserve bank presidents concluded that for the
present review and in view of the time limit prescribed it would be suitable to
join in submitting to you a single document, a copy of which is enclosed. The
enclosed answers reflect the views generally held by the members of the Board
and the presidents, although understandably some of us may have different shadings of view and emphasis on some points.
Sincerely yours,
W M . MCC. MARTIN, Jr.
STATEMENT OF W I L L I A M McC. MARTIN, JR., CHAIRMAN OF T H E
BOARD OF GOVERNORS OF T H E FEDERAL
RESERVE
SYSTEM
FOR THE MEMBERS OF T H E BOARD AND T H E RESERVE B A N K
PRESIDENTS
Question I J. Do you believe that a program coordinating fiscal,
debt management, and monetary policies should be set forth at the
beginning of each year for the purpose of achieving the goals of the
Employment Act, or alternatively should vie treat monetary and fiscal
policies as independent mutually exclusive stabilization policies?
Answer. It is important that monetary policy and fiscal policy be
coordinated in the promotion of our national economic goals. Pursuant to the Employment Act of 1946, early each year the President
transmits to the Congress, among other things, an economic report,
a review of the economic program of the Federal Government and a
program for carrying out the policy declared in the act, together with
such recommendations for legislation as he may deem necessary or
desirable. In addition, the Council of Economic Advisers presents its
appraisal of the various programs and activities of the Federal Government and its recommendations regarding national economic policy.
(29)
30
The President's program customarily specifies the fiscal actions
needed, in his judgment, to achieve the goals of the Employment Act,
and often notes the monetary policies that he believes would appropriately accompany the proposed fiscal and debt management actions.
Any economic program submitted must of necessity be provisional.
While the art of economic projection has progressed significantly
in postwar years, the possibility of error in forecasting the timing
and detail of actual economic performance—and, on occasion, in the
whole profile of developments to come—remains disturbingly high.
Also there is a high incidence with which unexpected events having
major economic implications take place—international political and
economic disturbances, civil disorders, strikes, and the like.
It must also be emphasized that any proposals with respect to
future monetary policies must also be provisional since the choice of
appropriate monetary policy will be contingent on the extent to which
actual economic developments conform to those projected, and on the
extent to which actual fiscal and debt management actions conform, in
both substance and timing, to those proposed in the President's
program.
Finally, any overall stabilization program must recognize the inherent advantages and disadvantages of alternative economic tools of
public policy. Some policy instruments are capable of gradual and
continuous shadings in degree of impact, while others require specific
actions involving time-consuming procedures. The major influence of
some on the economy appears only with a considerable lag, others
achieve their influence more promptly. The nature of the linkages is
both variable and imprecise. Generally, massive present or prospective
economic imbalances are best dealt with through adjustments in fiscal
policy. The distortions introduced when monetary policy is pushed
to extremes—in terms of effects on financial values, investment incentives, potential cyclical instability, and international relationships—
are large. But major changes in the intensity of fiscal stimulation or
restraint are not everyday occurrences; they take time to plan, enact,
and implement, as experience with both the tax cuts of 1964 and the
surcharge of 1968 attest, and, once made, they are not quickly reversible.
Similarly, expenditure programs—based on a history of political determination of social and national needs—are not usually susceptible
to abrupt and reversible changes of pace.
Monetary policy, on the other hand, is well suited to rapid and
marginal response to the emerging requirements of the economy. It
is continuously under review and subject to gradual, flexible, and
even reversible adjustments. It is the very essence of monetary policy
that it can respond to the unexpected development and that it can
adjust for divergencies between unfolding economic events and projections. Given the lags involved in some of the effects of monetary
policy, it is important that it be free to respond to the earliest indicators of a need for action.
While it is possible to describe, in general terms, the profile of
monetary policy that would be consistent with a given economic projection, and that, in combination with an appropriate fiscal program,
should help to achieve the Nation's overall economic goals, it does
not seem desirable to specify in advance the precise combination of
stabilization tools. In particular, it would seem most unwise to com-
31
mit monetary policy in advance to a particular course of development
without regard to the varying and frequently conflicting economic and
financial tendencies—domestic and foreign—that do in fact emerge
with the passage of time. To do so would rob it of the very flexibility
and adaptability that constitute the unique contribution of monetary
policy to the economic stabilization instruments at the Government's
disposal.
Question L2. If you believe a program should be specified, do you
believe that the President should be responsible for drawing up this
program, or alternatively should such responsibility be dispersed between the Federal Reserve System and agencies responsible to the
President? {Please note that informal consulting arrangements can
be made as desired whether responsibility is assigned to the President
or divided between the President and the Federal Reserve. The concern
here is with the assignment of formal responsibility for drawing up
the economic program.)
Answer. The responsibility for recommending to the Congress
changes in Federal expenditure and revenue programs clearly rests
with the President. Suggestions and advice may be sought from interested Federal agencies as to specific content, of course, and frequently
the Federal Reserve has contributed to this process.
In the President's report there often is reference to monetary as
well as fiscal policy, and the Council's report customarily discusses
monetary policy developments at some length. We believe that such
references are wholly appropriate, in view of the importance of financial developments to economic conditions generally, and in recognition
of the role of monetary policy in the Government's economic stabilization effort. Views as to what constitutes appropriate monetary policies
must of necessity be provisional for the reasons stated in answer to
question 1.1, but such policies must be taken into account as an important factor conditioning, and conditioned by, the economy's prospects.
We believe, however, that any specifications as to monetary policy
should continue to be regarded in the nature of suggestions of what
constitutes appropriate policy under clearly stated assumptions—
which may or may not prove correct—rather than as instructions to
the Federal Reserve System. The System was created by Congress,
and is answerable for its actions to the Congress; its role is that of
advising and cooperating with the executive branch of Government
in the public management of economic affairs, without being formally
a part of it. This division of responsibilities in the field of economic
policy is one of the desirable checks and balances of our system of
government, and we do not believe that the Congress should cede its
ultimate authority in the monetary sphere to the executive branch.
Question 1.3. Concerning monetary policy guidelines:
A. Should monetary policy be used to try to achieve the goals
of the Employment Act via intervention of money supply {defined
o,s desired) as provided in H.R. 1U or alternatively should H.R.
11 be amended to make some other variable or variables the immediate target of monetary policy; for example, interest rates,
bank credit, liquidity, high-powered or base-monkey, total bank
reserves, excess reserves and free reserves? Please define the target
variable or combination of variables recommended and state the
reasons for your choice. {If desired, recommend a target variable
32
or variables not listed here.) It would be most helpful if, in
providing the reasons for your choice., you list the actions the
Federal Reserve should take to control the target variable (or
variables) and also explain the link between your recommended
target of monetary policy and the goals of the economy as defined
by the Employment Act.
B. Should the guidelines of monetary policy be specified in
terms of some index of past, present, or future economic activity,
or alternatively in terms of the target variable's value or growth?
For example, should the President's 1969 program for achieving
the goals of the Employment Act be formulated to require consistency with some set of overall indicators of economic activity, or
alternatively so that your target variable attains a certain value or
growth regardless of the economic winds? Please indicate the
reasons for your preference.
G. For only those persons who recommend that some index of
economic activity be used to guide the monetary authorities in
controlling the target variable: Should we use a leading (forivard
looking), lagging (backward looking), or coincident indicator of
economic activity? It would be most helpful also if you would
identify the index you would like to see used and specify how the
target variable should be related to this index.
D. For only those persons who recommend that the guidelines
be put in terms of the target variable's vafoie of growth: Should
the same guidelines be used each year into the foreseeable future,
or alternatively, should new guideline be issued at the beginning
of each year conditioned on expected private investment, Government spending, taxes, etc.? Please indicate the reasons for your
preference.
E. For only those persons who recommend that the guidelines
be put in terms of the target variable's value or growth and who
also recommend that the same guidelines be used year after year
into the foreseeable future: What band of values or range of
growth do you recommend? (By way of clarification, a band of
values appears appropriate if your target variable is, say, free
reserves, whereas a range of growth is appropriate if it is, say,
money supply.)
F. For all those persons recommending that the guidelines be
put in terms of the target variable's value of growth (regardless
of whether you recommend using the same guidelines year after
year or revising them each year in light of expected private investment and fiscal policy): Under what circumstances, if any, should
the monetary authorities be permitted during the year to adjust
the target variable so that it exceeds or falls short of the band, of
values or range of growth defined by the guidelines issued at the
beginning of the year?
Answer:
Sumvmary.—In a dynamic and complex economy, with a particularly
dynamic and complex financial system, monetary policy cannot be
formulated solely in terms of the behavior of any single financial variable or any single class of variables. Over the postwar decades, there
have been major shifts in the financial structure and financial environment: shifts in savers' preference among the rapidly proliferating
33
variety of financial assets available through institutions and financial
markets; changes in borrowers' dependence on particular sources and
types of credit; changes in spheres and intensity of competition among
financial institutions; and shifts in emphasis in the monetary/fiscal
mix of stabilization policy. In light of these major structural and behavioral changes, it would have been most unwise to have determined
policy targets and objectives solely in terms of desired levels or changes
in a particular financial quantity or a particular financial price. Policy
decisions have always been based, and must continue to rest, on assessments of the impact of policy changes on a wide range of financial
markets and institutions, and on interpretations of the significance of
these changes for the ultimate goals of policy relating to employment,
prices, growth, and international equilibrium.
Background.—The philosophy of economic stabilization policy that
has developed in the United States over the past several decades increasingly has come to recognize that governmental policies can moderate the business fluctuations normally experienced in a dynamic
economy. The Employment Act of 1946 envisaged that the Federal
Government had clear responsibilities for adopting stabilization policies that would temper economic fluctuations, and thereby foster conditions conducive to the attainment of high-level employment and
output, and the maximum rate of economic growth that can be sustained
without inflation.
The task of realizing the goals set forth in the Employment Act of
1946 is not, of course, an easy one. The sources of disturbance to sustainable, noninflationary economic expansion are numerous. The
sources of instability often are difficult to identify, in particular when
they are associated with shifts in spending propensities in the private
sector.
Disturbances originating in the monetary and financial sectors of
the economy are also potential initiating sources of economic instability. For example, shifts in the public's financial asset preferences—
between currency and bank deposits, between classes of bank deposits,
or between bank deposits and other types of financial assets—may lead
to disruptive changes in financial market conditions. At the same time,
the possibility always exists that central bank policies could themselves be an initiating source of economic instability. The tools of
monetary policy are powerful and must be administered with care if
our economic objectives are to be achieved.
The Employment Act of 1946 did not in fact attempt to prescribe
any specific policies or techniques for achieving the goals it seeks.
Wisely, it recognized that stabilization policies would have to be
adapted to the needs of an ever-changing economy and that—in any
case—our understanding of economic fluctuations, and how to moderate them, had not reached the stage at which the precise amount
and combination of monetary-fiscal policies needed to assure stable
economic growth could be really determined.
We have learned much during the years since its passage about
what can be accomplished with timely application of the tools of
economic stabilization. One important lesson has been that there is no
simple touchstone by which to guide the conduct of monetary policy.
In an economy as dynamic as ours, no single measure of monetary
stimulus or restraint has been sufficient to serve adequately as an
34
exclusive indicator of what monetary policy has been, or as an exclusive guide to what it should be. The effects that stem from any
given monetary policy depend fundamentally on private reactions to
the policy, and these reactions are not static. They change over time,
partly because of the adaptive behavior of the private economy to the
policy measures themselves. Similarly, the international impact of
domestic policy measures, including monetary polic}^ actions, cannot
always be gaged precisely.
There have been considerable changes in the structure of financial
markets and in financial market responses to monetary policy during
the postwar years. They have affected significantly the variables that
the Federal Reserve must be concerned with in its assessment of
monetary policy and its effects on economic activity and the international position of the dollar. During the early years of the postwar
period, Federal Reserve policies were directed principally at preventing variations in the prices and yields of Treasury securities, rather
than at the more fundamental objectives of economic stabilization. Part
of the excess liquidity inherited from World War I I was worked off
during this period; nontheless, when monetary policy turned from
pegging bond prices to accomplish the objectives of stabilization policy
in 1951, its operations for a number of years took place in the context of a financial climate that heavily reflected the influence of the
enormous wartime buildup of liquid assets in the hands of the public
and of financial institutions.
During the first decade of the postwar period, therefore, the effects
of Federal Reserve policies on financial institutions were confined
more heavily to the commercial banks—and, indeed, to the impact on
commercial bank demand deposits—than has subsequently been the
case. Time deposits of commercial banks, during those years wrere held
primarily by small savers whose financial asset holdings were relatively insensitive to changes in monetary policy. Major nonbank financial institutions, with ample amounts of Treasury securities to sell
in order to meet private credit demands, felt only moderate effects of
changes in monetary policy on the growth of their resources.
The complexity of financial behavior that began to develop in the
latter part of the 1950's further complicated the task of central banking. On the one hand, financial institutions have become much more
aggressive in their competition for funds, largely as a consequence
of the progressive decline in their liquidity since the end of World
War II interacting with mounting demands for credit to finance expenditures. This increased competition has resulted in markedly
higher interest rates paid by the various competing institutions on
their deposits or shares, and it has also produced a diversification in
types of instruments offered by the institutions for the financial investor to hold.
Another development of major importance in financial markets relates to the increased sensitivity of financial investors to considerations
of yield in the placement of their financial savings, and their growing
willingness to substitute among a wider range of financial assets. As
a consequence, the monetary authorities have had increasingly to take
into consideration the effects of changes in policy on a broad range of
financial assets, including savings and loan shares, mutual savings
bank deposits, time deposits of commercial banks, policy loans of
35
insurance- companies, and intermediate- and long-term securities issued by the Federal Government, by States and municipalities, and by
corporations.
In particular, monetary policy decisions have had to take into account the potential effect of variations in time deposit growth on creditfinanced spending, and hence on the pace of economic expansion. The
accelerated growth in time deposits that has normally accompanied an
increase in rates paid by banks, for example, to some degree represents
funds that otherwise might have been invested in market securities, or
in the deposits and shares of nonbank thrift institutions. To that extent,
the effects of larger supplies of funds made available to borrowers by
commercial banks have been offset by the lesser rise in funds supplied
to credit markets by nonbank intermediaries, or directly by nonfinancial businesses and consumers. But to some degree, the accelerated
growth of time deposits reflects direct substitutions by businesses and
consumers of time deposits for demand balances in their liquid asset
portfolios. Substitutions of that kind, since reserve requirements are
lower on commercial bank time deposits than on demand balances, permits commercial bank credit to grow without a corresponding reduction in credit supplies through other channels. To that extent, the effect
of increased time deposit growth rates is expansionary.
The significance of any given change in the growth rate of time
deposits, therefore, depends on whether it does or does not imply
changes in the total supply of credit, and in credit cost and availability that are detrimental to the maintenance of economic stability. And
these effects in credit markets depend, in turn, on the factors motivating
the change in the public's demand for time deposits during any particular period of time.
The spreading of the effects of monetary policy beyond the commercial banking system to include the major nonbank financial institutions has complicated the problems of monetary decisionmaking still
more, although the substantive issues involved are similar to those
to be dealt with in connection with commercial bank time deposits. It
has become amply evident since 1966 that we cannot ^SFord to exclude
the major nonbank thrift institutions from consideration in formulating monetary policy. Flows of deposits and shares to these institutions,
and hence the amount of credit supplied by them to finance spending,
tend to be reduced markedly by policies of monetary restraint that lead
to increasing yields on substitutes for the liabilities of these institutions,
since the ability of these institutions to increase the rates they pay is
limited by the fact that their current incomes respond very slowly to
changing market rates of interest. Similarly, easing conditions in the
money and capital markets stimulate inflows into these institutions.
Because these institutions are heavily specialized in supplying funds
for homebuilding, such variations in flows of funds through them can
have major effects on residential construction. The home-building industry is heavily dependent upon a steady flow of mortgage money
from nonbank intermediaries.
The growth rate of credit supplied to borrowers through these nonbank intermediaries need not be associated closely with growth rates
of the money stock, or of commercial bank time deposits, or of total
bank reserves, or of other variables that are at times suggested as sufficient guides for the conduct of monetary policy. Indeed, at critical times
36
in the recent past it has not. During the early months of 1966, for example, the effects of monetary policy working through the inflows to nonbank thrift institutions began to exert a major restrictive impact on
the supply of mortgage money and hence on housing starts. The money
stock, on the other hand, continued to grow quite rapidly through
April. To establish monetary policy by fixing the growth rate of any
single variable, ignoring such evidence as may be available on the effects of monetary policy through other channels, would be to court
disaster.
Still another complexity arising in the late 1950's and continuing
throughout the 1960's has been the serious imbalance in the U.S.
balance of payments. One effect has been the development of new
financial instruments and markets, such as the Eurodollar market, in
which the effect of domestic policy actions are registered.
It is sometimes suggested that the way around the problems posed
by the increasing complexity of financial market behavior is to adopt
even broader definitions of "money," in the hope that a definition
might be found that would somehow cope with the broader influence
of monetary policy in financial markets. Undoubtedly, monetary processes are better understood by expanding analytic horizons to include
variables other than currency and demand balances in our efforts to understand the effects of monetary policy on the economy. But since the
interpretation of changes in nonmonetary financial asset holdings
depends on an understanding of the sources from which funds flow into
these assets, and the reasons for these flows, we cannot expect to
develop an adequate guide for the conduct of monetary policy simply
by the construction of a new definition of money. Our monetary history
does not indicate that there is any single financial asset, or combination of financial assets, that uniquely satisfies the public's liquidity preference.
As noted earlier, the significance to be attached to the growth of the
public's holdings of particular kinds of liquid assets, and combinations
of them, depends importantly on whether the associated changes in
credit market conditions are in the interests of economic stability.
Changes in interest rates and in other dimensions of loan contracts,
can therefore provide useful information on the course of monetary
policy. Credit market conditions must always be given close attention
in establishing guidelines for monetary policy, since it is through the
credit markets that monetary policy has its most direct effect on
spending. But like changes in the money stock, changes in credit market
conditions are partly the result of Federal Reserve policy, and also
partly the result of decisions of commercial banks, of nonbank financial
institutions, and of nonfinancial businesses and consumers. For that
reason credit market conditions cannot be an exclusive guide in the
formulation of policy decisions.
In seeking guidance for the conduct of monetary policy, therefore,
incoming information on both financial quantities and financial prices
must be assimilated and interpreted. Movements in financial quantities—such as total bank reserves, the money, stock, commercial bank
time deposits, and claims against nonbank intermediaries—on the one
hand, together with indications of cost and availability of credit—
including interest rates and nonprice terms of credit—on the other,
must be evaluated jointly to assess what effects monetary policy cur-
37
rently is having on the total supply of funds, its distribution among
the various sectors of the economy, and hence on the availability of
funds to finance spending.
This interpretation must, of necessity, seek to evaluate the behavior
of financial variables in light of underlying real developments in
markets for goods and services. It is particularly important to distinguish between the variations in demands for and supplies of credit
that are produced by changes in decisions to spend on goods and
services, and those associated with the public's desires to rearrange
financial asset portfolios, corporate mergers, and similar transactions.
Decisions giving rise to the first kind of variation in credit conditions
can lead directly to economic instability. The latter class of decision
does not directly alter the pace of economic expansion, but the resulting
side effects in financial markets may do so. The appropriate monetary
policies to be followed, in response to an observed variation in credit
demands or supplies, depend on which of these two classes of decisions
is responsible.
In the final analysis, evalution of whether monetary policy has
contributed positively to economic stabilization cannot be judged simply on the behavior of financial variables, no matter how carefully
they are intepreted. The ultimate test of monetary policy is the extent
to which it has succeeded in promoting our national economic goals
of maximum sustainable economic growth, maximum practicable employment, reasonable price stability, and a strong dollar at home and
abroad.
Question H. Concerning debt management policy: Given the goals
of the Employment Act what can debt management do to help their
implementation? (If you believe that debt management has no role
to play in this matter, please explain why.)
Answer. As a stabilization tool, debt management can play a useful
although circumscribed, role in implementing the goals of the Employment Act, as a complement to fiscal and monetary policies. In the early
1960's, for example, debt management contributed to maintenance of
upward pressures on short-term interest rates for balance-of-payments
purposes, thus giving monetary policy somew^hat greater flexibility
for adapting its policies to domestic credit needs. But a number of
considerations, including budgetary and legal constraints and the need
for a balanced debt structure, tend at most times to limit the contribution that debt management can make to economic stabilization. In
any event, any contribution of debt management may be overweighted
by ongoing fiscal and monetary policies, which between them tend to
have larger, more pervasive, and more sustained effects on interest
rates and credit availability.
Debt management policies are those related to the structure—primarily the maturity composition—of the outstanding publicly held
Federal debt. Shifts in the maturity composition of the Federal debt,
which is the main aspect of debt management, alter the liquidity of
the debt and/or the term structure of interest rates. Market expectations as to the future course of interest rates also play an important
role in affecting the term structure.
In the degree that changes in the relative supply of short- and longterm securities affect the interest rate structure and the availability of
funds, they will have some impact on financial flows and private
38
spending in various sectors of the economy. In particular, the distribution of liquid assets in the hands of commercial banks and elsewhere
in the economy may have a considerable effect on the nature and timing of the responses of the financial markets to monetary policy.
Changes in market interest rates, particularly short- and intermediateterm rates, may affect the ability of savings and loan associations and
mutual savings banks to compete for the public's savings, and thereby
influence the cost and availability of credit for housing. Changes in
short-term interest rates also particularly affect the ability of major
commercial banks to attract funds from corporations through large
negotiable time certificates of deposit, and influence bank ability to
finance other businesses. On the other hand, a debt management policy
that stresses debt lengthening operations would affect the availability
of funds for investment in State and local government and corporate
bonds, since insurance companies, trust funds, and others who purchase long-term Government debt may be using funds that would
otherwise be placed in private markets.
Because various segments of the domestic credit market, as well as
international flows of funds, may be affected by debt management
decisions, the debt managers are always faced with the need to evaluate how the cash raising and refunding problems connected with the
Government debt interact with economic and credit trends in the
country and how they phase in with fiscal and monetary policies.
There are, however, important technical problems of orderly debt
management procedure which sometimes tend to conflict with economic
goals. It is generally desirable to maintain a balanced debt structure—
with maturities reasonably spaced and not excessively large at any one
time—so as to avoid the continuous or awkwardly large refunding
operations that might tax the market's capacity to absorb Treasury
issues, given the steady flow of private issues into the market. Since
the public debt continuously shortens with passage of time, a balanced
debt structure requires the Treasury to be alert to opportunities for
debt lengthening operations. These operations are most feasible in
periods of declining interest rates (when rising bond prices make them
an attractive investment to hold). However, when interest rate declines
are associated with an undesirable slackening of economic activity,
the economic goals of the country may indicate the desirability of
keeping debt lengthening to moderate dimensions so as to encourage
investors to lend more to finance capital outlays of private sectors of
the economy. Thus, considerations aiming at achieving an appropriate
debt structure must be reconciled with the objectives of the Employment Act. It must also be kept in mind that the flexibility of debt
management in maintaining a balanced debt structure is limited by
the 414-percent interest rate ceiling on Treasury bonds, which eliminates sales of long-term debt at times when the market may be receptive, and when the absorption of savings into long-term Treasury issues would be consistent with economic stabilization goals.
Question I.S.A. H.R. 11 makes no provision whatever for conducting
open market operations for so-called defensive or road-clearing
p\irposes, that is to counteract seasonal and other transient factors affecting money market and credit conditions. Do you see any merit in
using open market operations for defensive purposes or should they
be used only to facilitate achievement of the Presidents economic pro-
39
gram and the goals of the Employment Act? What risks and costs, if
any, must be faced and paid if open market transactions are used to
counteract transient influences ?
Answer. The Federal Reserve System must be concerned both with
providing an efficient monetary system, which handles routinely the
multiplicity of daily payments of economic life, and with fostering
economic growth at a high level of employment while seeking to maintain the purchasing power of the currency at home and abroad. Section 12A of the Federal Reserve Act points up this dual responsibility
and focus of open market operations in the following language :
3. Governing principles.— (c) The time, character, and volume of all purchases
and sales of paper described in Section 14 of this Act as eligible for open-market
operations shall be governed with a view to accommodating commerce and business and with regard to their bearing upon the general credit situation of the
country.
Indeed, the two aims of a smoothly f u n c t i o n i n g monetary mechanism on the one hand, and a monetary policy geared to the achievement of national economic goals on the other, arc not readily separable.
An efficient monetary system is needed if monetary policy is to be used
effectively, for if the financial markets are to respond as intended to
national policy actions the mechanism must be protected from shortrun swings in such factors as the public's demand for currency, the
speed of check collections, international gold or currency flows, or the
size of Treasury balances held with the Federal Reserve banks. A striking recent example is the statement week encompassing the July 4
holiday in 1968 when open market operations routinely compensated
for the $740 million outflow of currency into the hands of the public.
Another important example occurred recently when the United Kingdom repaid its short-term swap drawings by funds obtained through
the International Monetary Fund, causing an absorption of £700 million of member bank reserves which had to be offset to maintain the
overall policy posture. So-called defensive operations, then, simply
prevent operating transactions from interfering with the effective implementation of monetary policy.
In our flexible financial system the Federal Open Market Committee
directs open market operations to aim at maintaining a degree of ease
or pressure on the banking system that is intended at the same time
(1) to foster monetary and credit conditions appropriate to national
economic objectives, and (2) to insulate the monetary system from
the effects of various factors, including temporary influences, that
are unrelated to policy. In this way, changes in monetary and credit
conditions over a period of time flow from conscious decisionmaking
on the part of the Federal Open Market Committee, rather than being
subject to sharp up-and-down swings as a result of short-term or
other special influences that have no policy relevance. To exert its desired influence over the growth path of the banking system's reserve
base, the Federal Reserve must take account of all the forces affecting
reserves.
If the central bank permitted wide week-to-week fluctuations in reserve availability to take place, and did not attempt to offset those fluctuations as is done now, the cost would be considerable. Fluctuations in
reserves would generate changes in bank credit that might well be
perverse from the standpoint of monetary policy objectives. Another
highly probable effect would be a sharp increase in short-term varia-
40
tions in interest rates, as markets generally sought to adjust to quick
ebbs and flows in reserve availability. In order to compensate investors
for the great uncertainty of sharply fluctuating interest rates, it is
likely that average levels of interest rates, particularly short-term
rates, would tend to be higher than otherwise. The U.S. Treasury, as
the largest borrower in the short-term market (with over $60 billion
of bills outstanding), might bear a particularly heavy share of the
higher interest costs.
While the question cited above refers to the "risks and costs" of
using open market operations to counteract transient influences, it
would rather seem to be the case that the significant risks and costs lie
on the side of not using oj>en market operations for defensive purposes.
Nor is the task of mapping out defensive operations, and executing
them, a significant drain on resources that could otherwise be better
employed. For as developed above, the planning and execution of these
operations is in practice inseparable from, and essential to, the carrying out of operations designed to achieve national economic objectives.
Question I.5.B. Do you believe that monetary policy can be effectively and efficiently implemented solely by open market operations?
Answer. Sole reliance by the Federal Reserve on open market operations in the conduct of monetary policy would greatly reduce the effectiveness and flexibility of such policy. Even if reserve requirements
were not subject to change and discounting were abolished, the System
would of course still be able to influence the volume of bank reserves
through open market policy. Nevertheless, there are many situations
in which the conduct of policy is greatly improved by the availability
of the other policy instruments and some situations that can properly
be treated only through the use of these other instruments.
Open market operations are the preferred technique for day-to-day
operations and, in many situations, as a vehicle of policy change. The
special advantages of the other instruments and the situations in which
they assist the development of effective monetary policies are developed below in answer to question I.5.C.
Question I.5.C. For what purposes, if any, should (a) rediscounting,
(b) changes in reserve requirements, and (c) regulation Q be used?
How might H.R. 11 be amended to implement your recommendations?
Answer, (a) Rediscounting.—Discounting and changes in the rate
charge on discounts constitute the oldest tool of monetary policy and
the one whose use is most widespread among the world's central banks.
The discounting mechanism permits the performance of the central
bank's role of lender of last resort and allows a broader variety of debt
to be monetized than if only open market operations were permitted.
From the point of view of the individual bank it provides a means of
meeting temporary reserve needs which frequently, in the nature of
the banking business, are unforeseen. Second, the existence of rediscounting provides a means through which the Federal Reserve can
supply reserves immediately and directly to the banks under pressure.
Open market operations do not provide such assurance. Third, the
existence of a discount mechanism cushions the impact of open market
operations not only on individual banks but also on the money market
generally, and thus permits such operations to be undertaken more aggressively without fear that they will have seriously disruptive effects.
Fourth, the existence of a discounting mechanism is an important di-
41
rect channel of communication between the Federal Reserve and its
member banks which increases the System's knowledge of trends and
developments in the market and in the banking system.
Changes in the discount rate are an important instrument of monetary policy. The precise role of discounting as a part of policy in the
future depends upon what actions may be taken in light of the reappraisal of the discount mechanism currently underway in the System. But as long as a discount facility exists there must be a discount
rate and policies with regard to changing its level. There have been
occasions m the past, and may well be m the future, when the decisive
influence of a change in the discount rate on market psychology, interest rates, and expectations generally, can be quite useful. This might
perhaps be especially the case when dealing with problems in foreign
exchange markets where clear-cut and massive action is sometimes required to stem the tide of adverse developments. Most of the major
central banks of the world have indeed used discount rate changes as a
principal means of dealing with foreign exchange market problems. It
might be noted, incidentally, that the usefulness of discounting would
be increased if proposed legislation removing the technical requirements for the eligibility of paper for discounting were enacted.
(i) Changes in reserve requirements.—In principle, any change in
the overall credit-creating capacity of the banking system that can be
accomplished through changes in reserve requirements could also be
accomplished through open market operations. There are at least four
situations in which reserve-requirement changes may have particular
advantages. First, special situations might require a massive and immediate tightening or easing of bank reserve positions. Such situations are hardly likely to be frequent and, indeed, are difficult to
spell out; but, as long as the possibility exists, there are obvious
advantages in holding changes in reserve requirements available for
use. A second advantage of reserve-equipment changes, in some circumstances, is the fact that they impinge immediately on every member bank, whereas open-market operations impinge first on banks in
the money market centers, with the influence spreading only gradually
to the rest of the banking system. Third, changes in reserve requirements may be designed to have specific effects on the composition of
bank assets and on the structure of interest rates. This sort of consideration has been an important reason for changes in reserve requirements during this decade, especially when it was desired to supply
reserves without encouraging an outflow of volatile short-term funds
or when it was desired to maintain flows of bank funds into mortgage
finance in a context of overall credit restraint. Finally, a change m
reserve requirements can be used in appropriate circumstances to give a
clear indication to the public that the System intends to change the
direction of policy or to pursue further an existing path.
(c) Regulation Q.—We believe that the rates paid by financial institutions to attract funds ideally should be completely free to reflect
market forces, and that healthy competition among financial institutions in this respect, as well as others, should be encouraged. The financial conditions of the past few years, however, have made interestrate ceilings unavoidable. High and rapidly rising interest rates have
at times in recent years put great pressure on financial institutions such
as the mutual savings banks and the savings and loan associations. The
21-570—68-
4
42
earning power of these institutions is limited by their necessarily heavy
commitment in long-term assets bearing the lower interest rates characteristic at the time they were issued. This has limited the ability of
these institutions to meet the competition of rising open-market rates
by raising the rates they offer to savers on their own liabilities. Thus,
for the proper functioning of these institutions and of the markets
they serve, notably the mortgage market, it has been necessary to reduce the pressure on them by limiting the rates they are allowed to
offer and, at the same time, by limiting the rates that could be offered
by the commercial banks as their competitors. As long as our financial
institutions are so varied in size, scope, and powers, it is not feasible to
eliminate the power to establish ceilings on interest rates paid on time
deposits when this appears necessary. Once the need for such ceilings is
acknowledged, the need to change them from time to time must also
be admitted in view of the substantial fluctuations that are often experienced in open-market rates. Under the circumstances, then, flexibility in setting these rates has been necessary to increase the efficiency of monetary policy and to protect the health of financial
institutions.
With regard to ways in which H.R. 11 might be amended the System has, on a number of occasions, recommended that the Congress
modify the laws relating to "nonpar clearance" of checks, those limiting the System's flexibility in fixing reserve requirements, and those
relating to the eligibility of member bank assets for discounting.
These matters continue to deserve congressional consideration.
Question I.5.D. Do you see any merit in requiring the Federal Reserve Board to make detailed quarterly reports to the Congress on
past and prospective actions and policies? Are there any risks amd
costs in this procedure? In what ways, if any, would you modify the
reporting provision? What information do you believe should be included in such reports as you recommend the Federal Reserve submit
to the Congress?
Answer. The Federal Reserve welcomes opportunities for full and
frequent interchanges of view with appropriate committees of the Congress regarding the discharge of its responsibilities for monetary
policy. It does not see merit, however, in a legislative requirement
for "detailed quarterly reports to the Congress on past and prospective
actions and policies."
The Board now makes public the records of recent policy actions
of the Federal Open Market Committee, prepared for inclusion in the
Board's annual report to the Congress, on a current basis throughout
the year, with a lag of approximately one-quarter. Information on
changes in discount rates and on changes in Board regulations, including those relating to reserve requirements and ceiling rates on
time and savings deposits is, of course, released at the time of the
actions.
Discussions are currently underway with the Joint Economic Committee of the Congress regarding possible arrangements for quarterly
reports by the Board to that committee. It is the tentative view of
the Board that such reports, to be most useful, should include an
analysis of all major monetary and financial developments of the
preceding calendar quarter. In any case, the Federal Reserve believes
that the purposes of such reports are most likely to be best served
43
if their content, frequency, and timing remain subject to modification over time m light of accumulated experience. A specific legislative requirement in this area would sacrifice the flexibility that may
be important in insuring that the reports are of maximum usefulness.
With respect to prospective policy actions, we believe that a legislative requirement for detailed quarterly reports would involve major
risks and costs. Advance commitments as to policy would seriously
damage the ability of the Federal Reserve to formulate and implement appropriate monetary policies. Furthermore, such commitments
could possibly generate unwarranted expectations in financial markets, in which expectations play such an important role.
Monetary policies are formulated by the Board and the FOMC
in light of a wide spectrum of current information available at the
time on current economic conditions, including data that are often
preliminary, and on the economic outlook as best as it can be assessed
at the time. But policies are modified when conditions are found
to depart from expectations, and/or when the expectations themselves
change.
In the nature of the case, then, monetary authorities should not commit themselves on policy actions beyond the immediate future. The
deliberations of the Board and the FOMC concerning the policy responses that might be appropriate, at later times, if events follow
specified alternative courses, hinge on specific assumptions, and the
range of alternative policy responses is often modified as economic
developments unfold. Thus, it could be seriously misleading to the
public for the Federal Reserve to present, at the beginning of a quarter,
a detailed prospectus of future actions and policies when in fact the
actual policies adopted would depend so heavily on the extent to which
domestic and foreign developments within the quarter alter the
System's assessment of future monetary and credit needs.
Moreover, regular prognostication by the Federal Reserve regarding its future policy actions—such as would be involved in the proposed quarterly reports—would be likely to stimulate large anticipatory swings in financial market conditions. Market participants are
themselves always speculating—in their actions as well as assessments—about the possible course of monetary policy and the prospects
for particular policy actions. Such activity frequently has significant
effects on short-run changes in financial market conditions, including
interest rates. Market conditions might well come to be more strongly
influenced by the System's quarterly statements than primarily by the
basic underlying forces of supply and demand. This, in turn, would
not only damage the ability of financial markets to perform their essential function of resource allocation, it would also interfere with the
ability of the Federal Reserve to assess the underlying strength of
market demands and supplies and to formulate policies appropriate
to the basic domestic and international economic situation.
Question I.5.E. What costs and benefits would accrue if representatives of the Congress, the Treasury and the CEA were observers at
Open Market Committee meetings?
Answer. Congress and the public are, of course, entitled to know
what actions are taken as a result of the discussions at meetings of
the FOMC, and the reasons for these actions. This information is made
public in a variety of ways as promptly as feasible, as noted in the
44
answer to the preceding question (I.5.D). We are inclined to believe,
therefore, that it would be unproductive for representatives of the
Congress, the Treasury, and the Council of Economic Advisers to sit
in at meetings at which, as observers, they would have no right to vote
or otherwise participate actively, and the results of which are, in any
event, made public m extensive detail. Neither does it appear likely
that the proposal would improve on present procedures for coordinating monetary policy with fiscal and debt management policies.
One obvious drawback to the proposal would be that the presence
of such observers might inhibit the full and frank exchange of views
that are essential to enable the Federal Open Market Committee to
operate effectively. We believe that all similar bodies that are assigned
comparable policy responsibilities are also given the opportunity to
meet in private to discuss how best to carry out their responsibilities.
This principle clearly extends to various regulatory agenices and commissions of Government, as well as to committees of Congress, and we
think it should apply to the FOMC as well.
Question II. H.R. 11 provides for the following structural changes
in the Federal Reserve System,:
1. Retiring Federal Reserve bank stock;
Reducing the number of members of the Federal Reserve
Board to five and their terms of office to no longer than 5 years;
3. Making the term of the Chairman of the Board coterminous
with that of the President of the United States;
An audit for each fiscal year of the Federal Reserve Board
and the Federal Reserve banks and their branches by the Comptroller General of the United States; and
5. Funds to operate the Federal Reserve System to be appropriated by the Congress of the United States.
Please comment freely on these several provisions. In particular it
would be most helpful if you would indicate any risks involved in
adopting these provisions and discuss whether their adoption woidd
facilitate the grand aim of H.R. 11, which is to provide for coordination by the President of monetary and fiscal policies.
Answer. II.l. Retiring Federal Reserve bank stock.
While ownership of Federal Reserve bank stock by member banks
of the Federal Reserve System is not essential, there appears to be no
compelling reason for eliminating such ownership. Such a change
would involve the loss of some intangible but important advantages
that result from such ownership of Reserve bank stock and could involve a risk of diminishing the effectiveness of the System's operations.
In addition, retirement 01 Federal Reserve bank stock could be construed, both at home and abroad, as indicating a change in the structure and character of the Federal Reserve System.
There is clearly no foundation for any assumption or inference that
ownership of Reserve bank stock by member banks enables them to
"control" the operations of the Reserve banks or to determine System
policies. The true effect and the advantages of such ownership of
Reserve bank stock were described in one of Chairman Martin's replies
to the 1952 Patman Questionnaire:
As a consequence of the public nature of the Federal Reserve banks, ownership of their stock does not carry with it the same attributes of control and financial interest usually attached to stock ownership in private corporations. The
amount of Reserve bank stock which a member bank must own is fixed by law
45
in relation to the member bank's own capital and surplus. Such stock may not
be transferred or hypothecated. Ownership of stock entitles the member banks
to no voice in the management of the affairs of the Reserve bank other than the
right to participate in the election of six of the nine directors of the Reserve bank.
As the result of the election procedure prescribed by the Federal Reserve Act,
each member bank votes for only two of the nine directors. Under the law, dividends on Federal Reserve bank stock are limited to 6 percent per annum; and in
the event of the liquidation of a Federal Reserve bank, any remaining surplus
would be paid to the United States.
Ownership of Federal Reserve bank stock by member banks is an obligation
incident to membership in the System—in effect, a compulsory contribution to
the capital of the Reserve banks. It was not intended to, nor does it, vest in member banks the control of the Reserve banks or the determination of System policies. Such control would obviously be inappropriate in view of the functions exercised by the Reserve banks.
Stock ownership by the member banks has certain definite advantages. It provides a wide decentralized base for the organization of a Federal Reserve bank.
The element of member bank interest, though without control, has contributed
to a breadth of judgment and experience on the part of the Reserve bank directors
in evaluating business-like methods in the operations of the Reserve banks as
public institutions. It gives to each member bank a tangible interest in, and direct
connection with, the Federal Reserve bank of its district, and this has real psychological value. It helps to create in member banks a greater interest in the
affairs of the System and understanding of its purposes and operations than
would be the case in the absence of such ownership. (Joint Committee Print of
the Joint Committee on the Economic Report regarding "Monetary Policy and the
Management of the Public Debt," 1952, pt. 1, pp. 261, 262.)
II.2. Reducing the number of members of the Federal Reserve
Board to five and their terms of office to no longer than 5 years.
The original Federal Reserve Act provided for a Board of two
ex officio members, the Secretary of the Treasury and the Comptroller
of the Currency, and five members appointed by the President for 10year terms. In 1922, provision was made for an additional appointive
member. The Banking Act of 1933 increased the terms of the six appointive members to 12 years. The Board was reconstituted by the
Banking Act of 1935, effective February 1, 1936, to eliminate the ex
officio members and to provide for a Board of seven appointive members with staggered terms of 14 years, with a prohibition against reappointment of a member after serving a full term.
With respect to the size of the Board, the possible advantages and
disadvantages of reducing the number of members were stated by
Chairman Martin in one of his replies to the 1952 Patman questionnaire :
Over a considerable period of time there have been proposals that the membership of the Board be reduced from seven to some lesser number, such as five or
three. The reason most commonly advanced for such proposals is that greater
importance would be attached to individual membership and that the position
would be more attractive to men of higher caliber. Another reason is that Board
decisions probably would be made more promptly. The timeliness of policy decisions is often extremely important and the need for expediting such decisions is
strongly stressed by those students of monetary policy who have come to feel
that the chief shortcoming of reserve banking policy over the years has been
that important decisions have frequently come too late.
Against proposals to reduce the size of the Board, it has been maintained that
the advantages of collective deliberation and judgment would be correspondingly
lessened, that there is at least safety and perhaps greater wisdom in numbers,
and that a reduction in the size of the Board would necessarily require reconsideration of the composition and possibly even the status of the Federal
Open Market Committee. Moreover, it is believed that a smaller board would find
it more difficult to operate effectively and promptly on some occasions because
of necessary absences, from illnesses or other causes, and the resulting lack of
4(3
a quorum. (Joint Committee Print of the Joint Committee on the Economic
Report regarding "Monetary Policy and the Management of the Public Debt,"
1952, pt. 1, pp. 302, 303.)
On balance, the disadvantages of a reduction in the membership
of the Board from seven to five would outweigh any possible advantages.
With respect to the length of terms of Board members, it is important to bear in mind that the relatively long term of office provided
for Board members since the establishment of the Federal Reserve
System has always been regarded as a means of protecting members
from political pressures. It is possible that the accomplishment of
this objective does not require a term as long as 14 years; but it is
questionable whether a term as short as 5 years would achieve this
purpose. Moreover, if reappointment should be precluded after service of a full term, as under present law, a qualified candidate for membership might be reluctant to interrupt his career for that period of
time. If the prohibition against reappointment should be eliminated,
on the other hand, considerations relating to possible reappointment
could conceivably inhibit objective public interest considerations.
Again balancing the pros and cons, we are inclined to believe that a
term of 5 years, with or without provision for reappointment would
appear to be undesirable.
It is noted that the provisions of H.R. 11 reducing the number of
members of the Board would be accompanied by provisions that
would abolish the Federal Open Market Committee and transfer
regulation of open market operations to the reconstituted Board.
Such a transfer of authority over open market operations to the Board
would not be desirable.
As Chairman Martin pointed out in replying to the 1952 Patman
questionnaire:
The present arrangement under which open market operations are placed
under the jurisdiction of a committee representing the Reserve banks as well
as the Board is consistent with the basic concept of a regional Federal Reserve
System. It provides a means whereby the viewpoints of the presidents of the
Federal Reserve banks located in various parts of the country, with their
technical experience in banking and with their broad contacts with current credit
and business developments, both indirectly and through their boards of directorsr
may be brought to bear upon the complex credit problems of the System. It
promotes System-wide understanding of these problems and closer relations
between the presidents and the Board in the determination of System policies.
In practice the open market policies of the Open Market Committee and the
credit policies of the Board have been coordinated and the existing arrangement has worked satisfactorily. (Joint Committee Print of the Joint Committee
on the Economic Report regarding "Monetary Policy and the Management of the
Public Debt," 1952, pt. 1, p. 294.)
II.3. Making the term of the Chairman of the Board coterminous
with that of the President of the United States.
It would be desirable to amend the law to make the terms of the
Chairman and Vice Chairman of the Board more nearly coterminous
with the term of the President.
In 1952, in his replies to the Patman questionnaire, Chairman
Martin noted that, when the Board was reconstituted by the Banking Act of 1935, it was specifically provided that the Chairman and
Vice Chairman should be designated for terms of 4 years and that the
possible purpose of this provision was to afford a new President an
47
opportunity to designate the Chairman and Vice Chairman. He stated,
however, that:
* * * Assuming such a purpose, the provision has not worked out satisfactorily
in practice because it has not been feasible to make appointments so that they
would coincide with the term for which the President is elected. It might be
preferable if the law were changed to provide that the President shall designate
the Chairman and Vice Chairman for terms expiring on a selected date, say
March 31, 1953, and on March 31 of every fourth year thereafter. (Joint Committee Print of Joint Committee on the Economic Report regarding "Monetary
Policy and the Management of the Public Debt," pt. 1,1952, p. 301.)
On April 17, 1962, President Kennedy submitted to Congress a
message recommending such an amendment to the law that would make
the terms of the Chairman and Vice Chairman of the Board generally
coterminous with the term of the President. Stating that Chairman
Martin concurred in this proposal, the President's message contained
the following paragraph:
Federal Reserve monetary policies affect, and are affected by, the economic
and financial measures of other Federal agencies. Federal Reserve actions are
an important part, but not the whole, of Government policies for economic
stabilization and growth at home and for the defense of the dollar abroad. Therefore, as has been recognized throughout the history of the Federal Reserve, the
principal officer of the System must have the confidence of the President. This
is essential for the effective coordination of the monetary, fiscal, and financial
policies of the Government. It is essential for the effective representation of the
Federal Reserve System itself in the formulation of Executive policies affecting
the System's responsibilities.
In a letter dated October 6, 1966, to Representative Abraham J.
Multer, chairman of the Subcommittee on Bank Supervision and Insurance of the House Banking and Currency Committee, Chairman
Martin stated that the Board believed that the terms of the Chairman
and Vice Chairman of the Board should be related to the President's
term of office and that a new President should be able to appoint a
Chairman of his own choice and should not be limited in his selection
to incumbent Board members.
A change in the law enabling the President to appoint a Chairman
of his own choice shortly after his inauguration would provide a practical basis for effective coordination of Federal Reserve monetary
policies with the fiscal and financial policies of the executive branch
of the Government without affecting the exercise of independent judgment by the Board in the discharge of the responsibilites imposed upon
it by Congress. Such an arrangement would in fact afford a means by
which the Federal Reserve, through the Chairman of the Board, would
be better able to participate, at the highest level of the executive
branch, in continuing efforts to promote the sound conduct of the
Government's financial affairs.
In order to accomplish the objectives of such a change in the lawT
any amendment for this purpose should provide for an adjustment in
the terms of members of the Board so that the term of one member
would expire in each odd year instead of an even year, thereby causing a vacancy to occur in the membership of the Board in the year of
a President's inauguration. Any such amendment should also provide
for a reasonable time lag, perhaps as much as 6 months, between the
time a newly elected President takes office and the expiration of the
terms of the incumbent Chairman and Vice Chairman.
48
II.4. An audit for each fiscal year of the Federal Reserve Board
and the Federal Reserve banks and their branches by the Comptroller
General of the United States.
It would be unnecessary and unwise to provide for audit of the
Federal Reserve Board and Federal Reserve banks by the Comptroller General of the United States. The most recent public statement by
a Federal Reserve official of the reasons for this judgment was made
Tby Gov. J. L. Robertson when he testified on September 14, 1967,
before the Committee on Banking and Currency of the House of Representatives with respect to H.R. 12754. The pertinent portion of
Governor Robertson's testimony is set forth below :
Let me try briefly now to set forth the present procedures for audit and examination of the Board and the Reserve banks, and add a few comments as to
why section 2 of H.R. 12754 is unnecessary and unwise.
Manifestly, Federal Reserve operations should be conducted with maximum efficiency and economy. To that end Congress has placed upon the Board of Governors, an arm of the Congress, direct responsibility for general supervision and
periodic examination of the Reserve banks. The Federal Reserve Act also provides that each Reserve bank shall have a board of nine directors chosen from
its district. They are outstanding in their communities; many have had broad experience in business and professional life, and are therefore able to apply to the
Reserve banks the high standards of efficiency prevalent in private enterprise.
Thus the Federal Reserve combines advantages of governmental control with
advantages of private business management.
Since 1952, the Board has been audited annually by independent public accounting firms, and their audit reports have been submitted to the Banking and Currency Committees of both House of Congress. We have endeavored to select topflight auditing firms for this work. The firms selected have been Arthur Anderson
& Co., Price Waterhouse & Co., Haskins & Sells, and, most recently, Lybrand,
Ross Broa and Montgomery.
The Federal Reserve Act provides that the Board "shall at least once a year,
order an examination of each Federal Reserve bank." The Board maintains a
staff of examiners who devote themselves exclusively to this work. The Board's
instructions to its examiners require, briefly, that the examination shall look to
(a) each bank's financial condition through appraisal of its assets and vertification of its assets and liabilities: (b) its proper discharge of all its responsibilities; and (c) its compliance with all applicable provisions of law and regulations. Each year, an outside commercial auditing firm (Haskins & Sells for 1967)
is engaged to accompany the Board's examiners on their examination of one of
the Reserve banks, to review, observe, and submit recommendations for improving, the examination procedures. Also, each Reserve bank has a resident auditor,
responsible directly to the bank's board of directors and not dependent on any
of the bank's officers for security of position. Throughout the year, he and his
staff make comprehensive audits of all phases of the bank's operations, reporting directly to the board of directors of the bank. Copies of these reports are reviewed by the Board of Governors of the Federal Reserve System.
In sum, then, we have in each Reserve bank an internal audit program conducted the year round by the bank's resident auditor and his staff, who, by a
deliberately established plan of organization, are directly responsible to the
board of directors and independent of the bank's operating management. In
addition, a staff of examiners directly employed by the Board of Governors in
Washington examines each bank every year and reports directly to the Board
of Governors. We have the statements of certified public accountants of national
repute that the examination procedures employed by the Board's staff conform to
generally accepted auditing standards. This combination of internal and external
scrutiny provides an objective audit coverage of the Reserve banks that is unexcelled in any other organization.
In addition, the System is subject to congressional scrutiny, a responsibility
which this committee and its distinguished chairman take very seriously indeed,
as you know. But some of the newer members of the committee may not fully
appreciate how thoroughly the committee and its staff, including the capable and
conscientious investigators who have been on loan to the committee from GAO
in recent years, have examined into expenditures by the Reserve banks. Not only
49
have the reports of examination of the Reserve banks been furnished to these
investigators, but when they asked to see the working papers used in the course
of the examinations these, too, were furnished, including the contents of our
examiners' locked work trunks- Detailed breakdowns of expenditures in each of
four categories were requested and furnished, together with descriptive material
and justifications for thousands of items selected from these categories by the
committee's investigators. They have visited several of the Reserve banks, where,
they reported, they "were courteously received and given all reasonable cooperation by bank personnel in accomplishing [their] work." (The quotation is from
page 317 of this committee's 1964 hearings on the Federal Reserve System after
50 years.)
The Board of Governors, then, stands ready to provide any information yott
seek concerning expenditures by the System. We take our responsibilities seriously, too, as the Government agency designated by the Congress to make sure
that the Reserve banks are carrying out efficiently the duties assigned to them
by law. Direct expenditures for audit and examination of the Reserve banks in
1966 totaled approximately $4 million. What GAO does for the Post Office, we d o
for the Reserve banks, reporting directly to you. This seems to us a sensible
arrangement, since we have the particular expertise related to Reserve bank
operations. If another arm of Congress were directed to do the same job, the end
result would be duplication and overlapping of responsibilities, with attendant
increases in costs and deterioration in operating efficiency and no apparent offsetting benefits.
Let me add a few comments about the wording of section 2. It provides that
GAO "shall have access to all books, accounts, financial records, reports, files and
all other papers, things, of property belonging to or in use by the entities being
audited, including reports of examinations of member banks." This provision
raises serious questions about whether the System would be able to maintain
relationships such as those presently in effect with foreign central banks, which
depend on our ability to assure others that we can maintain confidentiality when
they request it. As to one particular aspect of this problem, section 2 is crystal
clear: it specifically requires that we make available to GAO the reports of
examination of member banks. As I have indicated before, the System stands
ready to answer any question about its own expenditures. But we believe that
the long-established tradition that reports of examination of commercial banks
should be kept confidential is not only essential to maintain effective supervision,
but also to protect the privancy of customers of the member banks in their personal and business staffs."
II.5. Funds to operate the Federal Reserve System to be appropriated by the Congress of the United States.
This proposal contemplates that all earnings of the Federal Reserve
banks would be transferred to the Treasury of the United States and
that the expenses of such banks, as well as the expenses of the Board of
Governors, would be paid only from appropriated funds.
Adoption of this proposal would represent a radical alteration of
the basic concept of the Federal Reserve System and prevent the
System from discharging its statutory functions in the most effective
manner, which requires the exercise of independent judgment and
freedom from political and partisan pressures or the possibility of
such pressures.
Since the inception of the Federal Reserve System, the law has provided that the expenses of the Board of Governors, including the
salaries of its members and employees, shall be paid out of semiannual
assessments levied upon the 12 regional Federal Reserve banks. The
expenses of the Federal Reserve banks are paid from the earnings of
the Reserve banks which are derived principally from Government
securities acquired pursuant to open market operations designed by law
to aid in the maintenance of a sound basic economy and sound credit
conditions. Since 1947, under direction of the Board of Governors
pursuant to provisions of the Federal Reserve Act, the Reserve banks
50
have paid the greater part of their earnings to the Treasury of the
United States. At present, all of such earnings, after payment of
dividends to member banks and current expenses, and the maintenance
of the Reserve banks' surplus in an amount equal to their paid-in
capital, are transferred to the U.S. Treasury. Under this practice,
the Reserve banks since 1947 have paid over to the Treasury more than
$14 billion. In 1967 alone, the amount of such payments was nearly $2
billion.
A requirement that the expenses of the Board and the Reserve banks
be paid only from funds appropriated by Congress would create
unnecessary and hampering rigidities in the performance of the public
service functions of the System. More importantly, however, it would
inject political pressures and considerations into the formulation of
monetary and credit policies.
One of the major purposes of the Banking Act of 1933 was to
strengthen the Federal Reserve System by increasing the independence
of the Federal Reserve Board. (See Report of Senate Banking and
Currency Committee, April 22,1932, 72d Cong., p. 12.) Among other
amendments to the Federal Reserve Act made by the 1933 act in order
to accomplish this purpose was a change in section 10 of the Federal
Reserve Act to provide specifically that the Board should determine
the manner in which its obligations are incurred and its disbursements
and expenses paid and to provide specifically that funds of the Board
derived from assessments on the Federal Reserve banks "shall not
be construed to be Government funds or appropriated moneys." It
would be unfortunate if, after so many years, Congress should abandon
the basic principle that the expenses of the Board, as well as those of
the Reserve banks, should not be subjected to the limitations inherent
in the appropriations process.
Any change in the law that would make the Federal Reserve subject to the appropriations process would be logically inconsistent with
the following conclusions reached by the Subcommittee on General
Credit Control and Debt Management in 1952:
The independence of the Federal Reserve System is based, not on legal right,
but on expediency. Congress, desiring that the claims of restrictive monetary
policy should be strongly stated on appropriate occasions, has chosen to endow
the System with a considerable degree of independence, both from itself and from
the Chief Executive. This independence is in no way related to the unsettled
question of whether the Board of Governors is or is not a part of the executive
branch of the Government. It is naturally limited by the overriding requirement
that all of the economic policies of the Government—monetary policy and fiscal
policy among them—be coordinated with each other in such a way as to make
a meaningful whole. The independence of the Federal Reserve System is desirable, not as an end in itself, but as a means of contributing to the formulation of
the best overall economic policy. In our judgment, the present degree of independence of the System is about the best suited for this purpose under present
conditions. (Joint Committee Print of Report of the Subcommittee on General
Credit Control and Debt Management of the Joint Committee on the Economic
Report, 82d Cong., June 26,1952, p. 4.)
Question III. Your analysis of monetary developments, since 196U,
including policy induced changes and their effects on economic activity, is invited.
Answer. For most of the period since 1964, the United States has
been experiencing both the benefits and the problems of a full employment economy. The benefits have included an exceptionally low level
of unemployment, maintained even during the short slowdown in
51
early 1967. The problems have included an unacceptable and unsustainable rate of price inflation, which has offset the bulk of the gains
in money incomes, and has resulted in a sharp deterioration in the U.S.
international trading position and overall balance of payments. These
problems have been exacerbated by the delay in achieving adequate
fiscal restraint, putting too large a share of the stabilization burden
on monetary policy.
The economy approaches its potential: 1964 mid-1965
During 1964 the Federal Eeserve sought to influence the cost and
availability of funds and the growth in the Nation's liquidity so as to
contribute both to continued orderly expansion in the domestic economy and to further improvement m the U.S. balance of payments.
Throughout most of the year, the posture of monetary policy remained
one of ease with respect to domestic credit conditions, supporting the
stimulative effect of the March cut in Federal income taxes. During
this period, the unemployment rate declined to about 5 percent, as
economic activity expanded further.
Beginning in the fall of 1964, with the economy strong enough to permit it, the Federal Reserve reduced the degree of ease slightly in
order to minimize the outflow of funds attracted by higher shortterm interest rates abroad. In mid-August it became clear that the
balance-of-payments deficit in the second and third quarters was running much larger than the quite low total achieved in the first quarter.
In this situation, the Federal Open Market Committee moved in the
direction of slightly firmer money market conditions in order to raise
short-term interest rates somewhat, keeping them more in line with
short-term rates abroad.
In November, the Bank of England raised its discount rate 2 percentage points, to 7 percent, in response to the speculative attack on
sterling. Federal Reserve bank discount rates were raised from Sy2
to 4 percent, to counter possible capital outflows that might be
prompted by any wideing spread between money rates in this country
and the higher rates abroad. In response, short-term domestic market
rates moved up somewhat, after having remained relatively stable
earlier in the year. So that this action would not unduly restrict the
availability of bank credit, for domestic purposes, the Federal Reserve
continued to supply reserves to banks through open-market operations
and the maximum rates payable on time and savings deposits by
banks were raised.
As a result of the sustained growth over the preceding 4 years, the
economy began approaching full utilization of labor resources as 1965
developed. While plant utilization was not pushed up to the optimum
level, excess capacity did not prevent spending on new plant and equipment from remaining high. With continued expansion in demand, output, and employment, upward pressures on prices began to emerge.
Moreover, in the early months of 1965, the deficit in the U.S. balance
of payments continued to be large.
The Federal Reserve participated in the administration's credit
restraint program, announced in February 1965, to alleviate the balance-of-payments situation. To help reduce outflows of capital to foreigners, the voluntary foreign credit restraint program was set up,
under which the Board of Governors issued guidelines to banks and
52
other financial institutions which were designed to restrain their lending and investing abroad.
In an effort to reduce inflationary pressures that might develop as
economic growth was extended, and to reinforce the voluntary foreign
credit restraint program, the Federal Reserve began to supply less
reserves through open-market operations, relative to demands, so as to
encourage more moderate growth in the reserve base, bank credit,
and money supply. Member bank borrowings from the Federal Reserve rose in the first half of 1965, and the banking system moved from
a position of free reserves (excess reserves greater than borrowings)
to one of net borrowed reserves (borrowings greater than excess
reserves).
Emergence of inflationary pressures: mid-1965 late 1966
In the latter half of the year, although the balance of payments
was showing an improvement, demand pressures were increasing in
the domestic economy largely in response to stimulative fiscal developments—including the military buildup in Vietnam, the reduction in
Federal excise taxes, and the increase in social security benefit payments. Domestic price increases became more widespread, the unemployment rate moved down toward 4 percent, and plant capacity
utilization was high. With confidence that further rapid economic
expansion was in prospect, business speanding for inventories and fixed
capital rose rapidly, resulting in heavy demands for credit. As a result interest rates, which had shown little change during the first half
of the year from the levels of late 1964, also began to increase.
With unused resources moving nearer to critically low levels, and
with indications of continuing pressures from the business investment
boom and an acceleration in defense spending, the Federal Reserve
raised the discount rate by one-half of a percentage point, to 4 ^ percent, effective December 6. At the same time, to avoid a developing
constriction in the flow of funds in credit markets, the Board of Governors raised interest rate ceilings on time deposits under regulation
Q by a full percentage point to 5y2 percent.
The expansionary forces in the economy, which had gathered momentum after mid-1965, accelerated in early 1966. In a further effort
to blunt the inflationary impact of credit-financed spending, the Federal Reserve, in February, further increased the pressure on bank reserves through more restrictive open-market operations. With demand for credit still strong, interest rates rose sharply further through
the summer.
These higher market interest rates, together with intensified bank
competition for funds, led to a sizable reduction in net inflows of
savings to nonbank savings institutions and thence to the mortgage
market. As a result, a heavier share of the impact of monetary restraint
fell on the home building industry than on other sectors of the economy; industrial and other business concerns were still obtaining a
considerable amount of credit, though at rising interest rates, to finance
their increasing outlays for fixed capital and inventories.
During the summer the Federal Reserve took a variety of steps to
attempt to redress the uneven effects of financial restraint. These
measures were designed to help prevent rate competition for savings
among financial institutions from adding to the upward thrust of interest rates, to reduce the rapid growth of business loans at banks,,
and to moderate pressures on the mortgage market.
53
In July, the regulation Q ceilings on new multiple-maturity time
deposits were reduced. In addition, between July and September, reserve requirements on time deposits in excess of $5 million at each
member bank were raised twice. An attempt by some banks to avoid
ceilings by issuance of promissory notes maturing in less than 2 years
was forestalled by bringing them under reserve requirement and interest ceiling regulations. Furthermore, on September 1 a letter was
sent to each member bank which, while stating that reserves would be
provided to meet seasonal or emergency needs, requested their cooperation in curtailing the business loan expansion. Indeed, the continued
rapid expansion in business loans in a period of overall restraint on
bank credit expansion was seriously limiting the availability of bank
funds to meet other needs and threatened to cause excessive strains
in the market for obligations of State and local governments.
Finally, in late September, new temporary authority was enacted
by Congress which broadened the basis for interest rate ceilings on
time and savings deposits. Promptly thereafter the Federal Reserve
and other regulatory authorities acted to limit further, or to reduce,
interest rates payable on certain types of deposits and shareholdings
at commercial banks, mutual savings banks, and federally insured
savings and loan associations.
Economic pause and resumption of expansion: Late 1966-summer 1967
By early fall it became evident that monetary policy; aided by
certain fiscal restraints—including the suspension of the investment
tax credit and accelerated depreciation privileges—had considerable
success in achieving the objectives of curbing excessive aggregate demand and of damping inflationary pressures. Defense spending did
continue to rise sharply in the fall, but residential construction activity had already fallen sharply, the rate of increase in consumer expenditures had slowed, there were signs that business plant and equipment outlays would moderate, and business inventory accumulation appeared to be reaching a peak. Expansion in bank credit and money
supply slowed considerably.
Federal Reserve open market operations in the early fall were
modified so as to reduce some of the pressure on banks, and as fall
progressed, the Federal Open Market Committee shifted its policy
so as to stimulate moderate renewed expansion of bank credit and
easier conditions in financial markets. By the end of 1966, pressures
on financial markets had eased significantly and most market rates of
interest had declined sharply from their late summer peaks.
In the early months of 1967, with economic activity slackening, the
Federal Reserve extended the shift toward greater monetary ease
initiated in the fall of 1966. Open market operations wrere increasingly
directed toward easing domestic credit conditions. Furthermore, in
March, the Board of Governors authorized a reduction in reserve requirements on savings deposits and on the first $5 million of other
time deposits at each member bank, and in the following month the
Federal Reserve discount rate was reduced from 4% percent to 4 percent. Pressure on most financial markets continued to ease and corporations, banks, and nonbank savings institutions were able to improve
liquidity positions that had been eroded during the previous year's
monetary restraint.
The shift toward ease beginning in the fall of 1966 was set in motion
early enough so that a,n upswing in construction began in early 1967
and was a factor tending to offset the weakening in overall economic
54
activity. Moreover, credit was readily available to finance consumeroutlays on durable goods and to provide a cushion against businesses'
tendency to reduce the rate of inventory accumulation.
By early summer the prospects of a more rapid increase in economic
activity suggested the desirability of greater emphasis on restraint,
in the mix of fiscal and monetary policies, preferably through fiscal
measures such as the administration's proposed tax increase. The inventory adjustment was relatively short lived, and in the summer the
rate of business inventory accumulation began to rise again. Moreover, heavy Government expenditures continued to be a major stimulative force in the economy. And finally, inflationary price pressures
were becoming more widespread, as rapid economic expansion resumed, sizable wage settlements were reached in key industries, and
industrial prices rose.
Inflationary pressures mount: summer 1967-^mid-1968
The highly stimulative Federal budgetary policy continued in the
latter half of 1967 and the first half of 1968, leading to upward pressures on the economy. Since by the fall of 1967, no action had yet been
taken on the administration's recommendation for a tax increase, the
Federal Reserve System saw no choice but to move toward restraint.
Indeed, the U.S. balance-of-payments position appeared to be worsening, international confidence in the dollar was ebbing, and domestic
price increases were accelerating. At the time of the devaluation of
the pound, in mid-November, the Federal Reserve raised the discount
rate back to 4y2 percent, and open market operations were adjusted
in the direction of restraint. Late in December, the Board of Governors also announced a one-half percentage point increase in reserve
requirements against demand deposits in excess of $5 million at each
member bank effective around mid-January 1968.
During the first half of 1968, additional measures were taken to
moderate the sustained domestic and international pressures on the
dollar. The Federal Open Market Committee limited further the flow
of reserves to banks. In March, in response to large gold outflows
stemming from heightened speculation as to the possible devaluation
of the dollar, the Federal Reserve again raised the discount rate, from
41/2 to 5 percent. In April, the discount rate wras again raised—to
51/2 percent—and regulation Q ceilings were increased on all but the
shorter term CD's as holders of these instruments began to shift their
funds into higher yielding market securities.
The series of monetary actions beginning in late 1967, coupled with
continued large demands for funds by governments and the private
sectors of the economy, contributed to a sustained rise in market interest
rates. Along with the rise in rates was a slowing in the expansion of
bank credit, and reduced net inflows of funds to nonbank savings institutions. Less funds became available to finance construction, and
activity in this sector of the economy began to slow down. There w^as
evidence that some State and local government bond offerings were
postponed as a result of interest costs, with spending possibly affected
to a marginal degree.
In the latter part of June, Congress enacted a program of fiscal
restraint—including a tax increase and governmental expenditure reductions. This long-awaited move changed market expectations here
and abroad and interest rates declined from their earlier peaks. Overall pressures in capital and money markets have been reduced since
mid-1968, and the ability of banks and thrift institutions to obtain
funds for lending appears to have improved in some degree.
REPLY OF HON. HENRY H. FOWLER, SECRETARY OF
THE TREASURY
T H E SECRETARY OF THE TREASURY,
Washington, September 5,1968.
Hon.
WRIGHT
PATMAN,
Chairman, House Banking and Currency Committee, House of Representatives,
Washington, D.C.
DEAR MR. CHAIRMAN : In reply to your letter of July 9 with regard to the
hearings to be held on H.R. 11 by the Domestic Finance Subcommittee of the
Committee on Banking and Currency, I am enclosing answers to the questions
submitted.
Sincerely yours,
HENRY H .
FOWLER.
STATEMENT OF HON. HENRY H. FOWLER, SECRETARY OF THE
TREASURY
Question 1. Do you believe that a program coordinating fiscal debt
management and monetary policies should be set forth at the beginning
of each year for the purpose of achieving the goals of the Employment
Act, or alternatively should we treat monetary and fiscal policies as
independent mutually exclusive stabilization policies?
Answer—Treasury response. The question implies that there are
only two alternatives: (a) set forth a detailed program of fiscal and
monetary measures at the beginning of each year geared to a forecast
of the economy, financial markets and balance of payments, or (b) to
treat monetary and fiscal policies as independent mutually exclusive
stabilization policies. In our opinion, choice of either of the extreme
alternatives would be unlikely to further achievement of the goals of
the Employment Act of 1946 and other important goals, and under
some circumstances, might actually impede achievement of the desired
goals.
There should be little need to argue at any length the case against
treating monetary and fiscal policies as "independent mutually exclusive stablization policies." Economic theory and actual experience
with stabilization policy demonstrat-e conclusively that the attainment of multiple, and frequently conflicting goals requires the coordinated use of policy instruments. We are not so rich in policy instruments that we can afford to let monetary and fiscal policy go their
separate ways. Instead, these and other policy instruments must be
combined in such overall proportion as to promote a proper matching
between policies and objectives. Even then, the attainment of the goals
of the Employment Act and other important goals will be a continuing
task, requiring the best efforts of the executive, the Congress, and the
private community. But, without the coordinated use of policy tools,
the chances for success would be drastically reduced.
(55)
56
It is one thing to recognize that major policy tools must be used in
a coordinated way and quite another to argue that it would be useful
to set forth a very detailed monetary and financial program at the beginning of each year. The budget message of the President, the Economic Report of the President and the Annual Report of the Council
of Economic Advisers already go a long way toward specifying an
economic and financial program. It may be possible to go somewhat
further in spelling out financial assumptions underlying the economic
projections in these documents. But we do not believe that it would be
either possible or desirable to spell out prospective monetary and debt
management steps in a great deal more detail than is now the case.
One reason is the inherent difficulty of the forecasting process. It
is hard1 enough to project the probable movements of major economic
series. Our ability to project financial variable tends at present to be
even more circumscribed. A requirement to be highly precise might
under these conditions simply result in frequent large errors, and
would nto necessarily be a real aid in forward planning.
A second reason for questioning the usefulness of attempting to
specify the details of monetary policy for a year or so ahead relates to
the basic character of the monetary policy tool. One of the chief advantages of monetary policy as a stabilization tool is an ability to make
prompt changes of direction in response to a changing pattern of
events. Any monetary projection should typically be much provisional
than projections in the fiscal area, where discretionary changes in
policy are less frequent and less closely attuned to minor swings in
economic activity. If there is an attempt to pin down future monetary
actions too precisely, policymakers may lose the flexibility they need.
It might Tbe argued that little harm would result from presenting
very detailed projections of the economy, financial flows, and the
balance of payments along with a proposed package of fiscal, monetary, and other policies, even if the projections turned out to be very
wide of the mark. This, however, is not a convincing line of argument.
The publication of such official projections would inevitably tend to
suggest greater certainty as to the future course of events than could
actually be the case and might even tend to reduce the needed "freedom of maneuver" of monetary policy.
For these reasons as well as because of the traditional "independence" of the Federal Reserve within the Government, we believe that
the monetary projections that underlie the Economic Report of the
President must necessarily remain conditional, cannot be overly precise, and must typically recognize the need for monetary policy to be
used flexibly in the light of changing circumstances at home and
abroad.
Question 13. If you believe a program should be specified, do you
believe that the President should be responsible for drawing up this
program, or alternatively should such responsibility be dispersed between the Federal Reserve System and agencies responsible to the
President? (Please note that informal consulting arrangements can be
made as desired whether responsibiltv is assigned to the President or
divided between the President and the Federal Reserve. The concern
here is with the assignment of formal responsibility for drawing up
the economic program,.)
57
Answer—Treasury response. The President already has the responsibility for drawing up, at the beginning of each year, a detailed
economic program that is incorporated in his budget and Economic
Report messages. In this context, he usually does spell out, in a general
way, his assumptions regarding the monetary policies that would be
consistent with the proposed fiscal and economic program and that he
would regard as appropriate. In working out these assumptions, the
President usually takes account of the views of various agenices as
well as those of the Federal Reserve.
Responsibility for the presentation of such a set of economic recommendations, based on specified assumptions with respect to financial
developments and policies, should in our view continue to rest with the
President. For the reasons spelled out in our response to the previous
question, however, statements regarding assumed or desired monetary
policies must necessarily be provisional and leave ample room for the
flexible use of such policies. Moreover, given the traditional arrangements under which the Federal Reserve is directly answerable to the
Congress, formal responsibility for the determination and execution of
monetary policy must remain with the Federal Reserve and, ultimately, the Congress.
Question 1.3. Concerning monetary policy guidelines:
A. Should monetary policy be used to try to achieve the goals
of the Employment Act via intervention of money supply (defined as desired) as provided in H.R. 11, or alternatively should
H.R. 11 be amended to make some other variable or variables the
immediate target of monetary policy; for example, interest rates,
bank credit, liquidity, high-powered or base-money, total bank
reserves, excess reserves and free reserves? Please define the target
variable or combination of variables recommended and state the
reasons for your choice. (If desired, recommend a target variable
or variables not listed here.) It would be most helpful if, in providing the reasons for your choice, you list the actions the Federal
Reserve should take to control the target variable (or variables)
and also explain the link between your recommended target of
monetary policy and the goals of the economy as defined by the
Employment Act.
B. Should the guidelines of monetary policy be specified in
terms of some index of past, present, or future economic activity,
or alternatively in terms of the target variable's value or growth?
For example, should the President's 1969 program for achieving
the goals of the Employment Act be formulated to require consistency with some set of overall indicators of economic activity,
or alternatively so that your target variable attains a certain value
or growth regardless of the economic winds? Please indicate the
reasons for your preference.
C. For only those persons who recommend that some index of
economic activity be used to guide the monetary authorities in controlling the target variable: Should we use a leading (forward
looking), lagging (backward looking) or coincident indicator of
economic activity? It would be most helpful also if you would
identify the index you, would like to see used and specify how the
target variable should be related to this index.
21-570—68
5
58
D. For only those persons ivho recommend that the guidelines
be put in terms of the target variable's value or growth: Shoidd
the same guidelines be used each year into the foreseeable future,
or alternatively, should new guidelines be issued at the beginning
of each year conditioned on expected private investment, Government spending, taxes, et cetera? Please indicate the reasons for
your preference.
E. For only those persons who recommend that the guidelines
be put in terms of the target variable's value or growth and who
also recommend that the same guidelines be used year after year
into the foreseeable future: What band of values or range of
growth do you recommend? (By way of clarification, a band of
values appears appropriate if your target variable is, say, free
reserves, whereas a range of growth is appropriate if it is, say,
money supply.)
F. For all those persons recommending that the guidelines be
put in terms of the target variable's value or growth (regardless
of whether you recommend using the same guidelines year after
year or revising them each year in light of expected private investment and fiscal policy): Under what circumstances, if any, should
the monetary authorities be permitted during the year to adjust
the target variable so that it exceeds or falls short of the band of
values or range of growth defined by the guidelines issued at the
beginning of the year?
Answer—Treasury response. It is clear that monetary policy
should be used in conjunction with other policy tools to try to achieve
the goals of the Employment Act and other important objectives. Discussion of monetary "targets" should not, however, be allowed to obscure the fact that the ultimate objective is a prosperous, expanding
economy relatively free from inflationary pressures and providing a
wide range of employment opportunities. Monetary policy can help
contribute to the achievement of these objectives, but it would be
patently unrealistic to suppose that policy actions in the financial
sphere can always achieve a required effect upon such real variables as
production, employment, growth in the capital stock, et cetera.
Furthermore, there is no single most important financial variable, or
set of financial variables, to which the monetary authorities can safely
direct their exclusive attention. At different times and in different circumstances, the monetary authorities will find it advisable to seek to
influence economic and financial activity in different ways. In our
opinion, this makes advance specification of a single monetary guideline an undesirable step.
Monetary research in recent years has clarified the nature of the
transmission process by which an initial monetary effect on certain
financial variables works through to ultimate target variables such as
employment, output, prices, and the balance of payments. The Federal
Reserve System has been studying these matters very closely in recent
years and many of the questions have long been the subject of intensive
academic inquiry. The current study which your Committee has undertaken will provide a very useful sampling of the range of opinion and
controversy which still surrounds some of the unsettled questions in
monetary theory and policy.
59
Because of the considerable progress that has been made in recent
years in defining the methods and objectives of monetary policy, the
Federal Reserve should now be able at any particular time to specify
what financial variables it is seeking to influence and why. This is being
done by the System to an increasing degree subject to necessary constraints on the timing of the release of information.
It is our understanding that the System lias made a much greater,
and largely successful, effort in recent years to develop quantitative
measures of the impact and effect of alternative monetary actions.
However, we are reluctant to suggest that the Federal Reserve should
be encouraged, or directed, to concentrate upon a single quantitative
guideline, or combination of guidelines, as H.R. 11 contemplates. Research study within and without the System points to the complexity
of the interrelationships over time among financial and real variables
in the U.S. economy. Serious damage could be done to the prospects
for a successful stabilization policy if the System were forced to concentrate upon some single monetary "rule" or "guideline" since such
guides may rapidly become inappropriate in a dynamic situation.
Over the past decade, and particularly within recent years, there
have been a number of important and far-reaching structural changes
in the financial system and significant changes in investor behavior.
To cite but a single example, there has been an increasing degree of
responsiveness on the part of the public to changes in relative yield
on alternative financial assets. In conjunction with successive increases
in regulation Q ceilings, this has led to a blurring of the sharp distinction sometimes drawn between the money supply on a narrow
and a broad definition. A monetary guideline phrased rigidly in terms
of either definition could have led to an inappropriate monetary reaction at several times in the recent past. This is simply one manifestation of the difficulties encountered in attempting to establish, before
the fact, a single standard by which monetary policy would be guided.
In summary, the ultimate target is the productive performance of
the economy itself, not the behavior of some financial variable or set
of variables. The Federal Reserve can provide, and, we believe, is
providing reasonably specific information on the immediate target
variables it seeks to influence, and the presumed effects thereby exerted
on the economy and the balance of payments. But the Federal Reserve cannot safely limit its attention in advance to any single monetary guideline or set of guidelines. Therefore, we oppose the suggestion
that there should be an advance legislative, or executive, specification
of the immediate, as opposed to ultimate, targets of monetary policy.
Question I.If. Concerning debt management policy: Given the goals
of the Employment Act, what can debt management do to help their
implementation? (If you believe that debt management has no role
to play in this matter, please explain why.)
Answer—Treasury response. The influence of debt management
policies on the economic and financial situation is primarily through
alterations in the term structure of the public debt in private hands,
a process which typically proceeds by smiall steps at any time. The total
amount of public debt in private hands, of course, is determined more
by fiscal and monetary policy than by debt management decisions.
These debt management decisions can, however, have a significant
marginal influence on the ownership distribution of the public debt.
BO
Beyond this, at favorable times, debt management decisions may exert
an important catalytic effect on financial markets.
To illustrate the slow process of altering the term structure of the
public debt, it may be noted that 10 advance refunding operations over
a period of nearly 5 years were required to lengthen the average
maturity of the privately held marketable debt from 4 years 6 months
in September 1960 to 5 years 9 months in June 1965. From June 1965
to January 1968, a period of -approximately
years during which the
Treasury was unable to issue long-term securities because of the 4
percent limitation on bond coupons, the average maturity of the privately held debt fell to 4 years 4 months, a reduction of 1 year 5 months.
These figures, and consideration of the typical size of Treasury
debt management operations in terms of the overall amount of marketable public debt outstanding in private hands—usually 3 to 4
percent—suggest that it is unlikely that alterations in the maturity
structure of the debt can ordinarily be brought about rapidly enough
to have a major short-run influence on the liquidity of private investors, and, consequently, on their economic decisions. It seems reasonable to believe that alterations in the term structure of the debt
usually have only modest effects on interest rate patterns or on the
flow of funds. Nevertheless, debt management operations can, if carefully coordinated with other policy instruments, assist in the achievement of economic and financial goals.
It has often been argued that issuing long-term Treasury securities
in periods of economic slack absorbs available long-term funds, prevents long-term interest rates from declining as rapidly or as much as
they might otherwise decline, and, consequently, interferes with the
course of the economic recovery. Conversely, it is argued that debt
management should give primary stress to long issues at times of
inflation.
Assessments of these arguments among economists tend to vary
substantially. As a practicalmatter, however, the issuance of moderate
amounts of long-term Treasury securities in such circumstances is not
likely to have significant adverse effects. In such periods, long-term
investment funds are often temporarily placed in short-term instruments either to avoid being locked up indefinitely at low levels of
long-term interest rates or because there is no demand for such funds.
The offering of Treasury long-term securities, thus, may simply tap
funds which would not otherwise be in the long-term market. Also,
possible effects on long-term interest rates from an additional supply
of long-term Treasury securities are likely to be swamped by overall
downward pressures on interest rates resulting from monetary policy
actions and from the relative excess of supply compared to the demand
for funds in all maturity areas of the market. Moreover, in periods of
strong economic activity when interest rates are higher, the existing
statutory interest rate ceiling is likely to prevent really long-term issues—a situation that has been particularly evident since May 1965.
Hence, any rule that would confine Treasury issues of longer term (or,
at least, intermediate term) maturities to periods of economic strength
might in actuality preclude the Treasury from issuing such securities
at all and would thus result in a massive deterioration in the term
structure of the debt.
61
The report of the Commission on Budget Concepts focused attention on the total financing of the Federal budget as against the part
financed by Treasury operations. In this broader context the Treasury
Department, acting to monitor the timing and pricing of new issues,
can contribute to the maintenance of orderly marketing conditions and
a degree of continuity and stability in financial markets which otherwise might be missing. The significance of a broader definition of debt
management is underlined by the fact that private holdings of marketable Treasury debt declined by almost $3 billion from the end of
fiscal year 1964 through fiscal year 1968 despite substantial Federal
deficits during these years. In the same period, private holdings of
agency issues, including participation certificates and securities of the
home loan banks and land banks, increased by over $16 billion. Mention should also be made of the economic and financial significance
of the large volume of Federal loan guarantee and insurance activity.
In addition to the large volume of direct agency issues and other
Federal credit activities which give rise to a variety of Treasurybacked securities, the number and diversity of these operations—each
with its own program and cash-flow problems—require careful planning by the Treasury in attempting to coordinate their market impact.
An illustrative special circumstance occurred in 1966 when extraordinarily heavy private credit demands were pushing against an
increasing degree of monetary restraint and a threat of financial crisis
appeared to be developing. Debt management operations in the broad
sense contributed at that time significantly to the improvement in the
financial situation which followed the announcement of the President's
anti-inflationary program on September 8. These measures included
substantial reductions in Federal credit program activity and the
contemplated offerings of participation certificates or agency financing.
There is little question that financial markets can be catalyzed by
debt management decisions, either favorably at particular times or
unfavorably if offerings are not made with due regard to circumstances, including the preferences of investors and other market factors. To cite a recent example of a favorable influence: in the August
1968 refinancing, debt management operations appear to have facilitated and perhaps accelerated desirable adjustments to new conditions.
The pricing of the new security in August indicated the peak in rates
had passed and that a lower level of rates had become appropriate.
Financing in the intermediate area, moreover, provided an opportunity
to take advantage of favorable demand factors without placing undue
pressures on flows of funds in either the long-term or short-term
market areas.
In recent years, considerable attention has also been paid to structuring the maturity distribution of debt offerings in a manner that would
help minimize potentially adverse financial flows. Thus, in the early
1960's emphasis on adding to the supply of short-term securities and
the resultant effects on short-term interest rates helped to contain
the outflow of short-term capital abroad. More recently, debt management has been especially concerned with avoiding "dismtermediation"
that could unfavorably affect the net flow of funds to the thrift institutions and, hence, the availability of funds for housing.
62
Question 1.5. Concerning open market operations:
A. H.R. 11 makes no provision whatever for conducting open
market operations for so-called defensive or road-clearing purposes; that is, to counteract seasonal and other transient factors
affecting money market and credit conditions. Do you see any
merit in using open market operations for defensive purposes or
should they be used only to facilitate achievement of the President's economic program and the goals of the Employment Act?
What risks and costs, if any, must be faced and paid if open
market transactions are used to counteract transient influences?
B. Do you believe that monetary policy can be effectively implemented solely by open market operations?
C. For what purposes, if any, should (a) rediscounting, (&)
changes in reserve requirements, and (c) regulation Q be used?
How might H.R. 11 be amended to implement your recommendations?
In responding to these questions, a single answer appears
appropriate.
Answer—Treasury response. In 1950 the House Banking and Currency Committee's Subcommittee on Monetary, Credit, and Fiscal
Policies stated in its report:
It appears to us impossible to prescribe by legislation highly specific rules to
guide the determination of monetary and debt management policies, for it is
impossible to foresee all situations that may arise in the future. The wisest
course for Congress to follow in this case is to lay down general objectives, to
indicate the general order of importance to be attached to these various objectives, and to leave more specific decisions and actions to the judgment of the
monetary and debt management officials * • » (pp. 27 and 28 of the subcommittee report).
We believe that the same considerations regarding the conduct of
monetary policies are still relevant at this time. Circumstances may
arise in which one or another of the instruments of monetary policy
may be most appropriate for dealing with the economic and financial
situation. For this reason, we believe the Congress should not want
to direct the Federal Reserve System to use particular instruments
only in prescribed circumstances, or to seek to reduce the number of
policy tools now at the System's disposal.
As regards so-called defensive open market operations, we believe
that these are of definite assistance in carrying out the purposes of the
Employment Act and, indeed, are essential to the proper conduct of
monetary policy. These operations contribute substantially to the
smooth functioning of our money markets and financial system which
is of key importance to stable economic growth. Moreover, in the
absence of such operations, the proper conduct of monetary policy
could be severely complicated, since policymakers could find it extremely difficult to distinguish clearly between the effects of their actions that further basic policy objectives and those that affect transitory monetary market factors. Furthermore, a failure to undertake
defensive operations could well lead to excessive money market fluctuations and cumulating speculation that could interfere with the achievement of monetary policy goals.
The above observations should, of course, not be taken to imply that
there is no room for improvement in monetary policy instruments—
including, among other things, the possible development of devices
63
that would permit smoothing of money market conditions with relatively less reliance on defensive open-market operations. Research into
the possibilities for such improvement is being actively carried on by
the Federal Reserve System itself as well as by other students of monetary policy. Some of the results of this research—notably the proposals
recently made within the Federal Reserve for changes m the discount
mechanism—are currently being examined by various interested parties
as well as the Federal Reserve Board itself and are scheduled to be
subjected to further scrutiny by the Congress. I do not believe that I
should comment on such specific proposals until there has been an opportunity for careful further study.
Question i,5.D. Do you see any merit in requiring the Federal Reserve
Board to make detailed quarterly reports to the Congress on past and
prospective actions and policies? Are there any risks and costs in this
procedure? In what ways, if any, would you modify the reporting
provisions? ~What information do you believe should be included in
such reports as you recommend the Federal Reserve submit to the
Congress?
Answer—Treasury response. We believe that the System already
makes proper disclosure of its past policies. We would, however, see
no inherent objection to a requirement that formal reports be made to
the Congress on a regular quarterly basis as suggested by the question.
It is much more difficult, on the other hand, to visualize advantages
that might be gained if the System should attempt publicly to forecast its future actions and policies. Such forecasts would need to be
extremely tentative, since the Federal Reserve System does not control
administration and congressional actions on fiscal policy, nor can it
be expected to foresee many other autonomous events that may subsequently require policy changes. Even in such a highly tentative form,
however, the forecasts could have substantial disadvantages as already
noted in the answer to question 1.1 above. They are likely to be regarded as firmer than intended, and could well create anticipatory actions by participants in the private financial markets which could have
adverse financial and economic consequences. This, in turn, would
make it far more difficult for monetary policy to respond rapidly and
flexibly to evolving changes in economic and financial conditions.
Impairment of monetary policy flexibility, even inadvertantly, would
be a matter of considerable concern, since the responsiveness of Federal
Reserve policy to events is a major advantage of the monetary policy
tool and an essential ingredient of the proper functioning of economic
stabilization policies.
Question I.5.E. What costs and benefits would accrue if representatives of the Congress, the Treasury, and the CEA were observers at
Open Market Committee meetings?
Answer—Treasury response. The Treasury Department believes
that its relations with the Federal Reserve System are on a basis which
leads to a continuing, meaningful exchange of views on economic and
financial developments. For this reason the Department feels that it
would not benefit from sitting as an observer at FOMC meetings.
The Department would also be reluctant to see any change in the
conduct of Open Market Committee meetings which might have the
effect of limiting the frank exchange of views among members of the
Open Market Committee and could impair the traditional independence
64
of the System within the Government. It believes that the performance
of the Federal Reserve System is best judged by the results of its policy
actions, and notably the effects on the economy as such.
Question II. H.R. 11 provides for the following structural changes
in the Federal Reserve System:
1. Retiring Federal Reserve bank stock;
2. Reducing the number of members of the Federal Reserve
Board to five and their terms of office to no longer than 5 years;
3. Making the term of the Chairman of the Board coterminous
with that of the President of the United States;
Jp. An audit for each fiscal year of the Federal Reserve Board
and the Federal Reserve banks and their branches by the Comptroller General of the United States; and
5. Funds to operate the Federal Reserve System to be appropriated by the Congress of the United States.
Please comment freely on these several provisions. In particular it
would be most helpful if you would indicate any risks involved in
adopting these provisions and discuss whether their adoption woidd
facilitate the grand aim of H.R. 11, which is to provide for coordination by the President of monetary and fiscal policies.
Answer—Treasury response:
General comment.—In approaching the general subject of possible
structural changes in the Federal Reserve System, it is appropriate to
recall the following passages from the testimony on similar legislative proposals regarding the Federal Reserve that former Secretary
Dillon gave to the Subcommittee on Domestic Finance of the House
Committee on Banking and Currency in February 1964:
This committee is dealing with a living institution—an institution that has
demostrated its capacity to innovate, to experiment, and to adapt itself to a
very wide range of circumstances. But in this process of change, it has never lost
certain characteristics—an established tradition of independent judgment; a
mixture of regional participation in policymaking with ultimate central control
that is unique in our Government; an ability to attract highly qualified officials
and staff; and a reputation for operating efficiently and impartially.
The structure that has resulted does not fit easily into the framework of standard tables of organization. Policy responsibility is widely dispersed and coordination depends in part on informal working relationships built up over the years.
Vestigial elements of an earlier conception of private participation in central
banking policies—elements that are more symbolic than real today—are still
visible.
But change without clear purpose can be dangerous too. If there are persuasive
reasons for particular proposals—if it can be shown that ownership of Federal
Reserve bank stock by member banks has biased Federal Reserve policy decisions,
or if budgetary or auditing practices have been loose, to take two examples—by
all means, this committee should act. But I doubt the advisability of taking action
simply for the sake of achieving symmetry with other Government agencies,
particularly if there was danger that such action might impair a long tradition of
regional participation and efficient service of which I believe the country can
be proud.
These considerations, in my view, are fully applicable to the specific
proposals cited under question II. If the United States had to create
a brand new central bank today, the specific features that any one of
us might favor would not, in all likelihood, coincide precisely with
the existing structure. But this structure is one that is based on an
evolution of over 50 years, and that is on the whole working remarkably well. Hence, 1 do not believe that changes should be made unless
65
it can be shown that they are clearly needed and would result in
significant net benefits. In particular, it is highly important that no
steps be taken which might diminish public confidence in the efficiency
and integrity of our monetary management—a confidence which is
itself one of the essential preconditions for the achievement of the
goals of the Employment Act of 1946.
Question II J. Retiring Federal Reserve bank stock.
Answer—Treasury response. In terms of the actual operations of the
Federal Reserve System and the formulation and execution of monetary
policy, it makes no real difference whether Federal Reserve bank stock
is retired or not. The ownership of stock by member banks does not,
as such, give these banks any right or ability whatever to control the
Federal Reserve banks or determine Federal Reserve policies. Even the
right of member banks to participate in the election of Federal Reserve bank directors is not directly tied to the ownership of stock; if
the stock were retired, means could undoubtedly be found to retain
essentially the same system for electing directors as exists at present;
or, conversely, changes in the procedures for electing directors could
be made without retiring the stock. In contrast to private firms, moreover, Federal Reserve banks do not require capital stock as a financial
underpinning for their operations.
The case for retaining or retiring Federal Reserve stock thus basically hinges on the presumed intangible or psychological advantages
or disadvantages of Federal Reserve stock ownership. In opposition
to such ownership, it has been argued that it tends to convey an impression to the public—however unjustified this may be—that Federal
Reserve banks are in fact dominated by private banks. Those who
take this view argue that if the System is to make use of devices that
are of a largely symbolic nature, these should primarily stress the
public service character of the Federal Reserve. Proponents of retaining stock ownership, on the other hand, feel that this device has positive advantages in terms of giving member banks a greater sense of
participation in the System and in eliciting their interest and
cooperation.
We do not have a strong view regarding the relative weight that
might be given to these opposing considerations. However, given the
relatively smooth functioning of the Federal Reserve System under
present arrangements, it would appear that changes in the stock
ownership device should only be instituted if it can be demonstrated
that the arguments in favor of such action are compelling.
Question IL2. Reducing the number of members of the Federal Reserve Board to five and their terms of office to no longer than 5 years.
Answer—Treasury response. While some reduction in the size of
the Board's membership and the length of terms might prove useful,
specific proposals in this area need to take careful account of the benefits which accrue under the present system as a result of broad membership and the encouragement of careful deliberation removed from
political pressures. A reduction in the length of terms from 14 years
to as short a period as 5 years might, in particular, carry greater risks
of subjecting Board members to pressures of this kind than would be
desirable.
6(j
Question U.S. Making the term of the Chairman of the Board
coterminous with that of the President of the United States.
Answer—Treasury response. Adoption of this proposal would be
desirable. It was proposed to the Congress by President Kennedy in
1962, is favored by the Board of Governors itself, and has been explicitly endorsed by Chairman Martin on a number of occasions. Making the term of the Board Chairman (and also of the Vice Chairman)
coterminous with that of the President should help assure that an incoming President would have full cooperation in the formulation and
execution of financial policy. A high degree of cooperation and understanding has been developed between the Federal Reserve Board and
the executive branch through informal working arrangements in recent
years. It may be better, however, to make explicit provision for Presidential selection of the Chairman (and Vice Chairman) rather than
to assume that a cooperative working arrangement could always be
established easily and promptly at the beginning of a presidential
term. The Board itself would continue to be chosen under the existing
arrangements which have worked well and provided a necessary immunity from political pressures.
Question 114• An audit for each fiscal year of the Federal Reserve
Board and the Federal Reserve banks and their branches by the Comptroller General of the United States.
Answer—Treasury response. While it would be the prerogative of
the Congress to order a GAO audit of the Federal Reserve if it so
desired, it is not evident that such a step would be either necessary or
desirable.
Under the present arrangements, the Federal Reserve banks are
audited by a highly competent staff of the Board of Governors, while
the Board itself is audited by independent public accounting firms
of topflight reputation. These audits, furthermore, are made available to the Banking and Currency Committees of both Houses of
Congress, and are thus subject to detailed congressional scrutiny.
Unless it can be demonstrated that there are significant abuses which
have arisen under the present auditing system, there is no compelling
operational case to institute a GAO audit. We have no indications that
such abuses exist or that any occasional problems that might arise
would not be adequately corrected under the present auditing procedures. It might also be noted that institution of a GAO audit would
involve added budgetary expense and extra training of auditing
personnel.
It is sometimes argued that even if the above-cited points are entirely correct, a GAO audit procedure might still be desirable as a
symbolic measure, to assure the public that congressional scrutiny
of the System's operations is fully adequate. In weighing this argument, however, the Congress will also need to consider potentially adverse "symbolic" effects that could result from institution of the audit.
Thus, such a measure might widely be regarded as increasing the possibilities for reducing the independence of the System within the Government, and as possibly leading to undesirable interferences with
policies. While it may in theory be possible to prescribe that the audits
would have to be conducted strictly on the basis of standards and policy
guidelines set forth by the Board of Governors itself, very careful consideration would have to be given to the risk that, in practice, the
existence of a GAO audit could at times broaden into a review of
monetary policies and tend to impinge on policymaking as such.
67
Question II,5. Funds to operate the Federal Reserve System to be
appropriated by the Congress of the United States.
Answer—Treasury response. It w^ould not be desirable to make the
Federal Reserve subject to the regular congressional appropriations
process. There is every evidence that the Federal Reserve is managed
prudently and efficiently; thus there is no clear need for the proposal.
Adoption of the proposal would almost certainly lead to a major reduction in the existing degree of Federal Reserve independence within
the Government and in its insulation from day-to-day political pressures. It would also tend to introduce unnecessary operational rigidities
that might diminish the System's ability to respond very promptly
and flexibly to various domestic and international contingencies.
While the role of the Federal Reserve within the Government is in
many ways unique, it should be noted that the Congress has also exempted the other major bank supervisory authorities—that is, the
FDIC and the Comptroller of the Currency—from the regular appropriations process.
Question III. Your analysis of monetary developments, since 1964,
including policy-induced changes and their effects on economic activity,
is invited.
Answer—Treasury response. During roughly the first half of the
current expansion, monetary policy was consistently expansionary.
From 1961 through 1964, most long-term interest rates were relatively
stable and mortgage rates actually declined. There were regular annual
increases in the total and nonborrowed reserves of the banking system
in the
to 41/^-percent range and net borrowed reserves remained
positive. Short-term interest rates rose, but this partly reflected the
effect of policies designed to keep U.S. money market rates in reasonable alinement with key foreign rates.
From 1961 through 1964, commercial bank credit expanded steadily
at about 8 percent a year. Growth in the money supply, narrowly defined, averaged a little above 3 percent annually. Increases in regulation Q ceiling rates and an expanding economy led to large and continuing increases in time deposits. As a result, the money supply plus
time deposits grew fairly steadily at roughly 8 percent a year. While
there was some modification of monetary policy in the interests of
the balance of payments during this period, the general picture is one
of relative monetary ease in support of the continuing domestic
expansion.
Monetary expansion continued in the first half of 1965, although
in the face of relatively heavy credit demand member bank borrowings increased and net borrowed reserves turned negative for the first
time in the expansion. Late in the first quarter of 1965, the Federal
Reserve moved toward firmer conditions in the money market in an
effort "to reinforce the voluntary foreign credit restraint program
and avoid the emergence of inflationary pressures." Growth in both
total and nonborrowed reserves remained sizable during the first half
of 1965 and bank credit growth picked up to about a 10%-percent
annual rate. Long-term interest rates remained relatively stable while
short-term interest rates moved up to a new plateau following the
November 1964 increase in the discount rate and the subsequent policy
move toward firmer money market conditions.
68
From mid-1965 monetary policy began to operate in a different
environment. An economy nearing full employment was also faced with
the requirements of an expanding defense effort. Interest rates began
to rise, initially in response to expectational factors. While there was
no overt move toward monetary restraint until December, growth in
total and nonborrowed reserves slackened after mid-1965.
In early December 1965 the Federal Reserve increased the discount
rate from 4 to 4y2 percent and raised the regulation Q ceilings. (As is
well known, the administration was essentially in agreement with the
direction of the move. It did, however, object to its timing, which came
just before the period when budgetary and fiscal descisions were
reached.)
After the Federal Reserve action in 1965, the policy focus shifted to
fiscal measures and the budget program. Growth in total demand was
brought into reasonable correspondence with growth in productive
capacity by the second quarter of 1966, and the pace of expansion—
as reflected in quarterly increments in gross national product—became more moderate than in late 1965 and early 1966.
During much of 1966 monetary restraint was primarily reflected in
sharply rising interest rates and a drastic curtailment of mortgage
credit. On the other hand, business loan and bank credit growth were
not easily curtailed. In the first 8 months of 1966, bank loans to business
grew at nearly a 20-percent annual rate, only a little below the rate
in the second half of 1965. In retrospect, it appears that the December
1965 increase in regulation Q may have provided the commercial
banking system with more latitude to compete ratewise for funds,
primarily through the issuance of CD's, than was ideal during a
period of monetary restraint.
Serious financial strains and imbalances developed during the course
of 1966. These primarily took the form of selective pressures on
productive capacity and a growing imbalance in credit flows. By late
summer, interest rates had reached their highest levels in four decades
the housing industry was depressed, and steps had to be taken to insure
the continued orderly functioning of financial markets. With the announcement of the President's September 8 anti-inflationary program
and the benefit of subsequent steps taken by the Congress and the
financial regulatory agencies, pressures on financial markets were
relieved and a concerted easing of interest rates was set in motion.
The financial environment improved steadily throughout the balance
of the year, aided by a moderate shift toward monetary ease set in
motion by the Federal Reserve during1 the autumn.
During most of 1967, monetary policy was generally expansionary
in terms of growth in such measures as bank credit, money supply, and
reserves. Despite the slackening in the pace of economic activity in
early 1967, private financial demands were heavy throughout the entire
year. As an aftermath of the credit squeeze of 1966, efforts were made
throughout the private sector to rebuild liquidity and in some cases
to make advance provision for possible future credit needs. Furthermore, there was general belief in the business and financial community
that the slowdown in the economy was likely to be temporary in duration and would be followed by a period of more rapid expansion. As a
result, interest rates dipped only temporarily in early 1967 when the
pace of economic expansion slowed and then rose during the balance
of the year.
69
Monetary policy began a move back toward a more restrictive posture
late in 1967 with a one-half point rise in the discount rate to 4 ^ percent following the devaluation of sterling. As the outlook for fiscal
restraint remained uncertain, monetary policy was tightened further
in 1968 with the discount rate increased to 5 percent in March and
to 5y2 percent in April. There was general agreement on the need for
the application of restraint and monetary policy was for practical
purposes, the only available instrument. Fiscal policy was temporarily
immobilized during this period by congressional inaction on the
President's fiscal recommendations.
Eventual enactment of the President's tax program at mid-1968
reactivated fiscal policy and greatly increased the degree of fiscal
restraint being impjosed on the economy. The application of fiscal
restraint and the shift in expectations it brought about soon led to a
significant easing in interest rates. At mid-August the Federal Reserve
Board approved a ^-percent reduction in the discount rate, primarily
as a technical action to bring the discount rate more into line with
prevailing money market rates.
REPLY OF THE MEMBERS OF THE COUNCIL
OF ECONOMIC ADVISERS
T H E CHAIRMAN OF THE COUNCIL OF ECONOMIC ADVISEES,
Washington, D.C., November 22,1968.
H o n . WRIGHT PATMAN,
Chairman, Subcommittee on Domestic Finance,
Committee on Banking and Currency,
Washington, B.C.
DEAR MR. CHAIRMAN: I am enclosing the Council's responses to the list of
questions on monetary policy and the structure of the Federal Reserve you
sent to us last July. The Council members received independent requests for
their views as members of the economics profession. We have confined our efforts,
however, to the single joint response enclosed here.
We might indicate that we look forward with interest to your intended hearings on H.R. 11. While we have reservations about some of the proposals in
that particular bill, as indicated in our responses, we do think that some of the
proposed reforms might be helpful, and we have added one or two suggestions
of our Own. Moreover, an updated exploration of views on the workings of the
monetary policy process should prove useful to all financial economists both in
official positions as well as in academic life.
Sincerely,
ARTHUR M .
OKUN.
STATEMENT OF THE COUNCIL OF ECONOMIC ADVISEES TO
QUESTIONS SUBMITTED BY HOUSE BANKING AND CURRENCY
COMMITTEE
Question 1.1. Do you believe that a program coordinating fiscal, debt
management and monetary policies should be set forth at the beginning
of each year for the purpose of achieving the goals of the Employment Act, or alternatively should we treat monetary and fiscal policies
as independent rrmtually exclusive stabilization policies?
CEA response. In order to achieve to the greatest extent possible the
several, sometimes partially conflicting goals of economic policy—including high employment, reasonable price stability, vigorous growth,
and a satisfactory balance-of-payments position—it is clear that all
available policy instruments must be used together in a carefully coordinated manner. No one to our knowledge would seriously argue in
favor of total separation of fiscal, debt management, and monetary
policies as suggested by the second alternative posed in the question.
Real coordination, however, does not merely involve the formulation
of a program once a year, as implied by the first alternative in the
question. Indeed, a once-for-all program formulated at the beginning
of the year could well be a hindrance to the achievement of meaningful coordination of economic policies. What is required is a working
together of all the relevant agencies in a continuously evolving joint
effort to achieve the Nation's objectives in the light of constantly
changing circumstances.
(70)
71
The Council takes some pride in having helped during the past 8
years to institutionalize a good part of the policy coordination process.
Explicit economic programs have, of course, made up an important
part of the President's annual messages to the Congress on the state
of the Union, the budget, and his Economic Report, the latter supplemented in more detail by CEA's annual report. But these messages
have represented only a part of the process. Meetings, involving the
Secretary of the Treasury, the Director of the Bureau of the Budget,
the Chairman of CEA and, on occasion, the Chairman of the Board of
Governors of the Federal Reserve System, have been held from time
to time with the President, and informal dialog among these and
other agencies—both at an official and staff level—has gone on constantly. The purpose has been continually to advise the President on
the Nation's economic progress, and to evaluate and recommend new
programs and policy actions as they appear to be needed. This continuous dialog has provided the real basis for effective coordination
of policies.
We want to emphasize two points about the coordination process.
First, coordination should not be taken to mean that all policy instruments must necessarily be moving in the same direction. On the contrary, movement of one instrument toward, say, restraint may permit
another instrument to move toward expansion.
Second, we believe that any particular policy program should, in
its general formulation, treat the various instruments of policy in
different degrees of detail. In particular, fiscal policy can and should
be spelled out rather completely in the program, but unnecessary precision should be avoided in specifying the roles assigned to monetary
and debt management policy. This is simply prudent planning, designed to preserve as many policy options as possible so that ammunition is available to respond if actual economic developments should
depart from forecasted trends.
Fiscal policy decisions, in our opinion, should be made only at discrete intervals in order to promote a general course for the economy
during the period ahead. This reflects a recognition of both the blunt ness of fiscal policy—it does not lend itself readily to frequent marginal
adjustments—and the practical difficulties of turning it on and off
quickly. The extended delays in enacting the 1964 and 1968 tax bills
underscore the fact that taxes cannot be speedily adjusted in either
direction under existing procedures, and significant changes in expenditure programs are also not easily accomplished. For these reasons,
we think it is appropriate to settle as many issues as possible about
fiscal policy at the time the annual budget and economic program are
formulated. We should be prepared to alter these decisions if major
unforeseen circumstances develop. But we would expect—more often
than not—to live with those decisions until the following year's regular
budget review.
Monetary and debt management policies, on the other hand, are by
nature considerably more flexible. General directions can and should
be formulated in advance. But we believe they should always be considered as only tentative and provisional, based on the assumption
that the planned fiscal policy and other developments will unfold as
anticipated. Despite all the progress that has been and continues to be
72
made in forecasting the behavior of the private economy, projections
still are sometimes wide of the mark; moreover, fiscal policy commonly
turns out to be different from anticipations at the time of the January
budget. When errors are made in forecasting or in projecting future
fiscal policy, the inherent flexibility of monetary policy is very useful:
It can be used either to probe the new situation, standing ready to pull
back if the signs prove to have been misread, or to make a wholesale
swing away from earlier conceived directions. An overly detailed specification in the original program that might diminish this flexibility
would, in our opinion, be inappropriate. A masterpiece of coordination
in an initial program might end up in a nightmare if it precluded a
continuing adjustment to events as they actually unfold.
Question /J. If you believe a program should be specified, do you
believe that the President should be responsible for drawing up this
program, or alternatively should such responsibility be dispersed between the Federal Reserve System and agencies responsible to the President? (Please note that informal consulting arrangements can be
made as desired whether responsibility is assigned to the President or
divided between the President and the Federal Reserve. The concern
here is with the assignment of formal responsibility for drawing up
the economic program.)
CEA response. We believe that ultimate responsibility for achieving
the Nation's economic objectives rests jointly with the President and
the Congress, as the elected representatives of the people. Together,
they eventually must settle on a broad economic program and see that
the actions needed to carry it out are taken.
The nature of the system, of course, assigns to the President the tasks
of initial formulation of such programs. We believe this is altogether
appropriate. The competing views of all must at some point be reconciled into a cohesive program and, in our opinion, responsibility
for this reconciliation should rest in the highest elected office.
As noted in our answer to the preceding question, we believe that the
annual budget message and the other key Presidential messages formulating economic programs should contain detailed specification of all
fiscal policy recommendations. The President's responsibilities for
these messages are firmly established in the laws of the land. Of course,
the programs are only recommendations, since the Congress ultimately
bears the responsibility for enacting the enabling legislation.
Some discussion of the role of monetary policy should also be
included in the President's economic program. This discussion, as is
true of the rest of the message, should reflect the President's considered view of what is best for the Nation in the current circumstances, with the Federal Reserve and other knowledgeable agencies
giving freely of their advice in helping to formulate the program. But
the key point, as explained in the preceding answer, is that the role
assume for monetary policy should be provisional and couched only in
general terms, so that the monetary authorities are not inhibited in
responding to events as they actually unfold.
The President can and should continue to make his views known
on monetary policy issues as significant questions arise, and in our
opinion, the Federal Reserve should give careful consideration to
these views in its decisions. Ultimately, however, the Federal Reserve
is answerable for its actions to the Congress. We believe that this divi-
73
sion of responsibilities is workable and indeed has generally worked
satisfactorily. We have some suggestions to make in our response
to the questions about reorganizing the Federal Reserve which are
intended to assure continued coordination of policy between the Federal Reserve and the executive branch of the Government.
Question 1.3. Concerning monetary policy guidelines:
A. Should monetary policy be used to try to achieve the goals
of the Employment Act via intervention of money supply (defined as desired) as provided in H.R. 11, or alternatively should
H.R. 11 be amended to make some other variable or variables the
immediate target of monetary policy; for example, interest rates,
bank credit, liquidity, high-powered or base-money, total bank
reserves, excess reserves and free reserves? Please define the target
variable or combination of variables recommended and state the
reason for your choice. {If desired, recommend a target variable
or vari,ables not listed here.) It would be most helpful if, in providing the reasons for your choice, you list the actions the Federal
Reserve should take to control the target variable (or variables)
and also explain the link between your recommended target of
monetary policy and the goals of the economy as defined by the
Employment Act.
B. Should the guidelines of monetary policy be specified in
terms of some index of past, present, or future economic activity,
or alternatively in terms of the target variable''s value or growth?
For example, should the President's 1969 program for achieving
the goals of the Employment Act be formulated to require consistency with some set of overall indicators of economic activity,
or alternatively so that your target variable attains a certain vdkie
or growth regardless of the economic winds? Please indicate the
reasons for your preference.
C. For only those persons who recommend that some index
of economic activity be used to guide the monetary authorities in
controlling the target variable: Should we use a leading {forward
looking), lagging {backward looking) or coincident indicator of
economic activity? It would be most helpful also if you ivould
identify the index you would like to see used and specify how the
target variable should be related to this index.
D. For only those persons who recommend, that the guidelines
be put in terms of the target variable's value or growth: Should
the same guidelines be used each year irito the foreseeable future,
or alternatively, should new guidelines be issued at the beginning
of each year conditioned on expected private investment, Government spending, taxes, etc.? Please indicate the reasons for your
preference.
E. For only those persons who recommend that the guidelines
be put in terms of the target variable''s value or growth and who
also recommend that the same guidelines be used year after year
into the foreseeable future: What band of values or range of
growth do you recommend? {By way of clarification,, a band of
values appears appropriate if your target variable is, say, free
reserves, whereas a range of growth is appropriate if it is, say,
money supply.)
21-570—68
6
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F. For all those persons recommending that the guidelines be
put in terms of the target variable's value or groioth (regardless
of whether you recommend using the same guidelines year after
year or revising them each year in light of expected private investment and fiscal policy): Under what circumstances, if any, should
the monetary authorities be permitted during the year to adjust
the target variable so that it exceeds or falls short of the band of
values or range of growth defined by the guidelines issued at the
beginning of the year?
CEA response. We believe that flexible, discretionary monetary policy has made an important contribution to the achievement of the Nation's economic objectives and that it can continue to make such a contribution in the future. We do not, however, believe that it is possible
to select any single one-dimensional guide for the conduct of monetary policy that will be satisfactory in all circumstances. Indeed, questions 1.3. A - F seem to suggest a much tighter connection between monetary variables and the Nation's ultimate economic goals than we believe
actually exists.
It is our view that in seeking guides for monetary policy the Federal
Reserve should look primarily to those major measures of our overall
economic performance that economic policy ultimately hopes to influence. These include total output^ together with its rate of growth and
its relation to productive capacity; employment and unemployment;
the behavior of prices and wages; and the Nation's balance-of-payments position.
Since it is well known that monetary policy affects these major targets of economic policy only after some lag, we believe the Federal
Reserve must base its policies not on the most recently recorded values
of these target variables but on forecasts of their values extending several quarters into the future. Since there is commonly some uncertainty
concerning the behavior of Federal expenditures and taxes, forecasts
of fiscal policy as well as of the behavior of private demand are required. Such forecasts should be revised frequently as new data relating to the performance of the economy in the recent past become available. The forecasts will, of course, be conditional, based on an assumed
monetary policy to be followed by the Federal Reserve, and the System
should be prepared to adjust its policy as changes in the outlook seem
to require.
All sectors of the economy and components of aggregate demand are
not equally affected by monetary and credit conditions. In its conduct
of monetary policy, the Federal Reserve should, therefore, consider the
probable impacts of its actions on specific sectors. In particular, it
seems clear that residential construction is strongly affected by monetary policy, in large part because of peculiarities in the institutional
arrangements for financing homebuilding. For that reason, in the conduct of monetary policy it is especially important to consider the probable effects on housing activity. In addition, there may also be, under
some conditions, disproportionate effects on debt-financed spending
on schools, highways, and other public facilities by State and local
governments.
It is our view that the Federal Reserve should operate by influencing directly those variables that will, with a lag, affect the future
values of the target variables it is attempting to influence. This means,
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in our opinion, that it should focus primarily on interest rates and the
availability of credit. For example, it must attempt to judge whether
interest rates in the short-term open market are such as to generate
the flows of funds through thrift institutions that are needed to support the mortgage commitments and mortgage loans required to achieve
appropriate levels of housing activity in the future periods of its
forecast.
The Federal Reserve clearly cannot control independently both interest rates and the stock of money, since the two are linked together.
On the one hand, it can focus primarily on influencing interest rates
in order to obtain the flows of credit to key sectors of the economy that
are conducive to an appropriate level of overall economic activity,
allowing the money supply to be whatever it has to be to achieve these
results. Or, alternatively, it can focus primarily on controlling the
money supply, allowing interest rates to take on the values that are
consistent with the money supply so determined. If relationships in
the financial sector were fixed and unvarying, it would make little difference which approach was taken. But it seems clear that this is not
the case. There are frequent innovations in finance, and also evolutionary changes in behavior in the private sector such as the increase
that has occurred in the last few years in the sensitivity of investors
to relative changes in interest rates on different types of financial assets. Moreover, during any short-run period, there can be marked
changes in expectations which significantly affect investors' choices
among financial assets. In such a changing financial environment, the
level and rate of growth of the money supply required to achieve the
desired behavior of interest rates and credit availability may change
considerably from one situation to another. Since such empirical and
theoretical evidence as is available strongly indicates that it is interest
rates and credit availability rather than the money supply per se that
affect spending decisions, it seems wiser for the Federal Reserve to
concentrate primarily on control of interest rates and credit conditions,
letting the money supply adapt itself.
We realize that there are some economists who believe that there is
a very close connection between the money supply and GNP and that
monetary policy should therefore attempt single-mindedly to control
the money supply. (Among those who hold this view there is some
dispute about the proper definition of the money supply—some would
include only demand deposits and currency while others would also
include time deposits.) We do not, however, share this emphasis on
the overriding importance of the money supply (however defined).
The fact is that there is no simple and apparent relation between the
money supply and GNP. Moreover, we see no plausible reason why
there should be such a close relationship. It should be understood that
the Federal Reserve does not give people money—indeed, it is incapable
of changing the public's wealth or net worth (except to the relatively
minor extent that it causes changes in the market value of existing
debt claims thereby generating capital gains or losses). Federal Reserve operations change the composition of the public's balance sheet
by inducing people voluntarily to exchange one asset for another or
to increase or decrease both their assets and their liabilities by equal
amounts. Thus, these operations affect a wide variety of the public's
financial assets and liabilities. Movements—that is, flows—of all of
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these assets and liabilities can have repercussions on real economic
activity, and thus must be monitored carefully in the conduct of monetary policy. Out of the myriad of items in the public's balance sheet,
we can see no logical reason for attaching overriding importance to one
particular entry defined as the money supply.
Question H. Concerning debt management policy: Given the goals
of the Employment Act, what can debt management do to help their
implementation? (If you believe that debt management has no role
to play in this matter, please explain why.)
CEA response. Debt management policy plays some role in helping
us to achieve our economic goals. But we believe its role is somewhat
more marginal than the roles played by fiscal and monetary policy.
In broad terms, fiscal policy determines among other things, how
much debt there is to be financed, and monetary policy determines
what portion of the debt is absorbed by the central bank and what
portion is absorbed by the public. In comparison with these rather
basic issues, we think of debt management—the exact timing, maturity,
and other terms of financing—as being of second order importance.
Within its limited sphere of influence, one might distinguish between long- and short-run effects of debt management. In the long
run, debt management makes its mark by influencing the term structure of the debt held by the public. The full implications of alternative term structures of debt are not yet well understood. But we believe the term structure of debt has some influence on the structure of
interest rates and ultimately on spending-saving decisions by various
sectors of the economy. Moreover, a suitably balanced debt structure
can help to provide a financial environment in which monetary policy
works more effectively.
The long-run nature of the effects of debt management operations on
the structure of the debt bears emphasizing. The largest single debt
management operation in recent years involved an exchange of less
than 6 percent of the total amount of marketable Federal debt outstanding in private hands, and it changed the average maturity of the
total marketable debt by less than 5% months. Most operations have
been considerably smaller in size. To produce a major change in the
term structure of the debt would require a whole series of fairly sizable
operations.
In the short run, debt management operations can at times contribute
to the achievement of certain of our objectives by taking advantage of
rigidities in financial markets and also by working on market psychology. In the early 1960's, increases in the supply of short-term securities outstanding helped to hold up short-term interest rates, thereby
reducing the capital outflows that were adversely affecting the U.S.
balance of payments. In the fall of 1966, rigid controls on the size
and timing of offerings of Federal agency securities helped to restore
confidence in financial markets following the near panic situation
that developed during the summer. More recently, offerings have been
scheduled in such a way as to minimize direct competition with savings
flows to the thrift institutions so that these institutions would not be
unduly limited in the funds they have available for making new mortgage loans.
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Question IS.A. H.R. 11 makes no provision whatever for conducting open market operations for so-called defensive or road-clearing
purposes, that is to counteract seasonal and other transient factors
a,ffecting money market and credit conditions. Bo you see any merit
in using open market operations for defensive purposes or should
they be used only to f militate <achievement of the President's economic
program and the goals of the Employment Act? What risks and costs,
if any, must be faced and paid if open market transactions are used
to counteract transient influences?
CEA response. We believe that so-called defensive open market
operations are an appropriate part of Federal Reserve activities and
that the System should continue to engage in such operations. Of
course, as a practical matter, defensive open market operations are
not readily distinguishable from offensive operations. But granted
that such a distinction is conceptually possible, we feel that both types
of operations are needed to provide a smoothly functioning monetary
system that can both easily accommodate the multitude of daily financcial transactions that are necessary for our Nation's commerce and
business and also transmit efficiently the monetary policy forces aimed
at moving the economy closer to our national goals.
The purpose of defensive open market operations is to counter the
effects of short-run swings in factors that would otherwise generate
either excessive tightness or excessive ease in financial marlsets. If
swings in these other factors were self-canceling, defensive open market operations would not be necessary. But the other factors are not
that well behaved. Huge individual financial transactions may get
bunched into a particular day or week, the public's demand for currency may suddenly spurt, check collection schedules sometimes are
interrupted by weather, and international developments can cause a
sudden surge in gold or deposit flows. Left uncountered, these developments would lead to erratic fluctuations in short-term interest
rates as demands for funds varied in relation to the available supply.
Perhaps this would not be disastrous, but it would introduce unnecessary complications in the conduct of business which can be easily
avoided by using the Federal Reserve's open market operations to even
out flows of funds in the market.
In general, those who favor the elimination of defensive open market operations believe the Federal Reserve should seek single-mindedly
to control some well-defined quantitative index of monetary conditions,
such as the stock of money. For reasons indicated in our earlier answers, we consider this an overly simplistic approach to monetary
policy. Under the approach we favor, which places much more emphasis on interest rates and credit availability as guides to policy, it
is difficult to distinguish sharply between defensive operations and
other kinds. Nor is there a need to make such a distinction, since the
objective of policy is to move credit conditions smoothly in directions
that will contribute to the achievement of our economic goals.
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Questions I\5.B and 1.5.C.:
B. Do you believe that monetary policy can be effectively and
efficiently implemented solely by open market operations?
C. For w\hat purposes, if any, should (a) rediscounting, (b)
changes in reserve requirements, and (c) regulation Q be used?
How might H.R. 11 be amended to implement yowr recommendations?
CEA response. Our response considers both of these questions together.
As we have indicated in a previous answer, we believe the objective
of monetary policy should be to influence the cost and availability
of credit in ways conducive to economic stability. We further believe
that the chief means of influencing credit conditions should be through
regulation of the supply of reserves available to the commercial banking system for credit creation. Since open market operations are the
most flexible and effective tool for expanding or contracting bank reserves, we believe they should—and do—constitute the primary instrument of monetary policy.
The Federal Reserve discount window is best viewed as a safety
valve which enables banks—at a price—to escape pressures occurring
during periods of tightening credit when these pressures may inadvertently become unduly concentrated on particular banks. By providing relief directly to the banks that are most in difficulty, the discount mechanism permits the global pressures caused by open market
operations to be brought about more aggressively than would otherwise be possible and thereby makes monetary policy more effective.
We would like to see the discount rate changed somewhat more frequently and routinely than has customarily been the case in order to
keep it in a more consistent relationship to short-term market interest
rates. At the same time we recognize that the discount rate is on occasion a useful signal of the Federal Reserve's intentions—especially
to the international financial community at times of serious balanceof-payments difficulties—and we would therefore not favor the entire
elimination of discretionary changes in the rate.
Changes in reserve requirements are said to have advantages which
may at times make them superior to open market operations as a tool
for conducting monetary policy. One alleged advantage is that reserve
requirement changes provide a definite signal to all observers that
policy has changed. Another is that reserve requirement changes affect
all member banks immediately in contrast to open market operations
whose effects tend to show up first in the money centers and only
gradually spread to outlying banks. While the evidence in support of
these supposed advantages is somewhat limited, we believe that reserve
requirement changes may on occasion be useful as a tool of monetary
policy. On the other hand, we feel that frequent changes in reserve requirements would be undesirable; and, indeed, changes have been made
quite infrequently in recent years.
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The powers entrusted to the Federal Reserve under regulation Q
enter the monetary policy process at a somewhat different point from
the other instruments discussed above. Regulation Q has no direct
effect on bank reserve availability. Rather it may be viewed as the
second blade of a pair of scissors, cutting off bank competition for
time deposits whenever a squeeze on reserve availability through open
market operations or one of the other instruments pushes interest rates
up near or beyond the regulation Q ceilings.
In an ideal world, we would not favor the use of administrative
ceilings to prevent healthy competition for funds among financial
institutions. But the experience of the past several years makes it
amply clear that certain of our financial institutions—particularly
mutual savings banks and savings and loan associations—encounter
serious problems when interest rates rise to too high a level. Experience also demonstrates that pressure on these institutions and on
the housing sector which they are so important in fiancing can, under
some circumstances, be relieved by skillful adjustment of the regulation Q ceilings. Several of the financial reform measures enacted by
the Congress during the past 2 years have helped give these financial institutions a little more flexbility to live in a high interest rate
world. But as long as their funds are invested mostly in long-term,
rather illiquid assets bearing interest rates characteristic of several
years ago, it appears that there will continue to be a need for at least
a standby authority to set interest rate ceilings.
Question I.5.D. Do you see any merit in requiring the Federal Reserve Board to make detailed quarterly reports to the Congress on past
and prospective actions and policies? Are there any risks and costs in
this procedure? In what ways, if any, icould you modify the reporting
provision? What information do you believe should be included in such
reports as you recommend the Federal Reserve submit to the Congress?
CEA response. The Federal Reserve already makes numerous public
reports of its actions, the explicit reasons for them, and its view of the
general economic background underlying them. The interested observer can also piece together a reasonably good story of his own about
what the Fed has been doing by following the weekly and monthly
banking statistics. We feel that the combination of these reports and
statistics is adequate to meet most legitimate needs.
If the Congress, in its role as overseer of the Fed, should see the need
for still more information, however, we see no reason to object. Full and
frank reviews of recent actions and the reasons for them can improve
understanding and ultimately bring us a step closer to our basic
economic goals.
But we would strongly caution against attempts to force the Federal Reserve to spell out in detail what its current policy stance is
and what actions it plans to take in the future. Thus, we are completely opposed to that part of the proposal in H.R. 11 requiring details on "prospective actions and policies." Attempts to pin the System
down on prospetcive actions can only inhibit its flexibility in dealing
with actual situations as they develop. As indicated in our response to
question 1.1, this flexibility of monetary policy is something that we
feel should be preserved to the greatest extent possible.
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Question I.5.E. What costs and benefits would accrue if representatives of the Congress, the Treasury, and the CEA were observers at
Open Market Committee meetings?
CEA response. We see little benefit from having CEA or other outside observers attend Open Market Committee meetings. Policymakers
throughout the administration and the Congress have always reserved
the right to deliberate in private, and we feel that the Federal Reserve
has that same right. The presence of outside observers might work
to decrease the candor and independence with wThich views are expressed in the FOMC.
The suggestion that a CEA representative should be present at an
Open Market Committee meeting seems to imply that we would then
be in a better position {a) to press our own views and (b) to learn
what Federal Reserve policy actually is. Actually, however, the spirit
of cooperation that has been built up during the past 8 years has given
us adequate opportunity to make our views known and to hear the
views of others, and it is doubtful whether either we or the Federal
Reserve would benefit further in these respects by our attending
FOMC meetings.
Question II. Appraisal of the structure of the Federal Reserve.
H.R. 11 provides for the following structural changes in the Federal
Reserve System:
1. Retiring Federal Reserve bank stock;
2. Reducing the number of members of the Federal Reserve
Board to five and their terms of office to no longer than 5 years;
3. Making the term of the Chairman of the Board coterminous
with that of the President of the United States;
4. An audit for each fiscal year of the Federal Reserve Board
and the Federal Reserve banks and their branches by the Comptroller General of the United States; and
5. Funds to operate the Federal Reserve System to be appropriated by the Congress of the United States.
Please comment freely on these several provisions. In particular,
it would be most helpful if you would indicate any risks involved in
adopting these provisions and discuss whether their adoption would
facilitate the grand aim of H.R. 11, which is to provide for coordination by the President of monetary and'fiscalpolicies.
CEA response. If one were starting from scratch, one would probably propose a structure for the Federal Reserve System substantially
different from the present one. However, in evaluating proposals for
reform and reorganization of the System under present conditions, its
historical evolution and its effectiveness in performing its functions
must be taken into account. We believe that, on the whole, the Federal
Reserve has performed effectively in recent years in adapting monetary
policy to the changing domestic economy and our balance-of-payments
situation. Since an effectively functioning institution is more important
than a logical organization chart, we believe there is a need for caution
in recommending drastic changes in Federal Reserve organization.
Our detailed comments on the proposals contained in H.R. 11, which
follow, reflect this view.
II. 1. Retiring Federal Reserve stock.—We believe that it is somewhat anomalous for a public institution such as the Federal Reserve
to be "owned" by private stockholders. At the same time, however, we
SI
do not see that this anomaly has caused any difficulty with respect
to determination of System policy. Thus, we see no compelling reason
for eliminating the stock ownership. The risks involved in retiring the
stock seem small, though there is always the possibility that confidence
in the Federal Reserve could be weakened if the action were construed
to imply a fundamental change in control of the System. On balance,
we would favor this reform, although we do not believe the issue is
very important.
II. 2. Reducing Board membership to five and terms of office to no
more than 5 yecvrs.—We note that H.R. 11 includes a provision abolishing the Federal Open Market Committee. Although no reference is
made to this provision in the questionnaire, it is, in our opinion, the
most important change in Federal Reserve structure contained in
H.R. 11. Since the proposed abolition of the FOMC has a bearing on
the question of Board membership, we consider the two provisions
jointly.
Taken by itself—that is, assuming retention of the FOMC—the
proposal to reduce the number of Board members to five seems unwise
because of its implications for the balance of power between Board
members and Reserve bank presidents. Under present arrangements
the seven members of the Board can make their common views prevail
in the FOMC, since only five of the bank presidents vote in that Committee at any one time. We believe that this balance is appropriate and
should be preserved, so that monetary policy, at least in principle, can
be determined by presidentially appointed officials. This assurance
would be removed if the Board were reduced to five members, unless
there were simultaneous change in the structure of the FOMC.
Leaving aside the key question of balance within the FOMC, we see
advantages in having a smaller Board. We believe that a Board of
five might be somewhat more effective than one of seven.
With respect to length of term, we accept the philosophy in the
Federal Reserve Act that Board appointees should have terms long
enough to insulate them from political pressures. But we also believe
that the present 14-year term is longer than necessary for this purpose and also so long that it limits in an undesirable way the turnover of views and ideas. If the present seven-man Board is to be retained, a term of 7 years would strike a more appropriate balance
among the various objectives. On the other hand, if the Board were to
be reduced to five members, we believe a term of 10 years would be appropriate, rather than the 5-year maximum term contemplated in
H.R. 11.
Turning to the key question of abolition of the FOMC, we encounter conflicting considerations. A proposal to abolish the FOMC and
turn all the Federal Reserve's monetary policy powers over to a fivemember Board was made in 1961 by the highly regarded Commission
on Money and Credit. The Commission's rationale for this recommendation was that monetary policy should be in the hands only of officials who are appointed by the President and confirmed by the Senate. We svmpathize very strongly with this objective. Moreover, the
present FOMC, consisting of 12 members, is a somewhat cumbersome
administrative body, a fact which requires a high degree of diplomatic
skill on the part of the Chairman in achieving the consensus of views
necessary to conduct an effective and coherent monetary policy. Thus,
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there are sound arguments for eliminating the FOMC and concentrating power in the Board. But there are also risks involved in making
drastic changes in the organization of an institution that has, on the
whole, performed its functions satisfactorily.
In some instances, Reserve bank presidents have made very important contributions to the formulation of monetary policy. Furthermore, the Reserve bank presidents have often played a useful
role in the collection and presentation of information concerning
economic developments in their regions and in the administration
of nationwide banking and credit policies in those regions. If the
FOMC were abolished, with the Reserve bank presidents acting only
in an advisory capacity with no actual vote in policy formulation,
it seems certain that the stature of the office and of the personnel
occupying it would be sharply reduced, perhaps with adverse effects on the relations between the Reserve banks and their regional
communities. That is, abolition of the FOMC would probably produce a drastic change in the character of the Federal Reserve System, with results that are rather difficult to predict. For this
reason, we are hesitant to recommend abolition of the FOMC,
even though we can see some advantages in it.
As an alternative to abolition of the FOMC, we believe the
Congress should consider making Reserve bank presidents subject to Presidential appointment and Senate confirmation. This would
put the Reserve bank presidents in the same category as other officials
with major responsibility for national economic policy.
II. 3. Making the term of the Chairman of the Board coterminous with that of the President of the United States.—We fully
support this proposal. We note that Chairman Martin himself has
repeatedly supported such a provision and that on April 17, 1962,
President Kennedy submitted to the Congress a message making
a similar recommendation. We believe that enactment of this proposal would help provide the basis for increased trust between
the President and the principal officer responsible for monetary
policy. The Chairman would be better able to participate in the
councils of the executive branch and the Nation would be bettter
assured of effective coordination of economic policy.
We note that H.R. 11 proposes to give to the Chairman the power
to designate a Vice Chairman. We would prefer to leave this power
with the President, as the Federal Reserve Act presently provides.
We would, however, recommend a proposal making the Vice Chairman's term in that office also coterminous with that of the President,
in line with recommended change in the term of the Chairman.
We might also note that the current dating of Board terms is not
very compatible with an attempt to make the term of Chairman coterminous with that of the President. Under present law, terms of
Board members expire on January 31 of each even year. Thus, a new
President taking office on January 20 of an odd year might have to
wait as long as a full year for a vacancy to open up on the Board so
that he could appoint the man of his choice as a member and Chairman. This problem would be reduced if at least one member's term
expired each year, as contemplated both in H.R. 11 and in our recommendation for 7-year terms in our response to the preceding question. If terms continue to expire every other year, however, we would
suggest changing the law so that the expiration dates fall in odd rather
than even years.
83
A somewhat related problem that could inhibit the President's
choice of a new Chairman arises from the present geographical and
occupational limitations on Board membership—especially the restriction that no more than one member may be from any Federal Reserve district. This could prevent the President from securing the
best qualified Chairman if his choice should happen to come from a
district already represented on the Board. We suggest that the Congress consider an amendment that would eliminate these restrictions entirely, or at least liberalize them.
11.4. Animal audits of the Board, the Reserve banks, and their
branches by the Comptroller General.—We believe that the auditing
procedures presented in effect in the Federal Reserve System are satisfactory from the viewpoint of assuring that the Federal Reserve operates with efficiency and economy and in the public interest. Those procedures involve a complete examination annually of each Reserve bank
and branch by the Board's staff of examiners, an examination of one
of the Reserve banks each year by a commercial auditing firm, and a
continuous audit of each bank by a resident auditor, responsible to the
bank's board of directors. These examinations check not only the bank's
financial condition, but also its discharge of all responsibilities and its
compliance with law and regulations. In addition, the Board itself is
audited each year by independent public accounting firms. Reports of
these various examinations are available to the appropriate committees
of the Congress.
11.5. Congressional appropriation of fu/nds to operate the Federal
Reserve.—We doubt the need for this provision. As indicated in our
previous answer, we believe that the Federal Reserve is operated efficiently and economically. Moreover, virtually all of the System's earnings above operating expenses are already paid over to the Treasury of
the United States. In fiscal year 1968 alone, this payment was almost
$2.1 billion. A significant reduction in the net expense of the System
to the taxpayers presumably could be achieved only by curtailing operations, which we believe would be unwise.
Question III. Your analysis of monetary development, since 196J^
including induced changes and their effects on economic activity, is
invited.
CEA response. The Council's 1968 annual report has already summarized our views of monetary developments up through the end of
1967. We confine our comments, therefore, to developments thus far
this year.
Monetary and financial developments in 1968 fit broadly into two
periods. Interest rates climbed sharply in the early months of the year,
as monetary policy tightened in defense of the dollar and to curb
mounting inflationary pressures at home while enactment of the proposed tax surcharge continued to be delayed. Although there were temporary interruptions in the upward trend, by mid-May most rates had
climbed one-half to a full percentage point from their early 1968 lows.
High quality corporate borrowers were paying more than 7 percent
for funds and 3-month Treasury bills commanded a rate as high as
5.90 percent. During this period, interest rates reached peaks higher
than those attained in the widely heralded monetary crunch of 1966.
The breakup in late May of the logjam on the tax increase and its
ultimate enactment and imposition brought a marked easing of pressures and fears throughout financial markets. And with fiscal policy
finally assuming a more proper role, monetary policy was able to relax
84
somewhat the restraint imposed earlier, giving a definite signal in this
direction with a cut in the Federal Reserve discount rate initiated on
August 16. Market interest rates reflected these developments, dipping
in early August to levels below their lows set early in the year. This
downtrend has been somewhat reversed in more recent months, and
in early November the prevailing level of rates wTas high by historical
standards.
The degree of monetary restraint imposed in the first several months
of the year was quite severe. At a time when a burgeoning economy
was sharply stimulating private demands for credit and when the Federal Government was also a heavy net borrower in contrast to its
usual seasonal repayment of debt, increasingly restrictive steps by the
monetary authorities effectively slowed the amount of total credit
creation, particularly by commercial banks. These steps had actually
begun with the increase in the Federal Reserve discount rate from
4 to 4y2 percent following the devaluation of sterling in November
1967. This was followed by two further increases in the spring of
1968, bringing the rate to 5y2 percent by late April, its highest level
since the 1920's. Meanwhile the Federal Reserve had also increased
reserve requirements against member banks' deposits, and had steadily
tightened its open market policy.
The result was that growth of total bank credit slowed from a Hy 2
percent rate during 1967 to a 6y2 percent rate in the first 6 months of
1968. Credit demands were strong but banks simply could not meet
them, as interest rate ceilings established under regulation Q made
it increasingly difficult for the banks to attract new deposits to support
their lending operations.
The lower level of market interest rates prevailing in more recent
months has restored banks' ability to compete effectively for time
deposits. And acquistion of these and other funds has supported rapid
growth in bank credit since mid-year. Special factors accounted for
much of this gain, but it is clear that the easing in monetary policy
was filtering through to increased availability of credit.
Flows of funds to and from other financial intermediaries appear
also to have improved somewhat recently compared with experience
during the spring. Indeed, after reports of increasingly severe shortages of mortgage funds in the late spring, which helped to bring a
sharp curtailment in home building activity, the more recent signs
suggest that home builders and buyers have not had any undue difficulty obtaining mortgages, although still at high interest rates.
The one financial variable that has been rather at odds with the general picture described above is the narrowly defined money supply.
Thus after growing at a relatively moderate rate in the first 3 months
of the year, growth of the money supply accelerated very sharply during the April-July period. In large part, this seems to reflect a slow adjustment by the private sector of the economy to an unusually large
payout of Government deposits during this period. Rising transactions
needs associated with the rapidly growing economy and a heavy volume of securities market transactions may also have been a factor. As
we interpret it, this surge in the money supply was not indicative of
an early easing in monetary policy. Nor do we believe that return to
more normal money growth in subsequent months reflects a tightening
in monetary policy compared with its posture during the spring and
early summer. Developments this year point up the inherent dangers in
focusing exclusively on so narrow a financial variable as the money
supply.
STATEMENTS OF RESPONDENTS ON QUESTIONNAIRE
CONCERNING H.R. 11
STATEMENT OF E. SHEKMAN ADAMS, FIRST NATIONAL CITY BANK
I . MONETARY POLICY GUIDELINES AND OPEN M A R K E T
OPERATIONS
Coordination of fiscal, debt management and monetary policies is
obviously desirable, provided it helps to achieve wise policies. It does
not follow, however, that a "program" to accomplish coordination
should be announced at the beginning of each year. The word "program" suggests a degree of inflexibility that would be highly undesirable in economic policymaking.
This applies particularly to monetary policy. Your questions about
monetary policy guidelines seem to imply that monetary policy should
be conducted according to some sort of formula. One of the great
virtues of monetary policy is that it is flexible and can be adjusted to
changing conditions. I do not think that anyone can intelligently set
targets for a whole year in advance for any of the variables influenced
by monetary policy.
It is useful, nevertheless, to have some framework for thinking
about monetary policy. I find it helpful to think in terms of the ways
in which monetary policy affects economic activity. Monetary controls
are effective and have significance because they affect expenditures
made by individuals, by businesses, or by governments. These effects
upon spending are mostly indirect and are brought about through
the influence of monetary policy on credit conditions. They reflect
the reactions of the community to the credit conditions which the
monetary authorities are able to influence; namely, (1) interest rates,
the cost of credit, (2) the availability of credit, which is reflected
chiefly in the lending and investment policies of various suppliers of
credit, and (3) changes in the money supply, especially those which
reflect changes in bank credit.
All of these three factors need to be taken into account. Under particular circumstances, one or another of them may be of much greater
importance than the others. But none of them should ever be ignored.
This is one reason why monetary policy cannot be effectively and
efficiently implemented solely by open-market operations. These operations affect primarily the volume of bank credit. The monetary authorities need additional controls to exert the influence they should
be able to exert on interest rates and the availability of credit.
It also explains why I would not favor amending the Employment
Act to make specific reference to the growth of the money supply. I
would fear that such a change might encourage paying too much attention at times to this one factor and not enough attention to interest
rates and credit availability.
(85)
86
It would be far more constructive to amend the Employment Act
to make specific reference to price stability as a major goal of public
economic policy.
You ask about debt management policy. I think that the usefulness
of public debt management as a means of shortrun economic management is quite limited. In theory, debt management could be used to
combat inflationary or deflationary swing? in the economy, but this is
seldom true in practice. For instance, during a boom, countercyclical
policy would call for the issuance of long-term bonds by the Treasury
to curb capital spending. As a practical matter, however, one cannot
expect the Treasury to do much long-term financing when interest
rates are at historically high levels and when nonbank investors have
no desire to add to their holdings of Treasury securities.
I I . STRUCTURE OF T H E FEDERAL RESERVE
I share the view of the great majority of monetary economists that
it is definitely in the public interest to protect the Federal Reserve
from greater political pressure. Most of the structural changed proposed by H.R. 11 are designed to undermine the present degree of
semi-independence of the Federal Reserve within the framework of
government and are therefore undesirable.
One exception is that I think there may be merit in making the
term of the Chairman of the Federal Reserve Board coterminous with
that of the President of the United States. I have no judgment on the
advisability of reducing the number of the members of the Board.
I I I . RECENT MONETARY POLICY
The major monetary developments of recent years have stemmed
largely from the unprecedented expansion of the U.S. economy
accompanied by inflationary policies on the part of the Federal Government. Large budgetary deficits, incurred when the economy was
operating close to capacity, have been largely responsible for creating
inflationary pressures throughout the economy, including the reactivation of the wage-price spiral which the Government has done little to
restrain. We are now in the midst of an inflationary boom, the outcome of which cannot be predicted. Similarly, the Government's failure to deal effectively with the U.S. balance-of-payments problem
has brought the American dollar into serious jeopardy, and the end
of this story has not been written yet either.
The monetary authorities have been acutely aware of these developments and have taken them into account in formulating their policies.
On the other hand, it has been apparent that monetary policy could
not achieve price stability and balance-of-payments equilibrium
singlehanded. As Allan Sproul once observed, we cannot expect monetary policy to offset all the unwise policies in the rest of the economy.
Realizing this, the monetary authorities presumably felt that the
least bad alternative for them most of the time was to permit monetary
expansion to continue at a rather rapid pace, probably at a faster pace
than they would really have liked.
In the spring of 1966, the Reserve authorities apparently reached the
conclusion that the situation was worsening to such an extent that a
restrictive policy was called for. The "credit crunch" that followed
87
again demonstrated that, if it is used boldly, monetary policy can be
a powerful brake on the economy. However, policy became so restrictive that it threatened to create a chaotic situation in the financial
markets, and this again demonstrated the fact that, as a practical matter, there are real limitations on the extent to which this brake can
be applied in the real world.
However, the main lesson of recent monetary developments relates to
the matter of the coordination of monetary policy and other public
economic policies. The fiscal policies and other policies of the Federal
Government have had an inflationary impact on the economy. Although the monetary authorities have not had the power to correct
this situation, they nave done their best to exert a constructive influence—which is more than can be said for many officials in Government.
Whether they should have done more or less than they did is naturally
a question for debate among the Monday morning quarterbacks. But
this question is not really too important. What is important is that the
monetary authorities have sought consistently to act in the public interest, whereas fiscal and other governmental policies have been unwise
because they have reflected the pressures of political expediency. The
obvious lesson of this is that if we seek to achieve greater coordination
of monetary and fiscal policies, our aim should be to coordinate fiscal
policy with monetary policy, not the other way around.
In short, the authors of H.R. 11 are plainly concerned with a problem of great significance to our economic well-being. However, they
are approaching it from the wrong end and with the wrong assumptions. The problem lies not with monetary policy but with fiscal policy.
The need is not to destroy the semi-independence of monetary policy,
but rather to improve the organization and procedures that will help
to produce better fiscal policies. If the Congress would turn its attention to this problem, it could make a major contribution to the future
growth and stability of the American economy.
STATEMENT OF CAUL T. ARLT, UNIVEESITY OF ILLINOIS
Re No. 1.—The idea of a program coordinating fiscal, debt management, and monetary policies is an appealing one. To set forth this
program at the beginning of the year would involve a careful specification of the goals to be achieved. This is no easy task in view of the
plurality of goal variables with all their inherent conflicts. I am
assuming, of course, that the "goals of the Employment Act" would
include the more recently acquired objective of achieving a better
balance in the international payments position of the United States.
I believe there is merit in a program of coordination in that it would
require the Federal Reserve to "take a position" based on its understanding of the monetary mechanism, its reading of the economic
indicators, and its evaluation of the influence of nonmonetary policy
forces on the goals to be achieved. I should add, however, that if the
monetary authorities are to be forced into a more formalized program
of coordination, they assume an impossible burden if they must
coordinate with the type of fiscal policy experienced within the last
few years. Much of the criticism of the Federal Reserve with respect
to allegedly inappropriate growth rates of the money supply should be
analyzed in the perspective of the Federal Reserve attempts to cope
88
with the prolonged deliberations associated with efforts to institute
fiscal restraint.
Re No. 2.—I believe the President should be assigned the formal
responsibility for drawing up the economic program.
Re No. 3A.—Monetary policy should employ some intermediate
target variable as it works to achieve the goals of the economy. There
is need for some quantitative measure to indicate the thrust of monetary policy and one that is predictably linked to measures of spending
and income. Unfortunately, what that measure may be is still a matter
of dispute among economists. Arguments continue over the relative
feasibility of such guides as interest rates, credit volume, some reserve
measure, or the money supply. In my own thinking such measures as
interest rates or bank net reserve positions (free or net borrowed) are
poor indicators of the thrust of monetary policy. Because these reflect
both credit demand and supply forces it is difficult to derive from them
the contribution of the monetary authorities. In a related vein, it may
be said that the monetary authorities have very little control over
interest rates and the net reserve positions of commercial banks.
If proposed legislation specifies a target variable, I would urge that
it use either the growth rate of the money stock or the growth rate of
the monetary base as the more appropriate measures of what the
Federal Reserve is doing. But I would also submit, since economists
are not in agreement with respect to the "best" guidepost, that legislators proceed cautiously in their specification or financial targets and
avoid imposing hard and fast rules on the monetary authorities.
Of the two target variables, money stock changes and monetary base
changes, I prefer the monetary base. The supply of the monetary base
is substantially under the complete control oi the Federal Reserve
System. Recen/t studies have shown that movements in Federal Reserve
credit determine most of the movements of the monetary base. Although member bank borrowing from Reserve banks and changes in
the gold stock are not under the direct control of the monetary authorities, one may assume that open market operations may be used to offset short-term changes in these and other accounts in order to achieve
a desired level of the monetary base.
The demand for the monetary base consists of the demand of commercial banks for excess reserves and required reserves and the demand
of the nonbank public for currency. Banks' demand for required reserves is a derived demand reflecting the demands for private demand
deposits, Government demand deposits, net interbank deposits, and
time deposits.
Changes in the monetary base have an important influence on output, employment, and prices through an adjustment process in which
banks and the nonbank public adjust their holdings of real and financial assets so as to bring the amount demanded of the monetary base
equal to the amount supplied. In this process, economic activity, prices
of real assets, and interest rates are changed.
Empirical studies appear to show a relatively close relationship
between changes in the monetary base and changes in the money
supply. In the short run, however, changes in the money supply often
reflect movements in Government demand deposits or movements
between demand and time deposits. For this reason I tend to lean
toward the monetary base rather than the money supply as the best
available guide to monetary management.
89
Re No. 3 B and F.—It would be helpful if the Federal Reserve at
the beginning of the year specified a desired rate of growth of the
monetary base. The particular rate of growth selected would reflect
the consensus hammered out in the coordinated program drawn up by
the President.
To repeat earlier parts of this statement, I would insist that this
specified rate of growth of the monetary base be considered as a benchmark and not a binding prescription imposed on the monetary authorities. We are attempting to achieve a plurality of goals with inherent
conflicts and we must recognize that during the year the importance
attached to particular goals may change. Furthermore we are using a
target variable for monetary policy which may or may not be the most
appropriate measure or indicator. We do not yet know enough about
the strength and predictability of any of the possible financial variables suggested as intermediate guides to policy to impose a -fixed
course of action on the Federal Reserve. Accordingly I would urge
that the Federal Reserve be permitted to deviate from the specified
rate of growth if such action were accompanied by a detailed report to
Congress explaining the rationale underlying its policy decisions.
The distinctive advantage of specifying at the beginning of the year
a particluar rate of growth of some financial variable is that the public
gets a better understanding of the strategy employed by the monetary
authority whenever the target growth rate is changed. In short, my
position is that the monetary authority enjoys a wide area of discretion, but tied to that discretion is the responsibility for more detailed
communication with the public.
Re No. —We have not reached the point where debt management
may be used as an important stabilization tool. The most we can hope
for is the development of the neutral approach in which Treasury
debt offerings become more "regularized." I would also urge the removal of the ^-percent interest rate ceiling on Treasury bonds to
permit greater flexibility in debt management. It would be my hope
that improved and more regular financings by the Treasury could
then be achieved without requiring the Federal Reserve policy of
"an even keel" during the period of financing.
Re No. 5A.—I believe that money market facilities are adequate
enough and the participants sophisticated enough to adjust to many
of the money market changes now being cushioned by Federal Reserve "defensive" operations. Furthermore, it appears that Federal
Reserve emphasis on money market stabilization or "money market
strategy" has often led to unintended changes in such variables as
total reserves and the money stock which, I believe, are more closely
linked with the goals of spending and employment.
If policy is to be defined quantitively in terms of a longer run target
such as the desired rate of growth of the monetary base or money
stock, the monetary authorities would, of necessity, reduce the scope
of their operations designed to influence shorter run money market
variables.
Re No. 5 B and C.—Under most circumstances I would favor placing complete reliance on open-market operations. Reserve requirements
I would not change except during war emergencies and then it would
be more feasible to take off the limits to reserve requirement increases. The discount window as currently administered is not very
21—570—-68
7
90
effective. If current proposals for change, particularly with respect
to "automatic drawing rights" and more frequent changes in the
discount rate, are implemented, the discount window might prove
to be an effective supplement to open-market operations.
Regulation Q interest ceilings should be removed. Far too many
distortions in the flows of funds are produced in financial markets
where some interest rates are held by law or administrative decree,
while others are allowed to fluctuate freely. The experience of 1966
is a case in point.
Re No. 5 D and E.—I see merit in more detailed reporting to Congress by the monetary authorities, particularly with respect to past
actions and policies. Prospective actions and policies should be indicated only in general terms and, as explained earlier in this statement, I would not want the monetary authorities locked in by a
prescribed rate of growth of a target variable.
In keeping with my belief in a more complete disclosure of the
rationale underlying Federal Reserve actions and policies, I see merit
in the proposal to have selected observers at the Open Market Committee meetings. Some procedures would have to be adopted to prevent
indiscriminate revelations of FOMC deliberations and actions.
Re Part II on structure.—In keeping with the idea that the Federal Reserve be less independent of the President's office and more
independent of the banking community, I am in full support of
proposals No. 3 and No. 1.
^ As long as the Board must assume its numerous supervisory functions in addition to its monetary policy function, I see no merit in
reducing Board membership to five, nor do I see any advantage in
limiting terms to 5 years.
I am strongly opposed to propositions 4- and 5. These proposals
would contribute nothing to the President's program and at the same
time would violate what I regard as a healthy independence of the
central bank within Government.
Re III comments on recent monetary policy.—In retrospect it appears that the Federal Reserve was too drastic in its restraint from
April to^ October 1966 after having been too expansive in early 1966
despite intentions to restrain. Had the Board's monetary strategy
been geared to a target rate of growth of the monetary base or the
money supply the economy might have been spared the sharp changes
that developed in 1966.
The expansive policy of the monetary authorities in the first half
of 1967 was appropriate in view of the marked slowing up in the pace
of economic activity. The second half of 1967 is another story. In
the face of growing demands and rising spending, monetary policy
was too expansive. Although the Federal Reserve was aware of the
expansiveness of its monetary management, it avoided restraint because of the constraints of "even keel," the fear of renewed disintermediation, the influence of impending tax legislation, and the concern
over the position of the British pound. Underlying these concerns was
the fear that interest rates might rise too high if monetary policy
were to swing over to restraint.
The developments in 1967 pointed up the difficulties of obtaining
needed fiscal restraint as well as demonstrating the problems of achieving stabilization while attempting to realize an intermediate interest
91
rate objective. The need for coordinated policy was never more
apparent.
The substantial rate of growth of the money supply in July, August, and part of September of this year now appears to have been
excessive, although at the time the monetary growth probably reflected the generally pessimistic forecasts of a marked slowdown in
economic activity. The timing and impact of the fiscal restraint
package enacted in June now seem to have been miscalculated in
view of the continuing vigor of total spending.
STATEMENT OF JOSEPH ASCHHEIM, GEORGE WASHINGTON
UNIVERSITY
I.
QUESTIONS
ON
MONETARY-POLICY
GUIDELINES
AND
OPEN-MARKET
OPERATIONS
1. Question No. 1 limits the respondent's choice to that between the
two alternatives stated in the question. Yet these two alternatives do
not exhaust the full range of possible arrangements for the conduct of
fiscal, debt management, and monetary policies. This writer, for one,
regards neither of the two alternatives stated in the question as
desirable.
Consider the first alternative—that is, that a program coordinating
fiscal, debt management, and monetary policies should be set forth at
the beginning of each year for the purpose of achieving the goals of
the Employment Act. In conformity with the constitutional separation of powers in the United States, the monetary authority is a creature of the legislative branch, whereas the fiscal and debt-management authorities are components of the executive branch. The rationale
for such a separation of powers is that the money-creating function
and the money-spending function should not be vested in the same
branch of Government, so as to remove the temptation of the spending
branch to inflate. Such temptation is enhanced when both functions are
vested in the same branch of Government.
Now, to have the President, as provided by H.R. 11, include in his
program guidelines concerning monetary policy is to contravene the
separation of powers indicated above. Guidelines for the conduct of
monetary policy should not be charged to the Chief Executive's responsibility when it is not the executive branch that is charged with
the money-creating function.
Consider now the second alternative—that is, that we should treat
monetary andfiscalpolicies as independent, mutually exclusive, stabilization policies. This alternative is a strawman. Obviously monetary
and fiscal policies are not mutually exclusive, but rather complementary, policies. To interpret the notion of the independence of the
central bank as implying the exclusiveness of monetary policy is absurd. Monetary policy must at all times be conducted with reference
to the fiscal policy extent, or else economic stabilization will be undermined instead of enhanced.
Thus, the relevant question is not whether there should or should
not be coordination of monetary and fiscal policies. The objective of
economic stabilization makes coordination indispensable. Instead, the
question is: What kind of coordination should there be ? Should the
92
coordination be that which would be brought about through the
executive branch setting forth the guidelines for monetary policy as
well as conducting fiscal policy, or should there be another kind of
coordination? Having already responded in connection with the first
alternative that the constitutional separation of powers in the United
States calls for another kind of coordination, we now turn to the
suggestion of another kind.
A third alternative, one that overcomes the drawbacks of each of the
first alternatives, is the following. In conformity with the constitutional separation of powers, guidelines for the conduct of monetary
policy should be laid down not annually by the Chief Executive, but
more broadly by the legislative branch. In turn, the central bank, in
pursuit of the congressionally given guidelines, wTould informally but
constantly be expected to coordinate its monetary policy with the fiscal
policy conducted by the executive branch.
The monetary authority being the creature of the Congress it is the
responsibility of the Congress to lay down guidelines that will direct
the conduct of monetary policy toward economic stabilization. That
responsibility has thus far not been fully discharged by the Congress.
How the Congress can fulfill this responsibility will be suggested in
answer to question 3 below.
In line with my answer to question 1 above, I believe that the Employment Act of 1946 should remain intact in its provision for the
President's economic program.
3.A. The money supply, the level of interest rates, and the term
structure of interest rates should be stated in H.R. 11 as the target
variables of monetary policy. Specifically, the Federal Reserve System
should be directed to vary the money supply and to influence the level
and term structure of interest rates so as to promote the attainment
of the goals of the Employment Act. The money supply, defined as
currency plus demand deposits, constitutes the stock of generalized
purchasing power in the economy. The size of this stock is amenable
to central bank control with a high degree of precision. Variations in
this stock are a strategic factor in economic fluctuations. In contrast,
the level and term structure of interest rates are not amenable to central bank control with a high degree of precision. They are, however,
also important in determining the volume of economic activity. Yet
there does not exist a unique or stable relationship between the size
(or rate of change) of the money supply and the level (or rate of
change) of interest rates or term structure of interest rates.
Nevertheless, the level and term structure of interest rates are subject to considerable central bank influence via the weapon of openmarket operations amid a large and widely distributed Government
debt. Such influence can be exerted in order to contribute to economic
stabilization. It involves using open-market operations in two dimensions: (1) net absorption or release of the cash reserve base, thereby
varying the money supply; and (2) swapping operations that can
leave the money supply unchanged but alter the term structure of
Government debt.
3.B. The guidelines should not be specified either in terms of some
particular index or in terms of the target variable's value or growth.
Instead, the Employment Act of 1946, applicable to the entire U.S.
Government, should be amended in its goals to read, "maximum em-
93
ployment, production, and purchasing power consistent with reasonable price-level stability." In turn, the Federal Reserve Act should be
amended to provide congressional guidelines to the Federal Reserve
System. To specify these in terms of some index of economic activity or
the target variable's value or growth would be to curtail unduly the
monetary authority's range of discretion that is necessary over time in
pursuit of the goals of the Employment Act, as amended. There does
not exist a unique relationship between "maximum employment, production, and purchasing power consistent with reasonable price-level
stability" on the one hand, and any one index of economic activity or
any one value or growth rate of the target variable on the other hand.
Consequently, the Federal Reserve System should be afforded the discretion to vary the money supply and to influence the level and term
structure of interest rates as it deems necessary for economic
stabilization.
In practice, the FRS has not only sought to contribute to economic
stabilization in the sense of enhancing reasonable price-level stability
while attempting to counteract cyclical economic fluctuations. The
FRS has at the same time been engaged in (a) counterseasonal offsetting operations, and (b) lending to member banks at a rediscount
rate that is intermittently a subsidy rate. Neither of these two additional activities of the FRS is necessary for the economic-stabilization
role; indeed, both distract the FRS from focusing on the sufficiently
complex task of harmonizing its own economic-stabilization effort
with that of the fiscal authority. The private financial sector can be
expected to look after its own seasonality and member banks can be
expected to rely on the rest of the private economy for obtaining
loanable funds without subsidy from the FRS. Accordingly, the congressional guidelines for the FRS to be written into the Federal Reserve
Act should specify that the FRS is to conduct monetary policy aiming at economic stabilization without subsidizing commercial banks
and without engaging in defensive, that is, counterseasonal, operations.
Within those constraints, the FRS would be free to exercise its discretion in varying the money supply and influencing the level and
term structure of interest rates consistent with the goals of the Employment Act, as amended.
To help the implementation of the goals of the Employment Act,
debt management can be conducted in such a wray as to avoid interference with the conduct of monetary policy. This noninterference
approach to debt management vis-a-vis monetary policy implies that
debt management will be geared to the aim of minimizing the interest
burden of Government debt, given the conduct of monetary policy by
the FRS.
5.A., 5.B., and 5.0. See the answer to 3.B above.
5.D. Detailed quarterly reports to the Congress are too frequent to
be consistent with the exercise of discretion in the conduct of monetary
policy. On the other hand, annual reports seem to be too infrequent to
be timely. Semiannual reports would, therefore, be most appropriate*
5.E. The costs of having observers at Open Market Committee meeting are at least two. Firstly, such an arrangement detracts from the
free and full discussion that Federal Reserve officials might otherwise
engage in, but would avoid whenever they individually or collectively,,
w7ould be apt to lose face by admission or mistakes made. Secondly, it
94
would be difficult to prevent leakage of Federal Reserve decisions to
unauthorized individuals or even the public with various observers
present at meetings charged with important profit-and-loss implications as Open Market Committee meetings are.
The benefits of such an arrangement would be to increase advance
information about Federal Reserve decisions on the part of officials
who are observers. I consider the costs as substantially outweighing
the benefits.
I I . APPRAISAL OF T H E STRUCTURE OF T H E FEDERAL RESERVE
I favor structural changes (1) through (4) for reasons that led to
their suggestion as implemented in H.R. 11. In contrast, once structural change (4) has been enacted, structural change (5) seems to me
to be a redundant complication of the task of monetary policy. Once
it is provided that the FRS is audited by the Comptroller General
each fiscal year, subjecting the System to the congressional appropriation process, only encumbers the conduct of the System's work without
enhancing its honesty or trustworthiness.
I I I . COMMENTS ON REGENT MONETARY
POLICY
The subject of this section, monetary developments since 1964, is too
broad and far ranging to be dealt with in the context of the above
comments on H.R. 11.
STATEMENT OP GEORGE I . BACH, STANFORD UNIVERSITY
This is in response to your letter of July 9, requesting my comments
on numerous aspects of H.R. 11 on which hearings will be held this
autumn. I have organized my answers to correspond to the questions
sent with your letter.
1-1 ana 2. The Government should be concerned continuously with
the coordination of fiscal, debt, and monetary policies, looking toward
the achievement of the goals of the Employment Act of 1946. The
effects of monetary and of fiscal policies cannot, realistically, be considered in isolation. Since in fact monetary and fiscal policies both
affect the level of income, employment, and prices, it is important that
they be made with full recognition of these joint effects.
1-2. It seems to me appropriate that the President should at the
beginning of each year state in his Economic Report broad plans for
the achievement of the goals of the Employment Act. In substance, he
now does so. It would oe appropriate for him to be somewhat more
specific about the implications for monetary policy of the major economic proposals he makes at the beginning of each year if he wishes to
do so. IntlLat event, as I presume is the practice now, he would presumably want to confer with the officials of the Federal Reserve System,
or ask his Council of Economic Advisers to do so, before deciding on
his proposals. I see no advantage in trying to assign to the President
a sharper responsibility than this. This is true because neither the
President nor any other economic analyst can hope to spell out in
detail a year in advance what would be the most desirable monetary
policy actions—unless one were to substitute a specific legislative "rule"
for monetary policy, in which case suggestions from the President
might be superfluous.
95
I-3-A. Monetary policy should be used to help achieve the goals of
the Employment Act via control of the money supply and through
other channels. The basic objectives of monetary policy are presumably stable economic growth and high-level employment of men and
machines without substantial price inflation. Extensive research over
the past decade suggests that, if one were required to choose one intermediate variable on which the Federal Reserve should concentrate,
the money supply (defined as currency and demand deposits) would
be a reasonable selection. On the other hand, the evidence is not clear
that this should be made the sole immediate target of monetary policy.
A roughly stable growth rate in the money stock seems to be highly
correlated with a roughly stable growth rate of the real economy, but
there are numerous exceptions. Unless we can be sure that by stabilizing the rate of growth of the money stock we would also be making
the maximum contribution to stabilizing the growth rate of the economy, it would be unwise to prescribe such a "guideline" or "rule" as
the exclusive target of monetary policy. We cannot be sure of this
casual relationship on the basis of existing research findings.
Research results do seem convincing that the Federal Reserve should
pay substantial attention to the growth rate of the money stock, and
that there is a general presumption in favor of a relatively stable
growth in the money stock (of perhaps 2 to 6 percent per annum). But
more evidence is needed to justify placing exclusive reliance on this
guide to action. First, we aren't clear as to whether this narrow definition of money is superior to a broader definition, that includes time
deposits at commercial banks and possibly at savings and loan institutions. Second, use of the money stock as a sole target suffers from the
weakness that this target is not exclusively under the control of the
Federal Reserve, though the Fed can exercise rough control over the
money stock if it is willing to let interest rates fluctuate widely. As
long as any target (such as interest rates or the money stock) is partly
under the control of market forces, it is a dangerous and imperfect
guide to Federal Reserve policy and to the evaluation of that policy,
since we are never sure whether target changes are the result of Federal Reserve action or market forces. To meet this criterion, the best
intermediate target would be the "reserve base" (unborrowed reserves
plus currency in the hands of the public). This target is fully under
the control of the Federal Reserve, and on that score it would be a
preferable target to the money stock. Broadly, it would provide the
same results, and I believe that the Federal Reserve should pay substantial attention to the growth rate in the reserve base, as to the money
stock and to other important variables.
For the same reasons, exclusive reliance on interest rates as an
immediate target of monetary policy is extremely dangerous, since
interest rates are determined only partly by Federal Reserve action,
and partly by market forces.
I I - l - D . It seems to me appropriate for the Congress to provide
more specific directives for the Federal Reserve. Such a directive might
specify growth in the money stock and in the reserve base as important
indicators in the formations of monetary policy. I do not, however,
believe that Congress should specify either of these, or any other intermediate target, as the exclusive guide to monetary policy. There are
too many uncertainties about the linkage between monetary actions
U6
and the real economy to justify exclusive reliance on one target now.
As a practical matter, it is clear that the Federal Reserve does now pay
substantial attention to these variables, so it does not seem to me urgent
that such a statement be added to the Employment Act of 1946 or to
special legislation governing the Fed. This is in spite of the fact that
I do support a strong presumption that 2-to-6-percent annual growth
in the reserve base or the money stock will ordinarily contribute importantly to stable economic growth. The Fed should certainly be free
to deviate from such a presumption if special circumstances arise.
1-4. The use of debt management to help implement the Employment Act of 1946 is appropriate, though not a device of very great
importance. The evidence to date fails to support the argument that
shifts in the composition of the debt arising from conscious government policy play a major role in controlling the economy's growth
rate. On the other hand, I see no reason why this policy device should
not be used insofar as it can make an effective contribution.
I-5-A. As indicated above, I do not believe that H.R. 11 should be
adopted insofar as it directs the FOMC to conduct open operations in
accordance with "the programs and policies of the President." It would
be difficult, if not impossible, for the President to specify in advance
for a wThole year what the FOMC should do through open market operations ; for him to try to do so would serve no good purpose.
In giving any directive to the Fed, Congress or the President should
recognize the importance of short-run money market conditions as one
consideration in the implementation of monetary policy.
In my judgment, the Federal Reserve has been unduly concerned
many times in the past with short-term money market conditions. Care
should be taken that such considerations not be allowed to dominate
long-run monetary policy. The recent announcement of changes in the
discount procedure marks an important step toward placing more
reliance on the market to make its own short-run adjustments. However, seasonal variations, variations in float, short-term government
financing requirements, and the like, are important enough to justify
careful attention to them on a day-to-day basis. Pending a more complete understanding of how the markets now act and would act under
less Federal Reserve intervention, it would be dangerous to remove
completely such market conditions from considerations in making
monetary policy.
I-5-B and C. Open market operations seem to me the most important channel for the Federal Reserve to influence money markets and
the growth of the real economy. However, I see nothing to be gained
through removing the Fed's power to change reserve requirements, and
I favor more extensive use of rediscounting as a device to permit individual banks to adjust their reserve positions. I think that, as indicated
above, the recent Federal Reserve discount proposals are a step in the
right direction; I would move even further toward reliance on individual bank discounting.
I do not believe that regulation Q, or comparable ceiling individual
rates, are desirable policy. The Fed should rely more heavily on quantitative measures, mainly open market operations. However, the abrupt
elimination of direct controls and rate ceilings might be disruptive.
Thus, the Federal Reserve and other supervisory agencies should move
as rapidly as is feasible to raise such rate ceilings to the point where
97
they have little impact, thus gradually removing them from active use
except under exceptional circumstances.
I-5-D. I see no reason why the Federal Reserve Board should not
be asked by Congress to submit regular quarterly reports on the actions
it has taken, while recognizing that such reports should not be expected
for a matter of some weeks or possibly a couple of months after the
end of the quarter. I oppose any requirement that would make the
Federal Reserve report its prospective actions to the Congress. Public
announcement of such advance plans would make the implementation
of stabilizing monetary policy extremely difficult. For the Federal Reserve to tie its hands in this way in advance of unforeseen developments
would seem foolhardy under present circumstances. The present reports
of the FOMC, received some 3 months after the action is taken, seem
generally appropriate to me. They might be more detailed and more
clearly relate the actions taken to policy goals, but to try to enforce
more detailed quantitative as well as qualitative reporting would be of
dubious value, pending the results of further research on the entire
subject covered by H.R. 11.
I-5-E. I see no important advantages to be gained from having
representatives of the Congress, Treasury, or CEA as observers at open
market committee meetings. This reflects my judgments that there are
substantial advantages to be had from a Federal Reserve which has
substantial "independence" within the Government. To make the Federal Reserve completely independent of the executive branch and Congress would be foolish and pointless in a democratic government like
ours. But to make the Federal Reserve completely subservient to the
President would lose some real advantages that the Nation now gains
from having the Federal Reserve as a buffer between the day-to-day
swings of public and political processes and the longer range goals of
monetary policy. I have presented my views on this matter, including
a detailed analysis of the problem, in testimony before this committee
("The Federal Reserve System After Fifty Years," vol. 2, 1964,
pp. 1387-1398).
II-1-5. I have presented my views at length on these matters before
this committee in the 1964 hearings, "The Federal Reserve System
After Fifty Years" indicated above. Briefly:
1. I see little to be gained from retiring Federal Reserve bank stock
at this time. If the Federal Reserve were being established now, clearly
there should not be such stock owned by the commercial banks. On the
other hand, it has now become an accepted part of the system and does
no apparent harm. This is not an issue that would justify stirring up a
major controversy now.
2. If the structure of the Federal Reserve were to be re-formed, I
wTould favor a reduction in the number of Board members to five, and
shortening of the stated term of office. A five-man board with a 10-year
term of office would be an appropriate compromise between the desire
to keep the Board insulated from short-term political pressures and
also sensitive to changing public views reflected by both Congress and
the administration.
3. I strongly favor making the term of the chairman of the Federal
Reserve Board coterminus with that of the President of the United
States. To saddle a President with a Reserve Chairman in whom he
does not have confidence is likely to lessen the influence of the Federal
98
Reserve rather than to increase it. As a practical matter, the benefits
from a semi-independent Federal Reserve like ours come mainly in
assuring that the points of view of the monetary authorities is strongly
stated and duly considered in governmental policy formation and execution. Thus, it is highly important that both the President and the
Congress respect and feel comfortable with the Chairman of the Federal Reserve Board, if he is to participate effectively in influencing governmental macroeconomic policy as well as overseeing narrower money
market actions of the Federal Reserve itself.
4 and 5. Since I believe that there are substantial benefits from
maintaining a semi-independent Federal Reserve along the general
lines we now have, I oppose placing the Federal Reserve under annual
congressional appropriations or providing for an audit of the Federal
Reserve by the Comptroller General of the United States. As a practical matter, to place the Federal Reserve under these two rules would
be to put it closely under the control of Congress and to subject it to
short-run, almost day-to-day, intervention and control by the Congress.
The evidence indicates that the Federal Reserve currently is effectively audited by an outside auditor and that it exercises commendable care in the expenditure of funds. The likely savings to the public
from these two steps would be minute; the likely cost would be great
through eliminating the degree of independence which the Federal
Reserve now has from short-run political pressures. The Congress is
free at any time, under the present arrangement, to intervene in Federal Reserve operations and to call the Federal Reserve to account.
No more direct control seems to me needed or appropriate.
STATEMENT OP MARTIN BRONPENBRENNER, CARNEGIE-MELLON
UNIVERSITY (PRO-TEMPORE) VANDERBILT UNIVERSITY
1. I find it more than usually difficult to reply to your most recent
questionnaire to economists, dated July 9 of this year. This difficulty
is not only due to the searching character of your questions, but involves
my incomplete sympathy with the Employment Act of 1946, which
you appear to take as given and propose to strengthen from the monetary side. In my view, this laudably intentioned statute, taken seriously and literally, opens the door to unlimited cost-push inflation by
collusive bargaining between business and labor, with price and wage
increases chasing each others' tails in spiral fashion. This is because
monetary and fiscal agencies would be obligated to "validate" by expansive policies each sucecssive round of wage and price increases, all
in the name of maintaining full employment and output, and maximizing the economic growth rate. Whatever the deficiencies of Federal
Reserve monetary management in the years since 1946, it has deserved
primary credit for preventing any such "Latin America, here we come"
type of runaway inflation.
2. My personnel monetary-policy view, spelled out most fully in the
Journal of Law and Economics (1965) is that the monetary authority should so regulate the money supply that in each period (month
or quarter) it grows at a rate equal to:
The estimated growth rate of the full-employment labor force
in that period, plus
The estimated growth rate of man-hour productivity in that
period, minus
The estimated growth rate of monetary velocity in that period.
99
In symbols: (dM/M) = (dL/L) + (d^A) - ( d Y / Y ) . This formula can be derived from the equation of exchange (MV = P Y ) by
relating national income ( Y ) to the labor force (L) and labor productivity (7R), (Y = LTT), and by holding the price level (P) constant
(dP = O). It makes no difference which detailed definition of the
money stock (M) one uses, provided only that the definition of the
income velocity of circulation (V) is consistent with our definition
of M.
3. This rule should be followed as closely as may be by the monetary authorities, with unavoidable errors in one period compensated
by adjustments in the subsequent one rather than being permitted to
cumulate. The mechanism of following this rule should be primarily
open market operations, and secondarily variations of commercialbank reserve requirements. (In my opinion, the present upper limit
on the commercial-bank reserve ratio is too low, and should be either
raised substantially or replaced by a limitation on the permitted rate
of increase per year.) We should also reconsider imposition on commercial banks of variable "secondary reserves" of Federal debt securities, as has been advocated many times.
4. The monetary rule, and its anticipated effects, should serve as
guides for policy recommendations by other public agencies, including both the Congress and the members of the Washington administrative "Quadriad" (Treasury Department, Council of Economic
Advisers, Bureau of the Budget) more directly concerned with taxation, public expenditure, debt-management, and employment problems.
You will notice that the rule says nothing of the foreign exchanges.
My belief is that, like commodity markets, they should be left free,
subject only to limitations on daily (or possibly also longer-period)
rates of change in either direction.
I should also propose removal of the existing prohibition of interest
payments on bank deposits, or of the existing legal maxima on rates
paid on time deposits, certificates of deposit, savings and loan shares,
and similar credit instruments.
5. The details of Federal Reserve System structure embodied in
H.R. 11 seem, if you will pardon my saying so, matters of subsidiary
importance. I should, instead, be interested in procedures for identifying and disciplining members of the Board of Governors, or subsidiary staff members, responsible for egregious and continued breaches
of the proposed monetary rule.
6. Should experience indicate that this rule poses insurmountable
estimation problems or disorderly interest-rate gyrations, or should
collusive-bargainers be able to "strike" against it effectively over long
periods, we may consider suspensions, modifications, or return to "discretion," but we should not assume the worst in advance. Furthermore,
we should realize both the necessity of threatened unemployment and
excess-capacity to keep cost pushers under control and the initial implausibility of such threats unless actual unemployment and excesscapacity are permitted after bargained wages and administered prices
rise.
7. My criticism of post-1964 monetary policy is twofold. Most importantly : The Federal Reserve System has permitted the monetary
growth rate (dM/M) to fluctuate between wide limits, first letting
inflation proceed almost unchecked and then causing near-panic con-
100
ditions by sudden applications of monetary brakes. (The resulting
rises in interest rates and declines of credit availability, called crunches
could have been avoided at least cost by slower monetary expansion in
the first place.) My less important criticism, at least for the short run:
The long-period or average growth rate of the money supply has
been somewhat too high, and interest rates somewhat too low for pricelevel stability.
8. I am aware of wide divergencies between the positions outlined
above and the current "conventional wisdom" within my profession.
Perhaps two closing statements are in order: ( 1 ) 1 should not be read
to imply that "only money matters," and (2) I see no dichotomy between monetary and fiscal policy. We need not choose between them, and
both can work in harmony. Among those economic authorities with
whom I find myself most nearly (although not completely) in agreement are Karl B runner, of Ohio State and my colleague, Allan
Meltzer, of Carnegie-Mellon (both of whom have worked with you
and your committee), Milton Friedman, of Chicago, and E. S. Shaw,
of Stanford.
Submitted with respect transcending any disagreement.
STATEMENT OF KARL BRUNNER, OHIO STATE UNIVERSITY
R E P L Y TO Q U E S T I O N N A I R E ON H . R .
11
I. 1 AND 2
Two conditions are both necessary and sufficient for a meaningful
"coordination" of monetary policy, fiscal policy, and debt management
policy. The first condition involves an adequate choice of objectives and
a sufficiently clear and stable concensus concerning the relative weight
assigned to the objectives selected. The second condition pertains to an
adequate knowledge of the economic process linking policy actions and
objectives. Neither condition has been satisfied by our policymaking
institutions. The authorities neglected to acquire an adequate knowledge of monetary processes linking policy and the behavior of bank
credit, interest rates, and money supply. This neglect obstructs rational monetary policies and causes serious misinterpretation by the
authorities of their own policy. In the absence of any reliable knowledge about the broad properties of monetary processes any requirement to coordinate policies remains quite useless. There is little
advantage in coordination executed in the context of serious misinterpretations concerning the structure of monetary processes.
The recent trend in policymakers' choice of objectives poses another
problem for meaningful coordination. Policymakers appear inclined to
extend and complicate the range of objectives. Moreover, they also appear inclined to modify quite rapidly the relative weight of various
objectives or constraints. In such contexts every policy mix actually
pursued can be easily justified to be optimally designed and properly
coordinated. For every policy mix there exists a set of objectives and
a conception of monetary processes which permits a policymaker to
claim optimality of existing policies relative to such conceptions and
selected objectives and in the absence of a comparatively stable consensus concerning objectives and in the absence of validated conceptions about monetary processes the requirement of coordination is
premature and useless.
101
I.
3.A
If the authorities possessed perfect knowledge about the structure of
monetary processes their policies could be directly adjusted in response
to the desired state of ultimate goals summarized by the Employment
Act. Our imperfect knowledge and the lag in the accrual of information
concerning the state of the economy make it advisable to guide monetary policies in response to an intermediate target intercalated between
the instruments used for policy actions and the ultimate goals. The
money supply (inclusively or exclusively) still appears at the present
stage to provide the most reliable shortrun target of monetary policy.
The transmission of monetary impulses to the pace of economic activity is mediated by a relative price process affecting the whole range
of assests and liabilities. The impulse reaches the demand for current
output via the substitution relations existing between the holding of
assets and the purchase of their services, or the substitutions between
existing and newly produced assets. In the context of this transmission
process monetary policy is not restricted to channels operating essentially via investment expenditures, neither is it dependent on the relative importance of borrowing costs or the sizable occurrence of credit
transactions.
The Federal Reserve authorities could execute the target policy in
the following manner.
(a) First, the authorities determine an acceptable range for the
growth rate of the money stock over the next 6 months (see I. 3.B for
further remarks on this point).
( i ) The authorities assess the expected movement of proximate determinants of the money stock (i.e. of currency ratio, time deposit
ratio, adjusted reserve ratio, and Treasury deposit ratio) for the next
2 or 3 months.
(e) With the assessment of the proximate determinants available,
the authorities determine the growth rate of the base for the next
2 or 3 months required for the average growth in the money stock
determined in thefirststep.
(d) The assessment of proximate determinants should be reconsidered every month and consequently also the required growth rate
of the base.
One last aspect needs emphasis at this stage. The dispute concerning
the optimal choice of intermediate targets remains quite unsettled. A
good part of the discussion bearing on these and related issues was
unfortunately not designed to settle the pending issues. Such discussions could become substantially more constructive if every participant would specify the analytical and evidential results which will
dispose him to accept or reject any specific traget proposals, including
his own. These conditions wrould reveal more sharply the existence
or1 absence of an adequate analysis in support of a particular proposal.
I . 3. B AND D
Under the present circumstances broad indicators of economic activity closely associated with our ultimate goals offer poor guidance
for the continuous adjustment of policy. It was stated above that
the growth rate of the money stock is the most useful tjarget at present.
It would be inappropriate however, in the context of fixed exchange
102
rates, to impose a rigid constraint on the required growth rate of the
money stock. Monetary growth should be maintained within a band
(say 2-6 percent p.a. for the exclusive money stock) without any sharp
reversals and counterreversals following in close succession as in the
recent past. Adjustment of monetary policy to the conditions of the
balance of payments does not require the pronounced short run instability exhibited by past policies. A 6-month target between 2 percent
and 6 percent without radical changes between successive 6-month
periods should be sufficient to cope with balance-of-payments problems.
Frequent or decisive changes in the target should be justified by the
Federal Reserve authorities by a detailed analysis submitted to the
appropriate congressional committees. The procedure described is
loose and flexible enough to permit operation over several years. A
gradual adjustment with growing experience will unavoidably occur.
I.
3F
The Federal Reserve authorities should have the power to change the
growth rate within the band described above. Similarly, they should
be given the right to move on exceptional occasions outside the band.
In the latter case and in case the authorities change the target by
more than 1 percent between any two adjacent 12-month periods a
detailed report and analysis justifying the decision would be required.
The reports submitted should be subjected to hearings by appropriate
congressional committees. This procedure imposes some restrictions
on Federal Reserve policy and also generates pressures to acquire
better validated conceptions which are exposed to critical examination.
I.
5.A
The criteria guiding the Federal Reserve's defensive operations
dominated on many occasions its policy conception and reinforced
the misinterpretations of policy. The constraints on the required
growth of the base sketched above would sufficiently attenuate at the
moment the concern for defensive operations. Further restrictions
appear unnecessary at the moment.
I . 5. B A N D O
Neither academic literature nor Government documents have ever
established a case for the existence of reserve requirements or the
Federal Reserve's power to change the requirement ratios. Similarly,
no relevant analysis or evidence has ever been presented on behalf
of regulation Q. And the case for discount policy rests essentially on
strictly political considerations. From the point of view of a rational
monetary policy designed to shape a stable movement in economic activity, open market policy is the only instrument required for the
authorities. All the other instruments were dominantly used for
political purposes, or purposes of income distribution or allocative
purposes. The use of monetary policy instruments for purposes other
than monetary stabilization only aggravates the problems of confronting the Federal Reserve authorities.
103
I . 5. D AND E
The requirement of quarterly reports would contribute to the development of a greater sense of intellectual responsibility on the part of
the Federal Reserve authorities. The reports could be an excellent
device compelling the authorities to acknowledge their responsibility
to execute policy on the basis of whatever systematic knowledge is at
their disposal. The reports should require a description of their recent
policy including a detailed and specific justification for the interpretations advanced. The reports should also explain the recent movements
in the money stock and the role of policy in the observed behavior.
Moreover, the reports might usefully include projections of the money
stock and bank credit and describe the policy required to realize
such projections.
I I . 1 TO 5
The first proposal has little bearing on the conditions for a rational
monetary policy and the last proposal does not promise suitable pressures for a rational longrun policy.
Proposals 2 and 3 simplify the Federal Reserve's organizational
structure and should be welcomed. Proposal 4 might obstruct an allocation of resources by the Federal Reserve System which cannot be
justified in terms of monetary policy considerations and the conditions
required to prepare and execute a rational policy.
n i
Four aspects of oue monetary policy pursued since 1964 should be
recognized.
(a) The misinterpretation of policy conveyed to the public and the
press in the late fall of 1965. The increase in the discount rate was
generally interpreted as a move toward a more restrictive policy.
Policy became actually more expansionary until May/June 1966.
(5) A sharp reversal occurred around May/June 1966. The break
in policy was sudden and substantial. This reversal in policy was the
single most important factor contributing to the minirecession of
1967.
(o) A counterreversal occurred in November/December 1966. This
counterreversial was at least as sudden and pronounced as the previous reversal and prevented the retardation beyond the scope of a
minirecession. Policy during the year 1967 followed one of the most
expansionary courses on record, and contributed to the substantial
accelerations in economic activity and the price movements.
(d) Monetary policy continued in 1968 to apply substantial thrust to
the economy. Until August 1968, monetary policy has not contributed
to any significant retardation. But the aibsence of any further accelerations in current monetary policy generates a state where the consequences of last year's accelerations exert a slightly retarding effect.
Even without a sharp deflationary break in monetary policy we
should expect a moderate retardation in our economy this winter.
104
STATEMENT) OF MEYER L. BURSTEIN, WARWICK UNIVERSITY
AND ASPEN, COLO.
ANSWERS TO "QUESTIONS ON MONETARY POLICY GUIDELINES A N D OPEN
MARKET OPERATIONS"
1.1. Surely monetary and fiscal policies should not be treated as
independent.
2. H.R. 11 concerns the President's recommendations. Obviously the
President should alone be responsible for his own recommendations.
The question verges on larger questions of distribution of monetary
powers between the Executive and the Federal Reserve. Ideally such
powers should, I think, be concentrated in the former. Political
realities appear to favor the present arrangements.
3.a. My views on the theoretical aspects of this problem are fully
expressed in two books. M. L. Burstem, Money (Cambridge, Mass.:
Schenkman Publishing Co., Inc.; 1963) and M.L. Burstein, Economic
Theory: Equilibrium <& Change (London: John Wiley & Sons, Ltd.;
1968), esp. ch. 13. I would argue for a minimum of specificity in
H.R. 11 and perhaps to that extent am unsympathetic with H.R. 11 itself. Thus the quoted language would be improved, I think, by eliminating the words, "including the money supply as defined by him."
Turning to the question itself, I can think of no sensible reason for
concern with money supply for its own sake. So naturally I would be
more interested in policies focusing on such variables as interest rates
and credit availability, affected by monetary policies as they are, than
in policies focused on "M" purely and simply. The complexity of the
underlying analytical and practical problems is such that no specific
language should appear in the bill: it is enough to state that the President should give views on monetary policy. Elementary considerations
of legal draftsmanship as well as those of economic theory support this
conclusion.
3.b. In this context past performance is interesting only to the
extent that it permits prediction of future events. And, since econometrics is so crude a technique dealing with so difficult a subject, no specificity should exist on connection with these indexes.
3.c. I think that the question is rather futile. See my answer to 3.b.
3.d. Obviously one must be extremely flexible about this sort of
thing. Under no circumstances would wTe wish to give Government
functionaries incentives to cook their statistics in order to support one
or another rigid theory which they have become identified with.
3.e. No answer.
3.f. I would make no mandatory limitations. I am positively opposed to simplistic "rules" for monetary policies. I surely am opposed
to putting authorities into "statistical" straitjackets. My concerns along
these lines are heightened by international considerations. The ideology
which appears to underlie H.R. 11 included floating exchange rates.
But, so long as we do not have floating exchange rates, BOP considerations must loom large in official calculations and will from time to time
lead to substantial departures from paths suggested by internal considerations only.
4. Debt management can, I think, play a limited part, a distinctly
limited part, in implementing these policy goals. Only massive debt
management operations carried on over short intervals could have
105
much impact. These are empirical judgements. There is sound theoretical authority for debt-management operations to have some effects.
5.a. Let me begin by stating my strong opposition to the language
stated in 5.1 think it important that the deliberations of the Federal
Eeserve Board not be published and am unhappy about the degree of
publication which already has taken place. Such publicity is inconsistent with discretionary policies, and discretionary policies are favored
by me. (Cf. my answer to 3.f.) Of course, open market operations
inevitably will be used for defensive purposes from time to time: the
authorities cannot identify the forces against wThich they are operating
until rather long after the fact. Nor can I categorically oppose openmarket operations in this connection. Still I favor Federal Reserve
discounts and advances as the preponderant defensive device as did
the Mitchell committee: open-market operations are a crude procedure
to control forces which tend to operate unevenly, both geographically
and otherwise; the "size" of the defensive operations usually is open
ended while open-market operations are difficult to fine tune to that
extent.
5.b. No. My answer to 5.a goes far to support this answer. Obviously
the relationship of FR discount rate to market rates is considerably
important: large open-market sales would be less effective if discount
rate were permissive for example. Of course, we must distinguish
between open-market operations designed simply to accomplish a certain change in the monetary base from others in which the operator is
instructed to deal freely at specified bill rates: the latter instance has
effects not greatly different from policies geared to bank rate in the
traditional British fashion for example.
5.c. I have indicated that I regard rediscounting as a legitimate and
significant central-banking device. And reserve-requirement changes
can, from time to time, be useful, noting that greater selectivity of
impact effects is possible through these. I do not esteem regulation Q
in this connection. I would not refer to these matters in H.R. 11.
5.d. I make clear in 5.a that I am opposed to requiring the Federal
Reserve to make such reports. The upshot would find the Federal
Reserve more conscious of the political implications of their actions
than now is the case and would tend to polarize attitudes: as in the
United Nations, the political consequences of backing down tend to
become amplified under the glare of publicity.
5.e. None. This humiliating suggestion would cause the Board simply
to meet in each other's homes in secret.
II.l. No comment.
2. I favor this. An incompetent member now is permitted too long
a tenure if indeed competence ever has been critical for reappointment.
3. No, I am opposed. This would put the Federal Reserve into the
heart of politics, leading up to a worse system than at present: there
would be no real independence of the Federal Reserve but there would
be considerable administrative and other confusion.
4. Why?
5. Machievelli said, "either embrace men or annihilate them." Contumacious and petty measures such as this would not destroy the
powers of the Federal Reserve but would poison the atmosphere of
monetary policymaking.
III. This is too large a matter for treatment in this format.
21-570—68
8
106
STATEMENT OF PHILLIP CAGAN, COLUMBIA UNIVERSITY
I . ON MONETARY POLICY GUIDELINES AND O P E N - M A R K E T OPERATIONS
1. Do not use fiscal policy for stabilization. It is too slow and
cumbersome.
2. A program a year ahead is too far ahead to plan and is, therefore, impracticable. Policy changes need to be flexible. Only set
general policy for the year, provisional guides.
3. Concerning monetary policy guidelines:
A. Goal: Currency outside banks, plus demand and time
deposits. Target: Monetary base.
B. It is best to keep an even rate of growth to avoid disruptions—with only slight variations.
C. Nocomment.
D. Guidelines should be reviewed periodically—cannot look
a year ahead.
E. The guidelines should be determined by price trends.
F. Flexibility of money supply growth outside the guidelines should be allowed to some extent if recession develops or
price trends change.
4. Concerning debt management policy. Avoid rocking the boat.
Keep average maturity relatively constant.
5. Concerning open-market operations:
A. I agree with ignoring transient influences in conducting
open-market operations, but we must give marketing institutions time to adjust to this change of Fed behavior whereby
a money supply growth rule is followed.
B. Monetary policy can be implemented solely by openmarket operations.
C. Abolish rediscounting; do not change requirements;
abolish regulation Q.
D. There is no need for a report. Avoid wasteful paperwork.
If policy were a certain rate of monetary growth, intended
rate could be announced.
E. I see no merit in having observers at open-market committee meetings. Acrimony and indecision would result. Avoid
dispersing decisionmaking power.
II. No comment.
III. Concerning recent monetary policy, there has been too much
fluctuation in the money supply. This has been disruptive to the
economy.
STATEMENT OP GREGORY C. CHOW, IBM RESEARCH CENTE1
I . ON MONETARY POLICY GUIDELINES A N D OPEN M A R K E T OPERATIONS
1. I believe that a program coordinating fiscal, debt management,
and monetary policies should be set forth at the beginning of each
year for the purpose of achieving the goals of the Employment Act.
2. I believe that the President should be responsible for drawing
up this program.
107
3. Concerning monetary policy guidelines:
A. I believe that monetary policy should be used via intervention of money supply (defined as currency plus demand deposits
adjusted) alone. Interest rates, like other prices, should not be directly manipulated but left to the determination by market forces.
High-power money cannot serve as a target, but only as an instrument, since it affects the level of economic activity only indirectly
through its effect, among the effects of other factors, on the quantity of money. The Federal Reserve may be given much discretion in choosing the means of controlling the target variable (the
supply of money). It is fully recognized that the level of economic
activity is governed by other factors than the supply of money
(current, past, and even expected in the future), but controlling
this variable can diminish economic instability and promote economic growth.
B. The guidelines of monetary policy should be specified in
terms of the target variable's value or growth, rather than some
index of past, present, or future economy activity, because we do
not yet know precisely enough the dynamic relationships between
the target variable and future indexes of economic activity, and
because too much manipulation of money supply would by itself
create uncertainty in the economic world, thus leading to economic
instability.
C. Not relevant for my position.
D. The same guidelines should be used each year into the foreseeable future, again because of the reasons stated in B above.
E. I recommend 3.5 to 4.5 percent per year for the range of
growth of money supply (currently plus demand deposits adjusted) for the following reasons.
Empirical studies of the past seven decades, including my
own, have shown that the demand for money in constant dollars
is proportional to real GNP, given the rate of interest, and decreases by about 0.75 percent for a 1-percent increase in the rate
of interest. These findings are also consistent with postwar experience. From 1950 to 1967, real GNP grew at an average annual
rate of 3.7 percent, while the rate of interest increased at an average rate of 4.1 percent, thus accounting for about 3.7-(.75) 4.1
or 0.6 percent increase in the demand for money per year. Since
the supply of money increased at an average annual rate of 2.6
percent, the excess of supply over demand, at about 2 percent per
year, is sufficient to explain the rise in price (at an average annual
rate of 1.9 percent by the Consumer Price Index, or 2.2 percent
by th GNP deflator) during the same period.
Thus, if the rate of interest were to be kept from rising, the
supply of money should be increased at the same rate as real GNP.
From the experience of the last 5 years (1962-67), real GNP was
capable of growing at an annual rate of 4.7 percent. Therefore,
the growth of the stock of money at a rate of 4 percent can be
absorbed by the growth of real GNP without causing inflation
and rising interest rates—witness the period from 1962 to early
1965, when the stock of money was rising at about 4 percent per
year and both the rate of interest and the price level were fairly
stable.
108
A question still remains. Although a 4 percent growth in money
supply and in real GNP is consistent with stable price and stable
interest rate, can one exclude the possibility of rising price, to be
compensated for by rising interest rate ? This possibility is unlikely
if the rise in the rate of interest in the past has been due to insufficient money supply, or to the expectation effect of inflation resulting from an excess of money supply in certain periods. Both of
these causes will be weakened by the introduction of the policy
here recommended. Note, however, that insofar as the rate of interest is also affected by other factors, it may experience a rising
(or falling) trend independently of the monetary policy here
recommended, and should this happen, the demand of money
would fall (or rise), thus requiring a smaller (or greater) increase in money supply.
F. From the analysis just presented, I recommend that the range
of 3.5-4.5 percent for the rate of growth in money supply be adhered to for at least 5 years. After that, the range may be adjusted
for another 5 years only if there should be strong evidence for a
serious inflationary or deflationary trend observed during the first
5 years. Under no circumstances should monetary authorities be
permitted during the year to adjust the target variable outside the
range issued at the beginning of the year.
4. Concerning debt management policy: I believe that debt management has little role to play in this matter. Debt management here
presumably means managing the composition of Government debt, not
its total which is the result of past Government deficits and surpluses.
I share the view of the majority of economists that the quantity of a
certain form of assets, namely, money, has more influence on economic
activities and especially on the price level than does the composition of
one type of assets, namely, Government debt.
5. Concerning open market operations:
A. I do not recommend using open market operations to counteract seasonal and other transient factors affecting money market
and credit conditions.
B. I believe that monetary policy can be effectively and efficiently
implemented solely by open market operations.
C. For the purpose of stabilizing the rate of growth of money
stock, I do not see that changes in (a) rediscount rate and (b)
reserve requirements can accomplish any more than what open
market operations can. I am not in favor of regulation Q, or any
Government attempt to control the rate of interest in the market.
D. I see no compelling reason for requiring the Federal Eeserve
Board to make detailed quarterly reports to the Congress on past
and prospective actions and policies. As long as the President
shall transmit to the Congress by January of each year a program
including the growth of the money supply, it is not essential for
the Federal Eeserve Board to make detailed quarterly reports to
the Congress. Such a requirement may facilitate control of the
Federal Eeserve Board by the Congress, but if the President is to
coordinate monetary and fiscal policies under the amended Employment Act of 1946, it is his responsibility to insure proper
execution of these policies. The real question is .how the President
can fulfill his responsibility if the Federal Eeserve Board reports
directly to the Congress.
109
E. It is unnecessary to require representatives of the Congress
to serve as observers at Open Market Committee meetings because,
once given the responsibility and the rule of conduct, the Open
Market Committee should be given a free hand to discharge its
responsibility. If the committee should consider it beneficial to
have observers from the Treasuiy and the CEA (or from the
Congress), it could invite them on its own.
II. APPRAISAL OF THE STRUCTURE OF THE FEDERAL RESERVE
1. I have no strong feeling about the retiring of Federal Reserve
bank stock;
2. I am in favor of reducing the number of members of the Federal
Reserve Board to five and their terms of office to no longer than
5 years;
3. I am in favor of making the term of the Chairman of the Board
coterminous with that of the President of the United States;
4. I am in favor of an audit for each fiscal year of the Federal
Reserve Board and the Federal Reserve banks and their branches
by the Comptroller General of the United States;
5. As in II.l above, I have no strong feeling about the appropriation of funds by Congress to operate the Federal Reserve System.
The proposal under H.R. 11 seems superior to the existing arrangement, but the latter is not the main defect of the Federal Reserve
System today.
N I . COMMENTS ON RECENT MONETARY POLICY
I would not wish to attribute changes in economic activity since
1964 to specific monetary policies, because I believe that the assignment of cause and effect cannot properly be made by simply citing
the movements up and down of a few economic variables, especially
when the history is so short and recent. I would also warn against
readily accepting the criticisms of the Federal Reserve which are
based on such citing of movements between a few economic variables.
For example, whether the slow monetary growth in 1966 was the
main cause of the mini-recession early in 1967 can be answered only
by a much more elaborate analysis than the presentation of these facts
alone.
STATEMENT OF CARL F. CHRIST, THE JOHNS HOPKINS UNIVERSITY
DEIAR ME. PATMAN : I am honored by your request for my views concerning
H.R. 11. The pressure of other commitments has prevented me from writing a
detailed reply to your thoughtful questions.
However, I believe that my testimony before the Joint Economic Committee
on May 9, 1968, will give you a good deal of information about my opinions
concerning the proper relationship between the Congress and its creature, the
Federal Reserve System.
(The testimony follows:)
Mr. CHRIST. I am very glad to be here today, Senator Proxmire,
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
110
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.
At the outset we have to admit that we cannot hold the Federal
Reserve responsible for everything that happens in the economy. In
the first place, there are other factors 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 that 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 effect will be felt
next month or next quarter.
But even granted perfect prediction, we could not hold the Federal
Reserve responsible for everything, 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, acting under instructions from the Congress, undertakes a large increase
in spending, and that the Congress does not increase tax rates—when
I wrote this, the Congress didn't look as though it was going to
increase 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 expenditures 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 securities 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 Treasury 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
increases 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 stabilizing interest rates while the money stock falls, but cannot stabilize both.
Ill
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.
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 percent, 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; everyone agrees that this was far too fast for stability. During the depressions of 1921 and 1929-33, and all the recessions since 1921—they
were in 1924, 1927, 1938, 1949, 1954, 1958, 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. Similarly, a prolonged period of rapid growth in the money stock aggravates any
overheating that is in progress or that might develop.
112
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 Eeserve 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 Eeserve to follow any such rule, the Congress would thereby
restrict its own freedom of choice in some situations. Consider again
the case in which the Congress provides for a large increase in expenditure with no increase in tax rates, so that a large deficit develops.
If the Federal Eeserve 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 either—an undesirable situation. Notice that, if the Federal Eeserve 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
inflation, 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 increasing the amount of Government debt in private hands (that is, by
borrowing from the private sector). By choosing the level of Government 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 Government debt in private hands. The most important function of the Federal Eeserve is to control how this deficit financing is to be divided
between increasing the stock of money and increasing the amount of
privately held Government debt. This the Federal Eeserve does chiefly
by deciding what amount of Treasury securities 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 been speaking of a deficit, but if there is a budget surplus the
opposite choice is open to the Federal Eeserve, decrease either the
money stock or the private holdings of Government debt.
Just as the Congress has the authority to fix Government expenditures and taxes, and thus to fix the budget deficit, so the Congress has
the authority to decide how much of the 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 Eeserve ought to make the stock
of money grow at a rate between 2 and 6 percent a year. But the foregoing 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 dumped
on the private market by a budget deficit are not too large, and
113
conversely so that the amounts of Government securities taken out of
private hands by a budget surplus are not too large.
When I say the budget deficit or surplus should be kept within
suitable limits, I mean a range something like a deficit of from $15 to
$17 billion on the one hand to 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,
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 goods and services for
Government programs. Or the Federal Reserve alone can stimulate
aggregate demand by buying securities for the private sector 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 certain
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 Federal Reserve
is required.
It is extremely important to realize that the policies required of
the Treasury and the Federal Reserve to achieve the domestic objectives of full employment and stable prices will sometimes conflict with
the achievement of balance-of-payments equilibrium at a given exchange 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 reserves, we can continue in deficit on our balance of payments, but only
until the reserves are gone. Our other choices, among which wre may
choose now, but among which wTe 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.
114
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
judgment as to whether economic conditions are—or soon will be—too
bouyant or to 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.
There is the end of my opening statement, Senator Proxmire. I have
an appendix of tables at the end of the prepared statement that might
be useful
Chairman P R O X M I R E . Without objection it will be printed in the
record in full.
Mr. C H R I S T . Thank you very much.
(The appendix tables follow:)
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 money
stock
during
recession
Month during which the money stock reached its peak
March 1920
December 1922
September 1925
October 1929
March 1937
January 1948
July 1953
July 1957
July 1959
Number of
months before
the money
stock regained
its previous
peak level
15.0
2.0
3.0
33.0
6.0
2.0
.2
1.0
3.0
Source: M. Friedman and A. Schwartz, " A Monetary History of the United States." pp. 709-715, and
Bulletin, June 1964, pp. 682-690.
53
10
26
79
20
27
9
9
27
Federal Reserve
TABLE 2.—RATE OF CHANGE OF T H E U.S. MONEY STOCK ( D E M A N D DEPOSITS A N D CURRENCY, SEASONALLY
ADJUSTED) ANNUAL PERCENTAGE GROWTH RATES FOR CALENDAR YEARS AND QUARTERS, 1956-68
Rate for
rolonHar
Odiciiual
year
Year
1953
1954
1955
1956
1957
1958
1959
I960....
1961
1962
1963
1964
1965
1966
1967
1968
-
il.l
2.7
2.2
1
1.3
1
—. 7
3.8
1.6
i —. 6
3.0
1.4
3.8
4.1
4.7
2.2
16.3
Rate for calendar quarter
1
2
3
U.9
11.2
4.0
11.5
i.O
U.8
4.0
1-2.8
2.6
U.7
3.8
2.9
2.5
5.8
16.3
4.2
U.6
2.2
2.4
1.9
i.O
5.6
2.5
i -2.3
2.8
1.5
4.3
3.9
3.5
3.3
17.2
10.3
3.1
U.8
1.6
1-.3
3.2
i -.3
2.9
2.5
i - l . l
2.9
16.2
5.7
i —. 2
16.8
4
10.6
4.2
1.6
2.1
1-2.6
4.6
i -3.9
i.O
4.2
4.4
4.0
3.3
16.8
i —. 2
5.1
i 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.
115
TABLE 3.—AVERAGE ANNUAL GROWTH RATES OF SELECTED INDICATORS FOR THE U.S. ECONOMY OVER THE
PERIOD FROM 1948 TO 1967
[In percent]
Total
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
Price level (GNP deflator)
Population
GNP in money terms
GNP in real terms
U.S. Government debt privately held
Time deposits (commercial banks)
Money stock (currency plus demand deposits)
Money stock plus time deposits
U.S. Government debt privately held, in real terms
Time deposits in real terms
Money stock, in real terms
Money stock plus time deposits, in real terms
Velocity of money (GNP divided by the money stock)
Interest rate (Aaa bonds)
2.1
1.6
6.0
3.9
.7
8.7
2.4
4.6
—1.4
6.6
.3
2.5
3.6
3.6
Per capita
4.4
2.3
-.9
7.1
.8
3.0
-3.0
5.0
—1.3
.9
Source: Federal Reserve Bulletin, and Economic Reports of the President, 1968.
Chairman PROXMIRE. Thank you, Professor Christ.
STATEMENT
OF JACOB COHEN, UNIVERSITY
OF PITTSBURGH
I. REPLIES TO QUESTIONS ON MONETARY POLICY GUIDELINES AND OPEN
MARKET OPERATIONS
1.1 am in favor of a coordinated projection of fiscal, debt management, and monetary policies.
2. For purposes of centralized coordination, the President should be
responsible for drawing up the program.
3A. Recent discussions of "indicators" and "targets" have the virtues
of encouraging research on the linkages between monetary policy and
real output. At the same time, however, incomplete knowledge about
these linkages means that reliance on simplistic approaches—single indicators or targets—run the risk of failure.
An implicit assumption in such research is that monetary policy
must work through general quantitative controls rather than through
selective controls. Whether this is based on likely effectiveness or doubts
as to the political feasibility of controls are questions not found discussed in current monetary debates. From the standpoint of objective
economic analysis it is helpful to distinguish between the "economics"
and "politics" of economic policy.
While the linkages going from monetary policy to expenditures have
not been satisfactorily worked out, the linkages going "backward" from
expenditures to monetary policy are more certain. Expenditures by the
various sectors of the economy must be financed out of current income,
out of borrowing, out of dissaving (sale of existing physical assets, sale
of financial assets, reductions in money holdings). While these sources
of funds may not be sufficient conditions for an increase in spending—
nonfinancial sectors in the economy initially have to make decisions to
spend—yet these decisions are contingent upon sources of funds. The
analysis of monetary policy should put more emphasis on the final
linkage—the necessary conditions for expenditure.
Income flows are not directly affected by monetary policy. On the
other hand, financial sources of funds (borrowing, financial dissaving)
are the concern of monetary policy. We suggest that the appropriate
116
target for monetary policy is the volume and composition of financial
(credit) flows. While possibly this can be regarded as a "single" target, it is sufficiently comprehensive to be free of the limitations of
other targets currently being advocated.
The contemporary debate on targets centers on the use of the money
stock and on interest rates. Interest rates are an unsatisfactory target
because the relationship between interest rates and financial flows is
not a negative one. For interest rates to be a satisfactory target variable, increases in interest rates should indicate that financial flows are
being restrained and decreases that financial flows are being encouraged. A study of the statistical data (quarterly data 1952-67, seasonally adjusted and unadjusted) reveals that the corporate bond rate
and other money market rates and net funds raised by private domestic
nonfinancial sectors have moved in the same rather than in opposite
directions.1
If we correlate expenditures on consumer durables, residential construction by the household sector with both household personal savings and interest rates and similarly correlate corporate business
expenditures on inventories and plant and equipment with business
gross saving and interest rates, the same positive relationships appear
between expenditures and interest rates. Underlying these positive
correlations is the strong demand for credit in the postwar period.
If we conceive of financial markets in terms of supply and demand
curves for credit, these correlations suggest that the demand side of
the market has shown sharper fluctuations than the supply side. The
demand for credit has been the dynamic element responsible for both
fluctuations in interest rates and credit flows. Unless higher interest
rates originate on the supply side, interest rates will prove to be a
misleading target for monetary policy.
Some positive correlation can be found in the seasonally unadjusted
data between changes in the money stock (defined as net demand
deposits, foreign deposits plus currency outside banks) and net funds
raised by private domestic nonfinancial sectors. This relationship is
illusory, however because changes in the private sector's holdings of
money are a component of net sources of credit which in turn equal
funds raised by private sectors. If we subtract changes in the private
sector's holdings of money from net funds raised, the relationship
becomes significantly negative. If we expand the concept of funds
raised to include financial dissaving by the household and corporate
business sectors the negative relationship between these flows is further
strengthened. In view of these relationships, the money stock, like
interest rates, fails to offer a satisfactory proxy for the behavior of
financial flows.
Bank credit represents the category of financial flows with the
closest linkage to monetary action. As evidenced in the experience of
1966 sharp variations in the rate of growth of member bank reserves
together with maintenance or reduction of ceilings under regulation
Q can succeed in reducing the rate of increase in bank loans. It is
questionable however, whether the efforts of the Federal Eeserve can
be regarded as an unqualified success in view of the ensuing "liquidity
crisis."
11
am Indebted to Philip Wiest for running the regressions underlying these paragraphs*
117
More attention should be given to the possibilities of direct control
of bank credit. Because borrowers from banks have limited ability
to substitute one source of funds for another, control of specific categories of bank credit should be effective in controlling specific categories of expenditures. This empirical relationship between bank
loans and expenditures was recognized in the fall of 1966 when the
Federal Reserve attempted to control the boom in business capital
outlays by controlling business loans. If the Federal Reserve had the
power to impose special reserve requirements against bank business
loans the expansion in capital outlays could have been controlled
earlier in the boom without precipitating instability in finanicial markets, particularly the market for municipals. Consumer credit controls,
special reserve requirements against bank loans, secondary reserve
requirements against deposit liabilities—these are devices which have
a current or potential usefulness.
The regulation of an economy's expenditures by such specific controls has less analytical appeal than the development of "pushbutton"
controls or attempts to put the economy on "automatic pilot." Yet
there is ample intellectual challenge in evaluating (a) the past effectiveness of specific controls in the United States and Western Europe,
(b) the selective effects of general controls^ (c) the ability to "finetune" selective controls and (d) the transitional problems associated
with their introduction. Whether we are less economically free when
we are subject to such controls as compared with the effects of inflation
is a related philosophical issue.
B. While we suggest total financial flows in the economy as the
appropriate target, we would be opposed to guidelines which call for
a fixed rate of growth in financial flows. The composition of financial
flows and their linkages with real spending and financial spending
should temper any decision as to the appropriate rate of growth. For
example, a distinction would have to be made between a sector's borrowing or financial dissaving which financed real expenditures and
borrowing or financial dissaving which represented simply a shift in
portfolio composition. In the latter case, the extent of "financial overlay"—the ratio of financial flows to real expenditures would be changing and this would have to be considered. Secondly, a given volume of
financial flow may be increasingly directed into certain "bottleneck"
areas of spending and thus exert an inflationary effect even though
totalflowTsremained relatively constant.
Rather than gearing policy to the volume of financial flows the
monetary authorities should attempt to estimate the interplay of real
and financial flows in the economy. By projecting a "grid" of real and
financial transactions for the major sectors of the economy the monetary authorities would be better able to determine the optimal rate
of increase infinancialflows.
4. In times of depressed economic activity debt management can
minimize the Federal sector's competition for funds by selling of debt
to the banking system. If sold to the central bank (the law permitting) , variations in reserve requirements could control private bank
credit expansion in subsequent inflationary periods. If sold to the
commercial banks, supplementary reserve requirements which could be
satisfied by commercial banks' holding government securities would
prevent commercial banks from shifting from investments in governments into more profitable private loans.
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5A. Open-market operations should be used to counteract transient
factors (including seasonal factors) which otherwise would cause
short-run instability in interest rates. While the economy could possibly tolerate an increase in short-run fluctuations in interest rates,
the increased uncertainty as to interest rates could mean higher average interest rates with adverse effects on real investment.
Open market operations conducted with a view to offsetting transient
movements in bank reserves may conceivably exert their own unsettling effects on interest rates particularly in the Government securities market. Presumably, however, the instability in interest rate movements would be even greater without such intervention. Possibly the
revised use of the discount window as proposed by the Federal Reserve
can provide an adjustment mechanism without requiring open-market
transactions, thus avoiding interest-rate effects.
B. Rather than depending on the uncertain linkages running from
open-market operations to expenditures on the GNP, reliance should
also be placed on the control of credit by selective means, such as special
reserve requirements against deposit liabilities or certain categories
of bank assets, or downpayment and maturity requirements in the
case of consumer and mortgage credit.
C.(a) Rediscounting should be retained as a safety valve enabling
banks to make short-run adjustments in their reserves as the result of
seasonal or other transient factors. It is difficult to think of any useful
purpose being served by discretionary changes in the discount rate.
Recent Federal Reserve proposals to give commercial banks a basic
borrowing privilege with the discount rate moving with a "cluster"
of money market rates is a step in the right direction.
(b) More attention should be given to making variations in reserve
requirements a "two-way street." While increases are deemed a bluntedged instrument, such drastic action may sometimes be necessary.
With the likelihood that Federal borrowing will increase substantially
in the near future, the direct or indirect sale of debt to the Fed could
economize on Treasury interest payments. Increases in reserve requirements under such circumstances would control credit expansion based
on the associated increases in bank reserves.
(c) A major factor in shifts in funds between commercial banks and
savings institutions in recent years has been the upward adjustment
of interest rates on time deposits under regulation Q. The pre-1960
situation when time deposit rates were not competitive has much to
recommend it. The crunch of 1966 could possibly have been avoided
had successive increases in ceiling rates not taken place.
H.R. 11 could be amended on page 10 line 16 after "monetary affairs"
to state "including discount policy, reserve requirements, administration of regulation Q and the provision of stand-by powers to impose
selective credit controls."
D. The idea of reporting is a good one except that it would be more
consistent with the role of other departments or agencies involved in
economic policy for the Federal Reserve to report directly to the
President.
If reports are made quarterly the requirements should be for rather
general reports because of the possible tieing up of the resources of the
Federal Reserve in preparing such reports. The problem of timelags
in the availability of data would also be an argument for rather general
quarterly reports.
119
More detail could be provided in an annual report. Such reports
would have great usefulness if formulated in a flow-of-funds framework which forecast the likely expenditures and sources of finance of
the major sectors of the economy. The Federal Reserve has made internal use of the flow-of-funds accounts for projection purposes. Their
forecasts have never been published nor a step-by-step explanation
given of their derivation. Such projections would make explicit the
anticipated financial flows accompanying real spending plans and
would offer advance warning as to likely pressure points in the economy. The kinds of financial flows that need restraining could thus
be singled out.
E. Since H.R. 11 calls for the abolition of the Federal Open Market
Committee, the intent of this question is not clear. If open-market
authority is entrusted to the Board, it should be at the discretion of the
Board as to what other agencies of Government participated in their
deliberations. Informal consultations with other departments or executive agencies or with Congress are of course possible and have been
customary in the past.
I I . APPRAISAL OF T H E STRUCTURE OF T H E FEDERAL RESERVE
I would be in favor of all of the structural changes proposed with
the exception of 5-year terms for members of the Board. Overlapping
10-year terms would provide better continuity to the Board. Making
the term of the Chairman of the Board coterminous with that of the
President is an important step toward coordination of monetary and
fiscal policies under the President.
M.
COMMENTS ON MONETARY POLICY SINCE
1964
The outstanding impression provided by monetary developments
since 1964 is that we are in an era of inflationary pressures generated
by the competition of rising public expenditures with rising (and
possibly induced) private outlays. It is too must to expect that
conventional "hands-off" types of general monetary controls can succeed in curbing inflation. These must be supplemented by controls
which directly affect the sources of finance of "trouble-making" private
expenditures.
STATEMENT OF ROBERT L. CROUCH, UNIVERSITY OF CALIFORNIA
AT SANTA BARBARA
I . QUESTIONS ON MONETARY POLICY GUIDELINES AND OPEN MARKET
OPERATIONS
The economic authorities have three basic shots in their stabilizing
locker; debt management, fiscal, and monetary policy. Of these, the
former is distinctly less powerful than the latter two. It is residual to
the fiscal policy adopted. Given a certain budget deficit or surplus, new
securities have to be issued or old securities have to be retired. The
only decision is, which securities ? Potentially, this gives the economic
authorities some discretion over the structure of interest rates. If, in
the face of a budget deficit, they increase the issue of short-term
securities relative to long-term securities, they will raise short rates
120
relative to long rates; and vice versa. The impact of changes in the
structure of interest rates on aggregate economic activity is quite
limited, however. Consequently, the responsible authorities should
pursue what might be described as a balanced portfolio approach to
the problem. They should supply those securities which, in their judgment, the market is most readily prepared to absorb. Under no circumstances should they subordinate their monetary policy to the exigencies of debt management or fiscal policy. For example, the Federal
Reserve should not be pressured into purchasing Government securities
in an attempt, which would prove fruitless in the long run anyway,
to hold down the interest burden of the Government debt. The implications of the economic authorities' fiscal decision has inevitable repercussions on the level of Government debt. The monetary authorities
should not feel circumscribed in their policy by changes in the debt one
way or another. In particular, they should not feel obliged to bail out
the fiscal authorities from the repercussions of their actions which, in
the operationally most relevant case of a budget deficit, is higher interest rates. A given fiscal policy implies a certain debt. That should
be financed most "efficiently," that is, at the lowest cost but without
subordinating monetary policy to this task. This merely entails tailoring the individual securities issued to what the market will absorb
most readily.
The two major economic stabilization techniques are, then, monetary
and fiscal policy. The institutional context within which the economy
operates makes it far easier to employ monetary policy in the appropriate manner for stabilization purposes than fiscal policy. Since 1960
we have had two occasions in which fiscal policy has been consciously
employed for stabilization purposes. The tax cut of 1964 aimed at
inducing economic expansion and the tax increase and expenditure
cuts of 1968 aimed at inhibiting the unrestrained expansion underway
at that time. Even casual familiarity with the events at these times
indicates how difficult it is to operate fiscal policy in an efficient manner.
It is primarily a question of what is called the "action lag." This is
the time between the need for action being recognized and the action
itself being taken. The wholly appropriate congressional control
of taxes and expenditure decisions inevitably means that the time
between the need for action being recognized and the appropriate
actions themselves being implemented is a lengthy one. Deliberation,
debate, and decision on such weighty issues are inevitably time consuming. But during this process it is entirely possible, indeed probable,
that economic circumstances change to such an extent that the decision
which eventually emerges is inappropriate to the then prevailing economic circumstances. The economic authorities' timing, which is of the
essence where stabilization policy is concerned, is then more likely
to be off than on. Fiscal timing apart, the quantity of fiscal action is
also more likely to be wrong than right. Again, with congressional
control of our fiscal decisions, the eventual policy recommendations
are inevitably a compromise. There is no guarantee whatsoever that
it will be quantitatively appropriate. At best one can expect qualitatively correct decisions. That is to say, decisions which imply an
expansionary fiscal policy when economic expansion is called for and
vice versa. Given the institutional format in which the fiscal game is
played, it is only good fortune when the fiscal decisions are quanti-
121
tatively appropriate for stabilization purposes. I assume, in an imperfect world, that Congress adequately reflects our social preferences
vis-a-vis the public/private division of our economic activity.
Debt management policy is relatively unimportant and fiscal policy
is relatively inefficient as an economic stabilization device. What of
monetary policy ?
Fortunately, it can rise to the occasion. There is no doubt that an
appropriate monetary policy is capable of creating an economic environment in which the aspirations enshrined in the Employment Act
of 1946 would be fulfilled.
A competitive and predominantly free enterprise economy is quite
capable of generating employment for all those capable and willing
to work as long as it is not prevented from doing so by the introduction
of arbitrary and inappropirate monetary disturbances into the system.
The fact is that economic contractions and unrestrained expansion
do not just happen. They are caused—and caused by the monetary
authorities implementing erroneous polices. In recent years, there
have been three easily identifiable such instances. Two unnecessary
economic contractions or slowdowns and one unrestrained, unsustainable expansion. In 1960 and again in 1966 the Federal Reserve caused
the money supply to contract. The inevitable result was that, soon after,
the rate of growth in real gross national product fell almost to zero,
employment fell, unemployment rose, and industrial production declined. These events were not the inevitable and unavoidable consequence of a continuously adjusting free economy. They were the direct
and avoidable, consequence of the Federal Reserve contracting the
money supply. By way of contrast, the latter half of 1967 and in 1968
to date, the Federal Reserve has been pursuing a wildly overexpansionary monetary policy. A rise in prices of at least 4 percent is now
inevitable. There is no way this can be avoided. And if the present
policies continue to be pursued, prices will continue to rise at this
rate. In the last 8 years, then, the ill-conceived policies of the Federal
Reserve have subjected the economy to two bouts of unnecessary contraction and one bout of unnecessary overexpansion.
We need to create a monetary environment in which the self-generating growth potential of a competitive, free enterprise economy can
bring forth its fruit. Such an environment can easily be created. The
Federal Reserve should be bound by law to insure that the supply of
money (currency plus demand deposits) should be increased by at
least 3 percent per annum and by no more than 5 percent per annum.
If a wider definition of money was to be adopted (say currency plus
demand and time deposits), the maximum might be raised to 6 percent
per annum. The imposition of such a rule on the monetary authorities
in place of their current unlimited capacity for discretionary action
would free us from both deflation and inflation in the future.
I would recommend, then, that monetary policy and fiscal policy be
kept distinct and separate. The rule of monetary policy suggested above
would be sufficient to guarantee full employment and continued growth
without inflation in a free, competitive economy. Fiscal policy should
be eschewed as a stabilization device. It should merely reflect the
community's own decision on the balance they wish to establish between
private and public goods. Fiscal decisions would then affect the mix
of income (that is to say, the extent to which the gross national prod21-570—68
9
122
uct is comprised of private consumption and investment compared
to public consumption and investment) and not the level of income. A
budget deficit, for example, would lead to an increase in the public
component of gross national products at the expense of the private
component (due to the rise in interest rates which would occur); and
vice versa if it w7as decided to reduce our collective consumption of
public goods and a budget surplus was run. Debt management policy
should be reduced to the purely technical function of marketing the
debt implied by a deficit (or redeeming the debt that a surplus would
allow) most cheaply; without, of course, undermining the monetary
rule suggested above.
Question 2
The appropriate division of responsibility to institute the economic
reform suggested above is quite simple. (1) The monetary rule should
be laid down by act of Congress or, at the very least, by a resolution
expressing the sense of Congress. (2) Fiscal policy would continue
to be, as at present, the outcome of the deliberations of, and debate
between, both Houses of Congress and the Executive. (3) Debt management would remain the responsibility of the Treasury in consultation with the Federal Reserve.
Question 3A
As stated in answer to question 1, the immediate target of monetary
policy should be the achievement of growth in the supply of money
(narrowly defined) at a rate between 3 and 5 percent per annum. This
would be sufficient to guarantee full employment, continual economic
growth, and stability in the level of overall prices. There is no
reason to complicate this goal by diverting the Federal Reserve's
attention to other, subsidiary, variables such as bank credit, liquidity,
free reserves, interest rates, and so forth. Indeed, a large measure of
our past and present troubles have been, and are, directly due to the
Federal Reserve's focusing its attention on misleading targets. In particular, it pays entirely too much attention to the level of interest
rates. Usually, it is the Federal Reserve's myopic concentration on
this variable which imposes unnecessary gyrations on the economy.
The contemporary (summer 1968) situation is a case in point. Monetary, or nominal interest rates are at relatively high levels. The Federal
Reserve interprets this as indicative of monetary stringency. Rut, in
actual fact it is the result of a too easy monetary policy. During this
period, the Federal Reserve has been increasing the money supply at
between 8 and 10 percent per annum. This makes inflation of the order
of 4 or 5 percent per annum inevitable. Consequently, to compensate
for this anticipated inflation, lenders are only willing to lend at the
present high nominal interest rates. Paradoxically to some, perhaps,
nominal interest rates continuing at high levels indicates a too easy
monetary policy and not the reverse. Failing to understand this, the
Federal Reserve is attempting to lower interest rates by expanding
the money supply even more rapidly. This may be effective in the
short run but it is self-defeating m the long run since the anticipated
price increases that will ensue as inflation takes hold will feed back
to the interest rate and lead to higher levels still.
During contractions the Federal Reserve is misled by changes in
interest rates, too. In contractions, nominal interest rates fall. The
123
Federal Reserve is prone to interpret this as indicative of monetary
ease in spite of the fact that it is invariaJbly causing the supply of
money to decrease at the same time. Consequently, exactly when it
should be inducing an increase in the supply of money it is doing
exactly the opposite because it erroneously regards falling nominal
interest rates as self-evidently expansionary.
The ultimate goals of domestic economic policy are full employment, economic growth, and overall price stability. In a free enterprise, competitive economy, a money supply continuously expanding at
between 3 and 5 percent per annum is both necessary and sufficient to
achieve these ends. This, then, should certainly be the proximate target
of monetary policy. All other targets should be subordinated to
this end.
If, as I believe it should, a fixed rule of monetary expansion is
imposed on the Federal Reserve, there are certain institutional reforms
that should be introduced to ease the Federal Reserve's implementation of this policy. At the moment, it has three instruments of monetary control at its disposal; open-market operations; changes in bank
reserve requirement ratios; and changes in its discount rate. In their
present form, the latter two are counterproductive.
The existing reserve requirement ratios observed by commercial
banks are a patchwork hitsorical compromise. At present, they differ
among banks according to their geographic location and whether or
not those banks belong to the Federal Reserve System. In addition,
the reserves required against time deposits are lower than those required against demand deposits. This means that changes in the money
supply occur as a result of shifts in reserves among banks and between
the two classes of bank deposit. This means that, irrespective of the
Federal Reserve's capacity to determine the total of reserves, the
Federal Reserve's control of the supply of money is undetermined.
I do not wish to exaggerate the significance of these matters, but it does
seem that a more reliable control of the supply of money would be
established if (1) uniform reserve requirements were applied to all
member banks, (2) the same reserve requirement ratio was applied
to both demand and time deposits, and (3) all commercial banks were
compelled to become members of the Federal Reserve System. The
latter reform might be implemented through a strict judicial interpretation of the "currency clause" in the Constitution.
Having established uniform reserve requirement ratios for all banks
against both classes of deposits, the Federal Reserve's existing power
to make variations in these reserve requirement ratios should be
revoked. There may have been some justification for such a power in
the past, but there is no longer. There is no monetary event that
changes in reserve requirements ratios can achieve that cannot be done
better through open-market operations.
The operation of the discount rate mechanism in its present form
also leaves much to be desired. The original purpose of the discounting
privilege was to provide for a lender of last resort in the monetary
system to whom recourse might be made in times of financial stress.
It was designed to perform the function of a safety valve. It has,
however, developed into a semipermanent leak since it is usually set
below market rates of interest. This means that it is normally profitable
for banks to borrow from the Federal Reserve and lend the funds on
124
the private market. Consequently, there is frequently a state of excess
demand at the discount window. The borrowed funds which the Federal Reserve chooses to make available are, therefore, rationed among
the competing claimants by nonprice rationing techniques. Such administrative discretion should have no place in the monetary mechanism. The appropriate reform is to make the discount rate a penal
rate recourse to which would only be made in minimum amounts for
the minimum possible period while the bank in question makes appropriate adjustments in the scale of its operations as rapidly as possible.
While always being maintained above market interest rates, the
discount rate should be allowed to vary with them. At the moment,
discretionary changes in the discount rate are frequently misleadingly
interpreted. The latest example occurred with the reduction in the
discount rate in August 1968. This was widely heralded as a move
toward monetary ease following, by implication, a period of monetary
restraint. In actual fact, the Federal Reserve was allowing the supply
of money to increase at an annual rate of about 11 percent per annum
at this time. This is the antithesis of a tight money policy. If the Federal Reserve was subjected to the constraint of adherence to a monetary rule and the discount rate was pegged at a constant differential
above market rates and allowed to fluctuate with them, the Federal
Reserve's control of the money supply would be made more perfect
and both its, and the public's, attention diverted from a myopic concentration on interest rate changes.
The reforms suggested above to the reserve requirement and discount
rate mechanisms, leaves the burden of the implementation of continuous monetary expansion according to an announced rule solely
to open-market operations. They will prove adequate to the task.
Question SB
My answer to this question will be apparent from the context of the
discussion of the previous questions. Briefly, the immediate target
variable of monetary policy snould be an annual rate of increase in the
money supply (narrowly defined) between 3 and 5 percent. This rule
should be adhered to regardless of the so-called economic winds. In
fact, as I have said earlier, economic winds do not happen they are
caused. Adherence to the rule would allow calm and orderly economic
change to occur without periodic buffetings being imposed on the
economic system by destabilizing blasts of alternating hot and cold air
emanating from the Federal Reserve.
Question 3C
Not applicable.
Question 3D
The same rule of monetary growth should be adhered to year after
year in all except abnormal circumstances. Abnormal circumstances
should be subject to strict interpretation and require congressional
action. One has in mind, for example, a declaration of war as a reason
for modifying the rule. Small changes in the behavior of the goal
variables of domestic economic policy (low unemployment, the rate
of economic growth, and stability in the overall level of prices), should
not be allowed to induce abrogation of the rule of monetary expansion.
125
In a competitive, free enterprise economy continuously adjusting to
fresh stimuli, such small changes are only to be expected. They must
be accepted. The situation will be exacerbated, and not ameliorated,
by attempts to fine tune them out. In a dynamic economy one must be
prepared for adjustment and change to new circumstances. The crucial
thing is to create an environment in which such manifestations of
departure from equilibrium work themselves out quickly. Such an
environment would be created by the suggested monetary rule.
The rule should certainly not oe tampered with in the light of conjectural estimates about anticipated investment, Government spending,
taxes, and so forth. In a fully employed, growing economy such changes
would only affect the mix of income and not its level. And so they
should. They reflect individual decisions or democratically expressed
collective decisions and the achievement of them would only be frustrated by discretionary action allegedly designed to offset their effects.
The monetary authority should not be empowered to offset the attainment of our individual and collective decisions. On the contrary it
should be restrained from so doing. This is what the monetary rule is
designed to do.
Question 3E
The Federal Reserve should be mandated by act of Congress or congressional resolution to increase the supply of money, defined as the
sum of currency plus demand deposits, at no less than 3 percent per
annum and no more than 5 percent per annum.
Question 3F
See answer to question 3D.
Question ^
The short answer to this question is, very little, At best, debt management policy can affect the structure, as opposed to the general level, of
interest rates. However, recent research has shown that even their
capacity to bring about such changes in the structure is strictly limited.
Consequently, the Treasury and Federal Reserve should not concern
themselves with this issue. The Treasury, in consultation with the Federal Reserve, should, instead, so tailor their supplies (redemptions) of
securities as to minimize the interest cost associated with the national
debt. This means ordering their debt issue (or redemption) program
to accord with the relative preferences of the market.
Question 5A
The appropriate technique to employ to combat seasonal and transient factors affecting money markets is the so-called sale under
repurchase agreement. This provides "money with strings", as the
saying goes. In other words, it eases periods of seasonal and transient
stringency without diluting the Federal Reserve's permanent open market posture, which, if a monetary rule and the other technical reforms
mentioned in answer to question 3A are adopted, would be that of a
persistent net purchaser of securities on the open market in amounts
designed to implement the appropriate continuous growth in the money
supply.
Question 5B
Yes. See answer to question 3A.
Question 50
See answer to question 3A.
Question 5D
If the Federal Reserve was constrained by Congress to the monetary
rule that has been suggested, there is little information that the Federal Reserve could report to Congress that Congress would find interesting. No harm, though, would be done by introducing this formal
accountability of the Federal Reserve to the Congress. On those abnormal occasions when Congress frees the Federal Reserve to abrogate
the rule, Congress doubtless would require a detailed account of the
Federal Reserve's activities in the unusual circumstances.
Question 5E
If, as I recommend, a monetary rule is imposed by Congress, the proceedings of the Open Market Committee would be dull and supremely
uninteresting. Little benefit would accrue to outside official observers
and no harm would be done if they were absent. My own belief is that
few would wish to attend such dull proceedings more than once.
I I . APPRAISAL OF T H E STRUCTURE OF T H E FEDERAL RESERVE
The recommendations under this section are designed to reduce the
independence of the Federal Reserve and make it subservient to the
wishes of elected officials. This is to be commended as long as it does
not imply that monetary policy becomes a political football. This
could not, of course, occur if the monetary rule that has been suggested
was adopted. In such circumstances, it would be wholly appropriate
to subordinate the independence of the Federal Reserve and force upon
it the simple technical function of providing continuous monetary
growth.
I I I . COMMENTS ON MONETARY POLICY SINCE
1964
This period is almost perfectly designed to illustrate the difficulties
into which an independent Federal Reserve empowered to take discretionary monetary action can get the economy into. From June 1964 to
April 1965, the money supply increased at 4 percent per annum. This
was in conformity with the rule that has been suggested. Practically
all the economic indicators were favorable; real income was high and
rising, unemployment was low and falling and prices were relatively
stable. The Federal Reserve, however, did not leave well enough alone.
In April 1965 it began to accelerate the rate at which it was increasing
the money supply so that in the ensuing year from that date the money
supply increased by 6 percent. The inevitable followed. Prices which
had been rising at just over 2 percent per annum, soon began to rise at
3.3 percent per annum. The Federal Reserve's too-easy money policy
was generating an unsustainable expansion. It therefore reversed
itself. But instead of adjusting carefully back to a more reasonable
rate of monetary expansion, it over reacted. Beginning in April 1966,
the money supply was actually made to decline slightly. The pre-
127
dictable outcome followed. After a short lag, a recession set in. Between
the last quarter of 1966 and the second quarter of 1967, industrial production fell by 3.6 percent, the rate of increase in real gross national
product fell to a meager 1.1 percent and unemployment rose. Inflation
was effectively eliminated as evidenced by the reduction in the rate
of price increase to just over 2 percent. But reestablishment of this
relative stability in overall prices had been bought at the cost of lost
jobs and production.
Having overreacted in one direction, the Federal Reserve soon proceeded to overreact in the opposite direction. Instead of increasing its
rate of monetary expansion to a level capable of producing a sustainable expansion, it began flooding the economy with money. By
April 1968, this had reached unprecedented levels. Since that date the
Federal Reserve has allowed the money supply to increase at more
than 10 percent. Although it worked up to this orgy of overexpansion
gradually, the reemergence of inflationary forces was already apparent
in the second half of 1967. Prices were rising then at about 4 percent
per annum.
The budget was in chronic deficit at this time and this was identified
as the villain of the piece. The cry went up for a tax increase and an
expenditure cut. After due debate, a compromise program of fiscal
restraint was passed. This seems to have induced in the Federal Reserve
a sense of total abrogation of its responsibilities. Persuaded that the
fiscal reversal would take the heat off the economy it entered into a
period (which is still, unfortunately, in progress at the time of writing)
of ludicrous overexpansion. Involving, as it does, an episode of monetary overexpansion of historic proportions, the danger is that when
the inevitable inflation ensues and the Federal Reserve realizes that it
has unshakeable responsibilities for the economy's continued good
health which cannot be shrugged off onto the fiscal authorities, the
Federal Reserve will overreact. A monetary contraction together with
a tight fiscal policy contains the seeds of serious economic disorder.
The immediate policy problem as of August 1968 is, given the more
restrained fiscal position, to get the rate of increase in the money
supply down to a sustainable level slowly. The Federal Reserve must
reverse itself, but it must do it in a sober manner.
STATEMENT OF JOHN M. CULBERTSON, UNIVERSITY OF WISCONSIN
GENERAL
STATEMENT
The urgent need to improve the control of stabilization policy in the
United States does not, in my view, involve primarily a matter of improving "coordination" of monetary, fiscal, and debt management
policy. Improvement of control over stabilization policy seems to require not increased centralization of undefined or "discretionary" policies but a more basic restructuring of the control apparatus to reduce
the uncertainty of policy, free policy formation from the biases exhibited in the past, and make the formation of policy systematically
responsive to the available economic knowledge. A justification of this
diagnosis, evaluation of recent stabilization policy, and an outline of
a program to bring stabilization policy under more effective control
is developed at length in my recent book, Macroeconomic Theory and
Stabilization Policy (New York: McGraw-Hill Book Co., 1968).
128
Rather than now taking the actions defined by H.R, 11, I should
prefer giving priority to institution of a systematic program for
evaluation of monetary, fiscal, and debt management policies according to performance criteria defined by existing economic theory. Such
clarification of the performance of stabilization policy seems a necessary prerequisite to definition of or acceptance of the basic reforms
required to bring about a reliably controlled policy system. "Coordination" appears to be a euphemism for increased centralization of
power over stabilization policy by increasing the control over monetrary policy by the administration. Considering the manner in which
administrations of both parties have used fiscal policy and debt management policy—and the identifiable political biases m policy formation—it seems reasonable to fear that giving the administration
control also over monetary policy may result in a performance worse
than that of the recent past, and will increase the hazard of a catastrophically bad performance of stabilization policy.
REPLY TO QUESTIONNAIRE ON H . R .
11
I
1-2. An annual promulgation of stabilization policies is likely to
promote inflexibility of stabilization policies, make nominal stabilization policies subject to political biases, and be on balance harmful. The
conception of the Employment Act of 1946 that the Government
should at the beginning of the year determine the prospective gap in
total demand and fill it through policy actions is unrealistic, being responsive to the static, stagnationist view of the economy prevailing at
the time of its enactment, which has not been supported by subsequent
events. What seems required, rather, is to govern policy by defined
strategies or decision rules making them continuously responsive to
the changing economic situation. Such defined programs for policy
would reduce the discretionary element in policy formation and require consideration of political aspects of policy control within a new
set of terms of reference. Discretionary formation of stabilization
policy either by the administration or by independent agencies such
as the Federal "Reserve seems to give rise to definable biases and nonoptimal policies.
3. Definition of strategies or decision rules for monetary policy and
other branches of stabilization policy should rest upon a rational
process of strategy formation on the basis of economic theory. This
is not a suitable topic for offhand opinions or judgments.
One class of defective decision rules is those defined in terms of
variables that can lead to cumulative errors of policy because of lack
of allowance for feedbacks affecting the target variables. This class
of case is illustrated by the traditional credit approach to monetary
policy followed by the Federal Reserve. To illustrate the hazard of
cumulative error, the Federal Reserve judgment as to "proper" interest
rates and credit conditions errs in setting them too high, leading to a
softening economic situation or recession, leading to reduction in demand for credit and declines in interest rates (and "easing" of credit
conditions), leading the Federal Reserve further to reduce the provision of bank reserves and monetary growth, leading to further
economic weakness, and so on.
129
Decision rules defined in terms of the money supply (or in terms of
bank reserves if accurate allowance is made for changes in bank demand for reserves and other reserve factors that it is desired to offset)
can avoid this hazard of cumulative error from misestimated or ignored
feedback, since they relate directly to the politically controlled independent variable in question. Given enough knowledge regarding
the economic system, a decision rule stated in terms of credit variables
could be defined that is equivalent to any rule stated in terms of the
money supply, but existing knowledge does not suffice to permit this to
be done with confidence. Thus, under existing conditions of limited
knowledge, criteria defined in terms of the money supply are much
the less hazardous. They also avoid the evasive or politically biased
characterization of nominal policies by the Federal Reserve and the
administration based upon shifting, nonquantitative, or obscure credit
criteria.
4. The problem of defining alternative debt management strategies
and choosing the one that is optimal under existing limited knowledge
quite parallels the problems of control of monetary and fiscal policy.
Any assertion that "fiscal policy has no role to play in this matter'5
could only derive from the proposition that the behavior of total demand is invariant with respect to any conceivable conduct of debt
management. Existing knowledge does not suffice to support such a
proposition.
5. Again, the crucial problem is to achieve agreement on a reasonable
decision rule, strategy, or monetary-policy program, presumably one
defined in terms of the money supply (or equivalently in terms of bank
reserves). So long as such a decision rule is adhered to, temporary
smoothing operations by the Federal Reserve probably do little harm.
Building some allowance for seasonal changes in demand for money
into the decision rule seems appropriate in the present state of
knowledge.
The instruments of Federal Reserve monetary policy other than
open market operations are probably superfluous and ought to be
placed on a standby basis or eliminated. This involves some complications in member-nonmember bank relations, and other matters.
If the Federal Reserve operates under some defined strategy,
quarterly reports and presence of outsiders at meetings would be superfluous (although reports to Congress giving an official justification
should perhaps be required in the case of any discretionary departure
from the standard policy program). On the other hand, lacking a
defined policy program or set of performance criteria for monetary
policy, it is not clear that frequent reports or presence of outsiders in
meetings wTill result in improved policy actions. It may increase the
hazard of a catastrophically bad set of policies—as in the classic case
of an administration with an excessive fiscal deficit pressuring the
Federal Reserve to provide bank reserves to hold down interest rates.
If we are to attack the subject in terms of a catch phrase, "checks
and balances" seems as relevant as "coordination."
i i
The crucial problem seems to me to be bringing monetary policy
(and public information regarding it) under an effective control system. Adopting any defined program of monetary policy would imply
130
the reasonableness of some simplification of the Federal Reserve administration. The changes thus indicated, however, would be quite
different from the ones that would be called for under an approach
involving retention of discretionary monetary policy with the power
effectively transferred from the Federal Reserve to the administration.
Making the proposed administrative changes at this time, I fear,
would only muddy the waters with reference to the really important
problem.
in
The recent record is strikingly consistent with the interpretation
that variation in the rate of growth rate of the money supply (reflecting, at the margin, Federal Reserve actions regarding the provision of
bank reserves) has been a major cause of changes in the rate of growth
of total demand. In this period, the record obviously could have been
worse than it was, for runaway inflation and recessions were avoided.
However, it appears that a preferable performance could have been
achieved with a readily definable monetary policy. Perhaps more
importantly, the existing control system appears potentially subject
to cumulating errors on a dangerous scale, these in recent years being
avoided only late in the game and seemingly in a somewhat accidental
manner.
Deviations of the growth of total demand from a path that might
reasonably have been defined as a target seem attributable in least in
part to the below-normal monetary growth of 1959-62, to the excessively rapid monetary growth from the spring to 1965 to the spring of
1966, to the abrupt halting of monetary growth during the rest of
1966, and to the extremely rapid growth rate of the money supply since
the beginning of 1967.
This erratic and seemingly somewhat accidental monetary policy
cannot be justified as optimal in the light of existing knowledge, nor
can the control system from which it derives be characterized otherwise than as hazardous.
STATEMENT OE PAUL DAVIDSON, RUTGERS, THE STATE
UNIVERSITY
I . INTRODUCTION
Any objective inquiry into improving the economic effects of the
monetary policy of a central bank should begin with (1) a statement
of objectives of such policy and (2) a discussion of means that can
achieve these goals.
The four most often mentioned practical goals of monetary policy
are—
(1) To prevent inflation;
(2) To encourage full employment;
(3) To encourage sustained rapid economic growth;
(4) To counteract balance-of-payment deficits.
In framing these objectives I have deliberately worded objectives
No. 1 and No. 4 in negative or obstructive formats, while No. 2 and No.
3 utilize more positive wording. My rationale for this is to emphasize
that active pursuit of objectives No. 1 and/or No. 4 by traditional
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monetary methods will normally obstruct the achievements of objectives No. 2 iand No. 3. Accordingly, it is my view that monetary policy
should be oriented solely toward achieving full employment and economic growth. This does not mean, of course, that monetary policy
should operate in a vacuum. Nor does it mean that money and monetary policy cannot have some impact on the general price level or
the balance of payments.
What I wish to recommend is the coordination of monetary and
fiscal policy with an incomes and foreign trade price policy so that the
four objectives listed above can be approached simultaneously. Mere
coordination of monetary and fiscal policy, while a step in the right
direction, will not be the administrative panacea for reaching these
objectives under present institutions—even if accurate forecasts of
future events could be achieved.
Although discretionary control over the money supply is essential
if we are to obtain full employment and sustained economic growth,
any attempt to utilize changes in the money supply as the primary tool
to restrict general price increases or to cure balance-of-payments
deficits will, under our present market-oriented system, insure unemployment while severely hampering growth.
I I . FULL EMPLOYMENT AND ECONOMIC GROWTH
Full employment and economic growth with their promise of unprecedented prosperity, could presently provide a higher standard
of living for all Americans. Full employment and growth could mean
the rapid elimination of poverty in the United States. Full employment and growth could bring about increased social stability as group
antagonisms dimish with rising income levels. Full employment and
growth could improve our position in the cold war not only by
strengthening our defenses, while simultaneously increasing our aid to
the uncommitted countries, but it would also demonstrate to the world
the vitality of a market economy in providing for the economic and
social ladvancement of its citizens and its friends. With all these obvious advantages that accrue to a fully employed economy, surely
full employment and economic growth must be the primary economic
goals of our society.
Yet, except for the military escalation in Vietnam operating in
tandem with the 1964 tax cut, American economic policymakers, Republicans ;and Democrats, cabinet members and central bankers alike
have, for more than a decade, pursued a course designed to prevent the
achievement of full employment. The policymakers, of course, are
not malevolent but they have been trapped in a conflict of goals which
dilutes our fervor for maximum output.
Several years ago, Secretary of Labor Willard Wirtz posed the
problem very graphically when he said: "You sometimes get the feeling, sitting where I do that there is a shell game going on in the discussion of this particular [unemployment] problem, and that the
shells are marked 'inflation,' 'unbalanced budget,' and 'unfavorable
trade balance' * * * every suggestion which is made to iadvance the
purpose of full employment is met by one or another of these arguments, and very often by all three."
132
Why do we participate in such a game, the outcome of which cheats
us out of full employment and rapid growth ? The game goes on and
on because the winners (and the game is rigged so that we know who
the winners will be) outvote the losers at the polls. But majority rule
ought not to be tyranny. Majority rule is neither right nor proper
here because we have failed to guarantee an inalienable right to the
minority—the right to a job and a respectable level of income. Up to
now we have failed to create an economic environment in which democratic rule yields the optimum result within a monetary, market-oriented economy. Such an economic environment can be created, however, with an appropriate battery of monetary, fiscal, and income
policies. Until such coordinated policies are developed, this shell game
will continue and as the late President Kennedy lamented, we will
continue to content "ourselves with pious statements about the wastes
of our human resoures."
Ever since the 1930's, economists have realized the recessions can be
avoided and full employment can be achieved by fiscal policies such
as tax cuts or increased governmental spending and/or expansion in
the money supply. Moreover, if the economy begins from a position of
less than full employment, policies that stimulate increased economic
activity simultaneously reduce unemployment, and stimulate investment and growth; for one of the most important messages of the
"Keynesian" revolution in economics was the complementarity of
consumption and investment in recession. Thus we learned that it is
possible to have more butter, more plant and equipment, and more
guns, too, if only we had the courage to pursue certain fiscal and
monetary policies.
Although there continues to be a debate among economists as to
whether, as the Chicago school succinctly asserts, "money matters,"
that is, a questioning of the relative efficacy of expansionary fiscal compared to monetary policies, most economists now agree that expansion of market aggregate demand is a requirement for continuous
full employment and economic growth in peacetime. What has been
often overlooked in this professional controversy over whether "money
matters," is that an increase in market demand means not merely an
increase in wants but also an increase in the ability to pay for goods and
services. An increase in the ability to pay, in a modern market-oriented,
monetary economy, must involve an increase in the supply of money
before the increased demand can be made operational in the marketplace. This fundamental notion that an easy-money policy is a prerequisite to expansion and growth is, as I have tried to demonstrate
in a number of articles (1), (2), (3), an essential concept necessary
to the understanding of the mechanism underlying the traditional
Keynesian policy prescriptions for economic expansion.
As John Maynard Keynes wrote more than 30 years ago:
The banks hold the key in the transition from a lower to higher scale of activity * * ». The investment market can become congested through a shortage
of cash. It can never become congested through a shortage of savings. This is
the most fundamental of my conclusions in this field (6, pp. 668-669).
Or again:
A heavy demand for investment can exhaust the market and be held up by
the lack of financial facilities on reasonable terms. It is, to an important extent,
the "financial" facilities which regulate the pace of new investments * * * too
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great a press of uncompleted investment decisions is quite capable of exhausting
the available finance, if the banking system is unwilling to increase the supply
of money * * *. The control of finance is, indeed, a potent, though sometimes
dangerous, method for regulating the rate of investment (though much more potent when used as a curib than as a stimulus) (5, p. 248).
Easy-money policies are a necessary but not a sufficient condition
for stimulating economic growth,. If the desire for new investment
goods is weak because of poor profit opportunities, then easily obtainable finance will not, by itself, do the trick. If, on the other hand, the
desire for investment is strong among businessmen, the banking system
and the monetary authority can play an essential role in providing
funds on terms which the investors deem attractive. It is at the level
of financing investment projects that the money supply plays an essential role in stimulating economic growth in a monetized market
economy, once the investment desire is present in the economy.
Fiscal policy, on the other hand, may develop latent investment
demand either by increasing profit opportunities by augmenting consumer or Government demands in the marketplace or by increasing
after-tax profits on existing market demands by use of subsidies, tax
credits, or profit-tax cuts. Nevertheless, unless investors can obtain
funds, they cannot place orders for additional investment goods no
matter what level of profits are expected to be earned on these potential
investments. Since m modern, money economies with a developed
banking system, the money market may not "clear"; that is, there may
be an unsatisfied fringe of borrowers (particularly when business is
active), aggregate demand may be deficient merely because there is
a shortage of money. Accordingly, fiscal policy may be a necessary;
but it is not by itself a sufficient condition for full employment and
economic growth. In a monetary economy, it is finance (i.e., increases
in the money supply) which provides the energy fuel that permits
the investment tail to wag the gross national product dog.
It is obvious, therefore, that the necessary and sufficient conditions
for full employment require the coordination of fiscal and monetary
policy. To the extent that H.R. 11 has as one of its major objectives
"to improve the coordination of monetary,fiscal,and economic policy,"
it must be warmly supported.
Nevertheless, coordination of monetary and fiscal policy is not the
panacea for our economic problems. In the absence of a coordinated
"incomes policy" to prevent inflation and a foreign trade policy to correct balance-of-payments deficits, a coordinated fiscal and monetary
policy may be required to deal with these latter issues—a task which
they are not equipped to efficiently handle.
Accordingly, before providing my conclusions on H.R. ll's detailed
recommendations for coordination, I should like to discuss the inflation and balance-of-payments questions.
III.
INFLATION
The 1964 tax cut was the first major measure taken by Congress for
the expressed purpose of expanding aggregate market demand in order
to move toward full employment. This action plus the subsequent military expenditure expansion as hostilities in Vietnam increased brought
the United States close to full employment and rapid economic growth
134
for the first time in more than a decade. But with this achievement
came the usual corollary of a free market economy—rising prices.
No one is against full employment per se. Moreover, if one begins
in a recessionary period, full employment and rapid economic growth
are complementary objectives which simultaneously can be achieved
by a judicious mix of proper monetary and fiscal policy. It is the increasing inflationary effects as unemployment declines which constitutes a basic conflict and which induces policymakers to adopt measures designed to restrain aggregate demand, and hence hopefully
restrict price increases by creating slackness in labor and product
markets.
This fear of inflation is not new; however, the fear of massive unemployment which was generated in the great depression, as well
as the hot and cold wars which followed, overrode the objections to
inflation and made possible the expansionist policies in the forties
and early fifties. But almost a third of a century has passed since
the great depression and for many citizens these terrible years are
as remote as the ravages of the Civil War. Continuing inflation in
the forties and early fifties increased our fear of rising prices, while
the continuing prosperity has dulled, for most white urban workers
at least, the fear of unemployment. At the present time, inflation and
not unemployment appears to be the most likely source of economic
dislocation, although it is my firm belief, that much of the riots of
the urban ghetto community and the problems of the rural poor reflect the continuing unemployment and underemployment problems
in those sectors of the economy. A truly fully employed economy would
not only raise the level of real income for the entire community, but
it would open up job opportunities for members of many minority
groups, so that, in general, the average level of real income of these
minorities would rise more rapidly than the national average.
Under present institutional arrangements, however, the rate of
inflation that would accompany sustained full employment would
severly damage (1) the real income of those citizens on relatively
fixed money incomes, the so-called rentier groups—the retired, the
disabled unemployed, widowrs, orphans, mothers with abandoned children, and even some white collar workers, certain government employees such as policemen, teachers, etc., and (2) the real wrealth of
middle- and upper-income groups who held their wealth in the form
of savings accounts, bonds, and other fixed sum obligations. Moreover, even organized labor would find inflation galling in that it would
mean that collectively gained money-wage advances turned out not
to be as sizable an increase in economic welfare as they would have
been with stable prices. Management, on the other hand, might find
the increased truculence of labor (both organized and unorganized)
under sustained full employment exceedingly difficult to deal with.
The inflationary pressures would also create problems in export markets and encourage foreigners to compete domestically.
The resulting political winds, which were correctly foreseen 25
years ago by Kalecki, have produced a "political trade cycle," where,
as the level of unemployment declines and prices rise, rentier and
other interests combine to pressure government to return to the orthodox policy of cutting down budget deficits and restrictive monetary
policies. Thus it is not surprising that first the Federal Reserve Board,
135
and later the administration began to advocate restrictive policies
before full employment had been reached, much less sustained. These
restrictive policies, whether coordinated or not, ultimately place the
major burden of fighting inflation often on those citizens least capable
of bearing it—a group which may be called the LIFO workers—the
last hired in prosperity, the first out in recession. This group includes
young people just entering the labor force, unskilled workers primarily located in ghetto areas, and even older workers nearing retirement ages (unless protected by seniority rules). Equity, it seems to
me, requires that we redistribute this burden more broadly.
Of course, it is not irrational for the rentier and other groups to
bring political pressure to stop inflation since they can suffer absolute
(or at least relative) economic losses as prices rise. Though they may
favor full employment and economic growth in the abstract they
are forced by their economic self-interest to push for the only antiinflationary policies available—restrictive monetary and/or fiscal policies. As a consequence, no matter under whom or how well monetary
and fiscal policies are coordinated, we will be unable, for political
reasons, to achieve full employment and sustained economic growth
until a viable economic policy designed to sever the existing connection between rapidly rising prices and low levels of unemployment is
introduced and coordinated with monetary and fiscal policies.
In order to understand what general type of policy is required,
it is essential to explicitly define some basic economic concepts and
principles. Although economists have ofttimes demonstrated excessive
taxonomic dexterity in categorizing "causes" of inflation, we can avoid
many semantic problems by taking recourses to a few simple economic
concepts.
It is neither rising prices of nonreproducible goods such as rare
paintings or sculptures, nor the prices of securities listed on the New
York Stock Exchange, nor even the prices of reproducible nonconsumer goods like aircraft carriers, which are the main focus of
public concern in discussions of inflation. Inflation becomes a major
cause of public interest only when it is the market prices of reproducible goods that bulk significantly large in consumers' budgets that
are continuously increasing. Keeping this pragmatic view of the public concern about inflation in mind, the problem can be readily analyzed
by concentrating on what economists call the "flow-supply price of
goods," where the latter is defined as that price "which is sufficient
and just sufficient to make it worthwhile for people to set themselves
to produce the aggregate amount" [8, p. 373] of output. Our emphasis
on supply prices should not be interpreted as supporting the myopic
view that demand factors cannot affect price; nevertheless if the supply price for any given quantity of reproducible goods does not alter,
then no matter how far the market price may be momentarily displaced from that supply price, the price of future output will subsequently return.1
1 If only nonreproducible goods such as works of arts by dead artists were rising, no
major public policy problem would arise. iThis latter case would be an example of a pure
demand-price inflation and could readily be analyzed primarily by concentrating on changes
in demand factors.
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Supply prices can increase for three main reasons: (1) diminishing
returns, (2) increasing profit margins, and (3) increasing money
wages (relative to productivity increments).2
For more than a century, economists have taught that every expansion of output and employment will normally involve increasing costs
and increasing supply prices because of the law of diminishing returns.
Diminishing returns, it is held, is inevitable—even if all labor and
capital inputs in the production process were equally efficient—because
of the scarcity of some input such as raw materials or managerial
talent. Actually, however, economic expansion will lead to increasing
costs (and prices) not only because of the classical law of diminishing
returns but also because labor and capital inputs are really not equally
efficient. Expansion of output in our economy often involves the
hiring of less-skilled workers, and the utilization of older, less-efficient
standby equipment and therefore adds to diminishing returns. Thus,
as long as unemployment is declining, diminishing returns inflation
will be an inevitable and unavoidable consequence of further
expansion.
The severity of diminishing returns inflation will vary with the
level of unemployment. When the rate of unemployment is high (say
about 5 percent), idle capacity will exist in most firms, so that diminishing returns are likely to be relatively unimportant. As full employment is approached, however, an increasing number of firms will
experience increasing costs, and diminishing returns inflation will
become more important. Although in the short-run diminishing returns
inflation is an inevitable consequence of every expansion in employment, in the long run, improvements in technology, Government-sponsored training and educational programs, and increases in capital
equipment per worker can offset this price rise.
The second type of inflation will occur when businessmen (particularly in our more concentrated industries) come to believe that
the market demand for their product has changed sufficiently so that
it is possible for them to increase the markup of prices relative to
costs. If managers in many industries increase their profit margins,
we will experience a profits inflation as the supply or offer prices rise.
Third, every increase in money-wage rates, which is not offset by
productivity increases will increase costs, and if profit margins are
maintained, increase supply prices. Consequently, we can expect that
increases in money-wages induce price increases. This phenomenon is
often referred to as wage-price inflation. Since as unemployment levels
decline it is easier for workers to obtain (collectively and individually) more liberal wage increases, we may expect wage inflation to
become more pronounced as employment rises; although wage inflation can occur even without expansion, if labor is able to secure
increases which exceed productivity increments.
Historically, rises in the price level has been due to some combination of these three inflationary forces. Thus, changes in the price
level are ultimately related to changes in money wage rates, changes
in profit margins, and diminishing returns.
2 If imports are an important component of the output of most reproducible goods, then
rising import prices can affect the flow supply price. For the United States, I do not believe
this is a significant problem and hence I have omitted it from the discussion.
137
Every significant expansion in economic activity will induce some
price increases because of diminishing returns. With rising prices,
workers will, at a minimum, seek cost-of-living wage increases. Moreover, as pools of unemployment dry up, workers will be more impenitent in their total wage demands. Managers will be more willing to
grant wage increases m a rising market, for they are more certain
that they will be able to pass the higher labor costs on in higher prices.
Also, management will find that as they hire more workers to meet
the rising demands for their products, the cost of searching out and
training the remaining unemployed will increase; consequently, they
will often attempt to bid away workers from other employers rather
than to recruit from the remaining unemployed. In addition, if management believes that the growth in demand is sufficiently strong they
will increase profit margins and increase the inflationary tendency.
Finally, legislators may find that the legal minimum wage becomes
substandard as inflation occurs, and therefore, in a humanitarian
spirit, they may raise the legal minimum. All these factors feed back
on each other to create mounting wage-price pressures for as long as
the economic expansion is permitted to continue.
Since the rate of diminishing returns, the rate of increase in moneywage rates, and changes in profit margins are normally closely related
to decreasing unemployment levels, our present anti-inflationary policies are oriented to maintain a sufficiently high unemployment rate
to control the impact of changes in these factors on price levels. Any
monetary and/or fiscal policy aimed at preventing all price increases
before full employment is reached, can be successful only if they
perpetuate sufficient unemployment. All expansions in economic activity, whether they are initiated by increasing Government's demands
for goods and services or by an increase in demand by the private
sector tend to bring about some price increases.
It should be obvious, however, that any increase in aggregate demand would induce changes in the supply price of reproducible goods,
if there is no change in the money wage rate (relative to productivity)
or gross profit margins, only to the extent that diminishing returns
are present. Moreover, this diminishing returns associated price rise
would be a once-and-for-all rise associated with increasing real costs
of expansion due to lower productivity. Installation of new equipment and training programs would help offset any price rise due to
this aspect.
If, on the other hand, there is an increase in money wages in excess
of productivity, whether demand is unchanged or not, the resulting
supply price will be higher except if gross profit margins decreased
proportionately. Similarly, increases in gross profit margins can induce
price increases. Consequently, in the real world of changing levels of
aggregate demand (usually at less than full employment) an incomes
policy which controls both the money wage and profit margins will
provide more stability in the purchasing power of money than a policy
which permits "free" collective bargaining and unrestricted pricing
practices.
Although some economists have attacked such a policy as undesirable because it would not permit markets to optimally allocate resources, I believe that such a criticism is for all practical purposes,
irrelevant. First of all, these critics implicitly assume that present
21-570—68
10
138
resource markets are efficient allocators. There is, however, evidence
that indicates that existing labor markets are not very good allocators
under existing free collective bargaining arrangements [9, ch. 5].
More importantly, resource allocation merely requires changes in
relative prices and not in the general price level. Different variants
of income policy have been suggested which would permit these relative price changes while restricting a general price increase [7]
[9, ch. 6].
Secondly, any possible loss in social welfare due to possible resource
misallocation, in our economy, will be small relative to the welfare loss
resulting from our continuing failure to maintain full employment and
growth. As long as there are several million unemployed who are
willing and able to work, I think that an economy that continuously
utilizes these resources is less wasteful than a system which requires
millions to be perpetually "on the dole" (a system which ultimately
must foster social antagonisms) in order to maintain reasonable price
stability via monetary and fiscal policies alone.
In sum, there is no monetary or fiscal policy which can provide sufficient conditions to insure price stability, without wrecking any chance
of sustaining full employment and economic growth. Hence there is
an urgent need to develop a viable incomes policy.
An incomes policy obviously requires that the public interest be taken
into account at the wage bargaining table and when management is
making its pricing decisions. This policy must be considered a necessary supplement to monetary and fiscal policies which would guarantee
continuous full employment. In return for this guarantee of full employment and optimum production levels, labor would be required to
restrict its wage demands to, at most, rises in productivity, while business must hold profit margains constant.
The administrative details of implementing such a policy could
take a variety of forms. The British, for example, have established
restrictions on wage, salaries, and dividend increases. A National Board
for Prices and Incomes was established which can require notifications
of increases in prices and pay and can legally delay implementation of
these increases if the Board finds them unjustifiable and if voluntary
compliance to holding the price-pay levels cannot be obtained. In a
larger economy, such as ours, we may prefer a somewhat different arrangement that that adopted by the British. In any event, collective
bargaining or pricing decisions which do not take the public interest
into account should no longer be tolerated.
If, in fact, we could go even further and keep both money wages and
gross margins constant, then with technological progress, price levels
would decline. This would allow all consumers, including renters, to
share in the gains of technology. This ideal variant of an income
policy (which is less likely to be politically acceptable) would provide
the greatest degree of fairness; for as long as some groups in society
have their income fixed in money terms, then equity should require
that all remuneration be somewhat fixed in money terms.
The desirability of instituting a full employment policy in coordination with an incomes policy is clear. The problem is to find a political
leader who will advocate these policies which will be, at least initially,
unpopular. (Many people might find themselves liking the results of
such a policy, once they got over the shock of it.) Who will come forth
139
to demand a simultaneous full employment and an incomes policy \
Is there anyone in our society who will provide the political impetus
that will convince most of us to pay this required tariff to sustain full
employment ?
Obviously no one has yet appeared on the political scene. No one will
speak against the status quo and for the LIFO workers (who are
usually the young, the uneducated, the migrants, and the members of
minority groups, who are often disenfranchised by race, age, education,
and residential requirements). Many "liberal" groups are not ready to
admit that unions ought to be restrained in the public interest, while
"conservatives" do not desire to see managerial pricing decisions limited by the public interest.
i v . BALANCE-OF-PAYMENTS DEFICITS
I have held the payments problem for last for two reasons: (1) The
magnitude of the payments problem for the United States is small in
comparison to the previously discussed subjects; and (2) it is my personal belief that the United States should not allow foreigners to control its domestic economic policies; accordingly, methods for dealing
with payments deficit should have a relatively lower priority.
The traditional monetary policy approach for eliminating a payments deficit is tight money—a policy specifically aimed at (1) stanching net short-term capital outflows, and simultaneously (2) inducing
slack demand at home, thus encouraging industries with exportable
products to search for new markets abroad, while domestic demand for
imports decline. If such a policy is successful, although our balance-ofpayments position will improve, the recessionary effects makes it
socially undesirable.
An increase in exports relative to imports is the obvious cure for a
payments deficit. This can be accomplished without creating unemployment (or even devaluation) via an alteration in the domestic price
level relative to the foreign price level. A prominent English economist,
Sir Roy Harrod, has recently shown that an incomes policy could not
only be used to control the price level at home, but it could be used simultaneously to alter the export price level relative to import prices in
order to improve the balance of payments [4]. Hence, it would appear
that an incomes policy could be designed to concomitantly prevent
inflation and eliminate payments deficits, thus freeing monetary and
fiscal policy to concentrate on achieving full employment and growth.
Moreover, the utilization of an incomes policy, which allows export
prices to alter slowly relative to import prices, would tend to eliminate the need to alter exchange rates and thus reduce the possible capital gains incentive for speculation against so-called "key currencies."
V. CONCLUSIONS AND RECOMMENDATIONS
Having developed my position at length, I believe I can now succinctly present my major conclusions and recommendations to the
committee.
(1) A coordinated monetary, fiscal, and incomes policy should be
a major objective of economic policymakers. Since fiscal policy and
incomes policy are, by their very nature, likely to reside in the execu-
140
tive branch of the Government, it seems practical to give responsibility
for coordinating monetary policy with these other policies to the
administration.
To disperse power over these various policies would be almost to
guarantee that economic policies would, at times, be at cross purposes.
It is obvious that the brake on an automobile is a check on the accelerator, but no one seriously suggests that one passenger in the auto should
work the accelerator and another the brake pedal. By analogy, we cannot afford separate passengers to independently operate monetary, fiscal, and other economic policies.
Nevertheless, it is of limited value to only coordinate control of the
brake and accelerator pedals, while the steering wheel of money wages
and profit margins are left to be driven by an "invisible hand." As long
as unbridled wage and price decisions are permitted, disastrous crashes
can be avoided only by utilizing the brake pedal almost continuously
and/or constraining the accelerator pedal to permit very slow forward movements.
(2) The major instrument of monetary policy should be the money
supply and its prime target should be to provide sufficient finance to
bring the unemployment rate down, say to 3 percent or less.
As long as money markets do not automatically "clear," the expected
rate of return (adjusted for risk) on new investment projects can be
significantly greater than the rate of interest. Consequently, a reduction in the rate of interest may not stimulate additional investment
purchases as credit rationing limits the number of entrepreneurs who
can obtain finance in order to make operational their demand for
capital goods. Furthermore, when there is an unsatisfied fringe of
borrowers there is no way of knowing whether those investments
projects which are being financed are more productive than those projects which cannot obtain funds. Consequently, control over interest
rates rather than over the supply of money may result in misallocating
resources in the investment goods industries. The monetary authority
must, therefore, exercise its role via primarily the money supply and
not rely on interest rate changes alone to do the job.
(3) Although monetary, fiscal, and incomes policies should be coordinated, it must be recognized that the first two should be oriented primarily to achieving full employment and growth and should not be
concerned with price level problems per se. An incomes policy, on the*
other hand, should have primary responsibility for controlling our
domestic price level and its relationship to import prices.
(4) If rapid economic growth is to be sustained, the money supply
must increase in anticipation of the output growTth. In an uncertain
world, where expectations are volatile and often unpredictable, the relationship between the required increase in the money supply and theincrease in the economy's wealth is much too complex to be handled by
any simple rule. Money clearly matters in the process of economic
growth in a monetary economy, but a simple rule can be no substitutefor wise management of the money supply.
Accordingly, the money managers cannot fix their gaze to any onestatistical index—although they should always keep global statisticssuch as the unemployment rate and the rate of growth of gross national product in view. Nevertheless, disaggregative statistics on unemployment rates for particular groups and regional gross product
141
growth must also be utilized in suggesting a desirable coordinated fiscal, monetary and incomes policy. Price indexes, for reasons I have
already elaborated on, should be of secondary importance for the
money managers.
(5) Although it would be possible to achieve monetary policy solely
via open market operations (as long as the public owned a significant
amount of Government bonds), I see little reason for restricting
the Fed solely to this tool. If the objectives are clearly recognized, then
the Fed ought to be given as much flexibility as possible in choosing
the method of achieving these objectives, since no two particular cases
will be identical in all respects.
(6) Reducing the number of members of the Federal Reserve Board
should not necessarily be an objective. What is desired is better educated members who understand the interrelationships of monetary, fiscal, and incomes policies, not fewer members. I do not believe it is
essential that members need know the intricacies and mechanics of the
banking system any more than members of the Council of Economic
Advisers need know the labyrinthine relationships among governmental bureaus.
(7) If monetary policy is coordinated with the other economic
policies of the administration then I see no merit in having the Fed
making separate reports—separate from The Economic Report of the
President—to Congress. If monetary policy is left uncoordinated, then
a requirement for separate quarterly reports by the Fed not only has
little merit, but such a requirement might be detrimental if it opened
the Federal Reserve Board to more political pressure to pursue, what
I have labeled above, "political trade cycle" policies.
(8) Coordination would necessarily involve representatives of the
Treasury and CEA at open market committee meetings, and, I would
hope these representatives would be participants and not merely interested onlookers.
(9) As far as appraisal of the structure of the Federal Reserve is
concerned, I believe that it follows from my strong advocacy of coordination that (a) the Chairman of the Board's term be coterminous
wTit,h the President of the United States, and ( i ) since the Federal Reserve is an instrument of the public and not of the member banks,
there is no necessity to maintain the fiction of private ownership. Accordingly, the Federal Reserve bank stock should be retired.
(10) Since a central bank by its very nature as the monetary authority does not need a cushion of "undistributed profits," I see no reason
why the Federal Reserve should not pay all its earnings over to the
Treasury, while funds to operate the System would be appropriated
by normal legislative means. Certainly, if the Chairman of the Federal Reserve had to submit a budget request to the President—as does
the Secretary of the Treasury and the Chairman of the CEA—coordination of policy would be facilitated.
(11) The term of members of the Federal Reserve Board depends,
in part, on what individuals are likely to be appointed as members. If
members are to be selected primarily from the banking community and
are expected to return to this sector after a single term, then I believe
the longer term the better, for a long term frees the members from having their own future economic self-interest affect their decisions. If,
on the other hand, one anticipates selecting them from the academic
142
field—such as is now done for CEA members—then a term similar to
Cabinet members seems desirable if coordination is going to be efficiently accomplished. In any case the choice of 5 years rather than, say,
4 years, as H.R. 11 provides, strikes me as strangely incongruous
with political realities.
(12) It follows from my analysis in section III above, that the Federal Reserve's policies of the last 3 years have been socially undesirable.
The continued rise in the consumer price level during the past few
years is indicative of the failure of monetary policy to contain the inflationary pressures, while the continued high unemployment rate in
the ghettos must, at least in part, be associated with these policies. Ultimately, policymakers must recognize that labor and management in
our system share responsibility with the monetary and fiscal authorities for the maintenance of price level stability, full employment, and
economic growth. An incomes policy is an essential consort to a sound
monetary policy. Until this notion is accepted, modern market-oriented
systems such as ours will continue to follow erratic paths of economic
growth.
REFERENCES
1. P. Davidson, "Keynes's Finance Motive," Oxford Economic Papers, March 1965,
17, pp. 47-65.
2.
, "The Importance of the Demand for Finance," Oxford Economic Papers, July 1967,19, pp. 245-253.
3.
, "Money, Portfolio Balance, Capital Accumulation, and Economic
Growth," Econometrica, April 1968,86, pp. 291-321.
4. R. F. Harrod, Reforming the World's Money (London 1965).
5. J. M. Keynes, "Alternative Theories of the Rate of Interest," Economic Journal, December 1937, k7, PP. 663-9.
6.
, "The Ex-Ante Theory of the Rate of Interest," Economic Journal, December 1937, 47, pp. 663-9.
7. A. P. Lerner, "Employment Theory and Employment Policy," American Economic Review Papers and Proceedings, May 1967,57, pp. 1-18.
8. A. Marshall, Principles of Economics, 8th edition (New York, 1950).
9. S. Weintraub, Some Aspects of Wage Theory and Policy (Philadelphia,
1963).
STATEMENT OP WILLIAM G. DEWALD, OHIO STATE UNIVERSITY
R E P L Y TO QUESTIONNAIRE
ON H . R .
11
i.
1. Yes. An economic policy program would be useful. Monetary and
fiscal policies are not independent in their effects, at least not in the
short run. Thus, planning and coordination are essential to avoid
policy actions that have the wrong overall effects in magnitude or even
direction. It should be noted that coordination offers no assurance that
appropriate policy actions would be taken.
2. The President should be responsible for the national economic
policy program. He has the broadest responsibility, though the ultimate power for national policy is shared with Congress. Agencies reporting to the President carry out the administration's spending and
taxing policies. The Treasury and the Federal Reserve share authority
for monetary and debt management policies. All responsible authorities should be consulted in shaping the Nation's policy program, but
the President should coordinate it. Independent authorities such as the
143
Federal Reserve should be encouraged to exercise a right of public dissent and even independent action as an expression of Congress check
on the President's power. But Congress should require an explanation
of Federal Reserve actions, where possible, before they are taken.
3. It is a difficult problem to find proper guidelines and measures
of the stance of monetary policy. H.R. 11 specifies the money supply
as the appropriate guide. The money supply is not only affected by
policy actions, but also affects basic objectives. Interest rates are an
alternative guide. A problem is that changes in the money supply or
interest rates are brought about not only by policy actions, but by nonpolicy factors. Whether an increase in the money supply or a decrease
in interest rates is a reflection of an expansionary policy depends on
the nature of the economy and what action, if any, was taken. The
proper indicator of the expected effect of policy on goals would be a
dated sum of predicted effects of each policy instrument. Predicted
effects may be arrived at by simple extrapolation or by complex statistical techniques—but whatever the approach, it should be subjected
to critical evaluation.
Which particular target policymakers use is less important than
explicit accounting for the effects of actions on the indicator and on
ultimate goals. Interest rates, free reserves, and other largely equivalent measures of money market pressures are miselading indicators
where policymakers ignore nonpolicy effects on them and where there
is a shift in the relationship between such variables and goals. An
example is the decrease in interest rates induced by a decline in the
demand for credit to finance spending at the advent of recession.
Contractive policy actions have often been taken that prevented interest rates from falling as far or fast as they would otherwise because
policymakers have misinterpreted the source of easing in interest rates
and other measures of money market pressures.
Comparable criticisms can be made of the money supply and related
magnitudes as indicators of policy. For example, a financial crisis
would have the effect of increasing the demand for money and raising
interest rates. This in itself would tend to induce an increase in the
supply of deposits and money even if there were no policy actions. In
fact, the quantity of money might increase despite contractionary
policy actions, but less than would have been the case if there had been
no policy actions. There are serious shortcomings of any intermediate
variable as an indicator of the stance of policy where the structure
of the economy is not explicitly taken into account. In fact, it is necessary to do this just to define meaningful quantities.
I am inclined to measure the overall stance of the major instruments of monetary policy by what can be called maximum money—the
amount of Government-issued money 1 divided by the average required reserve ratio for commercial banks. Such a magnitude is almost altogether subject to control by the monetary authorities. It is
a constraint which importantly limits the expansion of bank deposits
and bank credit. Maximum money can be given the interpretation of a
policy-controlled constraint that affects the supply function of money
and is largely independent of demand factors. Admittedly, maximum
money or any alternative indicator of policy is at best an approxima1 A close relative of Milton Friedman's high "powered money" and Karl Brunner and
Allan Meltzer's "monetary base."
144
tion to an ideal—the effect of each policy instrument on economic welfare. Policymakers have often not only misjudged the magnitude but
also the direction of the effect of their actions. Increasing maximum
money would unambiguously be expansionary; reducing it, contractionary. Hence, directional errors, at least in terms of immediate effects,
would be avoided by reference to maximum money as a monetary policy guide. If there were no other monetary policy actions and the
amount of maximum money were increased, then the policy stance in
terms of its ultimate effects would unambiguously be expansionary even
if noncontrolled factors should induce a contraction in the actual quantity of money or increase in market rates of interest. If, as I believe,
there are significant effects of monetary policy actions in the short run,
then the appropriate policy would be to increase maximum money at
less than its long period average growth rate during periods of expected inflation and at more than average during periods of expected
deflation and unemployment. However, if lags in effects are long and
variable, then the proper policy would be to increase maximum money
steadily, unless economic performance deviated a great deal from objectives. Such a prescription for policy is made without regard to
other policies than open-market operations and required reserve ratios.
If there were other actions their effects would also have to be appraised. It is reasonable that no other actions should be taken or perhaps all in the same direction, at least until it is possible to predict the
magnitude of their effects with considerable accuracy.
4. Monetary policy involves changes in government demand obligations. Debt management includes policies that affect the supply of all
government debt. It is reasonable to expect that large changes in the
relative amounts of short- to long-term government debt would have
important effects on the economy, more important indeed than small
changes in government demand obligations. There are economists who
would deny this proposition because in their view only government
demand obligations are capable of affecting the economy. At the other
extreme are others who argue that it doesn't make any difference
whether government debt is issued in the form of long-term bonds or
demand obligations. In my view over sufficient time the economy will
adjust to whatever supplies of various maturities of government debt
are outstanding by the substitution of private securities. But debt management does have shortrun stabilization potential. Proper utilization
of debt management is to lengthen the average maturity of the government debt including reduction in demand debt during periods of
excessive spending. In the opposite circumstances it is appropriate to
shorten the average maturity of government debt and to increase
demand debt in order to stimulate spending. The historical record has
often shown perverse debt management policies from this point of
view. During the 1930's there was substantial maturity lengthening
in government debt. Government support policy during the inflation
of the Second World War and its aftermath had the effect of shortening the maturity of debt, making debts of all maturities essentially
short-term claims on the government. In the period since the Federal
Reserve-Treasury Accord in 1951, the average debt maturity has
tended to lengthen during periods of economic contraction and to
shorten during periods of expansion.
145
The demand for government securities of long term naturally rises
during periods of contraction as investors find weakening alternatives
to government debt. It is precisely at such times that the Treasury
should press short-term securities and government demand debt on
the market to force investors to turn to issues of private securities.
5. (a) It is reasonable that the Federal Reserve conduct open market
operations to prevent shocks to thefinancialsystem that are introduced
by the government itself—for example the effect of Treasury tax collections and spending. But seasonal variability in interest rates and
money market conditions in general may also reflect seasonal cost factors in the economy that should be permitted to direct resources toward
that period of time when they may be employed most efficiently. This
is generally recognized with respect to cyclical variation. But it is not
at all clear that open market operations to prevent seasonal variability
in interest rates contribute to economic welfare. The burden of proof
should be on the Federal Reserve to demonstrate how deseasonalizing
open market operations serve a useful purpose.
( i ) Monetary policy could be effectively implemented solely by open
market operations without causing windfall gains and losses to banks
as is a necessary result when there are changes in reserve requirements.
(c) Changes in other instruments of monetary policy should be introduced wherever there is a strong case that they can add to the efficiency of the financial system. Changes in reserve requirements are
appropriate to affect bank profits and the competitive position of commercial banks relative to competing financial institutions. Changes for
other purposes should be eschewed.
The availability of discounting from the Federal Reserve is not
necessarily as essential to an efficiently operating system. Nevertheless,
this central banking service is typically available not only in the
United States but elsewhere. It may provide a low cost way by which
the financial system can adjust to shocks. But adjustments will occur
whether discounting privilege is available or not. The unanswered
question is whether the adjustment by discounting would be cheaper
than alternatives. Given that there is a discounting arrangement,
changes in the discount rate can have an effect on the economy, though
probably a small one. It is reasonable that the discount rate should
more or less parallel changes in market conditions. The rate might be
automatically changed by fixing it at a certain interest differential
above short term government securities rates or possibly the Federal
funds rate.
(d) I think it is very appropriate that the Federal Reserve should
report to the Congress quarterly about prospective actions and policies
and their likely effects. There are risks in this procedure—risks to the
Federal Reserve that its limited ability to predict and to explain why
it does what it does will become a matter of public record. As indicated
above, I would modify the provisions of H.R. 11 to require the Federal
Reserve to explain the likely effects of proposed regulations. Reports
should include information pertinent to the explanation of the effects
of the actions of the monetary authority. The Federal Reserve should
indicate clearly the nature of the regulation, what the purpose is of
the change in the regulation, what will be the likely effects on banks
and on others. This year the Federal Reserve is to introduce major
changes in the definition of legal reserves and reserve requirements.
146
In some ways these changes establish an arrangement comparable to
that that exists in Canada—an arrangement in some ways designed to
maximize the destabilizing influence of the Bank of Canada on the
financial system.2 There is no public record of w^hat the Federal Reserve thinks it will accomplish by the new regulations. It has requested
major banks to supply opinions of likely effects on their operations.
But what of the public interest ? Congress created the Federal Reserve.
But it didn't create another legislative authority to introduce major
structural changes in banking.
Major changes in the structure of banking deserve a careful hearing
before Congress before they are introduced. Accordingly I would suggest that the H.R. 11 be amended to require reports from the Federal
Reserve on prosipective changes in banking regulations and their likely
effects.
(e) Should the meetings of the Open Market Committee be opened
to representatives of Congress, Treasury, and the Council of Economic
Advisors? I do not think so. The Federal Reserve is an agency of
Government charged with particular responsibilities. It is perfectly
reasonable for Congress to demand that the Federal Reserve explain
precisely why it does what it does and what it proposes to do, but I
can see no particular value in having outside observers at Open Market
Committee meetings. Presumably committees permit individuals to
take strong positions in argument and to get educated. Presence of outside observers might kill an aspect of the deliberative process. I think
it appropriate that the minutes of the Open Market Committee be
made public but that it deliberate in privacy.
II. APPRAISAL OF THE STRUCTURE OF THE FEDERAL RESERVE
1. A certificate of membership is a satisfactory substitute for capital
stock in the Federal Reserve banks. It is appropriate to eliminate Federal Reserve bank stock to demonstrate the public nature of the Federal Reserve. I would support this provision.
2. Reducing the number of members of the Federal Reserve Board
to five from seven would not have any particular cost. The quality of
people selected for the Board would be about the same. The committee
would still be large enough that it need not be dominated by a chairman. Hence, why have seven people when five could do the job? Cutting terms of office to no longer than 5 years might lead to an undesirable turnover of the Board but probably not. The opportunity to reappoint Board members would allow for development of very able central bankers if they could be recognized. That is the key problem, not
the number of members of the Board. I would support this proposal.
3. Making the term of the Chairman of the Board of Governors
coterminous with the President's term is a reasonable proposal and
I support it. It would permit coordination of overall economic policy.
4. The proposal for outside audits of Federal Reserve is also reasonable. Congress does not appropriate funds to operate the Federal
Reserve under the present arrangements. But Congress has the ultimate responsibility for Federal Reserve operations and should have
budgetary control.
2 H. G. Johnson and J. W. Wilder, "Lags in the Effects of Monetary Policy in Canada,"
Royal Commission on Banking and Finance. November 1962, p. 141.
147
5. I support the proposal that Congress appropriate funds for Federal Reserve operations. This would put some teeth in congressional
controls on the Federal Reserve and reduce the independence of the
Federal Reserve to introduce changes in policy and regulations without
congressional sanction.
III. RECENT MONETARY POLICY
Monetary policy has been unduly expansionary in the last year and
a half. If the economy slows in the future and monetary policy actions
follow the pattern of earlier downturns, the stance of policy can be
expected to become unduly contractionary. Monetary policy is inherently a highly flexible instrument of government stabilization
policies, but it has often been and continues to be misdirected by overlooking its own actions and to be myopic by not looking far enough
at the effects of its actions.
Recent changes in the structure of reserve requirements and borrowing from the Federal Reserve are massive in their likely effects on the
economy. Congress should demand an explanation, albeit after the new
regulations have been imposed, and require that no future changes be
made without legislative approval.
STATEMENT OF JAMES S. EARLEY, UNIVERSITY OF CALIFORNIA,
RIVERSIDE, CALIF.
My statement follows the series of questions that accompanied the
request for a statement of viewrs.
I. MONETARY POLICY GUIDELINES AND OPEN MARKET OPERATIONS
1. I emphatically believe that monetary andfiscalpolicies should not
be independent or mutually exclusive stabilization policies. Coordination is vital, and in my judgment not sufficiently provided at present.
My views as to how this could best be secured are set forth later.
A coordinated program set forth at the beginning of each year, as
proposed in the bill, might be useful, but there would need to be
flexibility to take care of uncertain and unanticipated developments.
My later remarks will clarify this position also.
2. I believe that the President should be responsible for formulating and coordinating programs in the monetary and fiscal fields, with
consultative arrangements with the Federal Reserve System.
3. Monetary policy guidelines:
A. I emphatically believe that the goals of the Employment
Act should not be sought via primary dependence on the regulation of the money supply. In my judgment the money supply, however defined, is a false and dangerous guideline. I agree with
Governor Mitchell and the staff of the Federal Reserve Board,
and with most other experts in this field, that no one variable is
sufficient guidance and that excessive concentration on any single
variable will be seriously misleading.
Although knowledge and techniques of monetary and credit
management need to be improved, I feel that the various criteria
used by the staff of the Board of Governors are intelligent ones
148
in the light of our present knowledge. If, however, a specific
group of variables were to be given more attention, I believe
they should be data on the flow of funds in the various credit
markets, together with the fundamental data of employment
conditions and price behavior.
B. I feel that the fundamental objective of monetary policy
should be cast in terms of the maintenance of high employment
and reasonable price stability. If one could assume that the various policies of Government—monetary, fiscal, and others—were
appropriately coordinated, then I would favor specifying some
maximum level of unemployment or general level of utilization
of economic resources as a "target variable." Again, however,
I think that following any single "target variable" or growth
rate thereof, regardless of the economic winds, would be a mistake.
C. If indexes of economic activity were to be used to guide coordinated monetary and fiscal policy, I would favor using leading
indicators rather than coincident or lagging ones. Although I
distrust formulas, I feel that the agencies doing economic forecasting and charged with responsibility for formulating policy
should pay very close attention to the "leading indicators" that
have beenidentined by the National Bureau of Economic Research.
4. Debt management policy: I believe that debt management can
have a supportive although not a large role in reaching the goals of
the Employment Act. It is usually appropriate to issue short-term
Government securities when stimulus to financial markets is desired,
and some benefit may come from concentrating borrowing in the longer
maturities in times of economic overheating. But there are disadvantages in pushing either of these policies too far, and I believe that
the main dependence should be on monetary and fiscal policy rather
than debt management.
5. I approve of the requirement in H.R. 11 that the Federal Reserve
System should conduct open market transactions in accordance with
the programs and policies of the President pursuant to the Employment Act, but I disapprove of the requirement that the Federal
Reserve Board must submit quarterly reports to the Congress, "stating,
in comprehensive detail, its past and prospective actions and
policies * * *." I do feel that the Board should be more responsive
than heretofore to the goals of the Employment Act and the President's economic program, and periodic reports might be useful but I
do not feel the Board can reasonably be asked to be this specific,
prompt, and anticipatory in its reports. Monetary and credit regulation requires a certain degree of uncertainty with respect to future
actions m an uncertain and changing world, and detailed reports on
prospective actions would be harmful, in my judgment.
A. I believe that the Federal Reserve System should continue to have
freedom to use open-market operations for "defensive" and "road
clearing" purposes. Such operations normally facilitate rather than
interfere with the achievement of the fundamental goals of the Employment Act.
B. I emphatically do not believe that monetary policy can be effectively and efficiently implemented solely by open-market operations.
For many reasons the rediscounting power is important to sound credit
management under our banking system. I agree with the recently is-
149
sued proposals for recasting the rediscount mechanism, as set forth
by a system committee of the Board of Governors. This program would
actually increase the role of rediscounting and of the rediscount rate
in our monetary regulation. I believe this would be wise.
C. (a) Rediscounting.—My views on this are set forth above.
(b) Changes in reserve requireinents.—These may be useful in
some circumstances, although I believe that rediscounting and open
market operations are normally the more effective set of instruments.
(c) Regulation Q.—Under present conditions the Reserve Board's
power over maximum deposit interest rates is desirable. The flow of
funds between banks and other depositary institutions is an important
determinant of the influence that money and credit exert on economic
activity. If properly used, the regulation of the deposit rates being
paid by financial institutions may help achieve monetary objectives.
The present system by which this regulation is divided among the
Federal Reserve Board, the FDIC and the Federal Home Loan Bank
Board is, however, an awkward and potentially dangerous one, and
I think firmer coordination should be secured in this matter. In the
absence of effective coordination, it might be better to let deposit
interest rates respond more freely to market forces, so long as there
is effective control of other monetary and credit conditions.
D. My views on Federal Reserve Board reports to Congress have
been stated above. I see some advantage in periodic reports so long
as they do not require great detail or specify precise future actions.
E. I would favor representatives of Congress, the Treasury and the
CEA being observers in Federal Reserve Open Market Committee
meetings. In fact, as explained later, I feel the Open Market Committee itself should be reconstituted.
II. STRUCTURE OF T H E FEDERAL RESERVE SYSTEM
If, as is stated, "the grand aim of H.R. 11 * * * is to provide for
coordination by the President of monetary and fiscal policies," I
feel that some but not all of the listed structural changes in the Federal
Reserve System are advisable:
1. I have no objection to the Federal Reserve banks being
changed from bank-owned to Government-owned institutions,
as provided in the bill, but I do not see that this change is vital
to reach the stated objective of H.R. 11.
2. I do not favor reducing the number of members of the Federal Reserve Board. There is a great deal of work to be done by
the Board, and the present number of members is not excessive.
In view of the desirability of experience and continuity, I also
question whether reducing the term of office to 5 years is advisable.
On the other hand, the present term of 14 years is probably
unduly long. Perhaps 7 years w^ould be a good compromise. This
would permit appointment of a new member at least every year.
3. I favor making the term of the Chairman of the Board
coterminous with that of the President. This does not imply that
there should be a new Chairman each time there is a new President,
but it would help make clear the ultimate responsibility of the
President for the functioning of the Federal Reserve System.
150
4. I see no important purpose that would be served by an annual audit of the Board and the Federal Reserve banks by the
Comptroller General of the United States. I believe that the internal auditing procedures of the System are adequate and on
the whole preferable.
5. I would not favor making the expenditures of the Federal
Reserve System subject to congressional appropriation. I think
congressional appropriation would make transitory political pressures greater than they should be. Monetary policy and central
bank operations are extremely complex, and must be carried out
professionally. Although the ultimate responsibility of the Federal Reserve to Congress and the Nation should be made clear,
the System should not be subjected to great political heat. If the
responsibility and authority of the administration over Federal
Reserve policies were made clear this, along with congressional
power to amend the Federal Reserve Act, would be sufficient
political influence, in my judgment.
I I I . COMMENTS ON RECENT MONETARY
POLICY
Much of the criticism of the Federal Reserve System made by economists has been of its purported failure to take sufficiently vigorous
action to combat the periods of underemployment and sluggish growth
during the later 1950's and the very early years of the 1960's. More
recently there has been criticism that the System has not vigorously
combatted the "creeping inflation" of 1965-68. It is in connection with
these criticisms that some economists have criticized the System for
not paying sufficient attention to changes in the quantity of money.
I share some of the criticism of the System with respect to the earlier
periods of underemployment. Partly because of international difficulties, but also, I believe, because of a real bias of the Board membership
of that time toward "avoiding inflation at all costs", the System did
not in my view carry on a sufficiently vigorous expansionary monetary
policy during several of the postwar recessions. The fact that during
some (but not all) of those periods the stock of money, narrowly defined, actually shrank slightly was not, however, the main cause of the
trouble. Other more sensible criteria would lead to the same conclusion.
Within the last 2 or 3 years the System has been criticized for letting
the money stock expand too rapidly during several intervals, including
parts of 1967 and 1968. More significant of the failure to curb undue
expansion, however, was the fact that bank business loans expanded
even more rapidly than the money stock in most of these periods. The
tendency toward rising prices and other signs of economic overheating
were other more reliable warnings of the difficulties besetting the System than the behavior of the money stock.
But we should not make the Federal Reserve, much less the money
stock, a whipping boy. Within the last year, for example, the System
has again been criticized because prices have risen seriously while the
money stock also expanded considerably. Those who argue that the
Federal Reserve should have taken a more contractionary policy than it
did, are saying in effect that interest rates should have been permitted
to go even higher, and credit become even tighter, than they have been
in recent months. The critics also overlook the fact that the main in-
151
fiationary causes of inflation in 1967-68 have been large Government
expenditures and deficits. Federal Reserve authorities, along with others, called repeatedly for greater fiscal restraint. It is a real question
whether the System, unsupported by fiscal policy, should have been expected to go much further than it did.
The main lesson of late 1965 and of 1967-68 is that improved coordination of monetary and fiscal policy is needed. It would be a tragedy
if the attention of the administration, Congress, the Federal Reserve
officials, and the general public was diverted from this lesson by the
simple-minded notion that some mechanistic control over the quantity
of money would be a remedy for this basic need.
Other provisions of the bill
I agree with the objective of permitting all FDIC-insured banks to
be members of the Federal Reserve System. In fact, I would favor
making this membership compulsory.
Other comments
1. I believe that the Open Market Committee of the System should
be reconstituted to include the Secretary of the Treasury and the
Chairman of the Council of Economic Advisers or their designates. I
also would recommend that the number of presidents of the Federal
Reserve banks on the committee should be reduced to three. I see no
objection and some advantage, however, in having the presidents of all
12 Reserve banks or their designates be present at FOMC meetings.
2. I think that serious consideration should be given to setting up a
new body having coordinating responsibilities and power in the monetary, credit and fiscal fields. Suitable membership for such a body
might be the Secretary of the Treasury, the Chairman of the Council
of Economic Advisers, the Chairman of the Federal Reserve Board,
and possibly the chairman of the congressional Joint Committee on
the Economic Report.
STATEMENT OF OTTO ECKSTEIN, HARVAKB UNIVERSITY
1. Fiscal and monetary policies, including debt management, must
be considered simultaneously and planned in consistent fashion. The
two policies can defeat each other if they pursue opposite objectives,
and excessive reliance on one instrument or the other can produce instability in financial markets.
2. The preparation of the monetary component of the fiscal-monetary policy plan for each year must reflect the actual distribution of
responsibility. So long as the statutes give considerable discretionary
independence to the Federal Reserve System, that agency must prepare
the program. It probably wTould be useful to have a mutual review of
the drafts of the respective reports, although final responsibility must
rest with the agencies that issue the reports.
3.A. The challenge posed to the traditional approach to monetary
policy by the Chicago school of monetary theory has resulted in a useful dialog which comes at an opportune time. Over the last 20 years,
economics has moved in the direction of more precise quantitative analysis. The financial aspects of the economic system have also become
increasingly subject to quantification, although this development is
more recent. As a result, the times are almost ripe for a quantitative
152
approach to monetary policy. Fiscal policy today rests on analyses of
the major macroeconomic magnitudes, such as the gross national product, the unemployment rate, the price level, and the balance-of-payments deficit. Increasingly, econometric models are used to work out
first approximations of the impact of alternative policies on the performance of the economic system. Monetary policy is on the verge of a
similar development.
I do not believe that the scientific tasks are complete, however. There
is no one target variable by wThich monetary policy can be measured.
On the one hand, there are sufficient technical "bugs" in each of the
measures that have been advanced to preclude their use. For example,
the "money supply", whether broadly or narrowly defined, is subject
in the short run, to large swings caused by irrelevant factors, such as
changes in Treasury deposits, tax collection dates, etc. Some of these
factors are partially corrected through the seasonal adjustment procedures; but such correction cannot be perfect because these technical
elements do not follow a rigid seasonal pattern. For example, the rate
of increase of the money supply has been subject to data revision a
year or two after the event because certain seasonal factors were overlooked in the initial estimates. To wholly tie the management of monetary conditions of the American economy to such slender statistical
reeds strikes me as farfetched. On the other hand, a thorough studv
would probably show that the optimal measure of monetary policy is
not one single number, but a pattern of numbers reflecting the several
dimensions such as money supply, the state of liquidity of the various
components of the financial system, the total lending capacity of the
banking system, and the level and structure of interest rates. The impact of the economy on the financial variables must also be identified.
Just as the impact of fiscal policy could not be identified properly until
we had estimates of the full employment surplus or deficit of the budget, we cannot measure monetary policy without correction for underemployment or overutilization.
3.B. I do not believe that we are ready to define precise guidelines
for monetary policy in terms of any index of economic activity or of
the monetary target variables. If the range of a guideline is set very,
very broadly, and if the guideline is not mandatory but simply demanding of explanation if violated, then its use could be adopted
more readily.
In my judgment, if guidelines are adopted, they must be related to
the performance of the economy, not to any index of money or credit
statistics. It seems to me inevitable that monetary policy must be based
on forecasts of the economy, particularly forecasts of the likely performance of the economy in relation to the major objectives of the
society. Of course, rational policy does not rely more on forecasts
than necessary, uses as brief a forecast as possible, and preserves as
much flexibility as possible to respond to changes in actual conditions.
But to tie policy to monetary targets puts the problem on the wrong
track.
3.C. I believe that the National Bureau of Economic Research
classification of leading, lagging, or coincident indicators has been
superseded by later econometric work. In its day it was a useful approach to business cycle analysis. Today any reasonable econometric
model, and there are several, incorporates these notions into particular
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equations, uses the leading indicator evidence systematically and in
rational, quantitative fashion. Econometric models, leaving to judgment those matters which inevitably must remain so ( such as the outlook on defense spending, the likelihood of tax changes, etc.) are the
best approach to forecasting and to the planning of policy. To be sure,
the models must be used with sophistication; changes in economic
structure, the presence of errors, and limitations of the data must be
recognized, and heavy weight must be given to the actual evidence of
coincident developments.
The monetary target variables must be defined in terms that can be
related to the economic model. If the money supply for, example, is
used as the target variable, then the econometric model must use the
money supply as a key variable reflecting monetary influences. Indeed,
the suitability of a target variable must in part be determined by its
ability to make itself felt in econometric models. Vague, general, longrun associations are not sufficient to choose a particular target variable
over others because the empirical associations are consistent with many
alternative economic relationships.
4. Debt management is part of the monetary policy of government.
Because interest cost is a genuine cost of government—despite its quaint
classification as a transfer payment in the national income accounts—
our Government cannot be insensitive to interest cost. Thus, it would
not be appropriate to make the stabilization objective the sole objective of debt management. On the other hand, the Treasury does have a
special obligation to modulate its actions so that they are broadly
consistent with general economic policy; its responsibility is considerably greater than that of even the largest private borrowers.
5A. The management of seasonal credit flowTs was certainly a primary goal of monetary policy at the time that the Federal Reserve System wTas established. We have no subsequent experience with a monetary system that does not contain a central bank managing money to
offset seasonal swings. We do not know how successfully the credit system would adapt to the removal of this form of management, No doubt,
alternative private arrangements would develop. We would not have
an annual money panic at the time of the seasonal surge in bank loans
tofinanceChristmas retail business. But I am not familiar with any attempt to spell out what these private institutions would be like. Nor
have I seen any studies measuring the social cost of public seasonal
credit management. Until there is evidence that there are major social
costs and that the private alternatives have been thought through, I see
no reason to engage in this economic experiment of considerable risk.
5. B, C, D, and E : I have not studied these questions sufficiently to
reach my own conclusions.
II. I have no firm views on the proper structure of the Federal
Reserve System. It does seem to me that the term of numbers of the
Federal Reserve Board is too long, and that the term of the Chairman
should be coterminous with that of the President of the United States.
I also have questions about the composition of the Federal Open Market Committee and of the role of regional bank presidents. The regional
bank presidents are not selected mainly for their periodic responsibilities for national economic policy. It is not clear to me why the
Federal Reserve Board itself is not also the Open Market Committee;
no doubt there are historical or practical reasons. The argument of
21-570—68
11
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regional presentation does not seem to me to carry as much weight
today as in an earlier economy.
I do not wish to submit a detailed review of monetary policy since
1964. On the whole, policy has promoted the general economic objectives of full employment, price stability, balance-of-payments equilibrium, and economic growth. One can quarrel with details of timing and
the extent of some immense credit for managing a flexible monetary
policy during a costly war financed mainly by borrowing.
STATEMENT OF DAVID I. FAND, WAYNE STATE UNIVERSITY
I . QUESTIONS ON MONETARY POLICY GUIDELINES AND OPEN
M A R K E T OPERATIONS
1. Do you believe that a^program coordinating fiscal, debt management, and monetary policies should be set forth at the beginning of
ecwh year for the purpose of achieving the goals of the Employment
Act, or, alternatively, should we treat monetary arid fiscal policies as
independent mutually exclusive stabilization policies ?
2. If you believe a program should be specified, do you believe that
the President should be responsible for drawing up this program,, or,
alternatively, should such responsibility be dispersed between the Federal Reserve System and agencies responsible to the President? (Please
note that informal consulting arrangements can be made as desired
whether responsibility is assigned to the President or divided between
the President and the Federal Reserve. The concern here is with the
assignment of formal responsibility for drawing up the economic
program.)
Answer 1.1.2. In my opinion, coordinating of fiscal debt management and monetary policies at the beginning of each year would be
desirable. It seems to me that too much emphasis has been placed
recently on the stabilization potential of shortrun changes in fiscal
policy. It is far from clear that the evidence does in fact support the
stabilization properties that are attributed to fiscal policy actions. I
would also suggest that monetary policy should be used to stabilize
aggregate demand, and not to bring about abrupt and substantial
changes in policy, as in 1966.
1.3. Concerning monetary policy guidelines:
A. Should monetary policy be used to try to achieve the goals
of the Employment Act via intervention of money supply (defined
as desired) as provided in H.R. 11, or, alternatively, should II.R.
11 be amended to make some other variable or variables the immediate target of monetary policy; for example, interest rates, bank
credit, liquidity, high-powered or base money, total bank reserves,
excess reserves, ana free reserves? Please define the target variable
or combination of variables recommended and state the reasons
for your choice. (If desired, recommend a target variable or
variables not listed here.) It ivould be most helpful if, in providing the reasons for yowr choice, you list the actions the Federal
Reserve should take to control the target variable (or variables)
and also explain the link betyo.een your recommended target of
monetary policy and the goals of the economy as defined by the
Employment Act.
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B. Should the guidelines of monetary policy be specified in
terms of some index of past, present, or future economic activity,
or, alternatively, m fezm? of the target variable's
or growth ?
For example, should the President's 1969 program for achieving
the goals of the Employment Act be formulated to require consistency with some set of overall indicators of economic activity,
alternatively, so that your target variable attains a certain
value or growth regardless of the economic winds? Please indicate
the reasons for your preference.
£7. For only those persons who recommend that some index of
economic activity be used to guide the monetary authorities in
controlling the target variable: Should we use a leading (forward
looking), lagging (backivard looking), or coincident indicator of
economic activity? It would be most helpful, also, if you would
identify the index you would like to see used and specify how the
target variable should be related to this index.
I). For only those persons who recommend that the guidelines be
put in terms of the target variable's value of growth: Should the
same guidelines be used each year into the foreseeable future, or
alternatively, should new guidelines be issued at the beginning of
each year conditioned on expected private investment, Government spending, taxes, and so forth? Please indicate the reasons
for your preference.
E. For only those persons who recommend that the guidelines
be put in terms of the target variable's value or growth and icho
also recommend that the mme guidelines be used year after year
into the foreseeable future: What band of values or range of
growth do you recommend? (By way of clarification, a band of
vahoes appears appropriate if your target variable is, say, free
reserves, whereas a range of growth is appropriate if it is, say,
money supply.)
F. For all those persons recommending that the guidelines be
put in terms of the target variable's value or growth (regardless
of whether you recommend using the same guidelines year after
year or revising them each year in light of expected private investment and fiscal policy) : Under what circumstances, if any, should
the monetary authorities be permitted during the year to adjust the
target variable so that it exceeds or falls short of the band of
values or range of growth defined by the guidelines issued at the
beginning of the year?
Answer 1.3. A-F. It is very hard to legislate guidelines that could
be followed by the monetary authorities in all circumstances. In general, if a rule or guideline is developed it should be in terms of the
money stock or of changes in the money stock, as these are among the
most important variables that the Reserve authorities can directly influence. It is also desirable to develop a stabilization program that does
not require too many short-run changes, as such changes may, at
times, become an independent source of instability
The recent suggestion of the Joint Economic Committee that the
Federal Reserve should try to keep variations in the money growth
rate in a 2- to 6-percent range each year has much to recommend it.
As we develop more experience with this approach it may be possible
to develop a better guide.
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74- Concerning debt management policy: Given the goals of the
Employment Act, what can debt management do to help their implementation? {If you believe that debt management has no role to play
in this matter, please explain why.)
Answer. 1.4. In my opinion the stabilization potential of debt management has been overrated. Debt management properly defined involves essentially a swapping operation, and its overall effects on
aggregate demand are a mixture of several effects. There is therefore
some question as to whether countercyclical debt management is worth
the cost. I would not, however, go to the other extreme and argue that
debt management should be primarily concerned with minimizing the
interest outlay on the debt. Probably the most sensible policy would
be to try to get a stable debt structure, which would indirectly contribute to the stabilizing role of monetary policy.
1.5. Concerning open market operations: H.R. 11 requires that the
FOMC conduct open market transactions "in accordance with the programs and policies of the President pursuant to the Employment Act
of WlfG^ And in this connection, H.R. 11 provides that "The Federal
Reserve Board shall submit a quarterly report to the Congress, stating
in comprehensive detail, its past and prospective actions and policies
under this section and otherwise with respect to monetary affairs, and
indicating specifically how such actions and policies facilitate the
economic program of the President
A. H.R. 11 makes no provision whatever for conducting open market
operations for so-called "defensive" or "road-clearing" purposes, that
is to counteract seasonal and other transient factors affecting money
market and credit conditions. Do you see any merit in using open
market operations for defensive purposes or should they be used only
to facilitate achievement of the President's economic program and the
goals of the Employment Act? What risks and costs, if any, must be
faced and paid if open market transactions are used to counteract
transient influences?
Answer I.5.A. The case for using open market operations for defensive purposes is not entirely clear to me. It is true that seasonal
and other factors could prove to be disruptive in the financial markets.
But defensive measures may also interfere with market processes and
make it difficult to recognize more basic f orces. At the present time we
may be oversupplied with techniques and weapons for such defensive
operations, and it may be desirable to examine these issues to determine
whether some of these operations can be dispensed with.
I.5.B. Do you believe that monetary policy can be effectively and
efficiently implemented solely by open market operations?
C. For what purposes, if any, should {a) rediscounting, {b) changes
in reserve requirements, and {c) regulation Q be used? How might
H.R. 11 be amended to implement your recommendations?
Answer 1.5. B. and C. Monetary policy could be effectively implemented solely by open market operations. It is not, however, clear
that this would necessarily be the most efficient way to operate the
central bank. The other measure mentioned in (c) may, therefore, at
times provide some extra flexibility for the authorities. But here again
it appears that we may have too many weapons. Why do we need both
a discount window, and a provision for borrowing at the penalty rate.
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1.5.D. Do you see any merit in requiring the Federal Reserve Board
to make detailed quarterly reports to the Congress on past and prospective actions and policies? Are there any risks amd costs in this procedure? In what ways, if any, would you modify the reporting provision?
What information do you believe should be included in such reports as
you recommend the Federal Reserve submit to the Congress?
Answer 1.5 .D. I think it might be useful for the Federal Reserve
Board to report to Congress on their policy actions. I am not clear
on whether one could expect them to disclose prospective actions and
policies unless we have a definite rule, and we eliminate all discretion.
1.5.E. What costs and benefits would accrue if representatives of the
Congress, the Treasury, and the SEA were observers at Open Market
Committee meetings?
Answer I.5.E. The benefits of having more officials at Open Market
Committee meetings is that it reduces the likelihood of a serious error.
At the same time, it also makes it more difficult to arrive at a decision.
On balance, a smaller group may be more desirable.
II. APPRAISAL OF T H E STRUCTURE OF TIIE FEDERAL RESERVE
H.R. 11 provides for the following structural changes in the Federal
Reserve System:
1. Retiring Federal Reserve bank stock;
2. Reducing the number of members of the Federal Reserve
Board to five and their terms of office to no longer than 5 years;
3. Making the term of the Chairman of the Board coterminous
with that of the President of the United States ;
It. An audit for each fiscal year of the Federal Reserve Board
and the Federal Reserve banks and their branches by the Comptroller General of the United States; and
5. Funds to operate the Federal Reserve System to be appropriated by the Congress of the United States.
Please comment freely on these several provisions. In particular, it
would be most helpful if you would indicate any risks iwoolved in
adopting these provisions and discuss whether their adoption would
facilitate the grand aim of H.R. 11, which is to provide for coordination by the President of monetary and fiscal policies.
Answer II. 1-5. I think that these provisions emphasize the fact that
the central bank is not a private institution but a Government agency.
They are, in my opinion, desirable measures.
III. COMMENTS ON RECENT MONETARY POLICY
Your analysis of monetary developments, since 1964, including
policy induced changes and their effects on economic activity, is
invited.
Comments III. The implementation of monetary policy since 1965
has been defective, even though Federal Reserve authorities diagnosed
the situation correctly arid took extraordinary measures to correct the
overall posture, when they discovered their errors. The authorities
misinterpreted interest rate movements in early 1966, and therefore
could not clearly assess the impact of their actions. They apparently
failed to distinguish between movements in nominal and real rates, and
between nominal balances and real balances, and like many others
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were oversold on the stabilization potential of short-run fiscal changes.
Their efforts to restrain later on in 1966 was therefore both abrupt
and severe, and generated a small crisis in the money markets—the
so-called credit crunch. Subsequent to the crunch they again overreacted to prevent the so-called minirecession of early 1967. In retrospect, it is evident that the Reserve officials overestimated the impact
of an increase in the (nominal) discount rate, and underestimated the
fact of extraordinary changes in the growth rate of the money stock.
The failure to recognize the diverging paths of nominal and real
interest rates when prices are rising (or falling) has caused errors in
policy in the past. Hopefully, this lesson of the 1965-68 period will
not be forgotten soon.
STATEMENT OF WILLIAM FELLNER, YALE UNIVERSITY
(1) When declaring that the attainment of "maximum employment,
production and purchasing power" is an essential objective of American economic policy, the Employment Act of 1946 uses terminology
that obviously requires interpretation.
For example, our recent unemployment rates—official estimates of
persons who at the time of successive recent surveys were looking for
a job but by then had not found one—are in the neighborhood of 3y2
percent with seasonal adjustment (3 percent without such adjustment).
For some time now the duration of unemployment has been 4 weeks
or less for well over one-half of the unemployed. But the duration has
been 15 weeks or more for a small proportion of the unemployed (during the year 1967 this proportion was about 15 percent) ; and the
incidence of unemployment has been different on different sections of
the population (distinctly lower on married men than on other members of the labor force; distinctly lower on whites than on Negroes,
etc.).
Many types of labor are in short supply. For some time consumer
prices have now been rising at a yearly rate of about 4 percent. New
wages settlements are said to involve 6 to 7 percent increases.
The language of the Employment Act is not particularly helpful in providing guidance in such a situation. Perhaps there is by now
reasonably general agreement among policymakers that of late we
should have played safer against inflation even at the expense of the
current unemployment rate in the foregoing sense. But this conviction can hardly be derived from a literal interpretation of the language
of the Employment Act which formulates "maximum employment" as
the goal of employment policy.
(2) On what to me seems the only reasonable interpretation of an
ambiguous text, the Employment Act tells us that policymakers should
aim for approximating full employment as closely as they can without sacrificing other essential objectives. The proper balancing of objectives must be left to the authorized policymakers of each period. It
is inconceivable that an act should specify all relevant objectives, and
should attach weights to these.
The Employment Act performs the function of serving as a reminder that major policies bear importantly on the employment level,
and that sacrifices at the expense of the level of employment are justifiable only if very important other objectives are at stake. The act,
159
as it now stands, serves as an effective reminder of this to the Federa] Reserve as well as to other policy agencies.
(3) In the long run the conflict between employment objectives
and other significant policy objectives is much smaller than over
periods of shorter duration. This is because raising the employment
level by inflationary means involves reliance on "money illusion," that
is, reliance on the inclination of individuals and of representatives of
private groups to be satisfied with the attainment of money-income
targets even if it turns out that given money-income targets correspond to smaller real incomes than had been assumed. Money illusion is rarely complete: it shows in failure fully to adjust the moneyincome targets to changes in the price level. Temporarily, policies based
on money illusion can appear to be more or less successful, though at
the expense of the stability of the price level. But money illusion
fades away gradually, and the possibility of achieving gams in the
employment level by inflationary methods gradually disappears. An
inflationary policy of forced high employment must sooner or later
be stopped. The measures by which this can be done inevitably reduces employment for a while below the level at which it could have
been kept without inflation.
Whether one does or does not regard the achievement of high employment and the avoidance of inflation as conflicting objectives depends therefore to a considerable extent on whether one takes a short
or a long view of the matter. For reasons not all of which need to be
described in derogatory terms different people assign different weights
to short- versus long-run considerations. However, the public is realizing now that long-run considerations have recently received much
too little weight.
(4) The practices of the recent past have been far from ideal. Any
fruitful analysis of past deficiencies suggests guidelines for the future. In this sense we shuold indeed be looking for guidelines. On the
other hand, I do not believe that the shortcomings of Federal Reserve policy could be remedied by subjecting the System to some specific
formula. The reason why this does not seem promising to me is that
in matters of such complexity no act or amendment could be sufficiently
specific (sufficiently unambiguous) to prevent the adoption of unfortunate policies based on ill-advised interpretations of the text. A
text so rigid as to leave no room for "interpretation" would be unacceptable because the details of the situations in which future decisions
will have to be made are unpredictable. At the end of these comments
I will formulate a proposition that could, I think, serve as a somewhat
flexible guideline to monetary policy (see point 6 below).
(5) In several phases of the recent past the Federal Reserve has
shown more concern with putting a brake on inflation than have other
groups of policymakers. The policies of the Federal Reserve have not
been very successful, but this is a different question on which I will
comment presently. I feel opposed to further integrating the Federal
Reserve System with the Government in the conventional sense because I feel that the Federal Reserve, as it is now constituted, could
more readily afford to take a long view of policy matters (and to accept temporary unpopularity) than can many other policy agencies.
I think Federal Reserve appointments should become less rather than
J 60
more "political." I will add that I see no advantage in exchanging the
stock of the Federal Reserve banks for certificates of membership.
(6) While the Federal Reserve has shown concern with inflationdangers, it has in recent years not been effective in fighting these dangers, not even as effective as it could have been given the fiscal policies
of the past 3 years. The Federal Reserve has rightly been criticized
for letting the economy become oversupplied with liquid assets—particularly with money in the broader sense of currency plus demand
deposits plus time deposits—though the past 3 years do not constitute a period of uninterrupted oversupply.
It follows from what I said earlier that I do not favor attempts to
formulate rigid rules for the rate at which the money supply (in the
relevant broader sense) should be expanded in order to avoid the
dangers of deflation without creating those of inflation. But it does
seem obvious to me that a policy purporting to be one of anti-inflationary restraints miscarries if it leads to an increase of the money supply
at a rate far in excess of the increase in output, and does so under
circumstances in which there exists no reason to assume that at the
given price level the public has a correspondingly increased demand
for money balances. And yet this is what was typically happening in
recent years.
I therefore consider it important that in the future Federal Reserve
policy should be much more mindful of the money supply (in the
broader sense) than it has been so far. It should be mindful of the
adverse consequences of an excessive or of an insufficient rate of increase of the money supply; and wThile the terms "excessive" and
"insufficient" must be interpreted in view of somewhat crude estimates
of the public's money demand at prospective levels of output, of prices,
and of other economic variables, this fact does not by anv means render
the foregoing statement empty (because estimates can be quite unreasonable, especially if they are merely implied). The Federal Reserve
should in the future be able and willing to justify changes in the money
supply in terms of reasonable assumptions concerning the effect of the
money supplv on acceptable objectives. Congressional committees
could exert a favorable influence on the Federal Reserve in this regard,
though I believe that our past policies would have been worse, rather
than better, if the Federal Reserve had been made part of the executive
branch of the Government.
A policy that oversupplies the economy with monev in order to
prevent interest rates from rising to "undesirable levels" is doomed to
become self-defeating even by its own standards, because the inflation
which it causes makes high money rates of interest correspond to low
real rates of interest. Hence, such a policy is apt to lead to very hito;h
money rates. This, too, follows from a proposition formulated earlier
in these comments: policies that work onlv as long as the public is
significantly influenced by money illusion will sooner or later backfire.
STATEMENT OF LEO FISHMAN, WEST VIRGINIA UNIVERSITY
T H E C A S E FOE N A T I O N A L I Z I N G T H E FEDERAL RESERVE S Y S T E M
The stated purpose of H.R. 11 is to make the Federal Reserve Svstem
resnonsive to the best interests of the people of the United States and
to improve the coordination of monetarv. fiscal, nnd economic poliov.
With this purpose I fully concur. To this end H.R. 11 provides for
161
explicitly assigning power over basic national monetary policy to the
President of the United States. Passage of H.R. 11 would thus explicitly invalidate the assumption of autonomy of the Federal Reserve
authorities with respect to basic national monetary policy.
In recent years many well-informed citizens as well as members of
Congress, other public officials, and professional economists have come
to recognize that the two most important sets of tools that can be used
in implementing public economic policy in the United States are the
tools of fiscal policy and the tools of monetary policy.
Somewhat less well known is the fact that each of these sets of tools
has its own advantages and disadvantages. At times the desired ends
may best be achieved by placing primary or even sole reliance on
monetary policy. In other situations it may be best to rely solely or
largely on fiscal policy. If fiscal policy and monetary policy are used
at cross purposes, each cannot fail to counteract, at least to some extent,
the effect of the other. Moreover, even if they are both ostensibly
directed toward the same general ends, neither monetary policy nor
fiscal policy can be used in optimum fashion unless they are adequately
coordinated with each other.
An essential feature of the Employment Act of 1946 is that it
assigns to the President, as Chief Executive officer of the Federal Government, the primary responsibility for coordinating all "plans, functions, and resources" of the Federal Government for the purpose of
promoting "maximum employment, production, and purchasing
power." Statements made at various times during the debates preceding passage of the act indicate clearly that this feature of the
act was not the result of careless drafting or lack of forethought.
Perusal of the debates in Congress preceding passage of the Employment Act of 1946 should be sufficient to resolve any lingering doubts
on this matter. It was the deliberate intent of Congress to strengthen
the role of the President with respect to the determination and implementation of national economic policy. When the legislation had been
revised for the last time and the Senate was about to vote on it,
Senator James H. Murray pointed out that the bill made it clear that
"the basic responsibility for developing the employment program
within the executive branch is that of the President * * *. The effect
of this act," he continued, "is to underscore the responsibility of the
President as the elected representative of the entire country, and as
head of the executive branch of the Government."
It is impossible for the President to discharge the responsibilities
assigned to him in the Employment Act of 1946 unless he exercises
the power to coordinate national monetary policy with national fiscal
policy. In fact, during the debates in Congress preceding passage of
the Employment Act of 1946 it was observed that monetary policy
would be used by the President to promote the purposes of the legislation. On the other hand, no reference was made in these debates to
the powers of the Federal Reserve authorities, nor was any mention
made of their right to exercise their powers independently of the
President.
In recent years, however, the Board of Governors of the Federal
Reserve System has claimed (and on several occasions has exercised)
complete autonomy with respect to monetary policy. On more than
one occasion William McChesney Martin, Chairman of the Board of
162
Governors of the Federal Reserve System, has stated before congressional committees that monetary policy to achieve broad national goals
is determined by the Federal Reserve System. On at least two occasions monetary policies were adopted by the Federal Reserve authorities despite objections expressed by the President and his advisers.
In April 1956, during Dwight D. Eisenhower's administration, the
Board of Governors raised the discount rate although the Chairman
of the Council of Economic Advisers and members of the Cabinet had
held that such action would not be consistent with other Government
policies designed to achieve the goals of the Employment Act of 1946.
Similarly, in December 1965, the Board of Governors raised the discount rate, although President Johnson had recently indicated that
he considered such a change ill advised and ill timed.
Chairman Martin does not often concede that monetary policy is
also determined independently of the Congress, but this is actually
the case. As Senator George W. Malone remarked to Chairman Martin
in 1957 when Martin appeared before the Senate Committee on
Finance, "Congress has not one iota of authority, except the authority
to change the [Federal Reserve] act * * *." Senator Malone also
observed, "Congress has nothing to do with [the administration of
monetary policy] * * *. We can talk to you, but we cannot do anything through it. Your judgment cannot be questioned for anything
done under that act, unless we amend it."
There is evidence that some dissatisfaction has existed in Congress
over the assumption of independence by the Federal Reserve authorities and also over the moneary policies they have followed. In its annual
reports, the Joint Economic Committee has repeatedly expressed disapproval of both the basic nature of monetary policy and the failure
of the Federal Reserve authorities to coordinate monetary policy with
the economic policy of the administration.
In the 1966 report, for example, the Joint Economic Committee declared that it was "seriously concerned about the conduct of monetary
policy in this country." The committee also stated, "While the rest of
the executive branch was coordinating activities and plans preparatory
to submitting them to Congress in January, the Federal Reserve w7ent
its own way."
As long as the Board of Governors continues to assert and to exercise complete autonomy in matters pertaining to national economic policy, it is possible for U.S. monetary policy and U.S. fiscal policy to be
oriented toward different and incompatible sets of goals. It is impossible for the President to coordinate all "plans, functions, and resources" of the Federal Government for the purpose of promoting
"maximum employment, production, and purchasing power."
Proponents of complete autonomy of the Board of Governors of the
Federal Reserve System in matters pertaining to monetary policy have
claimed that their point of view is soundly based on tradition and historical precedent, on judicial decisions, and on legislation enacted by
Congress. In other statements on this issue published within the past
few years I have demonstrated that these claims are not valid. (See, for
example, my article, "The White House and the Fed," which appeared
in the July/August 1966 issue of Challenge.) I have accordingly argued that if the President is to discharge the responsibilities assigned
to him in the Employment Act of 1946, he must exercise the power to
163
coordinate national monetary policy with national fiscal policy; that
the basis for such exercise of power by the President already exists;
and that the passage of new legislation is not necessary.
Nevertheless, the issue has not yet been resolved. Moreover, inasmuch as the structure of the Federal Reserve System and its relation to
the Federal Government are unique, there is some question of what
steps the President might take to bring about such a change and to
enforce his power to coordinate monetary and fiscal policies if he were
challenged by the Federal Reserve authorities. Accordingly, there
would be a definite advantage in the passage of legislation, such as
H.R. 11, dealing explicitly with these matters.
Three provisions of H.R. 11 are designed specifically to correct the
present situation. One of these requires the President to include monetary policy guidelines in his annual economic report. Another stipulates that open market operations and other tools of monetary policy
"shall be conducted in accordance with the programs and policies of the
President pursuant to the Employment Act of 1946 and other provisions of law." The third calls upon the Federal Reserve Board (which
would replace the present Board of Governors of the Federal Reserve
System) to submit a quarterly report to the Congress stating its past
and prospective monetary policy actions and indicating "specifically
how such actions and policies facilitate the economic program of the
President." These provisions of H.R. 11 should have the desired effect.
Their language is clear and explicit, particularly when considered
within the context of the statutes they amend, and the other supporting
provisions of H.R. 11.
To strengthen the coordinate relationship of monetary and fiscal policy under the direction of the President, H.R. 11 provides for substantial changes in the structure and financing of the Federal Reserve System. In effect the Federal Reserve System, which at present is owned
by the member banks, would be nationalized. Stock in the Federal Reserve banks now held by the member banks would be retired; all interest, discounts, assessments, and fees received by Federal Reserve banks
would be paid to the United States Treasury; operations of the Federal
Reserve banks and the Federal Reserve Board (which would also replace the Federal Open Market Committee) would be financed with
funds appropriated by Congress.
It is likely that these features of H.R. 11 will provoke considerab/e
controversy for reasons not directly related to the main purpose of
the bill. It may, therefore, be useful to consider some of the direct
effects of these provisions and to anticipate some of the arguments that
mav be offered against them.
Nationalization of any type of economic activity in the United
States is typically resisted and feared. There is a strong preference for
private ownership and control. An attempt to extent public ownership—and especially national ownership—to any type of economic
activity is generally opposed not only on its own merits, but also because it is viewed as an opening wedge for other similar encroachments
on free competitive enterprise.
In this case, however, such fears are without foundation. The Federal Reserve System, as noted above, is unique with respect to both
the organization and its existing relation to the Federal Government.
The Federal Reserve banks are certainly not free, competitive enter-
164
prises. The Federal Reserve System was organized and has for several
decades been functioning not for profit, but to influence credit conditions, to meet the needs of commerce and industry, and for various
other purposes related to the satisfactory functioning of the monetary
and economic system of the country.
Although each of the 12 Federal Reserve banks is owned by the
member banks in its district, the relationship is purely formal and involves virtually no power with respect to determination of important
policy decisions or control of the level or disposition of earnings. The
important controls and influences, to the extent that they are not
specified in Federal legislation, emanate largely from the Board of
Governors and the Federal Open Market Committee. Nationalization
of the Federal Reserve System thus cannot legitimately be regarded
as an encroachment on free competitive enterprise.
From a purely financial point of view, nationalization of the Federal
Reserve System in and of itself should have relatively little effect. Since
the stock in the Federal Reserve banks presently owned by the member
banks would be redeemed at par, the member banks would experience
no direct gains or losses. And since the member banks cannot presently
receive more than a 6-percent return on the par value of the stock they
hold in their Federal Reserve bank, they can probably earn at least as
great a return by loaning or investing the funds they receive when
the stock is retired.
H.R. 11 provides that future earnings of Federal Reserve banks will
be paid directly to the United States Treasury. Relatively large revenues are derived from the operation of the Federal Reserve banks,
mainly in the form of interest payments on U.S. Government
securities. But under existing arrangements the Treasury already receives over 90 percent of the net earnings (before payments to the
U.S. Treasury) of the Federal Reserve banks, since dividends
payable to member banks are limited to 6 percent as indicated above.
Clearly the magnitude of the possible increase in Treasury receipts
is not sufficient in and of itself to justify nationalization of the Federal Reserve System, nor is this the reason why proponents of H.R. 11
favor nationalization.
One possibility that cannot be completely disregarded is that some
State member banks might discontinue membership in the Federal
Reserve System if the Federal Reserve System were nationalized. Any
such defections, however, would be based largely on psychological
considerations, rather than on any substantive change in the operations
of the member banks or in their functional relationship with the Federal Reserve bank of their district.
If it should appear that large-scale defections might occur, incentives of one kind or another might be offered to State banks to maintain their membership. With minor adjustments, the recently proposed
plan to make Federal Reserve bank credit more readily available to
commercial banks might serve this purpose. It should also be noted,
however, that if open-market operations are used as the principal tool
of monetary policy, the effectiveness of monetary policy is not limited
by the number of member banks or by the volume of member banks'
assets.
165
Other organizational changes provided for in H.R. 11 also appear
to be consistent with the main purpose of the bill. Abolition of the
Federal Open Market Committee, for example, would virtually eliminate the influence of Federal Reserve bank presidents on national
monetary policy. This is as it should be. These presidents are appointed
by the board of directors of their respective Federal Reserve banks,
which are owned by the member banks in their district. There is no
reason why they should play an important role in the determination
of national economic policy, nor is there any true statutory basis for
their exercise of such a role. When the 1935 amendment to the Federal
Reserve Act was passed, Congress did not anticipate that open-market
operations would be used to achieve broad national economic goals.
Indeed at that time Congress specifically refused to grant to the Federal Reserve System any mandate to increase its powers in such a way
as to influence the general level of economic activity. The Federal
Reserve System is authorized by the Federal Reserve Act to use the
tools of monetary p o l i c y to cope with seasonal and other transient
factors affecting money market and credit conditions.
The fiscal autonomy of the Federal Reserve System has enabled it
to assert its independence of the Congress. This independence would be
terminated by H.R. 11 by virtue of the requirement that the Federal
Reserve System operate and administer its affairs with funds appropriated by the Congress. Regular appearances of its officials before
congressional committees authorized to inquire into the financial and
fiscal affairs of the Federal Reserve System will assure full disclosure
and publicity to the details of the operations of the Federal Reserve
System. This process wTill also help to make the Federal Reserve System more responsive to the will of democratically elected officials of
the Federal Government.
My support of H.R. 11 is not based on any sharp dissatisfaction with
the manner in which monetary policy has continuously been administered under the present structure of the Federal Reserve System.
Monetary policy has become a principal method for achieving the goals
of the Employment Act of 1946. The postwar prosperity, the small
number and minor character of the postwar recessions, and the record
long economic expansion that began in February 1961 have in no
small measure been made possibly by sound and judicious use of
monetary policy.
But the time has come for a change. Views and policies of a political nature are frequently espoused by the monetaiy authorities of the
Federal Reserve System. They have become prominent public figures.
Increasingly these officials find themselves in the center of political
controversy as they expound and defend their monetary policies and
the goals they hope to achieve. Monetary experts and technicians must
play a supporting role in the determination of monetary policy. But
the essential political decisions involved in monetary policy determination should be the responsibility of officials who are elected by the
people or who are responsible to elected officials. H.R. 11 will serve to
accomplish this change.
166
STATEMENT OF WILLIAM J. FRAZER, JR., UNIVERSITY OF
FLORIDA1
A bill (H.R. 11) before the House Committee on Banking and Currency seeks to amend both the Employment Act and the Federal
Reserve Act with the view to making monetary policy more responsive
to the need to achieve the goals of the Employment Act. One proposed
amendment would bring monetary policy and debt management explicitly into the Employment Act for the first time. It would require
the President, in presenting his economic program to the Congress,
to make recommendations on fiscal and debt management policies and
guidelines concerning monetary policy, including the growth of the
money supply. Other amendments provide for changes in the structure
of the Federal Reserve, mainly with respect to its policymaking functions. An objective is to improve the coordination of monetary, fiscal,
and economic policy generally.
The legislation comes after years of study, both of the present
structure of the Federal Reserve as a policymaking organization and
of guidelines or rules for the conduct of monetary policy. It gives
rise to a number of questions about the coordination of policies, the
appropriate target (s) for policy, the relationship between the
target (s) and business activity, the form in which target values
should be stated, the role of "defensive" and "dynamic" operations,
the necessary tools, and so on. Section I below deals with the specific
questions that have been raised by the Domestic Finance Subcommittee, pursuant to holding hearings on the legislation; and section II
is an appraisal of the structure of the Federal Reserve in the light
of the legislation, related suggestions, and the background of study
preceding it.
Strands of two familiar controversies about the making of decisions
with respect to Federal Reserve policy run throughout the present
paper; notably, the one over whether decisionmaking should be centralized within a single agency or governmental body or whether the
Federal Reserve should be relatively independent within the framework of government; and the one over whether the Federal Reserve
should follqwT a strict rule or exercise discretion in effecting changes
in monetary policy. The most common argument in defense of the independence of the Federal Reserve in the framework of government
is the quasi-judiciary one, as defined later. Others are introduced, however, relating to compensating errors and a proposed educational function for the Federal Reserve Board. The latter arguments in support
of some form of independence are said to be economic, as distinct from
pragmatic ones. In view of the provision in the legislation for quarterly reporting by the Board, and related guideline and rule suggestions, the arguments for some form of independence on the part of the
Federal Reserve are not necessarily in conflict with provisions for
changing the structure of the Federal Reserve. Nevertheless, with the
view to achieving one of the objectives of the legislation—namely,
making monetary policy more responsive—a case is made for tying
1 A number of individuals read and commented on the initial draft of the present paper;
namely, Profs. Frederick O. Goddard, George B. Hurff, Charles A. Matthews, James G.
Richardson, and Miss Lahoma Riederer, of the University of Florida, and Prof. William P.
Yohe, of Duke University. All are absolved from any responsibility for the commissions in,
and the omissions from, the paper.
167
Federal Reserve policy more directly to the need to refine measures of
and to attain national economic goals, all via newly defined reporting
procedures and a modified form of rules proposal. In particular, the
Federal Reserve should attain within limits, as suggested by the Joint
Economic Committee, a rate of change in the money stock (variously
defined), and should, in addition, achieve an average growth rate in
the money stock over longer periods of time, since the limits are set
to begin with to allow for errors and some defensive and countercyclical maneuvering. Provisions for deviations from the guidelines
are suggested. Deviations should be permitted when empirically verifiable explanations, as outlined later, can be given in the various reports for doing so.
In addition to the strands of controversy, there are throughout the
present paper critical appraisals of a banking view as distinct from a
modified monetarist's view. The banking view is said to be characterized by a preoccupation with banking mechanics, an emphasis on ties
to the money and credit markets, and an emphasis on the prospect of
influencing the achievement of national economic goals directly
through changes in the tone of the money and credit markets ana
degrees of credit ease or tightness. The "monetarist's" label has been
used to apply to those who emphasize mainly the relationship between
rates of change in the money stock and the national economic goals.
Even so, the present modified monetarist's view may be said to be
characterized by an emphasis on interrelationships between changes
in the structure of interest rates, changes in rates of change in the
stocks of bank credit and money, and national economic goals.
With reference to the strands of controversy and the banking and
monetarist's views, the Federal Reserve may be said to have traditionally been alined in defense of independence within the framework
of government, in defense of the exercise of discretion in policy
matters, and with the banking view. Its position in all three of these
instances may be said to have related to a form of mysticism, indeed,
a mystique as described later, not, of course, with respect to every
policymaker or every bank in the System but with respect to the policymakers as a group and the System as a whole. One's position on monetary rules and the Federal Reserve's exercise of discretion is closely
related to a view of economic knowledge (or lack of it). Also, the
original structure of the Federal Reserve System as a policymaking
organization, and the structural changes effected by the Banking Acts
of 1933 and 1935, are said to have been related to problems and economic knowledge of the times, all in relation to prevailing views
about the centralization of power. In view of these immediately foregoing interrelationships, section III below relates a review of aspects
of recent monetary policy to the banking view ascribed to the Federal
Reserve, and section IV is an overall view of notions about rules and
economic knowledge in relation to the Federal Reserve as a policymaking organization.
Some of whatever may be original in this paper centers about the
way in which various elements from earlier controversies are combined, along with analytical notions, in an appraisal of the structure
of the Federal Reserve as a policymaking organization. In summary,
arguments and analysis disclose and support the need for, and the
desirability of, the following: making monetary policy a more serv-
168
iceable instrument of overall economic policy; a form of guidelines,
as suggested by H.R. 11, by the Joint Economic Committee and as
presently modified; structural changes in the Federal Reserve, partially as provided by the present legislation; and reporting procedures, also as partially provided by H.R. 11. The original Federal
Reserve Act may be said to have given proper allowance for the banking view, given the economic knowledge and the characteristics of
the economy of its time, including a relatively close link between
commercial bank loans to business firms and expenditures by such
firms. With the passage of time, however, at least two things have
happened to render the structure of the Federal Reserve as a policymaking organization and the banking view inappropriate: (1) the
simple tie between bank lending and expenditures has been broken;
and (2) the emphasis in attaining national economic goals has shifted
to the more abstract plane of the interrelationships between interest
rates and rates of change in stocks of credit and money and in the flow
of income. Now to make monetary policy more responsive, changes in
the structure of the Federal Reserve are called for. The need for these
changes is indicated by the decline in the relevance of the banking
view and in the related role of judgment about the satisfaction of
credit needs. The proposal for a single policymaking board is supported, subject to the introduction of certain policy guidelines to
allow for the altered nature of the policymaking function, and subject to the retention of elements of the System's original regional
(or Federal) character. The guidelines and the latter provision are
defended on economic grounds.
I. MONETARY POLICY GUIDELINES AND OPEN MARKET OPERATIONS
Under the Employment Act of 1946 the President is responsible
for transmitting to the Congress each year an economic report setting forth a program for achieving national economic goals. The
reports have dealt with about the same topics over the years, with
varying degrees of emphasis on the public and private sectors, the
need for legislation to deal with the President's program, and on the
respective goals—for example, economic stability without inflation,
economic growth, full employment—and later poverty. The reports,
too, at least as early as 1954, have recognized the importance of the
Federal Reserve's control over credit in maintaining economic stability. The discussions on this subject were usually in general terms
of credit case or tightness, sometimes with emphasis on special aspects
of the economy such as housing. One characteristic of the Act and
another of the reports (including the President's report or letter of
transmittal and his Council's supporting report), however, are presently of special interest, notably: (1) the act has been viewed as giving expression to interest on the part of the Government in the aspects
of economic life outside the sphere of credit and monetary policies;
and (2) as the years have passed, more elaborate statistical information has been included in the reports, and the standards of achievement have been continuously on the rise.
The original framers of the act—with the leadership of Congressman Wright Patman in the House and others in the Senate—were
doubtlessly wise in proposing high standards of performance and
169
omitting requirements in the form of fixed quantitative targets. Now,
even so, the rising standards of performance and our enhanced ability
to cope with economic problems seem to require some form of more
specific statements, quantitative in character, particularly about credit,
monetary and interrelated policies. As provided in H.R. 11, the President's Economic Report is now to include recommendations on debt
management and monetary policy guidelines, and there are additional
questions about the Federal Reserve's traditional independence within
the framework of government as well as about their reporting on
credit and monetary policy. Recent hearings and a report by the Joint
Economic Committee also deal with standards for guiding monetary
actions [27; and 28].2 This section, consequently, deals with some of
the questions raised by H.R. 11 and related materials.
1.1.—Do you believe that a program of coordinating fiscal, debt
management and monetary policies should be set forth at the beginning of each year for the purpose of achieving the goals of the Employment Act, or alternatively should we treat monetary and fiscal
policies as independent mutually exclusive stabilization policies?
The recommendations for a fiscal policy must allow for monetary
policy,3 and vice versa. For example, shaping the revenues and expenditures of the Government so as to affect the flow of income and the levels
of employment and prices affects the amount of bank credit and money
needed to achieve maximum employment, production, and purchasing
power. Such a fiscal policy would also affect interest rates. A tax credit
for capital expenditures by businesses, such as initially adopted in the
United States in 1962, would in particular affect interest rates. The tax
credit seeks to alter the rate of return (or the flow of returns) on additional capital expenditures with the view to inducing a larger flow of
expenditures and in so doing it affects the rate of interest [14, pp.
9-11], defined either as some abstract rate or as a market rate.
The rate of return on additional plant and equipment and the rate
of interest are closely related. In fact, changes in the rate of return
on capital expenditures possibly have more direct effects on the rate of
interest than changes in bank credit [17, pp. 212-213] .4 This prospect
is, in addition, related to the view that the volume of bank loans to
manufacturing firms is more largely determined by conditions on the
demand side of the market for bank loans than by conditions on the
supply side [15, pp. 77-78].
2 Numbers in brackets refer to references listed at the end of this paper. Sometimes page
numbers are given in addition. References to the various sections and subsections of the
paper appear in parentheses : e.g., (sec. I) or (sec. I.S.A).
8 The term "monetary policy" is used to mean a variety of things. Sometimes it is used
synonymously with the term "Federal Reserve policy," particularly with respect to credit
conditions (as indicated by, say, a rate of interest), the money stock and bank credit (that
is the stock of bank loans and investments). At other times—particularly since "the
revival of belief in the potency of monetary policy" in the 1950's, and 1960's [20, pp.
2^3]—"monetary policy" means policy with respect to the rate of growth in the money
stock (defined as currency plus adjusted demand deposits, or as some broader measure,
for example including time deposits). The present question uses the term monetary policy
in the first of the preceding senses, but a; sharp distinction in meanings becomes important
in dealing with some of the questions as in the present instance.
* This point is related to the possible view that banks, bankers, and the banker-dominated
Federal Reserve (36, pp. 35-36) have unusual influence on the level of interest rates
(28, p. 22) as distinct, say, from the fiscal and tax policies of Congress. There was no doubt
a time historically when the availability of credit and interest rates on funds for business
expenditures were primarily and arbitrarily set by bankers, but the Congress today shares
a greater part of the responsibility for high or low interest rates, the inflationary element
in interest rates (19 and 23), and for prices than at a former time. There are the tax
policies, as well as a host of others, including those with respect to a sustainable level of
unemployment (20, pp. 7 - 1 1 ) , and some "natural" level of structural unemployment (i.e.,
unemployment due to the mismatching of job skills and job vacancies). Programs concerning job retraining and minimum wages are involved.
21-570—68
12
170
Despite the interrelationships between Federal Reserve and fiscal
policies, coordination of the policies should be sought on an informal
basis at least, and by having the Federal Reserve report explanations
for its policies to the Joint Economic Committee, as has been suggested
as a constraint 011 discretionary policy [28, p. 17]. There is a case for
the independence of the Federal Reserve as a policymaking organization as it may be revitalized (sec. II). The Federal Reserve's function, as redefined in H.R. 11 and this paper, could be viewed as special
and distinct, without there being excessive conflict in the uses of the
diverse Federal Reserve and fiscal policy instruments and in the
economic objectives of the Federal Reserve and the agencies of the
executive branch of the Government.
1.2.—If you believe a program should be specified, do you believe
that the President should be responsible for drawing up this program,
or alternatively, should such responsibility be dispersed between the
Federal Reserve System and agencies responsible to the President?
The responsibility for drawing up programs concerning economic
policies should be a function of the respective agencies. The Council
of Economic Advisers should be responsible for coordinating programs
of agencies in the executive branch, for presenting a general economic
forecast, and for expressing its views on rates of change in bank credit
and the money stock. The Federal Reserve should be responsible at
least for increasing the money stock during any quarter at an annual
rate, say, of not less than 2 percent or more than 6 percent (27, p. 230,
and 28, pp. 16-17), subject to other qualifications given later (sees.
1.3. and I.3.D toF).
As is presently the case, the Federal Reserve System should be
accountable to the Congress (and the Joint Economic Committee in
particular) for the achievement of national economic goals. The executive branch of the Government, too, subscribes to national economic
goals, but due to its essentially political character its relation to the
Congress will be more tenuous than that of the Federal Reserve, even
a revitalized Federal Reserve.
The Congress is responsible for specifying the national economic
goals to which all agencies of the Government subscribe. Any major
departure from the goals as defined by past interpretations, such as a
long-term goal of faster economic growth (that is, a higher rate of
change in gross national product per capita in constant dollars) should
be approved by the Joint Economic Committee, and possibly by congressional statute.
As further emphasized subsequently (Sec. I.3.B), once a specific
target value such as the rate of change in the money stock is set,
values for other variables are determined, given fiscal (or fiscal and
tax) policy and the structural characteristics of the economy. These
structural aspects have influence either by remaining unchanged or
being changed. They would include the degree of the inadequacy of
job skills for jobs, minimum wages, factors affecting the degree of
competition in product and labor markets (18, pp. 337-351), Government subsidies on housing, interest rate ceilings on FHA-insured and
VA-guaranteed mortgages (18, pp. 404-412), the extent of support
for mortgages in secondary mortgage markets, and so on. All of these
aspects of the economy are virtually beyond the purview of the Fed-
171
eral Reserve, although the effects of its policies will depend on them.
These must be considered. Nevertheless, monetary and credit policies
generally viewed can be frustrated directly in proportion to the Federal Reserve's efforts to give weight to the special effects resulting
from the structural characteristics of the economy.5
1.3.A.—Should monetary policy be used to try to achieve goals of
the Employment Act via intervention of money supply (defined as
desired) as provided in H.R. 11, or alternatively, should H.Ii. 11 be
amended to make some other variable or variables the immediate target of monetary policy f
As Mitchell has emphasized (27, p. 120), "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 economy." Even so, when the Board of
Governors and the Federal Open Market Committee are left free to
select one variable and then another and to express policy in any
of a wide variety of measures, and when a policy in the System is arrived at through a consensus of opinions about policy (first, of Federal
Reserve economists making recommendations and, then, by the policydetermining authorities), all as distinct from the reasons for the policy,
then ignorance is compounded by ignorance. The result of arriving at
a policy by consensus about the policy rather than the underlying reasons is a policy that cannot be explained by a proper use of language.
The written language comes to be used to conceal meaning and thwart
communication, while giving the appearance of dealing with fundamental truths.6
The joint committee is apparently correct in the view (28, p. 12)
that "the Federal Reserve does not appear to have developed a set of
priorities for its own guidance." 7 Moreover, they have not sought to
develop the explanations underlying their policies in any empirically
verifiable form; and the Federal Reserve's effort on a large scale proj5 Common illustrations of the effect of the Federal Reserve's policy (viewed in terms of
interest rates) involves instances in which some temporarily invariable ceiling exists on
the interest rate payable. Governor Mitchell, for example, cites as one of the best examples
of the effect of policy the postponement of a revenue bond issue of the Chesapeake Bay
Bridge (27, p. 131). He said, "if the level of interest rates was raised, it (the project) could
not be financed." Well, this is a perversion of the focus of monetary policy in the presumed
context of a relatively free enterprise economy, and it is not an illustration of the effects
of policy as it might apply, say, to manufacturing corporations (e.g., 15). The justification
for interest rates as a general credit control device would seem to require more than examples from the welfare and Government-oriented sectors of the economy. The tendency
to invoke such examples in defense of discretionary monetary policy is itself an example
of two things : (1) the extreme to which the defense of discretionary policy may be carried ;
and (2) the need for some stabilizing constraint on such policy.
6 This is why Representative Reuss has trouble with the language in which monetary
policy is discussed (27, pp. 229-23i3). This, too, is why the Joint Economic Committee
reports on the minutes of the Federal Open Market Committee as follows (28, p. 10) :
The minutes made available are couched in the most general, nonquantitative monetary
and stabilization terms. They have tried to indicate a considerable reliance on institution
and mystique in shaping actions rather than giving Congress, or observers of monetary
affairs, a full opportunity to follow the developing and sometimes conflicting concepts
or reasons which have influenced decisions.
7 The improvement of decision rules or even their possibility is not discussed in the
Federal Reserve System's writings. Ironically, Christian comments to me that his findings
(7) suggest "that a tacit, inarticulable, or unconscious set of decision rules were followed
by the monetary authorities over the study period." Possibly the absence of references to
rules in 'System research and the recurring possibility of the presentee of an unconscious
set come about because even the discussion of rules suggests an increasing obsolescence
of the tools of the trade of the discretionary authorities. The interests of officials can be
advanced with subtlety and power. In some instances these become competitive with some
and complimentary with other types of research.
172
ect, the Fed-MIT model, is just further evidence of a Federal Eeserve
"mystique" 8 noted in a committee report (28, p. 12).
A good bit of discussion has centered about defining the proper
indicator of Federal Reserve policy (14, pp. 16-25; and 26, pp. 91-102).
At the one extreme there has been the view that the true indicator
cannot be influenced by any factor outside of the control of the Federal Reserve. This narrows the responsibility for control to Federal
Reserve policy actions—that is, open market transactions and changes
in discount rates and reserve requirements. At a different level, there
has been a tendency to emphasize, as Dewald and Gibson do (11), that
regularity exists in noncontrolled factors affecting member bank reserves and that their behavior can be adequately predicted so as to
give the Federal Reserve control over member bank reserves. Going
a step further, there appears to be sufficient agreement that the Federal Reserve can (as distinct from should) control the money stock.9
At still another level of Federal Reserve responsibility there has
been a tendency to emphasize (1) credit flows or interest rates (27, p.
168), (2) the change in the relationship between prevailing and prospective rates (14, pp. 35-39), and (3) even changes in the structure of
rates (15, pp. 73-74). Gaines suggests (27, p. 168) that interest rates
are subject to the direct influence of the Federal Reserve in an operational sense; "while changes in the money supply are influenced by
Federal Reserve policy, the influence tends to be at a second remove
rather than at a direct point of entry of the central bank into the economic process." In the case involving the change in the relationship
between present and future rates the Federal Reserve is even made
responsible for the level of the income velocity of money. Changes in
business conditions, as indicated by changes in the velocity are said
to be brought to the level of Federal Reserve operations (14). This is
highly abstract. A potentially useful concept is simply set forth without elucidation.
Now changes in rates of change in bank credit, member bank deposit liabilities or the credit proxy (27, p. 132), and in the money stock,
and changes in interest rates and the term structure of rates are all
interrelated. The present point, however, is this: as one moves from
8 Characteristic of the mystique is the apparent assumption that knowledge about the
effects of policy exists and that it is embodied in judgment about the need for a particular
policy. Those invoking the mystique as a substitute for knowledge have often seemed to
present as their best defense, (1) an acquaintance wih a frustrating array of facts and
details and (2) the promise of future research to confirm the validity of their view. The
traditional tendency to invoke increasingly complicated detail as a disguise for knowledge
has apparently contributed to the Federal Reserve's support of the "Fed-MIT," "special
purpose," "large-scale," "econometric" model ( 1 0 ; and 14, p. 6). The model has been often
cited as progress in the right direction (27, pp. 190, 2 0 0 - 2 0 1 ; and 28, p. l;5).
The research support apparently resulted from a misconception of either monetary policy
or the special purpose model in its exploratory stages. Principal difficulties with the
model, apart from statistical ones commonly mentioned, concern (1) the emphasis on
linkages as "causal" sequences and (2) the prospect of varying a controlled variable so as
to achieve a specific target value in another so-called "dependent" variable.
9 The pro-rules economists of course accept this (27, pp. 77-118) and Guy E. Noyes of
Morgan Guaranty expresses a possibly widely held view as follows (27, pp. 181-182) :
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 Rhort, 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 whatever it chooses,
because large changes in short periods would create some institutional problems—but no
one is talking about large abrupt changes anyway. So this qualification has no practical
significance.
Tilford C. Gaines says (27, p. 200), " I think that if the state of knowledge is not yet
sufficient for them to provide a more sophisticated framework, that money stock would
be an acceptable first approximation."
173
changes in the rate of change in the money stock to changes in the
structure of interest rates, one is at the same time ascribing an increasing amount of responsibility to the Federal Reserve. The phenomena
they work with become increasingly complicated. At the highest level
of responsibility, we are holding the Federal Reserve responsible for
offsetting shocks to the economy from outside factors, for dealing with
shifts in expectations, and so on.
As a first approximation to minimizing chaos, however, the course
as suggested by the Joint Economic Committee is clear (28, p. 11): The
policymaking officials of the Federal Reserve System (or a reconstituted group as suggested in H.R. 11) should maintain on a quarter-byquarter comparison, an appropriate normal range of increase in the
money stock seasonally adjusted, say, of from 2 to 6 percent per
annum,10 subject to some qualifications as noted now and later (sec.
I.3.D to F). The present qualifications are as follows: (1) the policymaking officials should also be responsible for providing empirically
verifiable explanations for changes in the money stock extending above
the upper bound and below the lower bound; 11 and (2) the Federal
Reserve officials should be encouraged to pursue sophisticated policies
as they develop the capacity and understanding for carrying out such
policies. As mentioned elsewhere (15, pp. 68-69) :
If there is knowledge underlying deviations from simple rules such as given
growth rates in bank credit and the money stock, then presumably it can be put
in empirically verifiable form and verified, given large research staffs and the
modern computer. If such knowledge of policy and its effects cannot be demonstrated, then there would seem to be little room l e f t f o r judgment. In such a case,
adherence to a "neutral position" or simple rule would seem to be the best course.
I.3.B.—Should the guidelines of monetary policy be specified in
terms of some index of past, present or future economic activity, or
alternatively in terms of the target variable s value or growth?
The terms "economic activity" and "business conditions" may be used
interchangeably. The former suggests activity such as hours of work,
the number of people working, and so on. Economic activity may be
constant and coincide with given levels of employment, unemployment (and, therefore, with a constant percentage of unemployment),
prices, and rates of interest, as well as with constant rates of increase
in output, income, and the money stock (and, therefore, with a eon10 As the Joint Economic Committee has indicated (28, p. 17) "there is no intention
to make the 2- to 6-percent range a permanent and unchanging one." They note a variety
of factors that may affect the range. Selden mentions the desirability of change in any
monetary rule (27, p. 98).
11 An empirically verifiable explanation
would be one containing statements about
economic relationships between variables. They should be of a form that could be refuted
or affirmed by certain tests. The statements and accompanying discussion should be of
sufficient substance to permit testing in several ways: (1) by reference to empirical data
and results from statistical analyses of such data ; (2) by testing against known alternative
explanations to determine the best one ; and (3) by testing for logical consistency within
the explanation as well as for consistency with other explanations on other occasions.
Such complicated testing is important in social studies as distinct from laboratory sciences
for several reasons: (1) because of the inability to control certain variables while others
are operating; (2) because of the wide variety of interrelationships between economic
variables; and (3) because of the shortcomings of certain statistical methods when applied
to noncontrolled experiments (i.e., experiments in which other things are not controlled
when the effects of a given variable are being considered).
The Joint Economic Committee, or other potentially appropriate committees of the
Congress probably should not contend directly with the foregoing sort of explanation.
Nevertheless, there could be a shorter explanatory statement for the committee and a more
formal underlying statement. The availability of the latter to monetary economists and
other interested citizens would contribute to the soundness of the explanation. The socalled explanations to the Congress would not of course change radically, just by voting
a statutory requirement; there would still be a good bit of "Federal-Reserve-ese" for some
time. A statutory requirement, nevertheless, would stimulate movement in the right
direction.
174
stant ratio of income to money). Thus "economic activity," interest
rates, and the velocity ratio may all decline when output and income
are increasing, only at slower rates. This is the w7ay some economists
use the term "economic activity." 12 Although one must recognize the
difficulty in identifying turning points in business conditions as a
practical matter, commonly used ones are those of the National Bureau of Economic Research.13
In view of the foregoing, guidelines for Federal Reserve policy can
be specified in terms of levels for interest rates, prices, the ratio of income to money, and business conditions, on the one hand, and rates
of change for the money stock, income, and so on, on the other. Specifying targets in terms of these levels and rates of change is not inconsistent. The tw^o sets of changes are not alternatives as the above
question implies. For example, programs for achieving the goals under
the Employment Act may be formulated to call for given rates of
change in income, and given levels for employment (and unemployment as a percentage of the labor force) and economic activity.
The levels and rates of change as set forth, however, are not independent (17, pp. 304-319). Once a specific target value is set for one
of the variables, values for the others are implied, given fiscal policy
and the structural characteristics of the economy. Changing the interrelationships between the variables would for the most part require
structural changes in the economy. These would involve, for example,
changing the level of structural unemployment (i.e., unemployment
due to a mismatching of employee qualifications and job requirements) through educational programs, or changing housing demand
through Government subsidies and interest-rate ceilings on FHAinsured and YA-guaranteed mortgages. These latter changes are of
course outside of the purview of the Federal Reserve.
1.3.0.—Should we use a leading {forward-looking), lagging (backxoavd-looking) or coincidental indicator of economic activity?
Forecasters get relatively good scores if they can recognize turning
points in business conditions once or shortly after they occur, as Fels
emphasizes in reporting on the problem of forecasting and recognizing business cycle peaks and troughs (13, pp. 3-48) . He also notes (13,
pp. 47-48) weak evidence "that users of the NBER indicators approach
actually have done better than their fellows." One may, consequently,
view the matter of forecasting separately from that of selecting a desirable indicator of economic activity. Even so, indicators selected for
the purpose at hand should have their turning points coincide roughly
with turning points in business conditions as reported by the NBER.
These indicators also should relate fairly directly to the national economic goals for employment and incomes, on the one hand, and to
Federal Reserve influence in the operational sense, on the other.
There has been controversy over what we mean by "levels of business" in the context
of analyses of the relationship between the rate of growth of the money supply and the
level of economic activity (e.g., 14, note 29, p. 14). More recently and in a similar context, statements in Joint Economic Committee hearings by Wallich (27, p. 17 and 20)
and Davis (27, p. 310) attribute incorrect meaning to Milton Friedman's use of the terms
"business activity," "economic activity," and "levels of business." Therefore, I have sought
to be explicit about the use of the term "economic activity."
13 The National Bureau's dates for peaks and troughs are so widely accepted that Fels
uses them in scoring the accuracy o-f forecasters (13). In other words, he has the forecasters attempting to forecast or identify what the National Bureau will subsequently
date as a cyclical peak or trough. To change a Keynesian metaphor slightly, the matter
is analogous to forecasting the winner of a beauty contest: you must select not necessarily
the prettiest, but the one you think will be selected by the judges to be the prettiest. (On
the dating of turning points specifically, see ref. 13, note 2, pp. 3 - 4 . )
The suggested indicators are as follows: the ratio of income to the
money stock (i.e., the velocity of money ratio (14, pp. 1-41)) ; the interest rate on some long-term debt instrument (e.g., Moody's Aaa
corporate bond rate or that on long-term governments) ; and the
spread between the yields (as rates) on long- and short-term bonds
(15, pp. 66-101). These measures possess in high degree the attributes
listed above, especially after some smoothing and allowance for "noise,"
and allowance for the role of judgment and imperfections in the
NBER's technique. Moreover, the velocity-interest rate association is
one of the strongest that exists in economics (17). The relationship
holds for the economy generally as well as for the key business and
consumer sectors. So we have closely related variables as well as variables that relate to economic activity generally, and Federal Reserve
operations and national economic goals in particular. Abstracting from
the seasonal and defensive type operations of the Federal Reserve (37,
p. 8), the velocity-interest rate association is sufficiently strong to imply
an income target once targets for the money supply and a long-term
rate of interest are given.
In relating the target money stock variable or the target interest rate
variable to the velocity ratio, one should not think in terms of lags in
causal effects or in terms of invariant distributed lag patterns, as have
become so common in the monetary research of the 1960's (e.g., 27, p.
222; and 14, pp. 25-39). Friedman, for example, has measured the average lag time between peak rates of change in the money stock and the
peaks m business conditions, on the one hand, and that between trough
rates of change in the money stock and troughs in business conditions,
on the other. But these are averages and they likely vary with the duration of the cycle. Furthermore, m reviewing results from analyses of
so-called distributed lags in the relationships between time series, one
is confronted with a constant lagtime and a fixed distributed lag
pattern, whereas neither the lag time nor the pattern is invariant over
time.14
Now the foregoing points about the inadequacies of notions about
lagged "effects" and constant distributed lagged patterns may be illustrated in two different ways. Recall, to begin with, two very different
periods in monetary history: (1) the classical pushing on a string,
1937-38 period (8, pp. 26-32; and 34); and the intensive capital boom
ending in 1966 (15, pp. 72-93). In the one period, the economy was in
deep depression by post-World War II standards, excess reserves of
banks were substantial, and some negative yields were reported on
Treasury bills (8, pp. 29-30). In the boom ending in 1966, the reverse
conditions prevailed. We would not, I suggest, expect a given increment in reserves or a given rate of increase to have the same effect on
the money supply in these two instances or for the two effects to be
distributed in the same patterns. Indeed, the Board of Governors
thought that the link between reserves and the money supply was very
weak at the time of the 1937-38 recession.
14 To be sure, recent research reveals just such instability in so-called lag coefficients.
In testing for the stability of regression coefficients, for example, Christian concludes
as follows (7. p. 477) : "both the irregularity of response to inflation and the instability
of the coefficient of the lagged dependent variable further suggest that the distributed
lag formulation of the linear model is unreliable. It has also been demonstrated that the
single-period regression equation is substantially less efficient than the moving regression
in obtaining information about the behavior of the monetary authority."
176
The Federal Reserve has much more control under moderately stable
or high-employment conditions than under the extreme conditions of
1937 and 1938, or so it would seem. The lagged patterns are not fixed.
There is a premium on maintaining economic stability, both because
of welfare considerations and because of the greater control we have
over the economy.
Additional evidence of the inadequacies of notions about causal
sequences and lagged effects in the relationship between aggregate
time series is provided by an examination of characteristics of the
corporate manufacturing sector (16). In one traditional instance, it
has been common to view roughly parallel movements in bank loans
and business inventories and to conclude that the funds from the loans
were being used to purchase the inventories. As further research has
revealed, however, firms differ in their financial structures and holdings of inventories vary disproportionately with their reliance on bank
loans, all as they increase in asset size. Over time somefirmsare buying
inventories to a greater extent than others and some are borrowing
funds from banks, all in such a way that roughly parallel changes
occur in the time series. Other examples of the inadequacies of analyses
that treat relationships between aggregate time series as "casual" and
of a "fixed" distributed lag type could be cited (e.g., 15, pp. 66-104).
However, my summary answer to the question of how the target
variable (s) should be related to the index of business conditions
(namely, the velocity ratio) is to beware of notions of "causal" and
fixed distributed lags. Instead, rely on the concepts of cyclical and
secular changes, such that varying patterns between the series unfold
over time. We should conceive of entire cyclical and secular phases
and of the possibility of achieving sustainable rates of growth in stock
and flow variables, with the view to eliminating economic instability.
This is in lieu of thinking about a controlled variable that you change
by a specific amount to obtain, after a fixed time, a certain pattern of
effects, other things being equal in the sense that they remain unchanged. The other things are not unchanging in our going economy,
even though the statistical method in wide use (i.e., the classical, least
squares, regression method) has built into its computational mechanism the assumption that they are.15
There are, finally, cyclical and secular patterns in the aggregate
time series, and some of the respective series must reflect some responses
to the same factors, as well as aspects of the financial structure of firms
and other structural aspects of the economy. This is particularly true
if, as suggested above, the aggregate series are not causally related in
a strong and direct way. The apparent support for the view that some
time series share in common responses to the same changes in the
setting is one reason why expectations in monetary analysis deserve
some emphasis (e.g., 14 and 15). It is also a basis for agreement with
those who wish to reduce the wide swings in the rate of change in the
money stock as a means of stabilizing the economy, until we understand better the factors affecting expectations.16
15 These last sentences may be compared with footnotes 7 and 10 above.
18 References to expectations in the May 1968 hearings of the Joint Economic Committee
are instructive!
Mr. MITCHELL. Some of the monetary lags are short. The effect on expectations ia
immediate * * *.
Mr. MITCHELL. Well, this gets to be kind of troublesome. A lot of the meaning, the
influence of monetary action is on expectations.
Chairman PROXMIRE. Here is what I think is the kind of thing he (Professor Christ) is
getting at. He is pointing out that you did have this very hard to understand and explain
177
1.3. D to F.—Should the same guidelines be used each year into the
foreseeable future, or alternatively, should new guidelines be issued at
the beginning of each year conditioned on expected private investment,
Government spending, taxes, etc J Under what circumstances may
the guidelines be changed?
The rate of change in the money stock has been mentioned as the
guideline for Federal Reserve operations. Also, an appropriate normal
range of increase of from 2- to 6-percent per annum, after seasonal adjustment, has been mentioned (sec. 1.3.A.). This range should be sufficient (1) to allow for Federal Reserve's inability to achieve a target
value within the range during any quarter and (2) to permit some
countercyclical maneuvering, preferably with minimum rates occurring in expansion phases of business activity and maximum rates falling in recession phases. I would, however, further recommend an
average rate of change per annum for the longer period, since there
should be no question of the Federal Reserve's ability to achieve it.
The 2- to 6-percent range would seem to imply a secular growth rate
of about 4-percent per annum, depending on whether the Federal Reserve sought above or below average values most frequently.
The 4-percent average rate is on the high side, assuming a narrowly
defined money stock (i.e., currency plus demand deposits adjusted)
and judging from secular changes in the post-World War II period.
The Federal Reserve and possibly the Council of Economic Advisers,
therefore, may wish to suggest a lower stock and an accompanying
revision of the limits with the spread in percentage points remaining
unchanged. The principal justification for changing the secular rate
would be a revision of the outlook for the long run. Certainly, this
should be relatively stable, since it should be relatively free of the
effects of transitory influences. But revisions may be permitted in the
average growth rate at intervals, again with well-founded explanations for doing so. These revisions could correspond to the average
length of post-World War II business cycles. As stated earlier (sec.
1.3.A.), the Federal Reserve would still be free to vary the rate of
change in the money stock beyond the maximum rate or below the
minimum rate provided that an empirically verifiable reason can be
given for doing so.
An infrequent change in the average growth rate for the money
stock is preferred for a combination of reasons, namely: one objective
is to try to stabilize unwarranted changes in policy, and a distinction
between transitory and more pervasive influences should be possible.
If the guidelines can be changed frequently (i.e., the average rate and
the 2- to 6-percent range) without well-founded explanations for
doing so, then the guidelines as such are of no use at all.
situation that occurred last year (i.e., 1967), in which the money supply was increasing
rapidly and the price of money (i.e., the rate of interest) 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 inflationary, and because under these circumstances the
economic reactions 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
would not have that kind of expectations, and interest rates would be inclined to be lower.
(See 27, pp. 131, 133, and 140, respectively.)
178
I.Given
the goals of the Employment Act, what can debt management do to help their implementation?
In the management of the Federal debt, the Treasury exerts several
possible influences. These in turn have the possibility of helping in
the implementation of the goals of the Employment Act. The first set
of possible influences concerns changes in the composition of the debt,
both with respect to the Treasury's savings bond program and with
respect to the time-to-maturity distribution of the marketable portion
of the debt. The savings bond program (including advertising and
promotional aspects) has the possibility of influencing saving by the
public out of current income. This could imply some direct effect on
expenditures and therefore on the average of prices for current output, the rate of increase in gross national product and the level of
employment. Most of the potential influence of the savings bond program is likely on changes in the composition of individual savings and
secondarily on increases in the rate of change in saving out of current
income. The effect on current income is unlikely to be noticeable except
during periods of national emergency when appeals may be made to
patriotism.
Changes in the time-to-maturity composition of the marketable
debt (i.e., in proportions of the marketable debt according to short-,
intermediate-, and long-term debt instruments) have the possibility of
exerting two effects: (1) contributing to the potential effectiveness of
monetary policy (defined with respect to interest rates), and (2)
"twisting" of the term structure of interest rates or the yield curve
(i.e., varying the spread between the yields on long- and short-dated
Government securities, and at the same time varying the slope of the
line resulting from the fitting to a scatter of points consisting of yields
and corresponding dates for the maturity of different issues of Government securities). In the first instance, increasing the proportion of
the debt in the long maturity sector affects the liquidity of some financial institutions at the time of rising interest rates. As is well known,
a given rise in interest rates across all maturities is accompanied by a
greater price decline on long-term issues; and over the cycle of yields
on "default free" securities, the yields on short-term securities vary
more than those on long-term issues. The holders of long maturities in
effect get frozen in or locked in to some extent during the transition
from lower to higher rates.17 Thus, the larger the proportions of longterm issues the greater the potential for locking in the securities and
reducing liquidity. A difficulty encountered in relying on this effect is
that the commercial banks, significant holders of governments, have a
37 Evidence of a lock-in effect at commercial banks has been reported as a result of analyses of cross-section data for the 1965-66 period (29). The effect depends on reluctance to
realize losses on marketable securities. Kane finds, in particular, that banks' unwillingness
to take such losses varies inversely with their capital position. Underlying the reluctance
is the notion "that selling securities below their book value impairs reported bank capital
and the opinion that it is unwise for a bank to allow its reported capital to be impaired."
As reported by Kane, "this concern for the preservation of the accounting value of bank
capital has traditionally been rooted in: (1) bankers' fear of misinterpretation and criticism by stockholders, depositors, examiners, and colleagues in the banking fraternity ;
(2) bankers' desire to minimize interference from regulatory restrictions tied to the size
of the capital account (such as) maximum loans to one borrower maximum mortgage
holdings, etc."
The <favailability" doctrine—as the doctrine surrounding the lock-in effect of credit
policy was called)—was revived in the 1950's. Its principal defender at that time was Robert
V. Roosa, who for many years was associated with the Federal Reserve Bank of New
York and later with the U.S. Treasury. It was an attempt to explain the effectiveness of
credit policy in a world in which the central bank is unable or unwilling to bring about
substantial interest rate changes and in which rising interest rates were thought to have
little influence on capital expenditures anyway (18, pp. 631-634).
179
preference for business loans when credit-worthy business firms seek
them, as during extended periods of rising interest rates (15, pp.
77-78, 91-93).18 The lock-in effect is more than offset, probably by
the very forces giving rise to the higher interest rates to begin with.
Even so, the longer the average maturity of the marketable debt the
better, at least with respect to stabilization during an expansion phase
of business conditions.
In the second instance—that of twisting of the yield structure—the
twist is supposed to come about as a result of a change in the relative
supply conditions affecting the respective maturities of securities. The
change in maturity composition of the Federal debt, however, may be
minor in relation to developments in the private sector. Meiselman
suggests that it is minor (32). Another reason for not expecting effects
from altered supply conditions is that expectations about future rates
of interest play a prominent role in determining the structure of
interest rates. The expectations effects can potentially overwhelm the
supply effects from the changes in debt composition. The empirical evidence in support of the expectations theories is abundant, as reported
in Meiselman's review of current research (32) and elsewhere (31).
Kane and Malkiel report on a survey of expectations to determine
the potential for twisting the yield curve (30, pp. 343-355). They find
some dispersion of investor expectations at banks, nonfinancial corportions, and life insurance companies. They conclude from their
April 1965 survey findings and from a review of hypotheses that there
is some potential for twisting the yield curve by altering the relative,
supplies of different maturities (as in the Federal Reserve's "operation
twist" or "nudge" of the early 1960's), all in partial contrast with
Meiselman's conclusions from surveying current research (32).
Next, changes in the structure of rates have some effects, regardless
of whether Federal debt management or twisting operations by the
Federal Reserve have any. These effects have been dramatically described for savings and loan associations (e.g., 32). They result in
part, howrever, because of the peculiar attributes of those institutions.
They essentially borrow on short-term loans and specialize in the purchase of a single type of long-term security; namely, mortgages. Thus,
given the fact that the spread between long- and short-term rates on
"default free" securities varies fairly directly with the cycle of interest rates on "default free" securities, the savings and loan associations can find themselves in a weakened condition during an extended
phase of rising interest rates. The cost of the funds they borrow rises,
the returns on the mortgages purchased at low rates remain unchanged,
and new, higher yielding mortgages constitute a small proportion of
portfolios. Further, tight credit (i.e., rising interest rates) has a
strong effect on home construction and the supply side for the highyielding mortgages for a combination of two reasons: (1) household
income is a constraint on the household's ability to make payments;
and (2) both monthly and down payments increase and prohibit some
from financing. Ceilings on FHA-insured and VA-guaranteed mortgages also play a role at times (18, pp. 404-412).
18 Two arguments are usually advanced to oppose arguments for the lock-in effect. The«e
are (1) that banks cannot refuse to decline loans to depositors without incurring their
disfavor: and (2) as emphasized by Kane (29), "provisions of the Federal tax law treat
bank losses on security sales on very favorable terms."
180
The effects of credit policy on home construction (and, therefore,
national income) should not be exhibited as a good example of either
the potential effects of debt management or of credit policy. In fact,
we should not wish to destabilize the housing industry to stabilize the
economy, and we may in fact wish to isolate the housing industry from
changes in credit conditions entirely.
A conclusion to be drawn about the term structure from studies over
the last decade by independent analysts is as follows (32) : "The only
dependable way to change the relationship between short- and longterm interest rates is to change the level of rates." But I go even further, as far as the stablization aspects of rate changes are concerned.
Absolute levels of rates per se are not the proper measure to focus on
in conducting a credit policy. Speculative analysis (14, 15) has led to
the conclusion that the major interest rate relationship to focus on in
the case of the important business sector of the economy and in the
conduct of a stabilization policy is as follows: that between present
rates of interest (or rates of return of additional capital expenditures
by business firms) and the probability of a future rise in rates of
interest (or rates of return on additional capital). I will not labor
the analysis nor the support for it 19 in this compendium. The concluding points for section 1.%,. are these: (1) Federal debt management
is unlikely to have much influence on the term structure of interest
rates after initial market adjustments and the elimination of money
market "noise;" and (2) changes in the level of interest rates per se
are not the proper focus for a policy seeking to stabilize business
conditions.
I.5.A.—Do you see any merit in using open-market operations for
defensive purposes or should they ~be used only to facilitate achievement of the President's economic program and the goals of the Employment Act? What risks and costs, if any, must be faced and paid if
open-market transactions are used to counteract transient influences?
Open-market operations should be used to achieve a given rate of
growth in the money stock within limits (sees. 1.3.A. and I.3.D to F).
As proposed, these limits currently allow for seasonal variations in
the money stock and some countercyclical maneuvering by the Federal
Reserve. The rates of change in the money stock, moreover, may be
exetnded beyond the limits, when satisfactory explanations for doing
so are given. All of the policies directed at achieving stabilization or
secular changes, however, should be directed toward achieving the
goals of the Employment Act, with due allowance for the President's
economic program. The President's economic program is likely to be too
vulnerable to partisan political considerations. Federal Reserve operations should not be tied to it directly. For example, the temptation for
10 In brief, focusing on the difference between long- and short-term rates, say. on governments, cyclical changes in business, and financial activities of manufacturing corporations may be explained in terms of probabilities of future increases in interest rates. The
maximum yield spread over a cycle in interest rates (and business conditions) reflects the
strongest subjective probability of a future rise in the rate of interest over that cycle. The
maximum spread is said to reflect the most likely possibility of acquiring liquidity on
favorable terms. The acquired liquidity is then used as a source of funds for effecting an
increasing flow of expenditures as the expansion phase develops. Recession follows a
minimum-yield spread and the least likely prospects for a future rise in rates. Developments in this phase of activity are not exactly the converse of those in the expansion nhase.
Whether the expansion phase is an extended or brief one affects entire sets of developments. The object of policy, in such a context, is to stabilize swings in expectations about
the "normal" or "average" rate of interest, viewed as a subjective probability. Empirical
support is offered for this analysis (15, pp. 66-101)
181
a President to pursue, or effect the timing, on occasion, of an inflationary policy as a means of giving a temporary spurt to the economy
is too great, even though such a policy may be subsequently and overall
costly in terms of economic resources and unwarranted changes in the
distribution of income among the participants in the economy.
The rules or money stock proposal does not preclude the Federal
Reserve from using other targets—for example, "changes in the level
and structure of interest rates." It simply requires, as modified (sec.
7.-5. D to F), that the Board understands the interrelationships between the various targets and set forth meaningful explanations, especially for varying the rates of change in money stock beyond set limits.
There are seasonal patterns in the money stock. These probably
arise from "defensive," "seasonal," or "road clearing" activities of the
Federal Reserve. Such activities would include the occasional underwriting of new issues of Government securities. Quite likely the seasonal and defensive operations also eliminate some of the potential
seasonal and random changes in interest rates. Without further study
and experimentation, these defensive operations of the Federal Reserve
should not be eliminated. To be sure, as evidenced in part from published materials, the Federal Reserve's ( and particularly the New York
bank's) understanding of defensive operations is quite superior to the
System's understanding of the interrelationships between interest
rates, the term structure of rates, the money stock, and national economic goals. This asymmetry in understanding is due to two interrelated factors: (1) The dominant "banking view" of the Federal Reserve (33, p. 96; 34, pp. 35-41; and sec. I I below) ; and (2) the more
difficult nature of the task of fulfilling the "dynamic" responsibilities
attributed to the Federal Reserve since the Banking Acts of 1933 and
1935 and the Employment Act of 1946.
A problem that has existed with the Federal Reserve since the legislation of the early 1930's and the early post-World War II period, as
we are beginning to understand, is as follows: The Federal Reserve
focus, as characterized by the banker orientation of the 1913 act and
the immediately succeeding decades, has never been broadened to accommodate the changes in responsibilities. This is true despite the
fact that an earlier and fairly strong and direct tie between bank lending to business and business expenditures is irrevocably broken. The
large firms with significant impact on national economic goals can and
do organize and plan their activities so as to avoid strong dependence
on banks (16).
As an organization the Federal Reserve is banker oriented. Its organization, indeed, encourages a preoccupation with the mechanisms of
banking, at times, at the expense of the consideration of the achievement of national economic goals. There is temptation to focus on these
mechanics in the sense that one can demonstrate so much sound erudition with respect to them. They are quite appealing to the worldly
philosopher. The current challenge to dealing imaginatively and
soundly with relationships between the various intermediate targets
and national economic goals is demanding—disproportionately so in
the environment of the Federal Reserve as presently organized.
I.5.B and 0.—Do you believe that monetary policy can be effectively
and efficiently implemented solely by open market operations? For
what purposes, if any, shoidd (a) rediscounting, (b) changes in reserve
requirements, and (c) regulation Q be used?
182
The "dynamic" operations of the Federal Reserve—that is, those
directed toward the achievement of national economic goals—can be
conducted solely by open market operations. Even so, some extra efficiency might result in a fairly taut and stable economy from the use
of announcement effects in offsetting temporary shocks to the economy
(14, pp. 33-35). In this respect, continued control over discount rates
and possibly over legal reserve requirements (as ratios) may be useful.
Other means centering about reporting provisions could substitute (sec.
I.5.D). The role of announcement effects in stabilizing the domestic
economy, however, needs to be better understood than at present. In
addition, their role would probably be altered by the adoption of H.R.
II. Announcements about discount rate changes are useful, at times,
under the present organization of international financial transactions.
In the early years of the Federal Reserve, the discount rate and its
related mechanism were viewed as being related primarily to the conduct of "defensive" operations. These were regarded as the main operations of the System in its early years and de jure until the Banking Act
of 1933. No doubt, the discount mechanism is still important, however
modified (12), especially in the conduct of defensive operations and in
performing the System's function as "a lender of last resort." On the
other hand, with market and communication facilities of the postWorld War II type, commercial banks can acquire extra reserves for
overnight or for longer periods (18, pp. 37-39 and 286-298). The Federal funds market, trading in securities, and correspondent banking
arrangements, all facilitate the movement of extra reserves between
banks, and open market operations may supply reserves to the commercial banks as a group. Defensive operations could be efficiently carried out without the use of Federal Reserve discount window as a
means of extending credit, after a period of transition to some new
arrangement, including improvements in secondary markets for bank
assets and liabilities.
Federal Reserve authority to vary reserve requirements was introduced in the Banking Act of 1935. In the thinking of the period, the
added credit control was viewed in two ways: (1) as a means of tightening the link between the level of bank reserves and changes in money
and credit; (2) as a means of shifting some control from the regional
banks, including the New York bank m particular, to the Board. Thus,
in the light of current knowledge about the link between the level of
bank reserves, bank credit, and the money stock (11; 27; 34), and in
view of the provisions in H.R. 11 to centralize policymaking functions
at the Board level anyway, there is no strong justification for varying
the reserve requirements as far as credit and monetary policy are concerned. Variations in differentials in the requirements for broad classes
of banks and deposit liabilities affect the relative profitability of both
the classes of banks and the classes of deposits. One possibility is to
emphasize their use as a regulatory device as distinct from a general
credit and monetary control.20
Regulation Q, the authority under which the Federal Reserve regulates interest-rate ceilings on savings- and time-deposit type liabilities
20 Using changes in the differences between reserve requirements for different classes
of deposits or for different classes of banks does not mean, of course, there are no effects
on* say, the flow of credit and the money stock. These effects simply can be neutralized
(offset) in part or entirely or they can be permitted to operate, with open market
operations remaining the principal credit control device for purposes of carrying out credit
and monetary policies.
183
of commercial banks, should not be used as another general credit control device, as it apparently came to be used in the 1965-66 period.
Regulation Q should be eliminated, or changes in interest-rate ceilings
under the regulation should be confined to the regulation of interestrate competition.21 One possibility is to make the rate ceilings floating ceilings (that is, tie the ceilings to direct variations in some average of rates on the securities or the savings-type instruments of institutions for which the regulation of competition is sought).22 There
are too many ways to regulate credit simply and directly, such as
through open market operations, without resorting to the gymnastics
performed under regulation Q in the 1965-66 period.
The regulation of deposit interest rates was originally introduced
in the Banking Act of 1933 (25, ch. 2). The objective then and in the
years prior to the 1965-66 period was the regulation of competition
between selected financial institutions for savings. From 1936 to 1957
the rate ceilings under the regulation were invariable (and usually
above the rates actually paid over most of the period). After 1957
some adjustments were required as interest rates continued in their
secular post-World War II rise. For example, in late 1964 the maximum rate payable on time deposits of less than 90 days was raised
from 1 to 4y2 percent and, following the introduction of negotiable
certificates of deposit (CD's) in February 1961, commercial banks
were able to compete at times for the noncash liquid balances of businessfirms,such as those held in the form of short-dated Treasury issues
and commercial paper. Other rate ceilings and other classes of savings
affected more directly savings and loan associations and savers' shares
in them. As market rates moved upwTard in 1965, however, the rate
ceiling of 4 ^ percent adversely affected the competitive position of
the commercial bank's short-dated CD's. The ceiling on this class of
bank liabilities was raised along w7ith the ceiling on time deposits
generally to 5Y2 percent, and the growth of the CD holdings by business firms continued to increase. Commercial bank competition for
funds continued to increase in 1966, as did market rates of interest
generally. This time, as other market rates increased, the ceiling on
CD's w^as not raised further. Apparently, it was viewed appropriate
to allow some attrition in the CD's with the view to moderating the
expansion of commercial banks' business loans (2, p. 278). In September Congress granted the Federal Reserve the temporary authority
(later renewed and extended until September 1968) to set ceilings on
different bases,23 including size, and a ceiling of 5 percent was set
on CD's under $100,000.
What started as a regulation of competition for savings was broadened in 1966 into a credit regulation. In our Federal Reserve vernacular, regulation Q became a credit control device. Continuing the above
example, it works as follows: An increase in the yield on CD's in rela21 Haywood and Linke conclude from their study (2(5) that excessive interest-rate competition "was not and is not a sufficient problem to warrant continuous regulation of deposit interest rates." They recommend steps for the elimination of the regulation of
interest rates on savings and time accounts.
22 Haywood and Linke indicate that early versions of the Banking Act of 1933 would
have established interest-rate regulation such that the ceiling rates varied with market
rates (25, ch. 3).
23 The emergency, interest-rate ceiling legislation of September 1966 is broader based
than suggested in the text. The request for emergency legislation was supported by references to conditions in the housing market (25, ch. 4 ; and 27, p. 188), specifically the hope
to get more funds to the savings and loan associations. (Note the discussion under sec. / A )
184
tion to Treasury bills induces, say, large manufacturing corporations
to exchange some Treasury bills for cash (i.e., demand deposits) and
cash for new CD's. A net effect is a decrease in banks' demand deposit
liabilities and an increase in time deposit liabilities. A further net
effect, consequently, is a reduction in required reserves, and extra reserves to support further credit expansion, in view of a smaller reserve
requirement for time deposits. A decline in the relative yield on CD's
has the reverse effect.
1.5.D.—Do you see any merit in requiring the Federal Reserve Board
to make detailed quarterly reports to the Congress on past and prospective actions and policiesf Are there any risks and costs in this
procedure? In what ways, if any, would you modify the reporting
provision? What information do you believe should be included in
such reports as you recommend the Federal Reserve submit to the
Congress?
The Federal Reserve should make quarterly and annual reports to
the Congress, possibly through the Joint Economic Committee. There
could be, indeed, two sets of reports: (1) an annual report on the
essentially banking, supervisory, and administrative aspects of the
Federal Reserve, and (2) a quarterly report on those aspects of operations concerning defensive operations and mainly national economic
goals. The first set of reports could be directed primarily at the Senate
and House Banking and Currency Committees, and the second set at
the Joint Economic Committee or all three committees. The first set of
reports would mainly concern bank regulation, the performance of
banks (banking services and so on), the banking structure (monopoly
and competition in banking), and the budgetary and control aspects
of the Federal Reserve System. The second set of reports would be
the set concerning mainly economic stabilization, the goals of the Employment Act, and monetary and credit policies. This distinction between the reports would f acilitate the long-sought separation of purely
administrative functions from the essential policy functions (e.g., 1,
p. 346; and 9, pp. 87-88). Such a separation would go a long way toward improving communication with respect to Federal Reserve policy
(sec. IJH.A).
The major merits in having the Board make a report on future
and past aspects of money and credit policies and their relationship to
national economic goals are threefold: (1) the reporting would relieve
some of the present efforts devoted to trying to second guess the Federal Reserve; (2) the reporting would contribute to narrowing the
range of speculation about the Federal Reserve's plans and actions;
and (3) the possible need to explain policies, actions, and inactions,
would in itself go a long way toward assuring the pursuit of sound
policy. In the first two instances, efforts to second guess the Federal
Reserve engross a large part of the talents and resources of some very
able people, not only in financial institutions but in large nonfinancial
ones as well. However, even quarterly reporting and the publication
of forecasts would not wholly eliminate speculation about Board plans
and actions. There would still be speculation about the revisions in
the policy and in the forecasts. In the third instance, the reporting and
explanation requirements would provide for "an educational feedback" to the Federal Reserve. As a staff report, Subcommittee on
Domestic Finance, concluded (38, p. 83): "Such a feedback is required
185
to assure that mistakes lead to critical reevaluations of operating objectives and methods. Without it, past errors are almost sure to be
repeated in future years."
The reporting provisions of H.R. 11 should be modified to minimize
the reporting on the details of policy and to emphasize the explanations for the policies, particularly those concerning national economic
goals. The need to set forth explanations in empirically verifiable form
and to present supporting evidence was mentioned earlier (sec. 1.3.A).
The report should include balance-of-payments information, and information on the domestic economy such as the level of prices, employment (and unemployment as a percent of the labor force), and the
level and structure of interest rates, on the one hand, and rates of
change in bank credit (including loans and investments), bank reserves, the money stock, deposit and negotiable-type liabilites of banks,
and gross national product, on the other.
In minimizing detail in its policy report, however, the Board should
be required to do the following: (1) focus primarily on the interrelationships between the money stock and national economic goals as
noted earlier (sec. I.3.A) ; (2) present only a general statement of defensive operations; (3) review the relationship between its credit and
monetary policies and the economic program of the President (sec.
I.5.B) : and (4) comment on structural features of the economy, especially those affecting the attainment of goals (sees. 13. and I.3.B).
In particular, the provision in H.R. 11 about "stating in comprehensive detail" should be left open ended—that is, changed to emphasize "verifiable explanations" and the necessary supporting material.
The Board should be left free to present what is called for to support
its explanations, particularly for the need to vary rates of change in
the money stock beyond stated bounds (sees. 1.3.A and I.3.D to F).
An annual forecast should be expected every quarter, with attention
being given annually in the report to forecasting secular trends.
Reporting on prospective changes should take the form of a forecast, both with respect to policy measures and national economic goals.
The policy measures in the forecast should at least include the money
stock. Under an open-ended arrangement, the Board may also wish to
include such interrelated measures as the level and structure of interest
rates (as indicated by the spread between rates on long- and shortterm Governments) and the income velocity of money (sec. I.3.C).
The national economic goals would at least be given absolute values
in the forecasts.24 These may be accompanied by rates of change in
stock and flow variables (e.g., the money stock and income), as distinct
from interest rate, employment, and price-level variables. From the
policy point of view, the forecasts should center about crucial policy
variables and target values for national economic goals and the most
immediately related measures. Conceivably there could be target values
for national economic goals that would differ from the forecasts. For
example, there may be price-level and employment targets toward
which policy actions and inactions would be directed, but there may be
structural forces at work such as those giving rise to cost-push inflation, all such that forecast price and employment values would differ
from their target values.
24 The need to give quantitative content to the goals has long been assumed and in
some instances recognized (1, pp. 285-305).
21-570—6S
13
m
A danger in emphasizing detailed reports as distinct from verifiable
explanations in the reporting provision of H.R. 11 is that the request can be met too easily. Congressmen and others might be confronted with computer output from a model with n number of equations and possibly an n number of variables, n being any number,
probably a large one.
The adoption of the reporting procedure as outlined for H.R. 11,
as well as other related changes of H.R. 11, would result in some
personnel changes, extending to a number of economists. Even so, the
benefits outweigh the cost and risk of putting H.R. 11, with suggested changes, into effect.
L5.E.—What costs and benefits would accrue if representatives of
the Congress, the Treasury, and the CEA wrere observers at Open Market Committee meetings?
Under H.R. 11 Open Market Committee meetings would be Board
meetings. But assuming the Federal Reserve structure as a policymaking organization and its attributes in the mid-to-late 1960's, there
would not likely be any advantage in having additional representatives present. On the one hand, the meetings, at 3- or 4-week intervals, have been too frequent for purposes of reconsidering policies,
particularly those dealing with national economic goals, and, on the
other, there have been insufficiently frequent meetings for developing a majority support for an explanation of policy changes. The committee meetings have served mainly as a forum for reviewing economic
conditions and arriving at a consensus about policy changes, however
vaguely stated, and for issuing instructions in a general form to the
manager of the open market account. The attendance at meetings
has been large, since those attending possibly include seven members
of the Board, selected staff, 12 reserve bank presidents, advisers to the
respective president, and advisers to the FOMC as a whole. They are
essentially politcal meetings where consensus is sought on policy
changes rather than the underlying reasons. The attendance is too
large for a working session on fundamentals.
The improvements in policy discussions under H.R. 11, with suggested modifications, would follow from three sources: (1) having
the policymaking officials at one location for frequent working sessions;
(2) having the officials report the targets for policy actions and their
relationships to the achievement of national economic goals; and (3)
having the policymaking officials responsible for explanations of
changes in monetary policy. Reporting provisions with emphasis on
empirically verifiable explanations (sec. 1.3.A) should serve to lessen
the possibility that meetings of the Board would not degenerate into
essentially political meetings, as outlined in the previous paragraph.
IT. APPRAISAL OF T H E STRUCTURE OF T H E FEDERAL RESERVE
H.R. 11 is a bill intended, among other things, to "improve the coordination of monetary, fiscal, and economic policy." It contains certain provisions to achieve this end. An additional objective—notably,
to provide for coordination by the (President—is implied. The two
provisions bearing most directly on this objective of coordination by
the President are those (1) making the term of the Chairman of the
Board coterminous with that of the President, and (2) shortening
187
the terms of office from the present 14 to 5 years. Combined with the
transfer of current FOMC functions to the newly reconstituted Federal Reserve Board, these provisions presumably give the President
some additional influence over monetary policy via appointments and
thereby reduces the independence of the Board. Improving coordination of policies to achieve national economic goals, however, need not
necessarily imply greater control by the President. Nor, for that matter, need reductions to five members and 5 year terms be viewed as
giving the President too much direct control, given the minor changes
suggested in H.R. 11 in this paper. The issue of the Board's independence from some presidential and other influences may be related
to an educational function for board members and to the importance
of focusing on the goals of the Employment Act.
The common argument against independence is that "only the President can choose the monetary-fiscal policy mix appropriate to the
given situation with some hope of seeing it implemented" (1, p. 282).
The centralized authority can, in setting forth the mix, minimize
small mistakes in arithmetic and logic, and otherwise avoid crosspurposes and duplication of efforts. Several common arguments in
support of independence are (1) the quasi-judiciary one (i.e., the need
for removal or protection from immediate pressures, often arriving
from temporarily popular causes (35, pp. 59-62; 38, pp. 16, 23-24,
31-32; 9, pp. 85-86)), (2) the compensating-errors one (i.e., the need
of an independent agency to compensate for the errors of other policymakers (14, p. 25)) , and, (3) as some would add, the fewer-but-biggererrors argument (i.e., the argument that centralized authority makes
bigger mistakes because, for example, its opinions are taken too seriously and it seeks power and entrenchment). These arguments take
various forms. Earlier (sec. 1.5.A), the temptation to the President
to pursue short-run objectives, at the overall expense of the loss of
idle resources was mentioned. In addition, Arthur Burns comments
thusly (4, pp. 78-79) : "Centralization of economic authority in the
office of the President has its intellectual appeal, but let us not overlook
the protection against the risk of concentrated error that the economy
now derives from the dispersal of power in our governmental scheme."
Wallich views this type of argument as a pragmatic rather than a
logical or economic one [39] ,25
Below, as elsewhere in this paper, the latter argument is transformed
into an economic one and due regard is given to the public's right to
ultimately control. The economic argument proceeds from the simple
Wallich comments on coordination versus independence as follows (39, p. 30) :
" I t is popular to say that the President should have power over monetary policy in order
to coordinate the two instruments. That implies, however, something that is not at all
true, namely, that the President has power over fiscal policy. He does not have such nower.
He proposes, Congress disposes. It is not clear where the focus of fiscal policy is ; hut so
long as the President does not have power over short-term fiscal policy, I' can see no
logical reason to concentrate monetary power in his hands."
His argument is simply a pragmatic one :
"But the argument really is not a logical or an economic one. It is a pragmatic one.
The people who like a softer monetary policy are for coordination ; the people who prefer
a harder monetary policy favor Federal Reserve independence. Why is this? When there has
been a conflict between the Federal Reserve and the administration, which has been a rare
event, really, the pattern has always been very clear : the Federal Reserve is for the
harder, and the administration is for the softer policy. Hence, the pragmatic answer is
that to choose coordination means to choose a softer policy ; to choose independence is to
choose a harder policy. I have a strong suspicion that if the recent trend in appointments
to the Federal Reserve Board should continue, and if some day the Federal Reserve should
be more liberal than the rest of the Government, some of my friends will discover the
virtues of Federal Reserve independence and I shall be arguing for coordination."
26
188
fact that the current state of economic knowledge itself does not
justify or support attempts to alter every possible wiggle in the economic indicators through control over credit and monetary variables
(sec. IV). What is suggested is that the latter sort of policy may be
pursued when empirically verifiable explanations are offered. The
added potential influence of the public originates from two possible
sources: (1) primarily their elected Representatives in Congress in
combination with new reporting procedures (sec. 1.5.D) ; and (2) the
possible addition of budgetary controls of the Congress under H.R. 11.
The objective is appropriate control over the unaccountable use of
independence, rather than its annihilation.
The objective in appraising the adequacy of the structure of the
Federal Reserve as a policymaking organization need not turn on
the need for coordination through the President, so much as the need
to more consistently pursue the goals of the Employment Act.
The number of policymaking officials.—The most far reaching of
the proposals to alter the Federal Reserve is that reducing the number
of Board or, viewed differently, voting FOMC members. One's assessment of the most desirable number of Board members and the most
appropriate structure for policymaking purposes may depend on one's
view of the appropriate functions to be performed by the Board. As
emphasis has shifted—first, from the essentially practical exercise of
judgment about the adequacy of bank credit to suit the needs of commerce, industry, and agriculture to the impracticality of such judgments, and, then, to notions about explanations of relationships between policy measures and national economic goals—views about the
functions of the Board might be expected to have changed. Preliminary questions arise: Is the Board simply a group of overseers for
the Congress, with research directors and advisers the true policymaking if not voting figures? Is the Board's function as a policymaking group essentially similar to that of the Council of Economic
Advisers, with the obvious differences that the former specializes in
monetary and credit control and has the power to implement policies ?
Much has been said about the need to enhance the prestige or status
of the members of the Board. The Commission on Money and Credit
emphasizes it in recommending a reduction in the number of Board
members [9, p. 87]. However, a better way to enhance prestige might
be to warrant it. Some have suggested that the prestige of the Council
of Economic Advisers was enhanced by the type of issues and educational functions it engaged in during the early and mid-1960's. A
favorite topic of J. A. Livingston, a columnist, about the time of the
April 1967 appointment to the Board was that the Employment Act
of 1946 had created the Council of Economic Advisers. He said:
As the nation's Supreme Court of economics, the Council outranks the Board
as the Supreme Court of credit.
On another occasion he said:
The influence of the Federal Reserve Board in American economic affairs has
been declining since 1946. It has been layered in the Government hierarchy by
the Council of Economic Advisers * * *.
In assessing the functions of the Council of Economic Advisers,
Walter Heller (Chairman, 1961-64) writes of economic education of,
189
by, and for Presidents [24, pp. 26-57]. He views the economic advisers'
educational activity on behalf of the President, as:
Simply a case of doing on a small scale—though with greater detail, depth,
and diligence—what the President does on a grand scale, namely, communication, making the Government's economic policy and actions intelligible to the
citizen, a process essential to democracy; and "broadening consensus, carrying
the economic gospel not only to the uninformed but to the skeptic and the
heathen.
Heller points out that through public discussion, Council members
broadened the depth of public dialog on economic problems and concepts, tested newT ideas, and prepared the public for the President's
subsequent advocation and support of his economic programs. The
Council apparently sought at times to create an environment in which
certain issues could be discussed by political figures, without risking
the political consequences of treading new ground and attempting to
broaden public understanding, often of undramatic low7-stake issues.
Now, five Governors may be too many, if one takes the view that its
members are primarily a group of executive overseers, supervisors of
the various activities in the Board's plant on Constitution Avenue.
On the other hand, seven or 11 members may seem appropriate if one
takes such views as the following:
(1) That, as Senator Proxmire [27, p. 1] and others [5, pp. 322-368]
emphasize, the Congress has given the responsibility for determining
matters involving money under the Constitution, and that Congress
has chosen to delegate the exercise of this authority to the Federal
Reserve authorities under a trusteeship arrangement with the Federal
Reserve as the servant, creature, and agent of Congress,
(2) That the Board's functions in its own area are similar to those
of the Council, with the important exception that the Board has the
authority to implement policies, and
(3) That some geographical representation of the policy level in
monetary matters is desirable, all as envisioned by the Federal
(regional) character of the System in the original Federal Reserve
Act, congressional responsibility for money matters under the Constitution, and a proposed educational function for the Board.
Some Board members have functioned frequently as discussants of
timely economic issues, sometimes including issues before the Congress
and sometimes including appeals to relatively parochial groups. The
Board's independent position within the framework of Government
places it in a position to aid in educating the public about monetary
problems through pronouncements, speechmaking, and public appearances. In the 1960's, several areas stood out in which more public education would have helped in achieving national economic goals. These
involved, mainly, areas in which conflicts resulted in special governmental objectives, and the use of money and credit tools as means of
achieving the more immediate national economic goals, as well as such
ultimate objectives as maintaining a relatively free enterprise economy
and a reasonably "efficient system of world commerce, finance, and
production." The areas in question included (1) the U.S. balance of
international payments, (2) home construction, and (3) structural
unemployment.
Traditionally and for the foreseeable future, monetary policy measures and economic policies are fraught with controversy. This supports
190
the need for some geographical representation. Moreover, there are
styles in economics—an eastern view and a western view, a predominant Harvard view and then a Chicago view. There is "occupational
myopia," "tunnel vision," and so on. There are, as well, individual
and regional preferences for certain public policies and the means of
achieving them. To add compensating sources of stability two features
have been emphasized: (1) the geographical one, and (2) an empirical
one, the notion of presenting empirically verifiable explanations for
policy changes (sec. 1.3.A). There is, as Heller points out [24, pp.
7-8], a greater consensus among economists today than in the 1930's.
Taking a long view there has been a decline in "the warfare of rival
ideologies." There has also been some refinement of standards with
respect to empirical relevance. Emphasis on the need for potential
support from empirical evidence may be viewed as the essential ingredient for developing an understanding of the interrelationships
between policy measures and national economic goals.
H.R. 11 relieves the Federal Reserve's regional bank presidents
from policymaking functions. This is not undesirable, in view of the
following: (1) emphasis on a separation of policymaking and administrative functions, (2) the recognition of the role of regional bank
presidents as chief executive officers of operating banks, and (3) the
recognition of geographical regions in Board appointments. The Federal Reserve System, including its regional banks, has developed a
complex and useful information system for identifying changes in
business conditions [2, pp. 282-288]. Of key importance in this network is the maintenance on the part of the regional banks of contacts
with business economists, personnel and purchasing departments, and
decisionmakers in business and economic communities. To be sure [2,
p. 287], "from such contacts they [the regional banks] often can
distill a sense of changing attitudes or intentions before the consequences are reflected in economic statistics." This kind of informational system probably in part explains w^hy the Federal Reserve has
a relatively good record of identifying turning points in business
conditions [13; and 14, pp. 25-28]. This system need not be lost by
implementing the provisions of H.R. 11.
Varying the weight to the various aspects of the foregoing discussion of the functions and the appropriate number of Board members,
a board of from three or less to 11 members may be called for. A threemember board may follow from placing the weight primarily on the
executive function. Shifting the weight to the educational and geographical aspects of membership would increase the number of members. The Chairman, in any case, is the chief executive officer. Among
other executive functions, he votes to break the ties in the voting on
policy matters. In coordinating the Board, moreover, the Chairman
may give recognition to various functions and interests of members,
as well as to the need to implement and defend specific credit and
monetary policies. Special functions to be emphasized may include
the essential banking functions (sec. 1.5.D), as well as the credit and
monetary policy functions with interrelated degrees of emphasis on
fiscal policy, structural-type economic problems (sees. 1.2 and I.3.B),
the sectors of the domestic economy and international financial matters.
To achieve the objectives of H.R. 11, given the above criteria, a relatively large board with emphasis on adherence to a form of rule is
191
preferable as noted earlier (sees. 1.3.A and LSI) to F). Even so, shorter
terms than the present 1-1 year ones are desirable to permit the possibility of more frequent additions of freshness to the Board's deliberations. The term of appointments should depend in part on the number
of members—for example, 5-year terms for a five-member board, although 10-year terms may be preferable for such a board to avoid a
given President's appointing all members within a span of one term
plus 1 year. In particular, the timing of appointments should be
"staggered" as in the past to prevent a packing of the Board over a
short period by any single President .
Other provisions.—Other provisions of H.R. 11 call for (1) the
retirement of Federal Reserve bank stock, (2) an audit of the Board
and the regional banks and their branches, and (3) the removal of
the Federal Reserve System's exemption from congressional appropriations procedures, all as have been discussed on other occasions over
the years [5, pp. 353-391]. The first of these has indeed been wTidely
discussed [9, p. 91]. The retirement of the stock would eliminate the
symbol of the early view of the Federal Reserve as a joint private and
public enterprise. It would also help remove the stigma of a private,
banker-dominated organization controlling the money supply.
The last two provisions have often been related to the question of
the Federal Reserve's independence. An audit by the general accounting office seems appropriate [38, pp. 85-90; 5, pp. 353-368]. The need
for removing the Federal Reserve's exemption from appropriational
procedures is less clear. The flexibility enjoyed by the Federal Reserve
under present procedures has some advantages. Its reputation for
integrity and honesty among bankers and the business community is
good, in part perhaps because of the role of certain individuals in the
System, in part because of the association of the Chairman with the
regained freedom of the Federal Reserve in credit and monetary matters following the Treasury-Federal Reserve accord of 1951, and in
part perhaps because of appointments to the boards of directors of
the regional banks. The simple possibility of being subjected to the
congressional budgetary process probably in itself assures a good deal
of prudence and care in the scrutiny of expenditures. On the other
hand, there does appear to be a need for a reporting by the Board
and by the regional banks on some common and systematic basis, particularly for expenditures on research and information gathering operations, public relations, educational programs, and the cost of producing various services. There is the possibility that funds are not
distributed with sufficient regard for the size of the regional operations,
the geographical regions themselves, and the need for a broader and
more economical distribution of resources about the country.
III. MONETARY POLICY,
1964-66
Much may be said about various aspects and effects of Federal Reserve policy since 1964, with emphasis (1) on home construction (sees.
14. and 1.5. B and C), (2) on the regulation of deposit interest rates
(sec. 1.5. B and C), (3) on the wide variability in the rate of change
in bank credit (4, pp. 23, 71, 81,111-112,119,122), and (4) on the less
directly controlled sector comprising manufacturing corporations (15
and 16). This section focuses on the latter for several reasons: (1) ex-
192
penditures by manufacturing corporations are important in determining gross national product ; (2) the Employment Act's emphasis
on achieving goals in a relatively free market economy would seem to
require a justification for Federal Reserve policy with special regard
to the less directly controlled areas of the economy; and (3) references
to capital expenditures by business firms and bank loans to business
were prominent in discussions of Federal Reserve policy in 1966. The
1964—66 period as a whole is focused upon (1) because it was the second
of the major post-World War II booms in capital expenditures since
the initial postwar adjustment, and (2) because weaknesses in the
Federal Reserve's approach to economic stabilization and deficiencies
in its use of controls may be illustrated with reference to the period.
Weaknesses in the Federal Reserve's approach to economic stabilization.—The weaknesses in question are actually twofold: (1) there is
insufficient recognition of the Board or FOMC as public educational
bodies, and (2) under the present organization the policymakers as a
group become preoccupied with the banking mechanism as such and
apparently harbor preconceptions, harking back to an earlier banking
period, about the role of bank loans to businesses, as illustrated later.
In the first instance, in varying the rates of change in bank credit and
the money stock in order to achieve certain goals, residual or side effects follow because of structural features of the domestic economy
(sees. 1.2 and 1.3.B). The Federal Reserve has no control over this class
of effects, in the sense that congressional actions to change the structure are outside of its special field of authority. Its function or responsibility then becomes a matter of reporting to the Congress and educating the public about the need for legislative action. But this is insufficiently recognized.
In the period since 1964, stabilization polic}r may have been pursued
as if it were to operate on expenditures and achieve employment goals,
all independently of persistent U.S. deficits in the balance of payments,
possible structural unemployment (i.e., unemployment due to an inadequate alinement of job skills with job vacancies), and effects on
home construction. However, such a policy as outlined was not consciously pursued, judging from a review of the policy-oriented literature of the period. Quite possibly some amount of inflation may have
been accepted as a means of temporarily reducing the percentage of
employment, even at the possible cost of a loss of overall efficiency and
employment of resources in the long run, and even though such a policy
would have contributed to continued payments deficits, higher interest
rates, and problems in the home construction industry. This touches on
the so-called trade offs—that is, you trade-off a little of one undesirable
development for another. If trade-offs are being made, then the Congress and the public should be informed and educated.
H.R. 11 provides for better reporting (Sec. 1.5.D). Moreover, the
policymaking officials of the Federal Reserve have tended to speak to
some extent on the so-called structural problems in question. But this
educational function needs to be more formally recognized in any
restructuring of the Federal Reserve as a policymaking organization.
The current provision in H.R. 11 for five governors offers little as-
193
surance that the respective districts of the country will adequately
participate.
Deficiencies in the Federal Reserved use of controls.—Illustrated
below are (1) inadequacies of the Federal Reserve's view of its control
over bank loans to business and over business expenditures, and (2)
deficiencies in the Federal Reserve's use of controls. In general the main
criticism is this: the Federal Reserve's preoccupation with the apparent
security inherent in information gathering and with the appealing
details of the banking mechanism and simple linkages predominates
over the need for a broader conception of the developing situation.
There are detailed criticisms, too.
There are several principal elements in the ensuing illustrations.
First, abstracting from money-market "noise" and defensive aspects
of Federal Reserve operations (sees. 1.5. A and 1.5.D), increases in
the rates of increase in bank credit (and therefore banks' deposit
liabilities) contribute to a faster rise in business conditions and interest
rates once an expansion phase of business conditions is unfolding
[14]. Rates of change per annum in bank credit of 8.1, 8.5, and 13.8
percent occurred in 1963, 1964, and 1965, respectively; changes of 3.8,
4.3, and 4.9 percent occurred in the narrowly defined money stock
during the respective years, reflecting in part drains into time deposits;
and interest rates continued to rise. There wTas the $11 billion tax cut in
1964, and later increases in defense and other expenditures. The
analytical conclusion is that by accelerating the rise in bank credit
(and related bank liabilities), the Federal Reserve contributed to the
ensuing boom and the accompanying increase in interest rates.
As the market yield on 3-month Treasury bills increased from 3.64
to 4.08 percent during the year ended in November 1965, it become
necessary to raise the discount rate from 4 to 41/2 percent in December
of 1965, in part just to maintain the discount rate's relative position
in the structure of rates. This was later described by one Board member
as a public announcement of a shift to credit restraint [2, p. 277]. On
the one hand, credit and the related monetary policies contribute to an
expansion in business conditions and the accompanying increases in
market rates of interest and, on the other, the Federal Reserve takes
credit for a shift to credit restraint when an increase in the discount
rate is necessitated by expanding business conditions and rising market
rates of interest to begin wTith. This is peculiar.
The several additional ingredients of the present illustration are as
follows: (1) The noncash liquidity of manufacturing corporations may
be indicated by their noncash liquid assets net of bank loans as a
liability, both in relation to asset size; noncash liquid assets (say,
governments, although the category may include negotiable CD's as
well) may be liquidated in exchange for a reduction in bank loans, and
an increase in bank loans may serve as a substitute for the liquidation
of governments as a source of funds; and changes in governments and
bank loans, together and in combination with changes in cash, form the
principal means of adjusting liquidity, although these adjustments
need not relate exclusively, or even primarily to the need for temporary
funds [16, ch. 2]. (2) Corporate liquidity is related inversely with
194
business conditions and directly with the planning of capital expenditures [15, pp. 66-101]. (3) As firms increase in asset size (or by average
firm size in the case of industry groups) their noncash forms of
liquidity increase; in other words, as firms increase in asset size,
noncash liquid assets (i.e., marketable assets such as governments,
commercial paper, and negotiable CD's) increase significantly more
and bank loans significantly less in relation to asset size [16, chs. 3
and 4]. (4) Commercial banks have a strong preference for extending
"commercial" or business loans to credit-worthy businesses (as indicated, e.g., by their liquidity) when there is a strong demand for such
loans [15, pp. 77-78].
Now the first three of the immediately preceding ingredients are related to the planning of the financing of capital expenditures by
the mature industrial corporation. As described by Gralbraith [22],
the mature corporation is related to the need to plan as a result of
advanced technology, and by, among other things, the needs of the
decisionmaking groups for some independence from outside disturbances. A major means of achieving this is the planning of financing.
According to Galbraith, "no form of market uncertainty is so serious
as that involving the terms and conditions on w7hich capital is raised."
He says [22, p. 39], "apart from the normal disadvantages of uncertain
price, there is danger that under certain circumstances no supply will
be forthcoming at an acceptable price."
Large firms plan financing to a greater extent than smaller ones
and there is some evidence that these plans take account of expected
patterns of cyclical development [15]. Liquidity is built up in advance
of the bulk of capital expenditures, and worked down as the boom in
expenditures progresses. The reduction takes two forms and the one
may be traded off for the other. They include (1) a reduction in the
marketable-type liquid assets in relation to size and (2) an increase
in bank loans. One of the differential effects of not planning expenditures to a relatively high degree is shown in figure 1. Accepting
liquidity as a constraint, the series in the figure for the 1955 to 1957
and the 1964 to 1966 capital booms suggest that liquidity contributes
to differential patterns of capital outlays, with the thousand largest
manufacturing corporations increasing their proportion of the total
to over 80 percent. The reason the 1955 to 1957 and 1964 to 1966 patterns do not coincide with the 1958-60 expansion in business conditions
is that the expansion must be sustained for some time before the reductions in liquidity become a strong constraining factor on either overall capital expenditures or different sets of expenditures.
195
— — —
All Manufacturing
—
Durable Goods
Percent
FIGURE 1. CAPITAL EXPENDITURES
BY LARGE (AND LARGE DURABLE G O O D S )
MANUFACTURING FIRMS AS PERCENTAGES
OF CAPITAL EXPENDITURES BY ALL
(AND ALL DURABLE G O O D S ) MANUFACTURING FIRMS
N O T E : T h e p e r c e n t a g e s are computed from
NICB estimates of expenditures b y the thousand largest m a n u f a c t u r i n g corporations (and
durable goods m a n u f a c t u r i n g corporations
among t h e m ) and from Commerce-SEC estimates
of expenditures b y all m a n u f a c t u r i n g firms
(and durable goods m a n u f a c t u r i n g firms among
t h e m ) . Estimates are s e a s o n a l l y a d j u s t e d .
196
67
Biweekly
FIGURE 2 , BANK LOANS (TO BUSINESS) AND INVESTMENTS
BY WEEKLY REPORTING MEMBER B A N K S , 1964-1966
^Changes (in percentages) are changes from the comparable year-ago dace,
"^Data are biweekly averages for weekly figures.
^Revision in the series.
allow for the revision.
Percent changes, however, are adjusted to
Source of data: Board of Governors of the Federal Reserve System.
197
The final ingredient—commercial banks' preferences for business
loans—of this overall illustration is reflected in figure 2. Year-to-year
changes (as percentages) in bank loans were increasing in the 1964-66
period until about August of 1966. Year-to-year changes (as percentages) in bank investments were declining, and indeed the 1965-66
changes were negative.
Given the foregoing ingredients of this overall illustration, these
patterns—both of the changes in capital expenditures and of changes
in bank loans—are expected. They are expected when a boom proceeds
temporarily at a level that cannot be sustained as a matter of secular
change. In order to control and manipulate the changes, as distinct
from trifling with them, the entire process must be kept in view.
Federal Reserve actions under regulation Q in 1966, and their September 1 letter in particular are symptoms of a poorly conceived,
poorly articulated, and poorly managed set of developments.
Special' administratwe technique.—As noted earlier (sec. 1.5.B.
and C), as business conditions continued to expand in September 1966,
the ceiling interest rates on CD's under $100,000 was reduced to 5 percent and that on CD's of $100,000 and over was left at
percent
while market rates of interest continued to exert additional credit
restraint via a runoff in CD's. Twice during the summer reserve
requirements on member bank time deposits of over $5 million
were raised by 1 percentage point. But these were belated actions
coming late in a boom that had been encouraged by earlier credit and
money supply changes. Corning as they did, with banks facing strong
demand for business loans, they could only force further the liquidation of municipal securities by banks.
Having thus contributed to the liquidation of municipals, the prospect of further increases in rates of interest, and unsettled financial
market conditions, the Federal Reserve intervened in an attempt to
exercise control over bank loans via special administrative technique
[2, pp. 280-281, 288-290]. Questions are raised then both about the
use of the technique itself and its likely differential impact on businessfirmsof different size.
The technique for effecting control over bank lending was set forth
in a special letter from the Federal Reserve banks to all their member
banks in a letter. In August 1967 it was described in First National
City Bank's Monthly Economic Letter as "the FRB's now famous
September 1 letter to member banks."
The technique was adopted and the letter sent with a view to encouraging moderation in the expansion of business loans and in the
liquidation of investments. In the letter it was stated that the latter
objective "will be kept in mind by the Federal Reserve banks in their
extensions of credit to member banks through the discount window."
Continuing, the letter said that "banks adjusting their position
through loan curtailment may at times need a longer period of discount accommodation than would be required for the disposition of
securities." The view was expressed that "a slower rate of business
loan expansion is in the interest of the entire banking system and the
economy as a whole."
198
The September 1 letter and the technique outlined in it appear as
another example of the Federal Reserve's preoccupation with the details of the banking mechanism. In the long-run the administrative
control's only likely effect would be for larger firms, with their strong
propensity to plan, to reduce even further their reliance on bank loans
as a potential source of funds. In the immediate situation of September 1966, the major possible effect of the letter was likely discriminatory with respect to intermediate to small firms. Although large firms
were increasing their use of bank loans in 1966, the intermediate to
small firms were in relation to their size, still more dependent on the
loans. Thus, because of small firms' dependence and their more limited
access to other means of effecting cash adjustments, possible effects of
the attempt to control bank loans via administrative technique were
discriminatory.
IV. RULES ( " G U I D E L I N E S " ) , ECONOMIC KNOWLEDGE AND T H E FEDERAL
RESERVE: A HISTORICAL PERSPECTIVE
The history of rules to eliminate administrative discretion in the
management of money is a long one. In some respects it may be seen
as being broadly based in doctrine opposing the centralization of
power generally. The original Federal Reserve Act and the notions
surrounding it provide one such example. The System was to operate
automatically according to certain rules and related notions with the
view to expanding bank credit (and presumably money) to satisfy the
needs of trade (and presumably income), and the monetary policy
function of the System, such as it was, was decentralized. The rules
and the automatic functioning of the System centered about the "real
bills" doctrine, the gold-flows mechanism, and a simple quantity theory
of money. The only credit control instrument at the disposal of the
System in the early years was the discount rate, or more generally
the discount mechanism, and changes in the rate were initiated at the
regional bank level, as they are today, only the Board must approve.
The System was to perform as a "lender of last resort" and provide
additional liquidity to commercial paper originating at the commercial banks as they extended credit. This was done by the discounting of commercial paper ("real bills") or by advancing credit in a
properly secured form. The paper was real in the sense that the credit
originated in the extension of loans for the purchase of goods in shipment and inventories.
On a temporary basis, as in the case of a seasonal defense against
crisis, the Federal Reserve could serve as lender to the commercial
banks and therefore satisfy a temporary need for credit and possibly
avert the sort of recurring financial crisis of the pre-Federal Reserve
(i.e., pre-1913) era. Moreover, a properly functioning gold-standard
mechanism could serve as an overall regulator, both of the Federal
Reserve System and the growth of bank credit (and, therefore, the
money supply). As trade, credit, and the money supply expanded
excessively, the price level would rise in relation to price levels abroad
and set in motion an outflow of gold. The latter would serve to constrain the growth of bank reserves and the money supply (and thus
the level of prices, via the simple quantity theory of money). A decline
in the domestic price level in relation to foreign price levels had the
199
reverse effects. All the Federal Reserve had to do was to adhere to the
rules. There was little room for discretion. All was to work automatically. Economic stability was to be achieved, since it was thought to be
the result of the malfunctioning of the financial system to begin with.
In the 1930's and later, economists came increasingly to emphasize the
interrelationships between money and the financial and real good
sectors in analyzing cyclical and other changes in output, employment,
and prices.
Paradoxical as it may seem, however, the growth of monetary
analysis in the 1930's was accompanied by a widespread emphasis on
the ineffectiveness of monetary policy under alleged liquidity trap
conditions, such as may have prevailed in the 1930's. The renewal of
widespread belief in the effectiveness of monetary policy depended
largely on post-World War II research and the large amount of empirical work since the advent of the modern computer. A large portion
of this depended on certain reactionary souls, mainly at the University
of Chicago, who maintained a rather militant faith in the efficacy of
money, even when it was placed by some in a secondary position in
relation to fiscal policy [19].
As time passed in the 1920's, the Federal Reserve System, the domestic economy, and the gold-flows mechanism did not work exactly
as envisioned. The Federal Reserve Act had permitted the regional
banks to buy some securities in the open market as a means of obtaining
earnings for operating expenses, and soon this opened the door to the
prospect of exercising control over bank reserves via open market
operations. The opportunity for the exercise of discretion by bank
officials—particularly at the Federal Reserve Bank of New York,
under the leadership of Benjamin Strong—was broadened. The range
for discretionary administration was further broadened and formally
recognized in the Banking Acts of 1933 and 1935, following the catastrophic economic collapse of the early 1930's. Power in the Federal
Reserve shifted to the Board in Washington; general credit controls
came to include open market operations and changes in reserve requirements, all as emphasized in money and banking texts today.
Thus, observing the enhanced discretionary powers and the Federal
Reserve's traditional emphasis on reserves and bank credit, observing
an apparent loose link in the 1930's between bank reserves and the
money stock, and embracing a quantity theory of money with emphasis
on the level of prices—doing all of these things—Irving Fisher put
forth his 100-percent reserve scheme in 1935.26 Henry Simons, also,
advanced proposals for monetary reform in the 1930's. In addition, he
vacillated between favoring a rule for the money stock or an instruction to the authorities to keep the price level stable [21]. And, finally,
operating partly in the Fisher-Simon tradition and partly in the
empirical tradition of the National Bureau of Economic Research,
26 Under the 100-percent reserve scheme, the Federal Reserve—or a special currency
commission—would take over all of the assets of the commercial banks and the bainks
would in turn be required to hold 100 percent reserves against demand deposits. In this way
fractional reserve banking would be eliminated and open market purchases would increase
the money supply directly without any subsequent multiplicative effects resulting from
increments in reserves and fractional reserve requirements. The banks, of course, would
be compensated ; they would charge their customers for service, or as later suggested by
Milton Friedman, receive interest on their reserves. Also, the 100-percent plan, as noted
by Bronfenbrenner (3), might require other changes in financial institutions, e.g., investment trusts "to supply funds to the traditional small-business customers of commercial
banks." All of this, of course, was outside the mainstream of economic analysis in
the 1930's.
200
observing the economic consequences of the exercise of discretion by
Federal Reserve authorities, and studying wide variations in the rate
of change in the money stock—doing all of these things—Milton
Friedman and his followers of the post-World War II were—and
currently are—strong advocates of the need for some monetary rule.
Their advocacy and research in support of the need for some monetary
rule, moreover, came to have widespread impact on economic thinking
in the 1960's. Indeed, congressional hearings before the Senate-House
Economic Committee in May 1968, dealt essentially with a rules proposal and the possible need for constraint on Federal Reserve variations in the rate of change in the money stock [27]. Later, William
Proximire, chairman of the Economic Committee, spoke of the need
for the Federal Reserve "to adopt a constant and moderate monetary
policy." He noted that the committee recommends reports by the
Federal Reserve if during any quarter the increase in the money stock
is less than an annual rate of 2 percent or more than 6 percent. Surveying the record Proxmire said, "the Federal Reserve has a record of
deepening almost every recession or depression we have suffered in
the last 30 years by reducing the money supply." Continuing he said,
"it has often excessively increased the money supply to fan the flames
of inflation when the economy has been booming."
Bronfenbrenner* s review of monetary rides.—Bronfenbrenner
ranges widely over the rules-versus-discretion literature (3). In so
doing, he refers to an irrelevant state reached by comparisons of economic performance under a fixed rule proposal, on the one hand, and
discretionary policy, on the other. A main point he makes is that "even
if, in ordinary times, a given rule performs no better than ordinary
authorities, one may advocate it for the same reason be buys life
insurance 'loaded' in the company's favor." Bronfenbrenner also advances a proposal similar to Friedman's but, at the same time, includes
a package of guideposts for adjusting the money supply target.
The proposal is that the money stock grows at the same rate as income, including a labor force and an average productivity component.
To compensate for adjustments in the money stock that may be called
for because of special developments, Bronfenbrenner introduces
changes in velocity. Thus, before acting on the change in the rate
of change in the money stock, the authorities can make corrections "for
the effects of changing taste and financial innovations on the velocity
of the monetary circulation." This, of course, broadens the policy discussion to include the whole host of analyses of the velocity-interest
rates association [17].
Bronfenbrenner apparently thought that the introduction of guidelines for compensating changes in the money stock will make the
rule proposal more acceptable, more relevant to the world we live in.
In contrast, all of the invited participants in the May 1968 hearings
on rules versus authority wTere opposed to the idea of guidelines for
compensating changes, including in particular the guidelines suggested by Representative Reuss [27, pp. 229-231]. Moreover, as Selden
noted, such secular changes as the post-World War II rise in the income velocity of money could readily be compensated for in the framework of advocates of rules proposals. He said, for example: "a simple
procedure would be an annual review of the guidelines to determine
whether they need revision." Continuing, he said, "the guidelines could
201
be adjusted gradually to take care of longrun changes in the demand
for money/'
Hearings.—The May 1968 hearings before the Joint Economic
Committee were on the question of whether the Federal Reserve should
confine changes in the growth rate for the money stock within limits
such as 3 to 6 percent per year. Much of the discussion centered about
suggestions by Representative Henry S. Reuss that were made available prior to the hearings.
Reuss stated in the form of a rule simple limits for the rate of change
in the money stock per annum. These the membership of the Joint Economic Committee generally subscribed to,27 but Reuss went further
and also stated specific qualifications to the rule as a basis for gei:erating some discussion. Responses to the Reuss proposal and related
discussion and interest on the part of the Joint Economic Committee
have apparently brought out the following: the inability of the Federal Reserve to state any specific and consistent criteria for monetary
and credit policy; a fairly widespread agreement among participants
in monetary policy discussions over the desirability of having Congress set upper and lower limits to the growth rate per annum for the
money stock, subject to the need to give explanations to the Joint
Economic Committee for growth rates extending outside of the limits
for any given quarter; and the undesirability of listing specific exceptions to the limits on the rate of growth of the money stock.
Knowledge and the mystique.—A portion of the discussion of rules
and discretion centers about knowledge or lack of it. Most participants to the discussion agree that monetary and banking mechanics
and phenomena are complicated, but then part over the question
of knowledge. Traditionally the rules proponents have said that we
do not have sufficient knowledge of the effects and lags in effects of
policy to successfully use it as the Federal Reserve has sought to use
it. They conclude that in the absence of such knowledge some simple
rule, such as stability in the growth rate for the money stock, is best.
When we have the knowledge, then we make the departure. The proponents of discretion, on the other hand, have seemed to assume that
the knowledge exists or, at least, that judgment about the need for
a given policy was superior to any simple rule. Even so, we simply
note that central banking matters have often relied on a mystique.
Those invoking the mystique as a substitute for knowledge have
often seemed to present as their best defense, (1) an acquaintance
with a frustrating array of facts and details, and (2) the attitude
that study and research would confirm the validity of their new. This
additional research is always in a promising future, despite all that
has historically been completed. An example of the first characteristic
is Mitchell's statement that "excessive concentration of our attention
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." An example of the second
characteristic is the promise of the Fed-MIT, special-purpose, policy
model.
The challenge to the mystique has come from an outpouring of results from statistical analyses as well as from other research and
27 For an outline of the background of the committee's rules proposal, see Report of the
Joint. Economic Committee (28, pp. 16-18).
21-570—68
14
202
writing, all from a variety of sources. Interestingly—at least with
respect to the characteristic defenses of discretionary monetary
policy—discussion in the forum of the Joint Economic Committee
lias led to the position that the rule can be abandoned when an explanation can be given for doing so. Likely traditional defenses will
suffice as explanations for some time. Even so, a course of developments with respect to the rules-discretion controversy seems to be indicated, notably: justify deviations from the simple rule with empirically
verifiable explanations.
SELECTED REFEKENCES
1. Barger, Harold, The Management of Money: A Survey of American Expert
ence (Chicago: Rand McNally & Co., 1964).
2. Brimmer, Andrew, "Tradition and Innovation in Monentary Management,"
in Alan D. Entine (ed.), Monetary Economics: Readings (Belmont, Calif.:
Wadsworth Publishing Co., 1968).
3. Bronfenbrenner, M., "Monetary Rules: A New Look," Journal of Law and
Economics, October 1965.
4. Burns, Arthur F., and Paul A. Samuelson, Full Employment, Guideposts and
Economic Stability (Washington, D.C.: American Enterprise Institute for
Public Policy Research, 1967).
5. Clifford, Jerome A., The Independence of the Federal Reserve System (Philadelphia : University of Pennsylvania Press, 1965).
6. Chandler, Lester V., Benjamin Strong (Washington, D.C.: The Brookings
Institution, 1958).
7. Christian, James W., "A Further Analysis of the Objectives of American
Monetary Policy," Journal of Finance, June 1968.
8. Cloos, George W., "Pushing on a String: Monetary Conditions from the 193738 Recession to Pearl Harbor," Financial Analysts Journal, January-Februairy 1966.
9. Commission on Money and Credit, Money and Credit: Their Influence on
Jobs, Prices, and Growth (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1961).
10. de Leeuw, Frank, and Edward Gramlich, "The Federal Reserve-MIT Econometric Model," Federal Reserve Bulletin, January 1968.
11. Dewald, William G., and William E. Gibson, "Sources of Variation in Member Bank Reserves," Review of Economics and Statistics, May 1967.
12. Federal Reserve System Committee, "Reappraisal of the Federal Reserve
Discount Mechanism," Federal Reserve Bulletin, July 1968.
13. Fels, Rendigs, and C. Elton Hinshaw, Forecasting and Recognizing Business
Cycle Turning Points (New York: Columbia University Press for the National Bureau of Economic Research, 1968).
14. Frazer, William J., Jr., "Monetary Policy, Monetary Operations and National
Economic Goals," Schweizerische Zeitsohrift fur Volkswirtschaft und Statistik, March 1968.
15.
, "Monetary Policy, Business Loans by Banks and Capital Outlays by
Manufacturing Corporations," Southern Journal of Business, April 1968.
16.
, The Liquidity Structure of Firms and Monetary Economics ( dissertation approved at Columbia University, Department of Economics, February
1968).
17.
, The Demand for Money (Cleveland: The World Publishing Co., 1967).
18.
, and William P. Yohe, Introduction to and Analytics and Institutions
of Money and Banking (Princeton, N.J.: D Van Nostrand Co., Inc., 1966).
19. Friedman, Milton, "Factors Affecting the Level of the Rate of Interest,"
Conference on Savings and Residential Financing: 1968 Proceedings
(Chicago: U.S. Savings & Loan League, forthcoming).
20.
, "The Role of Monetary Policy," American Economic Review, March
1968.
21.
, "The Monetary Theory and Policy of Henry Simons," Journal of Law
and Economics, October 1967.
22. Galbraith, John Kenneth, The New Industrial State (Boston: Houghton
Mifflin Co., 1967).
23. Gibson, William E., "The Effects of Money on Interest Rates," Staff Economic
Studies, No. 43, Board of Governors of the Federal Reserve System, March
1968.
203
24. Heller, Walter W., New Dimensions of Political Economy (New York: W. W.
Norton & Co., Inc., 1967).
25. Haywood, Charles F., and Charles F. Linke, The Regulation of Deposit Interest Rates (Chicago: Association of Reserve City Bankers, 1968).
26. Hendershott, Patric H., The Neutralized Money Stock (Homewood, 111.:
Richard D. Irwin, Inc., 1968).
27. Joint Economic Committee, Congress of the United States, Hearings, Standards for Guiding Monetary Actions (Washington, D.C.: U.S. Government
Printing Office, 1968).
28. Joint Economic Committee, Congress of the United States, Report, Standards
for Guiding Monetary Actions (Washington, D.C.: U.S. Government Printing Office, 1968).
29. Kane, Edward J., "Is There a Predicted Lock-In Effect?: A Look at Cross
Section Experience in 1966." Technical Supplement to "Commercial Bank
Tax Swaps," New England Business Review, March 1968.
30.
, and Burton G. Malkiel, "The Term Structure of Interest Rates: An
Analysis of A Survey of Interest-Rate Expectations," Review of Economics
and Statistics, August 1967.
31. Malkiel, Burton G., The Term Structure of Interest Rates: Expectations and
Behavior Patterns (Princeton, N.J.: Princeton University Press, 1966).
32. Meiselman, David, "The Policy Implications of Current Research in the Term
Structure of Interest Rates," Conference on Savings and Residential Financing: 1968 Proceedings (Chicago: U.S. Savings & Loan League, forthcoming).
33.
, "The New Economics and Monetary Policy," Financial Analysts Journal, November-December 1967.
34. Morrison, George R., Liquidity Preference of Commercial Banks (Chicago :
University of Chicago Press, 1966).
35. Patman, Wright, "What Improvements are Needed in the Money Systems?"
in Richard A. Ward (ed.), Monetary Theory and Policy (Scranton, Pa.:
International Textbook Co., 1966).
36 .
, "Supplementary Views," Report of the Joint Economic Committee,
Congress of the United States, on the January 1965 Economic Report of the
President (Washington, D.C.: U.S. Government Printing Office, 1965).
37. Roosa, Robert V., Federal Reserve Operations in the Money and Government
Securities Market (New York: Federal Reserve Bank of New York, 1956).
38. Subcommittee on Domestic Finance, House Committee on Banking and Currency, Staff Report on Hearings, The Federal Reserve After 50 Years
(Washington, D.C.: U.S. Government Printing Office, 1964).
39. Wallieh. Henry C., "Monetary versus Fiscal Policy," Conference on Sowings
and Residential Financing: 1966 Proceedings (Chicago: U.S. Savings &
Loan League, 1966).
STATEMENT 0E MILTON FRIEDMAN, UNIVERSITY OF CHICAGO
Unfortunately I cannot reply in full to your interesting question
to economists because other commitments make it impossible for me
to take the time that would be required. As a poor substitute, may I
simply record my own views briefly on the appropriate guidelines for
monetary policy. In my opinion, two points are critical—one with
respect to the quantity of money, the other with respect to interest
rates.
1. In the present state of our knowledge, I believe that the best—
or least bad—guideline for monetary policy is steady growth of the
quantity of money at a rate that on the average will mean stable prices
of final products. The precise growth rate required for this purpose
depends on the specific definition of money adopted. For a definition
corresponding to currency plus all commercial bank deposits adjusted—
demand and time—the appropriate rate is around 5 percent per year.
For a definition limited to currency plus adjusted demand deposits
only, the appropriate rate is a trifle lower. In my opinion, it would
be desirable for Congress to instruct the Federal Eeserve to adopt this
204
policy. That would assure that the Federal Reserve System would provide a steady and stable background for private and public economic
policy, instead of being itself a source of instability as it so often has
been in the past and as it is currently being at this very moment.
If Congress does not legislate this rule for the Federal Reserve System, the next best alternative is the one suggested by the Joint Economic Committee in its recent report; namely, that the Federal Reserve at least be required to report to Congress when it permits or
forces the money supply to grow at rates outside a range such as the
2 to 6 percent per year specified by the Joint Economic Committee.
2. On interest rates, the desirable policy is to permit interest rates
to be determined completely by free markets. The present prohibition
on the payment of interest on demand deposits should be removed.
The present authority given to the Federal Reserve System and to
other governmental financial agencies to set the ceilings on the rates
of interest that commercial banks and other financial institutions can
pay on time deposits should be eliminated. Discounting should either
be abolished or the discount rate should be linked to market rates and
set higher than market rates so that it will be a penalty rate. The
present limitations on the interest rates that the Government may set
on its debt obligations should be removed. A free competitive market
in loanable funds is no less desirable than a free and competitive market in other goods and services.
The problems of the organization of the Federal Reserve System
are extremely important so long as the two guidelines just outlined
are not in effect. If these guidelines were put into effect, the problem
of organization would become of little importance because the present
power of the Federal Reserve System to introduce instability into the
economy would be eliminated.
As a matter of principle, I am opposed to independence for the
Federal Reserve System. Monetary policy should be administered by
a governmental agency in the regular administrative hierarchy ultimately responsible to Congress. I have discussed this issue at length
in a paper entitled "Should There Be an Independent Monetary Authority ?" (in Leland B. Yeager, ed., In Search of a Monetary Constitution, Harvard University Press, 1962, pp. 219-243) of which I am
enclosing a reprint.
A full discussion of my views on monetary policy is presented in my
book entitled A Program for Monetary Stability. Experience since this
book was written has given me no reason to alter the major recommendations it contains.
More recently, I have discussed the general problem of monetary
policy in my presidential address to the American Economic Association in December 1967 which was published in the March issue of the
American Economic Review under the title of "The Role of Monetary
Policy." I have discussed current monetary policy in a number of
columns in Newsweek. I am enclosing reprints of these items.
In closing, may I express my appreciation and the appreciation of
other academic students of monetary problems for the important role
which you have played in keeping these significant issues in the forefront of public discussion, for assembling relevant evidence, and stimulating the Federal Reserve System to examine its owrn policies and
procedures critically from time to time, as well as explaining them
205
to the public at large. My best wishes to you in the continuation of
your good work.
(The supplementary materials follow:)
[From Leland B. Yeager (ed.), In Search of a Monetary Constitution,
Harvard University Press, 1962]
Cambridge, Mass.:
SHOULD THERE B E AN INDEPENDENT MONETARY AUTHORITY?
(By Milton Friedman)
The text for this paper, to paraphrase the famous remark attributed to
Poincare, is, "Money is too important to be left to the central bankers." The
problem that suggests this text is the one of what kind of arrangements to set
up in a free society for the control of monetary policy. The believer in a free
society—a "liberal" in the original meaning of the word, but unfortunately not
in the meaning that is now current in this country—is fundamentally fearful
of concentrated power. His objective is to preserve the maximum degree of freedom for each individual separately that is compatible with one man's freedom
not interfering with other men's freedom. He believes that this objective requires
power to be dispersed, that it be prevented from accumulating in any one person
or group of people.
The need for dispersal of power raises an especially difficult problem in the
field of money. There is widespread agreement that government must have some
responsibility for monetary matters. There is also widespread recognition that
control over money can be a potent tool for controlling and shaping the economy.
Its potency is dramatized in Lenin's famous dictum that the most effective way
to destroy a society is to destroy its money. It is exemplified in more pedestrian
fashion by the extent to which control over money has always been a potent
means of exacting taxes from the populace at large, very often without the
explicit agreement of the legislature. This has been true from early times, when
monarchs clipped coins and adopted similar expedients, to the present, with
our more subtle and sophisticated modern techniques for turning the printing
press or simply altering book entries.
The problem is to establish institutional arrangements that will enable government to exercise responsibility for money, yet will at the same time limit the
power thereby given to government and prevent the power from being used in
ways that will tend to weaken rather than strengthen a free society. Three kinds
of solutions have developed or have been suggested. One is an automatic commodity standard, a monetary standard which in principle requires no governmental control. A second is the control of monetary policies by an "independent"
central bank. A third is the control of monetary policies by rules that are legislated in advance by the legislature, are binding upon the monetary authority,
and greatly limit its initiative. This paper discusses these three alternatives
with rather more attention to the solution through a central bank.
A COMMODITY STANDARD
Historically, the device that has evolved most frequently in many different
places and over the course of centuries is a commodity standard; that is, the use
as money of some physical commodity such as gold, silver, brass, or tin, or cigarettes, cognac, or various other commodities. If money consisted wholly of a physical commodity of this type, in principle there would be no need for control by the
government at all. The amount of money in society would depend on the cost of
producing the monetary commodity rather than on other things. Changes in the
amount of money would depend on changes in the technical conditions of producing the monetary commodity and on changes in the demand for money.
This is an ideal that animates many believers in an automatic gold standard.
In point of fact, however, as the system developed it deviated very far from this
simple pattern, which required no governmental intervention. Historically, a commodity standard—such as a gold standard or a silver standard—was accompanied
by the development of alternative forms of money as well, of fiduciary money of
one kind or another, ostensibly convertible into the montary commodity on fixed
terms. There was a very good reason for this development. The fundamental
defect of a commodity standard, from the point of view of the society as a whole,
is that it requires the use of real resources to add to the stock of money. People
must work hard to dig something out of the ground in one place—to dig gold out
206
of the ground in South Africa—in order to rebury it in Fort Knox, or some similar
place. The necessity of using real resources for the operation of a commodity
standard establishes a strong incentive for people to find ways to achieve the
same result without employing these resources. If people will accept as money
pieces of paper on which is printed "I promise to pay so much of the standard
commodity," these pieces of paper can perform the same functions as the physical
pieces of gold or silver, and they require very much less in resources to produce.
This point, which I have discussed at somewhat greater length elsewhere 1 seems
to me the fundamental difficulty of a commodity standard.
If an automatic commodity standard were feasible, it would provide an excellent solution to the liberal dilemma of how to get a stable monetary framework
without the danger of irresponsible exercise of monetary powers. A full commodity standard, for example, an honest-to-goodness gold standard in which 100
percent of the money consisted literally of gold, widely supported by a public
imbued with the mythology of a gold standard and the belief that it is immoral
and improper for government to interfere with its operation, would provide an
effective control against governmental tinkering with the currency and against
irresponsible monetary action. Under such a standard, any monetary powers of
government would be very minor in scope.
But such an automatic system has historically never proved feasible. It has
always tended to develop in the direction of a mixed system containing fiduciary
elements such as banknotes, bank deposits, or government notes in addition to
the monetary commodity. And once fiduciary elements have been introduced, it
has proved difficult to avoid government control over them, even when they were
initially issued by private individuals. The reason is basically the difficulty of
preventing counterfeiting or its economic equivalent. Fiducary money consists of
a contract to pay standard money. It so happens that there tends to be a long
interval between the making of such a contract and its realization, which enhances the difficulty of enforcing the contract to pay the standard money and
hence also the temptation to issue fraudulent contracts. In addition, once fiduciary
elements have been introduced, the temptation for government itself to issue
fiduciary money is almost irresistible. As a result of these forces, commodity
standards have tended in practice to become mixed standards involving extensive intervention by the state, which leaves the problem of how intervention is
to be controlled.
Despite the great amount of talk by many people in favor of the gold standard,
almost no one today literally desires to see an honest-to-goodness full gold
standard in operation. People who say they want a gold standard are almost invariably talking about the present kind of standard, or the kind of standard
that was maintained in the 1930's, in which there is a small amount of gold in
existence, held by the central monetary, authority as "backing"—to use that very
misleading term—for fiduciary money, and with the same authority, a central
bank or other government bureau, managing the gold standard. Even during the
so-called "great days" of the gold standard of the 19th century, when the Bank of
England was supposedly running the gold standard skillfully, the monetary system was far from a fully automatic gold Standard. It was even then a highly managed standard. And certainly the situation is now more extreme. Country after
country has adopted the view that government has responsibility for internal
stability. This development, plus the invention by Schacht of the widespread direct control of foreign exchange transactions, has meant that few if any countries are willing today to let the gold standard operate even as quasi-automatically as it did in the 19th century.
Most countries in the world currently behave asymmetrically with respect
to the gold standard. They are willing to allow gold to flow in and even to inflate
somewhat in response, but almost none is willing either to let gold flow out to
any large extent or to adjust to the outflow by allowing or forcing internal prices
to decline. Instead, they are very likely to take measures such as exchange controls, import restrictions, and the like.
My conclusion is that an automatic commodity standard is neither a feasible
nor a desirable solution to the problem of establishing monetary arrangements
for a free society. It is not desirable because it would involve a large cost in the
form of resources used to produce the monetary commodity. It is not feasible
because the mythology and beliefs required to make it effective do not exist.
1A
Program for Monetary Stability
pp. 4 - 8 .
(New York: Fordham University Press,
1959),
207
AN
INDEPENDENT
CENTRAL BANK
A second device that has evolved and for which there is considerable support
is a so-called independent monetary authority—a central bank—to control monetary policy and to keep it from being the football of political manipulation. The
widespread belief in an independent central bank clearly rests on the acceptance—
in some cases the highly reluctant acceptance—of the view I have just been
expressing about a commodity standard, namely, that a fully automatic commodity standard is not a feasible way to achieve the objective of a monetary
structure that is both stable and free from irresponsible governmental tinkering.
The device of an independent central bank embodies the very appealing idea
that it is essential to prevent monetary policy from being a day-to-day plaything
at the mercy of every whim of the current political authorities. The device is
rationalized by assimilating it to a species of constitutionalism. The argument
that is implicit in the views of proponents of an independent central bank—so far
as I know, these views have never been fully spelled out—is that control over
money is an essential function of a government comparable to the exercise of
legislative or judicial or administrative powers. In all of these, it is important
to distinguish between the basic structure and day-to-day operation wTithin that
structure. In our form of government, this distinction is made between the constitutional rules which set down a series of basic prescriptions and proscriptions
for the legislative, judicial, and executive authorities and the detailed operation
of the several authorities under these general rules. Similarly, the argument
implicit in the defense of an independent central bank is that the monetary
structure needs a kind of a monetary constitution, which takes the form of rules
establishing and limiting the central bank as to the powers that it is given, its
reserve requirements, and so on. Beyond this, the argument goes, it is desirable
to let the central bank have authority largely coordinate with that of the legislature, the executive, and the judiciary to carry out the general constitutional
mandate on a day-to-day basis.
In recent times, the threat of extension of government control into widening
areas of economic activity has often come through proposals involving monetary
expansion. Central bankers have generally been "sound money men," at least
verbally, wThich is to say, they have tended to attach great importance to stability
of the exchange rate, maintenance of convertibility of the nation's currency
into other currencies and into gold, and prevention of inflation. They have therefore tended to oppose many of the proposals for extending the scope of government. This coincidence of their views in these respects with those of people like
myself, who regard narrowly limited government as a requisite for a free society,
is the source of much of the sympathy on the part of this group, whom I shall
call "new liberals," for the notion of an independent central bank. As a practical
matter, the central bankers seem more likely to impose restrictions on irresponsible monetary power than the legislative authority itself.
A first step in discussing this notion critically is to examine the meaning of
the "independence" of a central bank. There is a trivial meaning that cannot be
the source of dispute about the desirability of independence. In any kind of a
bureaucracy, it is desirable to delegate particular functions to particular agencies. The Bureau of Internal Revenue can be described as an independent
bureau within the Treasury Department. Outside the regular government departments, there are separate administrative organizations, such as the Bureau
of the Budget. This kind of independence of monetary policy would exist if,
within the central administrative hierarchy, there were a separate organization charged with monetary policy which was subordinate to the chief executive or officer, though it might be more or less independent in routine decisions.
For our purposes, this seems to me a trivial meaning of independence, and not the
meaning fundamentally involved in the argument for or against an independent
central bank. This is simply a question of expediency and of the best way to
organize an administrative hierarchy.
A more basic meaning is the one suggested above—that a central bank should
be an independent branch of government coordinate with the legislative, executive, and judicial branches, and with its actions subject to interpretation by the
judiciary. Perhaps the most extreme form of this kind of independence in practice, and the form that comes closest to the ideal type envisaged by proponents
of an independent central bank, has been achieved in those historical instances
where an organization that was initially entirely private and not formally part
of the government at all has served as a central bank. The leading example, of
course, is the Bank of England, which developed out of a strictly private bank
208
and was not owned by or formally a part of the Government until after World War
II. If such a private organization strictly outside the regular political channels
could not function as a central monetary authority, this form of independence
would call for the establishment of a central bank through a constitutional
provision which would be subject to change only by constitutional amendment.
The bank would accordingly not be subject to direct control by the legislature.
This is the meaning I shall assign to independence in discussing further whether
an independent central bank is a desirable resolution of the problem of achieving
responsible control over monetary policy.
It seems to me highly dubious that the United States, or for that matter any
other country, has in practice ever had an independent central bank in this fullest
sense of the term. Even when central banks have supposedly been fully independent, they have exercised their independence only so long as there has been no
real conflict between them and the rest of the government. Whenever there has
been a serious conflict, as in time of war, between the interests of the fiscal authorities in raising funds and of the monetary authorities in maintaining convertibility into specie, the bank has almost invariably given way, rather than the
fiscal authority. To judge by experience, even those central banks that have been
nominally independent in the fullest sense of the term have in fact been closely
linked to the executive authority.
But of course this does not dispose of the matter. The ideal is seldom fully
realized. Suppose we could have an independent central bank in the sense of a
coordinate constitutionally established, separate organization. Would it be desirable to do so? I think not, for both political and economic reasons.
The political objections are perhaps more obvious than the economic ones. Is
it really tolerable in a democracy to have so much power concentrated in a body
free from any kind of direct, effective political control? What I have called the
new liberal often characterizes his position as involving belief in the rule of
law rather than of men. It is hard to reconcile such a view wTith the approval of
an independent central bank in any meaningful way. True, it is impossible to dispense fully with the rule of men. No law can be specified so precisely as to avoid
problems of interpretation or to cover explicitly every possible case. But the kind
of limited discretion left by even the best of laws in the hands of those administering them is a far cry indeed from the kind of far-reaching powers that the laws
establishing central banks generally place in the hands of a small number of men.
I was myself most fully persuaded that it would be politically intolerable to
have an independent central bank by the memoirs of Emile Moreau. the Governor of the Bank of France during the period from about 1926 to 1928, the period
when France established a new parity for the franc and returned to gold. Moreau
was appointed Governor of the Bank of France in 1926, not long before Poincare
became Premier after violent fluctuations in the exchange value of the franc and
serious accompanying internal disturbances and governmental financial difficulties.. Moreau's memoirs were edited and brought out in book form some years
ago by Jacques Rueff, who was the leading figure in the recent French monetary
reform.2
The book is fascinating on many counts. The particular respect that is most
relevant for our present purpose is the picture that Moreau paints of Montagu
Norman, Governor of the Bank of England, on the one hand, and of Hjalmar
Schacht, at that time Governor of the Bank of Germany, on the other; they were
unquestionably two of the three outstanding central bankers of the modern era,
Benjamin Strong of the United States being the third. Moreau describes the views
that these two European central bankers had of their functions and their roles,
and implies their attitude toward other groups. The impression left with me—
though it is by no means clear that Moreau drew the same conclusions from
what he wrote, and it is certain that he would have expressed himself more temperately—is that Norman and Schacht were contemptuous both of the masses—
of "vulgar" democracy—and of the classes—of the, to them, equally vulgar plutocracy. They viewed themselves as exercising control in the interests of both
groups but free from the pressures of either. In Norman's view, if the major
central bankers of the wrorld would only co-operate with one another—and he had
in mind not only himself and Schacht but also Moreau and Benjamin Strong—
they could jointly wield enough power to control the basic economic destinies of
the Western World in accordance with rational ends and objectives rather than
2
Emile, Moreau,
[1954]).
Souvenirs
d'un
gouvernenr
<le la Banque
de France
(Paris:
Genin,
209
with the irrational processes of either parliamentary democracy or laissez-faire
capitalism. Though of course stated in obviously benevolent terms of doing the
"right thing" and avoiding distrust and uncertainty, the implicit doctrine is
clearly thoroughly dictatorial and totalitarian.
It is not hard to see how Schacht could later be one of the major creators of
the kind of far-reaching economic planning and control that developed in Germany. Schacht's creation of extensive direct control of foreign exchange transactions is one of the few really new economic inventions of modern times. In the
older literature, when people spoke of a currency as being inconvertible, they
meant that it was not convertible into gold or silver or some other money at a
fixed rate. To the best of my knowledge, it is only after 1934 that inconvertibility
came to mean what we currently (take it to mean : that it is illegal for one man to
convert paper money of one country into paper money of another country at any
terms he can arrange with another person.3
I turn now to the economic or technical aspects of an independent central
bank. Clearly there are political obpections to giving the group in charge of a
central bank so much power independent of direct political controls, but it has
been argued, there are economic or technical grounds wrhy it is nevertheless
essential to do so. In judging this statement, much depends on the amount of leeway that the general rule governing the central bank gives to it. I have been
describing an independent central bank as if it could or would be given a good
deal of separate power, as clearly is currently the case. Of course, the whole
notion of independence could be rendered merely a matter of words if in fact
the constitutional provision setting up the bank established the limits of its
authority very narrowly and controlled very closely the polices that it could
follow.
In the 19th century, when wide support for independent central banks developed, the governing objective of the central bank was the maintenance of exchange stability. Central banks tended to develop in countries that professed
to have commodity currencies, which is to say had a fixed price for the commodity
serving as the monetary standard in terms of the nominal money of the country.
For two countries on the same standard, this meant a fixed rate of exchange
between the corresponding national currencies. In consequence, the maintenance
of such fixer! rates had to be the proximate aim of the central bank if it was
to achieve its major aim of keeping its currency convertible into standard
money. The Bank of England, for example, was narrowly limited in what it
could do by the necessity of keeping England on gold.
In the same wray, in the United States when the Federal Reserve System was
established in 1913, it never entered into the minds of the people who were
establishing it that the System wTould really have much effective control internally in ordinary times. The Reserve System was established when the gold
standard ruled supreme, and when it wras taken for granted that the major
factor determining the policy of the System, and hence the behavior of the
stock of money in this country, would be the necessity of maintaining external
equilibrium with the currencies of other countries. So long as the maintenance
of a fixed exchange rate between one country's currency and the currencies of
other countries was the overriding objective of policy, the amount of leeway
available to the central bank was narrowly limited. It had some leeway with
respect to minor movements of a short-term character, but it ultimately had to
respond to the balance of payments.
The situation has changed drastically in this respect in the course of the past
few decades. In the United States, which is of most immediate concern to us,
the Reserve System had hardly started operations before the fundamental con3 Another feature of Moreau's book that is most fascinating but rather off the main track
of the present discussion is the story it tells of the changing relations between the French
and British central banks. At the beginning, with France in desperate straits seeking to
stabilize its currency. Norman was contemptuous of France and regarded it as very much of
a junior partner. Through the accident that the French currency was revalued at a level
that stimulated gold imports, France started to accumulate gold reserves and sterling
reserves and gradually came into the position where at any time Moreau could have forced
the British off gold b^ withdrawing the funds he had on deposit at the Bank of England.
The result wras that Norman changed from being a pr ucl boss and very much the senior
partner to being almost a suppliant at the mercy of Moreau. Aside from the human drama,
it emphasizes how important it is whether the rate of exchange is fixed 5 percent too low or
5 percent too high. Britain went back on gold in 1925 at a price of gold in terms < f thp
pound that was probably something like 5 or 10 percent too low. and France went back
<le facto at the end of 1926 and de jure in mid-1928 at a price of gold in terms of francs that
was 5 or 10 percent to^ high. This difference meant the difference between the French being
at the mercy of the British and the British being at the mercy of the French.
210
ditions taken for granted when it was established had changed radically. During
World War I, most of the countries of the world went off gold. The United
States technically remained on gold, but the gold standard on which it remained
was very different from the one that had prevailed earlier. After the end of
World War I, although other countries of the world gradually reestablished
something they called the gold standard, the gold standard never again played
the role which it had before. Prior to World War I, the United States was
effectively a minor factor in the total world economy, and the necessity of maintaining external stability dominated our behavior. After the war, we had become
a major factor to which other countries had to adjust. We held a very large
fraction of the world's gold. Many countries never went back on gold, and those
that did went back in a much diluted form. So never again has there been anything like the close domination of day-to-day policy by the gold standard that
prevailed prior to 1914. Under these circumstances, "independence" of the central bank has become something meaningful, and not merely a technicality.
One defect of an independent central bank in such a situation is that it
almost inevitably involves dispersal of responsibility. If we examine the monetary
system in terms not of nominal institutional organization but of the economic
functions performed, we find that the central bank is hardly ever the only
authority in the Government that has essential monetary powers. Before the Federal Reserve System was established, the Treasury exercised essential montary
powers. It operated like a central bank, and at times a very effective central
bank. More recently, from 1933 to 1941, the Federal Reserve System was almost
entirely passive. Such monetary actions as were taken predominantly by the
Treasury. The Treasury engaged in open-market operations in its debt-management operations of buying and selling securities. It created and destroyed money
in its gold and silver purchases and sales. The Exchange Stabilization Fund
was established and gave the Treasury yet another device for engaging in openmarket operations. When the Treasury sterlized and desterilized gold, it was
engaging in monetary actions. In practice, therefore, even if something called
an independent central bank is established and given exclusive power over a limited range of monetary matters, in particular over the printing of pieces of pape
or the making of book entries called money (Federal Reserve notes and Federal
Reserve deposits), there remain other governmental authorities, particularly the
fiscal authority collecting taxes and dispersing funds and managing the debt,
which also have a good deal of monetary power.
If one wanted to have the substance and not merely the form of an independent
monetary authority, it would be necessary to concentrate all debt-management
powers as well as all powers to create and destroy governmentally issued money
in the central bank. As a matter of technical efficiency, this might well be desirable. Our present division of responsibility for debt management between the
Federal Reserve and the Treasury is very inefficient. It would be much more efficient if the Federal Reserve did all of the borrowing and all of the managing of
the debt, and the Treasury, when it had a deficit, financed it by getting money
from the Federal Reserve System, and when it had a surplus, handed the excess
over to the Federal Reserve System. But while such an arrangement might be
tolerable if the Federal Reserve System were part of the same administrative
hierarchy as the Treasury, it is almost inconceivable that it would be if the central bank were thoroughly independent. Certainly no government to date has been
willing to put that much power in the hands of a central bank even when the bank
has been only partly independent. But so long as these powers are separated, there
is dispersal of responsibility, with each group separately regarding the other
group as responsible for what is happening and with no one willing to accept
responsibility.
In the past few years, I have read through the annual reports of the Federal
Reserve System from 1913 to date, seriatim. One of the few amusing dividends
from that ordeal was seeing the cyclical pattern that shows up in the potency
that the authorities attribute to monetary policy. In years when things are
going well, the reports emphasize that monetary policy is an exceedingly potent
weapon and that the favorable course of events is largely a result of the skillful
handling of this delicate instrument by the monetary authority. In years of depression, on the other hand, the reports emphasize that monetary policy is but
one of many tools of economic policy, that its power is highly limited, and that it
was only the skillful handling of such limited powers as were available that
averted disaster. This is an example of the effect of the dispersal of responsibility
among different authorities, with the likely result that no one assumes or is
assigned the final responsibility.
211
Another defect of the conduct of monetary policy through an independent
central bank that has a good deal of leeway and power is the extent to which the
policy is thereby made highly dependent on personalities. In studying the history
of American monetary policy, I have been struck by the extraordinary importance
of accidents of personality.
At the end of World War I, the Governor of the Federal Reserve System was
W. P. G. Harding. Governor Harding was, I am sure, a thoroughly reputable
and competent citizen, but he had a very limited understanding of monetary
affairs, and even less backbone. Almost every student of the period is agreed that
the great mistake of the Reserve System in postwar monetary policy was to permit the money stock to expand very rapidly in 1919 and then to step very hard
on the brakes in 1920. This policy was almost surely responsible for both the sharp
postwar rise in prices and the sharp subsequent decline. It is amusing to read
Harding's answer in his memoirs to criticism that was later made of the policies
followed. He does not question that alternative policies might well have been
preferable for the economy as a whole, but emphasizes the Treasury's desire to
float securities at a reasonable rate of interest, and calls attention to a thenexisting law under which the Treasury could replace the head of the Reserve
System. Essentially he was saying the same thing that I heard another member
of the Reserve Roard say shortly after World War II when the bond-supported
program was in question. In response to the view expressed by some of my colleagues and myself that the bond-support program should be dropped, he largely
agreed but said, "Do you want us to lose our jobs?"
The importance of personality is strikingly revealed by the contract between
Harding's behavior and that of Emile Moreau in France under much more difficult circumstances. Moreau formally had no independence whatsoever from the
central government. He was named by the Premier, and could be discharged
at any time by the Premier. But when he was asked by the Premier to provide
the Treasury with funds in a manner that he considered inappropriate and undesirable, he flatly refused to do so. Of course, what happened was that Moreau
was not discharged, that he did not do what the Premier had asked him to, and
that stabilization was rather more successful. I cite this contrast neither to
praise Moreau nor to blame Harding, but simply to illustrate my main point;
namely, the extent to which a system of this kind is really a system of rule by
men and not by law and is extraordinarily dependent on the particular personalities involved.
Another occasion in U.S. history which strikingly illustrates this point is our
experience from 1929 to 1933. Without doubt, the most serious mistake in the
history of the Reserve System was its mismanagement of monetary matters
during those years. And this mismanagement, like that after World War I, can
very largely attributed to accidents of personality. Benjamin Strong, Governor of the Federal Reserve Bank of New York from its inception, was the dominant figure in the Reserve System until his death at a rather early age in 1928.
His death was followed by a shift of power in the System from New York to
Washington. The people in Washington at the time happened to be fairly mediocre.
Moreover, they had always played a secondary role, were not in intimate touch
with the financial world, and had no background of long experience in meeting
day-to-day emergencies. Further, the chairmanship changed hands just prior
to the shift of power and again in mid-1931. Consequently, in the emergencies
that came in 1929, 1930, and 1931, particularly in the fall of 1930, when the
Bank of United States failed in New York as part of a dramatic series of bank
failures, the Federal Reserve System acted timorously and passively. There is
little doubt that Strong would have acted very differently. If he had still been
Governor, the result would almost surely have been to nip the wave of bank failures in the bud and to prevent the drastic monetary deflation that followed.
A similar situation prevails today. The actions of the Reserve System depend
on whether there are a few persons in the System who exert intellectual leadership, and on who these people are; its actions depend not only on the people
who are nominally the heads of the System but also on such matters as the fate
of particular economic advisers.
So far, I have listed two main technical defects of an independent central
bank from an economic point of view: first, dispersal of responsibility, which
promotes shirking responsibility in times of uncertainty and difficulty, and second, an extraordinary dependence on personalities, which fosters instability
arising from accidental shifts in the particular people and the character of the
people who are in charge of the system.
212
A third technical defect is that an independent central bank will almost
inevitably give undue emphasis to the point of view of bankers. It is exceedingly
important to distinguish two quite different problems that tend to be confused:
the problem of credit policy and the problem of monetary policy. In our kind
of monetary or banking system, money tends to be created as an incident in the
extension of credit, yet conceptually the creation of money and the extension of
credit are quite distinct. A monetary system could be utterly unrelated to any
credit instruments whatsoever; for example, this would be true of a completely
automatic commodity standard, using only the monetary commodity itself or
warehouse receipts for the commodity as money. Historically, the connection
between money and credit has varied widely from time to time and from place
to place. It is therefore essential to distinguish policy issues connected with
interest rates and conditions on the credit market from policy issues connected
with changes in the aggregate stock of money, while recognizing, of course, that
measures taken to affect the one set of variables may also affect the other, and
that monetary measures may have credit effects as well as monetary effects
proper.
It so happens that central-bank action is but one of many forces affecting the
credit market. As we and other countries have seen time and again, a central
bank may be able to determine the rate of interest on a narrow range of securities,
such as the rate of interest on a particular category of Government bonds, though
even that only within limits and only at the expense of completely giving up control over the total stock of money. A central bank has never been able to determine, at all closely, rates of interest in any broader or more fundamental sense.
Postwar experience in country after country that has embarked on a cheapmoney policy has strikingly demonstrated that the forces which determine rates
of interest broadly conceived—rates of return on equities, on real property, on
corporate securities—are far too strong and widespread for the central bank to
dominate. It must sooner or later yield to them, and generally rather soon.
The central bank is in a very different position in determining the quantity of
money. Under systems such as that in the United States today, the central bank
can make the amount of money anything it wishes. It may, of course, choose to
accept some other objective and give up its power over the money supply in
order to try to keep "the" or "a" rate of interest fixed, to keep "free reserves" at
a particular level, or to achieve some other objective. But if it wishes, it can
exercise complete control over the stock of money.
This difference between the position of the central bank in the credit markets
and in determining the money supply tends to be obfuscated by the close connection between the central bank and the banking community. In the United States,
for example, the Reserve banks technically are owned by their member banks.
One result is that the general views of the banking community exercise a strong
influence on the central bank and, since the banking community is concerned
primarily with the credit market, central banks are led to put altogether too
much emphasis on the credit effects of their policies and too little emphasis on
the monetary effects of their policies.
In recent times, this emphasis has been attributed to the effects of the Keynesian
Revolution and its treatment of changes in the stock of money as operating primarily through the liquidity preference function on the interest rate. But this is
only a particular form of a more general and ancient tendency. The real-bills doctrine, which dates back a century and more, exemplifies the same kind of confusion between the credit and the monetary effects of monetary policy. The banking and currency controversy in Britain in the early 19th century is a related example. The central bank emphasized its concern with conditions in the credit
market It denied that the quantity of money it was creating was in any way an
important consideration in determining price levels or the like, or that it had
any discretion about how much money to create. Much the same arguments are
heard today.
The three defects I have outlined constitute a strong technical argument against
an independent central bank. Combined with the political argument, the case
against a fully independent central bank is strong indeed.
LEGISLATED RULES
If this conclusion is valid, if we cannot achieve our objectives by giving wide
discretion to independent experts, how else can we establish a monetary system
that is stable, free from irresponsible governmental tinkering, and incapable of
being used as a source of power to threaten economic and political freedom? A
213
third possibility is to try to achieve a government of law instead of men literally
by legislating rules for the conduct of monetary policy. The enactment of such
rules would enable the public to exercise control over monetary policy through
its political authorities, while at the same time preventing monetary policy from
being subject to the day-to-day whim of political authorities.
The argument for legislating rules for monetary policy has much in common
with a topic that seems at first altogether different; namely, the Bill of Rights
to the Constitution. Whenever anyone suggests the desirability of a legislative
rule for control over money, the stereotyped answer is that it makes little sense
to tie the monetary authority's hands in this way because the authority, if it
wants to, can always do of its own volition what the rule would require it to do,
and, in addition, has other alternatives; hence "surely," it is said, it can do
better than the rule. An alternative version of the same argument applies to the
legislature. If the legislature is willing to adopt the rule, it is said, surely it will
also be willing to legislate the "right" policy in each specific case. How then,
it is said, does the adoption of the rule provide any protection against irresponsible political action ?
The same argument could apply with only minor verbal changes to the first
amendment to the Constitution and, equally, to the entire Bill of Rights. Is it not
absurd, one might say, to have a general proscription of interference with free
speech? Why not take up each case separately and treat it on its own merits?
Is this not the counterpart to the usual argument in monetary policy that it is
undesirable to tie the hands of the monetary authority in advance; that it should
be left free to treat each case on its merits as it comes up? Why is not the argument equally valid for speech? One man wants to stand up on a street corner
and advocate birth control; another, communism; a third, vegetarianism; and
so on, ad infinitum. Why not enact a law affirming or denying each the right to
spread his particular views? Or, alternatively, why not give the power to decide
the issue to an administrative agency? It is immediately clear that if we were
to take up each case separately, a majority would almost surely vote to deny
free speech in most cases and perhaps even in every case. A vote on whether
Mr. X should spread birth control propaganda would almost surely yield a majority saying "no"; and so would one on communism. The vegetarian might
perhaps get by, although even that is by no means a foregone conclusion.
But now suppose all these cases were grouped together in one bundle, and
the populace at large was asked to vote for them as a whole: to vote whether
free speech should be denied in all cases or permitted in all alike. It is perfectly
conceivable, if not highly probable, that an overwhelming majority would vote
for free speech; that, acting on the bundle as a whole, the people would vote
exactly the opposite to the way they would have voted on each case separately.
Why? One reason is that each person feels much more strongly about being
deprived of his right to free speech wrhen he is in a minority than he feels about
depriving somebody else of the right to free speech when he is in the majority.
In consequence, when he votes on the bundle as a whole, he gives much more
weight to the infrequent denial of free speech to himself when he is in the
minority than to the frequent denial of free speech to others. Another reason,
and one that, is more directly relevant to monetary policy, is that if the bundle
is viewed as a whole, it becomes clear that the policy followed has cumulative
effects that tend neither to be recognized nor taken into account when each
case is voted on separately. When a vote is taken on whether Mr. Jones may
speak on the corner, it is not clearly affected by favorable effects of an announced general policy of free speech, and an affirmative vote will not produce
these effects. In voting on the specific case, it is only peripherally relevant that
a society in which people are not free to speak on the corner without special
legislation is a society in which the development of new ideas, experimentation,
change, and the like are all hampered in a great variety of ways. That these
ways are obvious to all is due to our good fortune of having lived in a society
that did adopt the self-denying ordinance of not considering each case of speech
separately.
Exactly the same considerations apply in the monetary area. If each case is
considered on its merits, the wrong decision is likely to be made in a large
fraction of cases because the decisionmakers are examining only a limited
area and are not taking into account the cumulative consequences of the policy
as a whole. On the other hand, if a general rule is adopted for a group of cases
as a bundle, the existence of that rule has favorable effects on people's attitudes
and beliefs and expectations that would not follow even from the discretionary
adoption of precisely the same policy on a series of separate occasions.
214
Of course, the general rule need not be explicitly written down or legislated.
Unwritten constitutional limitations supported unthinkingly by the bulk of the
people may be as effective in determining decisions in individual cases as a
written constitution. The analogy in monetary affairs is the mythology of gold,
referred to earlier as a necessary ingredient of a gold standard if it is to serve
as an effective bulwark against discretionary authority.
If a rule is to be legislated, what rule should it be? The rule that has most
frequently been suggested by people of a generally "new liberal" persuasion is
a price-level rule; namely, a legislative direction to the monetary authorities
that they maintain a stable price level. I think this is the wrong kind of rule.
It is the wrong kind of rule because the objectives it specifies are ones that the
monetary authorities do not have the clear and direct power to achieve by their
own actions. It consequently raises the earlier problem of dispersing responsibilities and leaving the authorities too much leeway. There is unquestionably a close
connection between monetary actions and the price level. But the connection is
not so close, so invariable, or so direct that the objective of achieving a stable price
level is an appropriate guide to the day-to-day activities of the authorities.
The issue of what rule to adopt is one that I have considered at some length
elsewhere.4 Accordingly, I will limit myself here to stating my conclusion. In
the present state of our knowledge, it seems to me desirable to state the rule in
terms of the behavior of the stock of money. My choice at the moment would
be a legislated rule instructing the monetary authority to achieve a specified rate
of growth in the stock of money. For this purpose, I would define the stock of
money as including currency ouside commercial banks plus all deposits of commercial banks. I would specify that the Reserve System should see to it that
the total stock of money so defined rises month by month, and indeed, so far
as possible, day by day, at an annual rate of x percent, where x is some number
between 3 and 5. The precise definition of money adopted and the precise rate
of growth chosen make far less difference than the definite choice of a particular
definition and a particular rate of growth.
I should like to emphasize that I do not regard this proposal as a be-all and
end-all of monetary management, as a rule which is somehow to be written in
tablets of gold and enshrined for all future time. It seems to me to be the rule
that offers the greatest promise of achieving a reasonable degree of monetary
stability in the light of our present knowledge. I would hope that as we operated with it, as we learned more about monetary matters, we might be able to
devise still better rules which would achieve still better results. However, the
main point of this paper is not so much to discuss the content of these or
alternative rules as to suggest that the device of legislating a rule about the
stock of money can effectively achieve what an independent central bank is
designed to achieve but cannot. Such a rule seems to me the only feasible device currently available for converting monetary policy into a pillar of a free
society rather than a threat to its foundation.
[From the American Economic Review, March 1968]
T H E ROLE OF MONETARY POLICY*
(By Milton Friedman**)
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 relaA Program for Monetary Stability, pp. 7 7 - 9 9 .
•Presidential address delivered at the 80th annual meeting of the American Economic
Association, Washington, D.C., Dec. 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*, Harvey 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!
4
215
tive stability of the 1920's 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 alike, 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 lead1 a horse to water but 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 depression, and an alternative to monetary policy for meeting the depression and his
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 wide 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 in1 the Government budget, contribute to the
"euthanasia of the rentier," and maybe, stimulate investment a bit to assist Government spending 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 denouement came with the Federal Reserve-Treasury Accord in 1951,
although the policy of pegging Government bond prices was not formally abandoned 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 policyThis revival was strongly fostered among economists by the theoretical
developments 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 orthodox 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, unemployment 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 revaluation 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
authorities 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 willing borrowers—not because the horse would not drink.
It fell because the Federal Reserve System forced or permitted a sharp reduction
J In [2], I have argued that Henry Simons shared this view with Keynes, and that it
accounts for the policy changes that he recommended.
216
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.
In 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 attempt to adjust them to the course of economic activity,
so emphasis 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 marvelously 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
common coin some itwo 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
monetary policy as being to "maintain the value of Government bonds. * * *
This country" he wrote, "will have to adjust to a 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
Machlup 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 Machlup wrote, "Questions regarding the rate of interest, in
particular 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 longtime 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 opinion—
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, "Our
contributors do not discuss the question of money supply. * * * The contributors
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 Survey of Contemporary Economics, edited by Howard Ellis and published 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 compensatory
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 interest 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 this humbling inquiry, I recommend that you
compare the sections 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 that to the position of 1945. There
are of course many differences between then and now, less in the potenev attributed to monetary policy than in the roles assigned to it and the criteria bv
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 prevention
of inflation a continuing but definitely secondary objective. And there is major
217
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 well 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 MONETARY POLICY CANNOT DO
From the infinite world of negation, I have selected two limitations of monetary
policy to discuss: (1) It cannot peg interest rates for more than very limited
periods, and (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 believed,
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 reaction against simple-minded Keynesianism. In the United States, this reaction
involved widespread recognition that the wartime and postwar pegging of bond
prices was a mistake, that the abandonment of this policy was a desirable and
inevitable step, and that it had none of the disturbing and disastrous consequences
that were so freely predicted at the time.
The limitation derives from a much misunderstood feature of the relation
between 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 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 wTill 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 further, 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.
21-570—68
15
218
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 falling 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
interest—but to do so it would have to start out in what seems like the opposite
direction, 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.8
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 unemployment 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.
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 longrun
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 imbedded'
in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and sup2 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 supply alone.
219
plies, the cost of gathering information about job vacancies and labor availabilities, the costs of mobility, and so on.3
You will recognize the close similarity between this statement and the celebrated Phillips Curve. The similarity is not 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. Implicitly, 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 than 75 percent a year—as, for example, Brazilians did a few
years ago. Then wages must rise at that rate simply to keep real wages unchanged. An excess supply of labor will be reflected in a less rapid rise i*n nominal
wages than in anticipated prices,4 not in an absolute decline in wages. When
Brazil embarked on a policy to bring down the rate of price rise, and succeeded
in bringing the prise rise down to about 45 percent a year, there was a sharp
initial riae in unemployment because under the influence of earlier anticipations,
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
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-Bacin Acts, and the strength
of labor unions all make the natural rate of unemployment higher than it would
otherwise be. Improvements in employment exchanges, in availability of information 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
unemployment at a level below the "natural" rate. For deflniteness, suppose that
it takes 3 percent as the target rate and that the "natural" rate is higher than
3 percent. Suppose also that we start out at a time when prices have been stable
and when unemployment is higher than 3 percent. 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 prices. 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
demand 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.
3 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 anticipated nominal wages to make allowance 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 average
rate of change of prices, and hence the anticipated rate, has been relatively stable. For
such periods, nominal wages and "real" wages move together. Curves computed for different 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 price varies considerably, the Phillips Curve will not be well definod. 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.
220
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—though real wages
anticipated by employees went up, since employees implicitly evaluated the
wages offered at the earlier price level. Indeed, the simultaneous fall ex post
in real wages to employers and rise ex ante in real wages to employees is what
enabled employment to increase. But the decline ex 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
wrages 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 unemployment at its target level of 3 percent, 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 monetry 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 determinate 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
monetary 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
temporary trade-off comes not from inflation per se, but from unaniticipated
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 "high" and "rising" that we all recognize in simpler forms. A
rising rate of inflation 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 2 to 5
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 qualification. 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 adjustment 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 inflation 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 unemployment, 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.
221
II. WHAT MONETARY POLICY CAN D O
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 studies 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 contrivance for sparing time and labor. It is a machine for doing quickly and commodiously, what would be done, though less quickly and eommodiously, without
it: and like many other kinds of machinery, it only exerts a distinct and independent 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 the 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 most important lesson that history teaches about what monetary
policy can do—and it is a lesson of the most profound importance—is that monetary 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, mistakes, 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, would have
been steadier and more productive of economic well-being if the Federal Reserve
had avoided drastic and erratic changes of direction, first expanding the money
supply at an unduly rapid pace, then, in early 1966, stepping on the brake too hard,
then, at the end of 1966, reversing itself and resuming expansion until at least
November 1967 at a more rapid pace than can long be maintained without appreciable inflation.
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 gotten 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 future—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
222
no longer does, since there is scarce 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 exclusively 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
wrould otherwise be desirable. This will temporarily mean higher interest 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 inflation, 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 peacetime 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 believe that the potentially of monetary policy in offsetting other forces making for instability is far more limited than is commonly
believed. We simply do not know enough to be able to recognize minor disturbances
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 suggests that the path
of wisdom is to use monetary policy exi>licitly to offset other disturbances only
when they offer a "clear and present danger."
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 fairly 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 the
authority has often done, it takes interest rates or the current unemployment
percentage 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
deposits, or this total plus commercial bank time deposits, or a still broader total.
For the United States in particular, exchange rates are ail undesirable guide. It
might be worth requiring the bulk of the economy to adjust to the tiny percentage
consisting of foreign trade if that would guarantee freedom from monetary
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 percent or so of our resources
223
devoted to international trade while reserving monetary policy to promote the
effective use of the 95 percent.
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
directly 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 understanding of monetary phenomena advances, the situation will change. But at the
present stage of our understanding, the long way around seems the surer way 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 when it moved, it went too far, producing the sharpest change in the rate of monetary growth of the post-war 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 between 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 6 or 9 or 12 or 15 months
later. Hence they feel impelled to step on the brake, or the accelerator, as the
case may be, too hard.
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 percent per year rate of growth in currency plus all commercial bank deposits or a slightly lower rate of growth in
currency plus demand deposits only.6 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.
6 In an as yet unpublished article on "The Optimum Quantity of Money." I conclude
that a still lower rate of growth, something like 2 percent 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.
224
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.
FRIEDMAN, "The Monetary Theory and Policy of Henry Simons,"
Jour. Law and Econ., Oct. 1967, 10, 1-13.
3.
9 ± Program for Monetary Stability. New York 1959.
4. E. A. GOLDENWEISER, "Postwar Problems and Policies," Fed. Res. Bull., Feb.
1945, 81, 112-21.
2. MILTON
5. P. T. HOMAN AND FRITZ MACHLUP, ed., Financing American Prosperity.
New
York 1945.
6. A. P. LERNER AND F. D. GRAHAM, ed,, Planning and Paying for Full Employment. Princeton 1946.
7. J. S. MILL, Principles of Political Economy, Bk. I l l , Ashley ed. New York
1929.
MILTON FRIEDMAN ON CURRENT MONETARY POLICY
I have been watching with increasing apprehension, concern and incredulity
the behavior of the quantity of money over the past 8 months. The Federal
Reserve System clearly dioes not intend to produce a serious recession in 1967.
Yet continuation of their present policy will make such an outcome all but
inevitable.
The accompanying chart shows the reason for concern. It plots two monetary
magnitudes: MI, the total usually designated "the money supply" by the Fed;
and M2, a broader total that includes also time deposits at commercial banks.
The striking feature of the chart is the sharp reversal in both totals in April
1966. Before then, both totals were growing rapidly. Since April, MI has actually declined—something it has rarely done except before and during severe
recessions—and M2 has grown at a sharply reduced rate. Since September, both
totals have been declining.
This is the sharpest turnaround since the end of the war. Slower monetary
growth was badly needed in order to stem inflation—but a good thing was carried too far.
Do changes in the quantity of money matter? There is massive historical evidence that they do. Every economic recession but one in the United States in
the past century has been preceded by a decline in the rate of growth of the
quantity of money. And the sharper the decline, the more serious the subsequent recession—though this tendency is far from uniform.
Changes in monetary growth affect the economy only slowly—it may be
6 or 12 or 18 months or even more before their effects are manifest. That is
a major reason why the connection is easily overlooked.
Recent experience conforms to the historical record. Acceleration of monetary growth in 1962 was followed by economic expansion. The monetary growth
rate was too high—but it took until 1965 for its cumulative effects to produce rising prices. The price rise started) the Fed talking about the need
for tighter money, but it acted in the opposite direction; monetary growth
accelerated still more, intensifying inflationary pressure and producing the
rapid price rises of recent months. The sharp braking of monetary growth in
April of 1966, has in turn only recently been showing up in spreading signs
of pending recession.
Why has the Fed permitted the quantity of money to behave so eratically?
Primarily, I believe, because it has used misleading criteria of policy—it
is inconceivable that the quantity of money as measured by MI could decline
for 8 months if the Fed had been determined to have it grow. It is as if
a space vehicle took a fix on the wrong star. No matter how sensitive and
sophisticated its guiding apparatus, it would go astray. Similarly, the men
who guide the Fed have been going astray because they have been looking at
interest rates and other measures of credit conditions rather than the quantity of money.
225
N'owswcek—Van Dyke
}
Interest rates began rising in 1965 because of the sharp rise in the demand for
credit that accompanied the onset of inflation. The Fed slowed the rise by accelerating monetary growth—but the rates continued rising, and the Fed interpreted this as a sign that it had tightened, whereas in fact it had eased.
Similarly, interest rates are currently showing some weakness—because the
demand for credit has been declining in response to monetary restriction since
April 1966. Yet the Fed interprets the weakness as a sign that it has eased—
whereas only the Fed's continued tightness prevents interest rates from falling
more rapidly.
The Fed's erratic policy reflects also its failure to allow for the delay between
its actions and their effects on the economy. Said Governor Robertson of the
Board in a recent speech: "Monetary policy will be formulated by the Federal
Reserve, day by day, in the light of economic conditions as they emerge." This is
a formula guaranteed to produce bad policy. If it is followed, the Fed will continue to step too hard on the brake until the recessionary effects are clear and
unmistakable, and then will step too hard on the accelerator. Like a good duck
hunter, the Fed should lead its target, not shoot where it now is.
What policy should the Fed now adopt? It is almost surely too late to prevent
a recession—that damage has already been done. It is not too late to prevent the
recession from turning into a severe downturn. To that end, the Fed should at
once act to increase the quantity of money at a rate of about 5 percent per year
for M2. If the Fed adopted and persisted in such a policy, it could moderate the
coming recession without paving the way for a new burst of inflation.
[From Newsweek, June 3, 1968]
MONETARY POLICY
(By Milton Friedman)
In two earlier columns on monetary policy, I was highly critical of the Federal
Reserve System for acting too late and then, when it did act, for overreacting.
This time, I come to praise, not to criticize. Since November 1967, the Fed has
moved not only in the right direction but also by about the right amount.
226
The recent record is summarized in the accompanying table, which gives the
annual rate of growth for two monetary totals, for industrial production, which
is a sensitive index of changes in economic activity, and for consumer prices.
Because it takes time for monetary changes to exert their influence, the rates of
growth of production and prices are given for periods that begin 6 months later
than the corresponding periods for money.
Rate of change (percent per year)
Period for money
April 1965 to April 1966
April 1966 to January 1967
January 1967 to November 1967.
November 1967 to April 1968
Money1
Mi
M2
6.0
-.2
7.7
4.7
9.6
3.7
11.9
5.3
Industrial
production
9.9
-2.3
5.2
Consumer
prices
3.7
2.3
4.0
Period for production and prices
October 1965 to October 1966.
October 1966 to July 1967.
July 1967 to April 1968.
* Mi = currency plus adjusted demand deposits. M 2 = M i plus time deposits in commercial banks.
As an aid in interpreting these numbers, let me note that a long-term rate
of growth in M2 of about 5 percent per year would be consistent with roughly
stable prices. The 5 percent would match the growth in output and leave a little
over to satisfy the desire of people to hold somewhat more money relative totheir income as they become richer.
From April 1965 to April 1966 the Fed permitted the money supply to grow
rapidly despite signs that inflation was accelerating. At long last, in April 1966,
it stepped on the brake—abruptly and, as the table shows, too hard. The result
was the so-called money crunch in the fall of 1966, the slowdown in the economy recorded in the decline in industrial production, and a cut in price inflation
from a rate of 3.7 percent per year to a rate of 2.3 percent per year.
The sharper response of production than of prices is typical. An inflationary
process, once underway, develops an inertia of its own. It takes an economic slowdown to stop the acceleration of prices and, even then, it takes a long time to
restore price stability. That is why it is so important to prevent inflation from
gaining momentum.
Concerned by the signs of emerging slack in the economy, the Fed reversed
policy in January 1967. This time, to its credit, it acted more promptly than usual.
But, as usual, it reacted too sharply, not only restoring, but exceeding the earlier
excessive rate of monetary growth.
As a result, I wrote last October, "it is almost surely too late to prevent an appreciable price rise—that damage has already been done. It is not too late to prevent the price rise from turning into a severe inflation. To that end, the Fed
should at once act to limit the increase in the quantity of money to a rate of
about 5 percent per year for M2. If the Fed adopted and persisted in such a policy,
it could moderate the coming inflation without paving the way for a new
recession."
It was too late to prevent an appreciable price rise. Prices have recently been
rising at 4 percent per year. But in November 1967 the Fed did reverse its policy
and M2 has been growing since at only slightly more than 5 percent per year.
There has not yet been time for this moderate policy to have much effect—as is
reflected in the absence of any entries for production and prices in our table
matching the final period for money. But if the Fed persists in its present policy,
the exuberant expansion in the economy will taper off later this year and so will
the rate of price rise—whether or not there is a tax increase. There may also be
some rise in unemployment before the price inflation is brought under control,
though any rise is likely to be small.
But will the Fed persist? Will it keep its cool? Or will continuing inflation
lead it, as in April 1966 to step still harder on the brake in the hope of getting
quicker results? Alternatively, will the first signs of reduced expansion and increased unemployment lead it, as in January 1967, to start the printing presses
whirring again and set off a new burst of inflation?
The Fed's steadiness in the past 6 months—despite the gold crisis, high, and
rising interest rates and the controversy over Government expenditures and
taxes—is a hopeful augury.
STATEMENT OF GARY FROMM, THE BROOKINGS INSTITUTION
Thank you for the opportunity for submitting a statement in regard toH.R. 11.
While I find much in the act that I would approve, I also see certain dangers. In particular, allowing the President directly to control
monetary policy makes that stabilization and growth instrument subject to the viscissitudes of shortrun fluctuations in political opinions.
Moreover, mistakes in forecasting would tend to be magnified if all
countercyclical policies were closely coordinated.
At this juncture, I would recommend that the Federal Reserve be
given clearer congressional guidelines as to its economic objectives
and be required more fully to disclose its anticipated stabilization program and report on the results. Formalization of the coordinating relationships vis-a-vis the Council of Economic Advisers, the Bureau of
the Budget, and the Treasury Department might be helpful, too.
As to administrative reforms, certainly some are in order. However,
at present, greatly weakening the Board's autonomy might be deferred
until the response to improved guidelines, reporting, and coordination can be assessed.
Should you desire, I would be happy to comment on these matters
at greater length.
STATEMENT OF TILFORD C. GAINES, MANUFACTURERS HANOVER
TRUST CO.
H.R. 11
1. QUESTIONS ON MONETARY POLICT GUIDELINES AND OPENMARKET OPERATIONS
I. Do you believe that a program coordinating fiscal, debt managemerit, and monetary policies should be set forth at the beginning of
each year for the purpose of achieving the goals of the Employment
Act, or alternatively should we treat monetary and fiscal policies as
independent mutually exclusive stabilization policies?
It w^ould be helpful to have a program set forth at the beginning of
each year aimed at broad coordination of public economic policies.
Such a program would have to be flexible to permit adaption to
changing circumstances and, in most cases, would deal only with
objectives rather than with techniques for achieving those objectives.
2. If you believe a program should be specified, do you believe that
the President should be responsible for drawing up this program, or
alternatively should such responsibility be dispersed between the Federal Reserve System and agencies responsible to the President? (Please
note that informal consulting arrangements can be made as desired
whether responsibility is assigned to the President or divided between
the President and the Federal Reserve. The concern here is with the
assignment of formal responsibility for drawing up the economic
program).
The responsibility for drawing up the program should be dispersed
between the Federal Reserve System and the agencies responsible to
the President, with the end product a single document signed both by
the Federal Reserve and the Council of Economic Advisers (as agent
for the President). Differences between the agencies on the economic
228
outlook and on broad policy objectives would seldom arise, and if they
should arise there would be advantages in having them discussed in
open debate rather than suppressed. Only two cases come to mind of
such differences in recent years: in 1950-51, when the Federal Reserve
abandoned support of a pegged interest rate structure and in late 1965
when the Federal Reserve raised the discount rate contrary to the wish
of the administration. In both cases, subsequent events vindicated the
Federal Reserve. This does not argue that the Federal Reserve possesses
infallible wisdom, but it does suggest the danger of imputing such wisdom to the executive branch. There is the further point that the tradition of central bank independence grew out of a long history of currency debasement by monarchs and elected officials. Perhaps this is no
longer an important consideration, but it does suggest that the central
bank might best be permitted its present independence unless there are
clear benefits to be derived from restricting that independence. There
has been close cooperation between the agencies of the executive branch
and the Federal Reserve in developing economic policies. The only
benefit that might be realized by changing the present arrangements
would be the concentration of policy power in the executive branch.
This would seem to be a dubious benefit.
3. Concerning monetary policy guidelines:
A. Should monetary "policy be used to try to achieve the goals of the
Employment Act via intervention of money supply {defined as desired) as provided in H.R. 11, or alternatively should H.R. 11 ~be
amended to make some other variable or variables the immediate target
of monetary policy; for example, interest rates, bank credit, liquidity,
high powered or base-money, total bank reserves, excess reserves and
free reserves? Please define the target variable or combination of variables recommended and state the reasons for your choice. (If desired,
recommend a target variable or variables not listed here). It wouid be
most helpful if, in providing the reasons for your choice, you list the
actions the Federal Reserve should take to control the target variable
(or variables) and also explain the link between your recommended
target of monetary policy and the goals of the economy as defined by
the Employment Act.
The immediate target variable of Federal Reserve operations in
trying to achieve the goals of the Employment Act should meet two
requirements: First, it should be related causally to economic activity;
second, it should be a variable that the Federal Reserve System is able
to regulate within rather broad limits. Based on my observation of
the American financial system, money supply—however defined—does
not meet either of these requirements. The rate of change in money
supply is primarily a result rather than a cause of the rate of change
in current dollar economic activity and, in any case, there is reason to
doubt that the Federal Reserve is able to regulate rate of change in
money supply. The second quarter of this year provides an illustration of the impotence of the Federal Reserve in regulating money
supply growth. Demand deposts in the second quarter grew at an
8.5-percent annual rate, in spite of severely restrictive Federal Reserve policy. For the Federal Reserve to have attempted to reduce that
rate of growth to fall within any reasonable target range would
have required policy actions that would have been devastating to the
orderly functioning of the national and international money market.
The popular monetary theories are rooted in experience in compara-
229
tively primitive 19th century economies, experience that is not wholly
applicable to our highly complex financial system. The simple fact is
that our financial mechanism offers a vast array of competitive financial assets among which the holder of financial claims may select, and
there is no realistic way that the Federal Reserve may prevent the
conversion process among these claims. None of this is to say that
money supply would not grow at a fairly orderly rate if the economy
itself were growing at an orderly rate, but the cause-effect relationship
runs from orderly economic growth to orderly monetary growth rather
than the reverse.
A preferable target variable would be the total and composition of
credit flows within the flow of funds accounting system. The broad
economic projection prepared by the Council of Economic Advisers
each year is translatable into rough approximations of the credit required, by sectors if the growth targets in the Council's projections
are to be achieved. Through its operations in the Government securities market, and perhaps in Government agency securities, the Federal Reserve System is in a position to have a marginal influence upon
the overall availability of credit and the availability of credit at different maturity sectors.
B. Should the guidelines of monetary policy be specified in terms
of some index of past, present, or future economic activity, or alternatively in terms of the target variable''s value or growth? For example, should, the President's 1969 program for achieving the goals of
the Employment Act be formulated to require consistency with some
set of overall indicators of economic activity, or alternatively so that
your target variable attains a certain value or growth regardless of
the economic winds? Please indicate the reasons for your preference.
Policy guidelines should be derived consistent with the growth target established in the report of the Council of Economic Advisers.
The relationship between the financial variables which the Federal
Reserve might use as an immediate target, including the proposed
flow of funds target, is not invariable with respect to real economic
growth. Therefore, to establish guidelines in terms of some fixed rate
of growth in the immediate target variable would not guarantee optimum results for the ultimate variable, real economic growth.
G. For only those persons toho recommend that some index of economic activity be used to guide the monetary authorities in controlli/ng
the target variable: Should we use a leading (forward looking), lagging (backward looking) or coincident indicator of economic activity?
It would be most helpful also if you would identify the index you
would like to see used and specify how the target variable should be
related to this index.
There is no single index of economic activity that is wholly adequate
for guiding the monetary authorities in controlling the target variable.
All business condition analysis is an effort to predict the future from
a wide array of data measuring the immediate past and present. Mechanically, perhaps the most useful approach would be continuous
measurement and prediction of the economy through the medium of a
comprehensive predictive model, such as the MIT-Federal Reserve financial flows model. The month-by-month output of such a model
would measure the extent to which the economy was achieving and was
expected to achieve the targets for economic growth established by the
Council of Economic Advisers in collaboration with the Federal Re-
230
serve System. The model would simultaneously test the extent to which
the financial flow targets were being achieved and the extent to which
failure to achieve the immediate financial flow targets might be impeding achievement of the economic growth target.
Concerning debt management policy: Given the goals of the Employment Act, what can debt management do to help their implementation? (If you believe that debt management has no role to play in
this matter, please explain why.)
The principal contribution of debt management should be to avoid
financing operations or practices that would needlessly interfere with
the olderly flow of funds to other users of credit. At times of huge
Treasury deficits, as in the past 2 years, there is little that debt management can do to avoid being a disruptive influence, since it is inescapable that some part of the money raised by the Treasury will be
preempted from other uses, with resulting distortions in sectorial economic and financial balance. During what one may hope w ill be more
typical periods of only moderate deficit or surplus, the principal area
of interest in Treasury financing is the refunding of existing debt
rather than the financing of new debt. At such times, three considerations might guide the Treasury. First, every effort should be made to
maintain an orderly maturity distribution of the debt in order to avoid
a piling up of short debt that would require more frequent and larger
Treasury financing operations.
This guideline does not imply that the Treasury must attempt to
sell large amounts of long-term bonds; it does imply that the Treasury
design its financing so as regularly to place new securities in the intermediate maturity range. Second, the Treasury should avoid massive
shifts in the debt between maturity areas. For example, the refunding
of several billions of dollars of maturing debt into the long-term area
might be feasible at a time of easy bond market conditions, but the resulting preemptng of long-term funds and freeing of short-term funds
would have selective effects upon the availability of credit to different
types of borrowers. In particular, such financing could have serious
backlash effects upon the mortgage market. Third, Treasury financing
should be devised with an eye to the international money market and
the U.S. balance of payments. The effect of Treasury financing decisions upon the term structure of interest rates might, at certain times,
sharply influence the movement of short-term funds into or out of the
United States. This should not be a determining consideration, but it
should have an influence upon Treasury planning.
5. Concerning open market operations: H.R. 11 requires that the
FOMC conduct open market transactions "in accordance with the programs and policies of the President pursuant to the Employment Act of
And in this connection, H.R. 11 provides that "The Federal
Reserve Board shall submit a quarterly report to the Congress stating,
in comprehensive detail, its past and prospective actions and policies
under this section and otherwise with respect to monetary affairs, and
indicating specifically how such actions and policies facilitate the economic program of the Presidents
A. H.R. 11 makes no provision whatever for conducting open market operations for so-called "defensive" or uroad-clearing" purposes,
that is to counteract seasoned and other transient factors affecting
money market and credit conditions. Do you see any merit in using
open market operations for defensive purposes or should they be used
231
only to facilitate achievement of the Presidents economic program
and the goals of the Employment Act? What risks and costs, if any,
must be faced and paid if open market transactions are used to counteract transient influences?
There is no realistic way that the Federal Eeserve can avoid some
amount of "defensive" open market operations. At different seasons of
the year, over specific holidays, etc., there are very large changes in
available reserves. For example: deposits increase seasonally each fall
and winter, causing required reserves to increase; deposits are pulled
down sharply over the Labor Day weekend and the Fourth of July as
consumers withdraw currency for long weekends or vacations. It is difficult to see what point would be served by permitting these predictable
influences upon bank reserves alternatively to ease or tighten the money
market. To the extent that the Federal Reserve goes to a longer reserve
averaging period, liberalizes use of the discount window, or permits
reserve excesses as well as shortages to be carried into the next averaging period, the need for day-to-day defensive open market operations
will, of course, be reduced.
The various amendments to Federal Reserve regulations currently
being proposed will move in this direction, but some intervention to
deal with seasonal variations in reserve needs will still be required. It
would seem that the heart of this question is not whether all defensive
operations should be avoided, reducing open market operations to a
mechanical provision of a predetermined amount of new reserves each
week, but whether all of the daily in-and-out operations now undertaken to steady the "tone of the market" are necessary. Expressed in
this way, and in consideration of the changes in the regulations now
pending, it does seem the money market could be given greater latitude
for making its own day-to-day adjustments without the continuous
mothering of the open market desk.
B. Do you believe that monetary policy can be effectively and efficiently implemented by open market operations?
C. For what purpose, if any, shoidd (a) rediscounting, (b) changes
in reserve requirements, and (c) regulation Q be used? TIo%o might
H.R. 11 be amended to implement your recommendations?
Open market operations are the most powerful of the instruments
available to the Federal Reserve System, but probably should not be
relied upon exclusively for achieving immediate Federal Reserve
targets. For example, if open market operations are to avoid the dayto-day defensive actions aimed at limiting fluctuations in the reserve
base or in the "tone of the market," it is essential that liberal discount
facilities be available in order that banks may make day-to-day or
week-to-week adjustments through the discount window for shortterm fluctuations in total reserves. Also, as distasteful as any form of
price control may be, the record suggests that regulation Q may be
used in certain circumstances to achieve restraining effects on bank
credit, or to assist in directing savings flow through intermediaries,
that cannot be as effectvely achieved through open market operations.
Ideally, one might like to see all types of interest rate regulation
abandoned, so as to permit the private credit markets to allocate credit
competitively.
Realistically, however, traditional attitudes toward interest rates and
their reflection in political concern suggests that the objective of a truly
competitive financial system is not a likelihood for some while. One in-
232
strument of Federal Reserve policy that might be foregone is changes
in reserve requirements. In fact, reserve requirements themselves (particularly on time deposits) are in the nature of a discriminatory tax
on commercial banks, and the very principle of reserve requirements
should be carefully examined. Given their existence, however, there
can be little justification for the periodic increases in requirements that
have been made in recent years when open market operations could as
easily and more equitably have accomplished the same thing. I would
have no specific recommendations for amendments to H.R. 11 that
might incorporate these comments on the use of instruments other
than open market operations in the executive of Federal Reserve policy.
D. Do you see any merit in requiring the Federal Reserve Board to
make detailed quarterly reports to the Congress on past and prospective actions and policies? Are there any risks and costs in this procedure? In what ways, if any, would you modify the reporting provision? What information do you believe should be included in such reports as you recommend the Federal Reserve submit to the Congress?
The principal advantage that might be obtained from requiring the
Federal Reserve Board to make detailed quarterly reports to the Congress would be a better informed Congress, better able to exercise its responsibilities for the management of the Nation's money. There would
be obvious costs in the preparation and hearings on such reports, but
such costs would be nominal when viewed against the benefits that
might be obtained. There should be no risks in this requirement unless
the hearings were used as the forum for a vendetta against the Federal Reserve or unless the hearings led to instructions from the Congress that the Federal Reserve achieve highly precise targets, an outcome that could be realized only at the cost of Federal Reserve flexibility and financial market stability. In its reports to the Congress, the
Federal Reserve should review the broad economic targets toward
which policies have been aimed, the immediate targets expressed in
terms of credit flows, the actions that have been taken to achieve those
targets, and the degree of success obtained on both the immediate targets and the ultimate economic targets.
E. What costs and benefits would accrue if representatives of the
Congress, the Treasury, and the CEA were observers at Open Market
Committee meetings?
The suggestion that representatives of the Congress, the Treasury,
and the CEA attend Open Market Committee meetings as observers
probably will encounter serious opposition because of the high degree
of confidentiality essential to these meetings. In the abstract, it is by
no means obvious that this opposition is well grounded. After all,
carefully selected Members of the Congress and of other Government
agencies participate in the most highly confidential discussions within
such critical functions as the Defense Department. There is no reason for presupposing that representatives from the Congress, the
Treasury, and the CEA would be less responsible in guarding the
confidentiality of Open Market Committee meetings than are the 40
or 50 Governors, bank presidents, and senior staff people who now
attend these meetings. It was my privilege to attend meetings of the
Open Market Committee for a number of years while I was associated
with the Federal Reserve Bank of New York.
It occurs to me that an important benefit from having outsiders,
particularly Members of the Congress attend these meetings would be
233
the impression that the observer would form of the intelligence and
dedication to responsible money and credit management that characterizes the meetings. The observers would be useful as liaison between the Federal Reserve, the Congress, and the other departments
of Government. In particular, the Members of the Congress attending
these meetings would be much better able to understand the objectives
that the Federal Reserve had been pursuing and the often intricate
reasons why those objectives were not fully realized. Unfortunately,
all of this is in the abstract. In the actual case, if the observers were
people prejudiced against the Federal Reserve System and committed
to its destruction, the result of their attendance at meetings of the
Open Market Committee would be disruptive to Federal Reserve
policy and injurious to the welfare of the United States. It follows
that if such observers are to be invited to FOMC meetings, the Federal
Reserve should have some voice in their selection.
II. APPRAISAL OF THE STRUCTURE OF THE FEDERAL RESERVE
*
II.R. 11 provides for the following structural changes in the Federal
Reserve System:
1. Retiring Federal Reserve bank stock;
2. Reducing the number of members of the Federal Reserve
Board to five and their terms of office to no longer than 5 years;
3. Making the term of the Chairman of the Board coterminus
with that of the President of the United States;
Ip. An audit for each fiscal year of the Federal Reserve Board
and the Federal Reserve Banks and their branches by the Comptroller General of the United States; and
5. Funds to operate the Federal Reserve System to be appropriated by the Congress of the United States.
Please comment freely on these several provisions. In particular, it
ivould be most helpful if you would indicate any risks involved in
adopting these provisions and discuss whether their adoption would
facilitate the grand aim of H.R. 11, which is to provide for coordination by the President of monetary and fiscal policies.
Some of the structural changes in the Federal Reserve System provided in H.R. 11 are rather unimportant while appearing to be dramatic while others of great substance appear to be innocent. Specifically, retiring the Federal Reserve bank stock now owned by the
member banks appears to be a fundamental alteration in the character
of the Federal Reserve System, shifting it from private to public
ownership, but logically this should not be a significant change. The
Federal Reserve System has been wholly independent of the member
banks from its founding, and the ownership of the Reserve Banks by
the member banks has not given the member banks any control or influence upon Federal Reserve policy. The present form of corporate
structure has given each Reserve bank a board of directors, providing
the mechanism for an important flow of information from industry
and finance into the Federal Reserve. But these boards could be redesignated advisory committees and serve the same function.
The matter of providing that the Comptroller General of the United States audit the Federal Reserve Board and the Federal Reserve
banks each year has been strongly resisted by the Federal Reserve as a
21-570—68
16
234
foot in the door of their independence that might lead to ultimate,
complete loss of independence. To a reasoning person it might seem
that this is carrying the principle of the camel's nose somewhat further
than could be supported. There is a clear dividing line between the
right of the Government to audit the Federal Reserve System and a
decision to bring Federal Reserve policy under control and determination by the executive branch of the Government. Similarly, there
should be no objection to making the term of the Chairman of the
Federal Reserve Board coterminous with that of the President of
the United States. In fact, the incumbent Chairman on numerous occasions has proposed that this be done. The practical issue involved
here is that a harmonious relationship between the Executive and the
Federal Reserve is much more likely to be achieved if the President is able to select his own Chairman from among the members
of the Board at the beginning of his term of office. In turn, the improved harmony between the Executive and the Federal Reserve
should tend to promote a better meshing of fiscal and monetary policies toward common economic ends.
Even in the case of these logically innocuous changes, however, the
question arises as to whether under the actual circumstances the
changes would be desirable. What is important in addition to the
logic of the case is the motivation behind the proposed changes. If
the motivation is no more than a tidying up of unimportant anomalies
in the law, then it would be difficult to argue against the changes.
But if the motivation is a desire to weaken or substantially alter
the Federal Reserve System through a process of gradually nibbling
away at the arrangements that safeguard Federal Reserve independence, then the changes should be strongly resisted. The minor
benefits to be obtained from the proposals would not justify the
dangers to the economic welfare of the country of a vulnerable, weakened central bank.
The other structural changes proposed in H.R. 11 could be of major
significance for the effective functioning of the Federal Reserve System. The proposal to reduce the number of Governors to five and to
reduce their terms from 14 to no longer than 5 years is such a
change. There certainly is nothing sacred about the present sevenman board and the present 14-year term of office, but a board consisting of seven men has functioned well and has brought in a broad
range of interests and points of view.
Also, the 14-year term has enabled the incumbent Governors to
learn in depth the often complex theoretical and practical issues with
which monetary policy must deal. In actual fact, a number of Governors have not served out their full terms, so that each President in
recent years has had an opportunity to appoint more new Governors
to the Federal Reserve Board than would be indicated by the 14 years
provided in the Federal Reserve Act. At the same time, the long years
served by any number of the Governors has made possible a continuity
of policy and a depth of wisdom and understanding that shorter
terms and steady turnover would not. As in all proposed changes of
existing law or custom, the first question that must be anwered is
whether or not change serves a useful purpose of sufficient importance
to justify its enactment. In this case, the system of seven Governors
235
serving 14-year terms has worked well and there is no apparent overriding reason why this arrangement should be changed.
Similarly, H.R. 11 would eliminate the Open Market Committee
and concentrate responsibility for open market operations in the
Board of Governors. Anyone familiar at firsthand with the work of
the Open Market Committee is aware that the inclusion of five of
the presidents on the committee has contributed importantly to the
debt of discussion. Of course, Reserve bank presidents could continue
to advise on developments in their respective districts, so that the
regional contribution now provided for through meetings of the Open
Market Committee would not be wholly lost.
But once again, the question should be answered as to precisely what
the advantages are that would be derived from this change. The
Congress established the Federal Reserve System in a form consistent
with our Federal Republic—a central bank with the various regions
of the country represented in the policymaking organization. The
system has worked well and there is no apparent reason why it should
be changed.
Finally, the proposal that funds to operate the Federal Reserve
System be appropriated by the Congress is an apparently innocent
proposal but one that is potentially dangerous. The long history of
money management has repeatedly emphasized the need for the central bank to be as independent as possible from the political process.
There is no more certain way to get the central bank involved in the
political process than to make the appropriation of funds necessary
for its existence subject to action by the Congress. By comparison with
other Government agencies, the total staff and total expenses of the
Federal Reserve System are nominal. There certainly can be no suspicion that the Federal Reserve is spending lavishly and that such
expenditures might be curtailed if subjected to congressional scrutiny.
It is not possible to foresee economies from this proposal; its only
apparent purpose would seem to be to bring Federal Reserve policy
directly under congressional control, and the only reason for this
objective would be to enable the Congress to direct the Federal Reserve as to the kind of policies that should be followed if its appropriations are to be approved. The System has worked well as now
constituted and almost surely over the history of the Federal Reserve
has worked better than would have been possible if Congress had
been calling the tune.
STATEMENT OF WILLIAM I. GREENWALD, CCNY
Replies to questions on monetary policy guidelines and open market
operations, invited by Congressman Wright Patman, chairman, House
of Representatives, Subcommittee on Domestic Finance of the Committee on Banking and Currency, on September 18, 1968.
answers—I
(1) I endorse a program coordinating fiscal, debt management,
and monetary policies being set forth at the beginning of each year
for the purpose of achieving the goals of the Employment Act.
(2) The target program, for administrative simplicity, might be
236
best vested in the Office of the President, assuming formal consulting
arrangements are mandated.
(3) (A) Monetary policy to achieve targets and goals via intervention of the money supply is supported, again, in order to minimize
the number of interventions.
(3) (B) The guidelines for monetary policy need specification in
terms of future economic activity (real terms), sustained by a certain
value of growth (money terms). The reason for my preference is the
unsettled and unresolved scientific theory and evidence regarding
monetary theory.
(3)( C) No comment.
(3) (D) No comment.
(3) (E) No comment.
(3) (F) No comment.
(4) Debt management policy has to be coordinated (subordinated)
with monetary-fiscal guidelines set for the target program.
(5) (A) Very short term factors—that is, seasonal and transient
elements—should be neglected and minimally influenced by monetary
intervention.
(5) (B) No.
(5) (C) The power to control and change margin requirements
were given to the Federal Reserve System by section 7 of the SEA
of 1934. The power over this selective and particularistic control might
better be transferred to the Securities and Exchange Commission.
(5) (E) In my opinion, the costs and benefits, aside from those
relating to communication of economic information, primarily are
administrative matters.
II
(1) No comment.
(2) No comment.
(3) No comment.
(4) I endorse an annual audit of the type indicated.
(5) I support a continued financial independence of the Federal
Reserve System from either the executive or legislative branch, in
order to minimize the political factors in the System.
No comment.
i n
S T A T E M E N T OP H E R S C H E L I. GROSSMAN, B R O W N
UNIVERSITY
H.R. 11 raises three basic and distinct questions regarding the formulation and execution of monetary policy.
I. What variable or variables should be used as proximate indicators
of the consistency of current monetary policy with its goals and as
proximate targets for monetary policy?
2. What should be the relative importance of fixed rules as contrasted with current discretion in selecting and determining the appropriate value of these proximate targets?
3. To the extent that current discretion is to be exercised, ivho should
have the authority to exercise it?
These comments begin with a discussion of the goals of monetary
policy and then consider each of these questions in turn. In summary,
the conclusions reached are as follows:
237
1. Interest rates and the money supply should be used as complementary indicators and proximate targets for monetary policy.
2. Discretion should be permitted in the execution of policy, so long
as it is agreed to give priority to macroeconomic goals and to make
explicit© the rationale for policy actions.
3. The formal authority to formulate and execute monetary policy
probably should not be transferred from the Federal Reserve System
to the administration, although to do so would not be likely to have
significant consequences.
I. GOALS OF MONETARY
POLICY
All three questions posed above deal directly with some operational
aspect of monetary policy. However, in each case the answer will vary
depending upon the ends or goals of monetary policy. First, proximate indicators or targets, which are not themselves goals of policy,
may be useful because the effects of policy upon the goals are either
not predictable with certainty or not immediately manifested (or at
least immediately observable). A good proximate indicator and target
would be both a good predictor of the goal variables and itself more
immediately observable than the goal variables. Second, rules may be
preferable to discretion because they may be an effective way to prevent the pursuit of undesirable goals. Third, the operationally most
significant consequence of assigning the authority to carry out policy
may well be that certain goals will be favored. Consequently, the first
step in discussing these questions must be to specify the goals which
monetary policy is to serve.
Monetary policy traditionally has been concerned with a variety of
goals, wThich are often incompatible. Incompatibility implies that
tradeoffs must be made among the goals. These historical goals may
usefully be classified according to whether they involve the value of
money (the price level) or the allocation of resources.
The classic goal of price level stability immediately presents a conflict with another macroeconomic goal of low-aggregate unemployment of scarce resources. Unfortunately, policymakers have frequently
obscured the need for establishing priorities in this area by advancing
meaningless arguments such as "an unacceptable rate of price increase,
if not halted by accepting modest unemployment now, inevitably will
lead to severe unemployment at some future time." However, although
the trade-off between price level stability and low unemployment appears rarely to have been explicitly recognized in the public statements
of monetary policy formulators, it has undoubtedly been important
in practice. We may suppose that policy typically aims for the minimum aggregate unemployment consistent with a maximum tolerable
proportionate rate of price level increase (denoted by P*). If the higher
the acutal rate of price level increase (denoted by P) the lower aggregate unemployment, P* becomes a target as well as a maximum rate.
Examples of resource allocation goals of monetary policy have been
facilitation of (cheap) financing of the public debt, stability (profitability) of financial institutions, high level of activity in the construction industry, and stability of exchange rates and the price of gold.
There seems to be a general consensus among economists that monetary policy should be principally, if not exclusively, concerned with
238
macroeconomic goals. Allocation goals seem inappropriate for two
principal reasons: First, whereas monetary policy is just about unique
in being capable of direction toward macroeconomic goals (fiscal policy
seems too inflexible to be generally a practical alternative), other
policies may be used to achieve allocation goals. Consequently, both
sets of goals could in principle be achieved if monetary policy gives
precedence to the macroeconomic goals in any case of conflict. For
example, construction activity could be insulated from the effects of
high-interest rates by the removal of legal constraints and by direct
subsidies. Second, and perhaps more basic, these particular allocation
goals seem to be in themselves generally unworthy because they imply
a less economically efficient allocation of resources. For example, why
should a ceiling be put on interest rate increases in order to protect
financial intermediaries—whose essential activity is speculation on the
future level of interest rates through borrowing short and lending
long—from their own mistakes? Why should the relative riskiness
of this activity be artificially reduced ? Similarly, why should foreign
exchange dealings be made relatively less risky by exchange rate stabilization %
II. PROXIMATE INDICATORS OF MONETARY POLICY
The allocation goals of monetary policy all have the common characteristic that they more or less directly imply limitations on the behavior of market interest rates. The effects of monetary policy upon
interest rates are both very predictable and quickly observable, at least
relative to the effects upon the price level and aggregate unemployment. Consequently, if and when any of these allocation goals are paramount, the need for and interest in proximate indicators is minimal.
However, regardless of the relative importance of the various allocation and macroeconomic goals, so long as monetary policy is at all
seriously concerned with either of the macroeconomic goals, the question of choice of proximate indicators becomes interesting. Suppose,
for simplicity, that the conflict between goals is resolved by saying that
monetary policy should ignore allocation considerations, and should
aim for constant equality between P* and P. The question is how can
one tell whether current monetary policy is consistent with this
equality.
One cannot simply look at current P. Because of lags, currently observed P is probably completely independent of current monetary
policy. Three sorts of lags should be distinguished, each of which
contribute additively to the total lag: First, the latest available data
on P is not current P. The process of collecting and reporting information takes time. (This observation lag might be termed technical,
whereas the other two lags relate to economic behavior). Second, the
reaction time of aggregate excess demand to monetary policy is likely
to be finite. Third, the reaction time of P to changes in aggregate excess
demand is also likely to be finite. In addition, even once these reactions
begin they are likely to be distributed over time, with relatively small
initial weights. Consequently, even though monetary policy could in
principle bring about any desired change in P with only these reaction
times separating cause and effect, in reality such relatively large doses
239
of monetary policy as to be impractical are likely to be necessary to
effect large changes in P even that quickly.
The consequence of any of these lags is that evaluation of current
monetary policy requires prediction of the effects of current monetary policy upon future P. Such forecasting might be simplified by
finding an endogenous variable whose reactions to monetary policy
are more quickly observable than those of P, but whose value gives a
reliable indication of the future course of P. Such a variable could
serve as a proximate indicator and target for monetary policy. Two
prominent and conceivably qualified classes of candidates for this
role are indexes of the level of interest rates and measures of the
supply of money. Both of these classes have much shorter observation
lags than does P. Also, both these classes have the potential for indicating the level of aggregate excess demand in the near future and thus
for predicting P in the more distant future. In addition, both these
classes contain certain variables—for example, money market rates
and high-powered or base money—which appear to be immediately, or
almost immediately responsive, to monetary policy.
In order to infer from the observed level of interest rates (denoted
by r) information about the future relationship between P and P*, one
must know how r compares with that level of interest rates (denoted
by r*) which would generate (with a reaction lag) a level of excess
aggregate demand which in turn would generate (with a reaction
lag P equivalent to P*. Of course, r* is not observable. Nor is it easy
to infer, because not only does it vary with exogenous shifts in the
excess demand function, but it is also dependent, through the distributed lag in the response of aggregate demand to the level of
interest rates, upon past value of r.
The obvious alternative to r as a proximate indicator is the rate of
growth of some concept of the money supply (denoted by M). We
may suppose that the excess flow supply of money balances will
correspond fairly closely to some subsequent level of excess aggregate
demand. In order to use M as an indicator, we must know the rate of
desired additions to money balances (denoted by M*) which would be
associated with r*. Of course, like r*, M* is not observable, and the
inferences about it involve analogous difficulties.
Ideally, both the correct interest rate and money supply indicators
should imply the same evaluation of current monetary policy. However, given the uncertainties involved in ascertaining both r* and M*,
it would seem foolish to rely exclusively on either one. At any moment,
policymakers may be more confident about their estimates of either
r* or M*, and should draw their conclusions accordingly. As forecasting techniques improve, confidence about the reliability of either of
these indicators wTill increase. At the same time, better forecasting,
perhaps paradoxically, will lessen the value of proximate indicators
by improving the reliability of direct inferences about the effects of
monetae policy upon P. However, for the foreseeable future, the
element of uncertainty in forecasting is likely to remain substantial.
In this situation, presumably all available knowledge should be utilized.
Interest rate and money supply indicators should be regarded as
complements, not as substitutes.
240
Policymakers often refer to and apparently utilize other variables
as proximate indicators of monetary policy. Of these, the two which
seem most prominent are various concepts of the supply of bank credit
and the quantity of free reserves. Regarding bank credit, it is hard to
see how this could even potentially be a relatively useful indicator
since its value reflects both the total supply of credit as well as the
desired degree of intermediation between ultimate borrowers and
lenders. Regarding free reserves, as frequently noted, the actual
quantity is only meaningful in relation to the unobservable desired
quantity. Consequently, the use of free reserves as an indicator is
roughly equivalent to the use of high-powered or base money.
III. R U L E S VS.
DISCRETION
The preceding discussion suggests that the selection of good proximate indicators and targets for monetary policy and the determining
of their appropriate values is a relatively sophisticated task. The question then arises as to whether this process should be left to current
discretion or guided by simple rules, to be reviewed only periodically.
The advocacy of rules is, prima facie, a defeatist attitude; for it almost
certainly excludes the attainment of the degree of perfection which
in principle would be possible under discretion. Nevertheless, rules
have been advocated because it is felt that in practice they would
enhance the achievement of the chosen goals of monetary policy. This
improvement might result either from better execution of the means
of monetary policy or from better formulation of the goals themselves,
or from both. As regards means, advocacy of rules implies a low
opinion of either the degree of understanding or of the forecasting
ability possessed by any possible discretionary formulators of monetary
policy, or of both. As regards goals, advocacy of rules which are
incompatible with the pursuance of certain goals implies disagreement with these goals and belief that a discretionary authority might
pursue them.
The question of rules vs. discretion, of course, cannot be answered
in general, but only in reference to specific rules and to a specific
monetary authority. The only rule which seems to be currently receiving serious consideration would involve a constant M, for some
concept of the money supply. Viewed as a method for achieving
equality between P and P*, the performance of this rule would depend
upon the constancy of M* for the selected money supply concept.
Advocates of this rule concede that it probably would not smooth out
minor cyclical divergences, but argue very convincingly that it would
exclude the possibility of major inflations or contractions. However,
given the current state of knowledge and understanding, even on the
part of those currently responsible for formulating monetary policy,
such a rule does not appear attractive. Currently, the chances of discretion resulting in a major mistake are probably nil. Moreover, discretion, now, probably w^ould be capable of near perfection in achieving
equality P and P* even in the very short run, if it were directed
exclusively toward that goal. The record of monetary policy during the
1960's seems not to be inconsistent with this view.
241
Ail entirely independent motivation for advocating the constancy
of M is that such a rule would generally be inconsistent with pursuance of the allocation goals of monetary policjr. Consequently, to the
extent that the authorities are likely to give priority to allocation
goals in times of goal conflicts, such a rule could enhance attainment
of the macroeconomic goals. However, if the essence of the dispute
does relate to goals, clarity would certainly be enhanced by confrontation directly with this issue, rather than through the subterfuge of
operational rules. Moreover, if agreement were achieved regarding the
priority of macroeconomic goals, the full potential of discretionary
policy formulation could then be realized in achieving them.
The distinction between rules and discretion becomes in principle
purely formal if the rules are reviewed very frequently. In practice,
however, even in these circumstances an operationally significant difference may exist. For example, it has been suggested that rules or
guidelines be formulated which the policymakers could violate so long
as they stated their reasons. In effect, this arrangement would permit
complete discretion, but, at the same time, would cause the rationale for
policy actions to be made explicit. Such explicitness would prevent
sloppy or casual formulations and better and more widespread understanding of policy. The danger of explicitness generating unfavorable
expectations is probably minimal.
IV. THE DISTRIBUTION
OF
AUTHORITY
Given that discretion is to be exercised, the question then must be
answered as to how to distribute the authority to exercise it. In the
present context, this issue is equivalent to the question of how independent the Federal Reserve System should be of the administration
and the Congress. Again, in regard to this issue, both the means and
ends of monetary policy may be considered, although the latter are
probably more relevant. With respect to means, there would seem to
be no a priori reason to expect that either the Fed or administration
officials would generally have greater understanding or knowledge of
effects of monetary policy. Only the Congress, because of the sluggishness with which it operates, is obviously not qualified to execute
monetary policy.
The argument about the distribution of authority arises primarily
because the exercise of discretion in the execution of monetary policy
carries with it the ability to exercise discretion in establishing priorities
among the possible policy goals. The possibility of separating these
two aspects of the policymaking process is limited by the fact that
what are for the policy executor ends in themselves can usually be
represented to be means to achieve more generally agreed upon goals.
For example, the allocation goals of monetary policy are often argued
quite plausibly, if fallaciously, to be prerequisites to the attainment
of the macroeconomic goals.
One argument which could resolve this issue as a matter of principle
is that the independence in goal choice of the monetary authority
from the immediate will of the elected representatives of the people
is undemocratic. However, historical precedent suggests that the contrary principle of effective checks and balances is just as relevant. In
any event this issue is more likely to be decided as a matter of practice
than of principle.
242
At present the Fed has, on paper at least, a significant degree of
independence in determining the course of monetary policy. Moreover,
because the political process makes fiscal policy very inflexible, authority over monetary policy implies ultimate authority over stabilization policy. However, in exercising this authority the Fed is subject
to pressure from the administration. The force of this pressure is not
directly observable by outsiders. However, it would appear likely
that it is generally great enough to make the administration the ultimate arbitor of monetary policy. Consequently, so long as the administration still received the advice and counsel of Fed officials, very
little of consequence would likely be changed by a formal transfer
of authority from the Fed to the administration. Moreover, the present
formal separation of power does force the Fed and the administration
to explain, at least to each other, the arguments for the policies which
they are advocating. In addition, the present arrangements offer an
amount of political convenience to the administration in that they
allow for blaming the Fed for ultimately beneficial policies which
may be unpopular in the short run, for example, "tight money."
S T A T E M E N T OF S E Y M O U R E. H A R R I S , E M E R I T U S , H A R V A R D
VERSITY
AND UNIVERSITY
OF C A L I F O R N I A ,
SAN
UNI-
DIEGO
INTRODUCTION
The integration of monetary policy with fiscal and debt policy could
be greatly improved. It is simply upside-down economics for the Fed
to go one way and the President and his advisers another. We cannot,
as cannot other nations, afford the luxury of independence for the central bank, nor control of monetary policy for 15 years by one official
who, however devoted, nevertheless is ruled by an excessive fear of
inflation. H.R. 11 is a long step forward toward integration and reduced powers for the Fed.
I - L . THERE SHOULD BE A COORDINATION OF MONETARY A N D FISCAL POLICY
An appropriate mix of monetary and fiscal policy is needed. In the
years 1961-63, for example, the Government relied on both expansionist fiscal and monetary policy in order to get out of a moderately stagnate economy. In 1965-66 recourse was had to monetary restriction
because the Fed feared an inflation. Inadequate recourse was had to
fiscal policy, with the result that excessive dependence on monetary
restriction induced the dangerous crunch of 1966. In 1967 and 1968,
inadequate use was made of restrictive fiscal policy and the Fed,
though fearful of a return to the crunch of 1966, returned to monetary
restriction.
1 - 2 . W H O IS TO BE RESPONSIBLE?
The current attack is to discuss the issues of economic policies among
the Treasury, the Budget Bureau, and the Council of Economic Advisers. They tend to determine fiscal policy. But they also consult with
the Fed. In my opinion the three agencies of the executive should recommend policies to the President. Since monetary policy is a necessary
weapon, some negotiation with the Fed is necessary.
243
But the role of the Fed should be limited. The executive should have
increased control over monetary policy. The Fed through most of its
history has been excessively fearful of inflation, and therefore has generally provided less than the optimum monetary resources.
Independence for the Fed is not supportable. It is the responsibility
of the executive to determine the supply of money and its price. It is
unwise for the Fed to operate in one direction and the President in
another—as in 1966.
This does not mean that the Fed operates merely to further the
Treasury's objective of low money rates. In the early post-World
War I I period the Government could be criticized for imposing a
cheap-money policy in order to reduce the cost of money to the
Treasury.
Under Eisenhower, there was much talk of the independent monetary policy. Actually the Fed, generally interested in restrictive policies, gave Eisenhower what he wanted. The President feared inflation and hence cooperated with the Fed in the pursuant of high money
rates. Under Kennedy, the President paid lipservice to the independence of the Fed. But he insisted upon supplies of money adequate
enough to assure a return to prosperity. The supply of money increased
substantially and yet long-term rates were stabilized.
Interest rate on Aaa bonds, for example, were as follows: 1952
= 2.96; 1960=4.41; 1965=4.49.
In the 8 Eisenhower years, the average rise of real GNP was 3 percent ; in the first 5 years of Kennedy and Johnson, under expansionist
monetary policies, was 5 percent.
Despite the expansionist monetary policies from 1961 through 1965,
the rise of prices was but 1.3 percent a year as compared with 2 percent
from 1952 to 1960.
In 1966,1967, and 1968, the results of policy were not as good as in
earlier years. Prices rose by 1.7, 2.9, and 2.9 percent in the years 1965,
1966, and 1967, and may well rise by 4 percent in 1968; and despite
restrictive monetary policies in 1966 and 1968. Moreover, in 1967 and
1968, the rate of rise of real GNP tended to decline. One explanation
of this fact is that wages' rates were beginning to rise at a more rapid
rate and also excess capacity had been greatly reduced. Additional
resources were not provided in proportion as demand rose; and hence
the rise of demand brought some additional inflation.
I - 3 - A . W H A T GUIDELINES FOR MONETARY POLICY?
Monetary policy should be enlisted for achieving maximum growth
and employment, relative stability of prices, the latter both to stimulate output and improve the competitive position of the United States;
and as a means of attaining money rates low enough in relation to
expected profits to stimulate investment and cut down unemployment.
Creation of money as a means of reducing unemployment should
be used with caution. By 1965-66, with unemployment falling below
4 percent, there was evidence of increased pressure on prices.
Money rates, indebtedness of member banks, reserves of member
banks, free reserves are not guidelines of monetary policy. They are
tools for achieving an expansive or restrictive monetary policy.
244
I - 3 - B . GUIDELINES OF MONETARY POLICY?
The guidelines should be especially given by movements in GNP,
employment, prices, rate of interest. When prices are rising too much
in relation to output, that guide should suggest some moderation in
the expansion of money. In the first 5 years of the Kennedy-Johnson
administration, for example, GNP (real) rose about five times as much
as prices. This was an index of successful general policy, and particularly of monetary policy. But in 1967, GNP rose by 2y2 percent
and prices by 3 percent. Even a rise of GNP 5/6 as much as prices may
not be a bad record. A rise of GNP is a plus item; but the increase of
prices is a minus item. But the issues are not merely economic. Ideological issues are also relevant. Rising prices hurt those whose incomes do
not respond to the inflation, and notably the old and savers. In general,
the rise of prices is likely to be accompanied by higher levels of employment and less unemployment. Hence a case may be made for a
policy of some inflation since it brings less unemployment, and hence
a lesser degree of concentration of ill fortune on the unemployed.
I—3—C. GUIDES TO MONETARY AUTHORITIES
The indicators of the NBER are useful and especially the leading
indicators (LI) which anticipate change. But individual Li's often
vary in the direction of movement. They raise many other problems
also. Basing policy on past behavior of Li's may be misleading, and
in part because in more recent years Government intervention has become a more important factor. Hence the past movements of (say)
stock market prices or rate of interest may not be a very good guide
for the future. In fact, one can raise some general issues of projections
along these lines. Thus a projection of GNP for 1969 may prove to be
off by a good margin, the explanation being a Government policy not
anticipated. A prognosticator may also prove to be right only because
unanticipated Government policy brought about the growth (say)
anticipated. The economist who guesses right because he also guessed
right on Government's contribution is to be applauded. But if his
projections are confirmed by history only because of policies he did
not anticipate, his credit should be limited.
At any rate, the use of Li's should give better results if recourse is
had to a dozen (say) that in the past proved reliable (and not all 36),
and if the trends for several months, rather than one or two, are
considered.
I—3-D. VARYING GUIDELINES
Indeed, guidelines should vary from year to year. A strong case can
be made out, for example, for seeking a 5-6 percent rise of output per
year in the years 1961-64, years of large excess capacity and output
substantially below potential; and at the same time should seek a rise
of output restricted to 4 percent in 1967 and 1968. Why the difference ?
In the earlier period, a substantial rise of output is possible without
inflation because part of the rising demand can be absorbed out of
excess capacity. But in 1968 the country can profit primarily from an
increase of numbers on the labor market and a 2-3 percent increase
of productivity. Insofar as demand rises above 4 percent, which
measures the gains from these channels, then the excess of demand
245
would be reflected primarily in a rise of prices rather than one of output. The policy of tax increases and expenditure reduction of 1968 has
been supported in order to contain growth to a level of around 4
percent.
Of course the task of the Government depends on the contribution
of the private economy. Should consumption, private investment,
anticipated Government expenditures, and the excise of exports yield
an unacceptable level of output and unemployment, then the Government has to increase its contribution by raising expenditures and (or)
reducing taxes. Moreover, the Government has to consider the strain
on the economy associated with the automatic rise of taxes that accompanies increasing income. In planning for the end of the Vietnam
War, the Government takes into account the reduction of military expenditures and the rising income and taxes without change of tax
structure. Should military expenditures decline by $15 billion, and tax
receipts automatically rise by $10 billion with a $40 billion gain in
income, then the Government will have to provide $25 billions through
increased spending on nonmilitary items and cuts in taxes. (I assume
that the military will not make up for the lag in new weapons of recent
years.)
I - 3 - E . VARIATION I N TARGETS GROWTH?
The variations should be related to the potential of the economy.
Labor supply, hours of work, productivity gain, (related) the contribution of capital and technology will suggest potential growth. Over
long periods of time, the annual gain of man-hour output—say 3 percent—can, through the operation of the compound interest law, greatly
increase output. In 25 years output would double; in 50 years increase
by 3% times.
I-3-F.
MONETARY AUTHORITY ALLOWED TO ADJUST TARGETS VARIABLES
DURING T H E YEAR ?
I would give the monetary authority full authority to adjust to
changing prospects. Projections for 3 or even 6 months yield reasonably good results. But beyond 6 months, the actual change may diverge
greatly from the projected one. If by June, the economy seemed to be
on the downgrade surely the Fed should be tempted to introduce expansionist policies. In early 1968, the tax increase and spending cut
seemed to support an anti-inflationary policy. But even in the first half
of 1968, there were signs of trouble: high and rising interest rates,
excessive inventory building, unsatisfactory housing, reduced Government contributions to spending, greater doubts about the economy—all
of these raised questions. By the middle of 1968, a growing consensus
feared an economic decline. Surely the Fed restrictive monetary policy
should be abandoned. (I write in August 1968).
All planned economics operate on the principle that when developments deviate from the expected, freedom to change policies should
prevail.
1 - 4 . T H E ROLE OF DEBT M A N A G E M E N T
Debt management can contribute much. For example, when the
economy is just beginning to recover, it is mistaken policy for the
Government to issue long-term securities in large amounts. The effect
246
is then to raise interest rates just when the economy needs the lift of a
decline in rate. The Eisenhower administration made such mistakes.
Again, when the economy needs high short-term money rates in order
to increase imports of capital and discourage outward movements, then
the appropriate policy is to issue large amounts of short-term paper
and thus get the short-term rate up. Hence the balance of payments
would improve. Moreover, the long-term market could then be protected to some extent against rises, with favorable effects on the
economy.
In the great crisis of 1966, the country, and especially the housing
industry, were starved for money. The Executive helped prevent a
disaster by withdrawing large issues that were to be sold and in this way
reduced competition in a badly provisioned market.
I—5—A. USE OF OPEN MARKET OPERATIONS
I am not sure I understand the thrust of this question. In general, I
would use open market operations to increase or reduce the reserves of
member banks. The size of reserves largely determines the amount of
money that banks create. This is of course not the only determinant.
There is something to the idea that when reserves are maintained or
built up through a rise of indebtedness to the Fed, then the expansive
effects of a rise of reserves is less than when the additional reserves stem
from purchases of securities to raise the reserves of member banks.
A comparison of Federal Reserve bank credit and member bank
reserves from 1960 to 1967 will suggest the contribution of open market
operation.
[In billions of dollars]
December
1960
Federal Reserve credit outstanding
P.S. held
Discounts and advances
Gold stock
Currency in circulation
Member bank reserves
27.2
27.3
.1
18.0
33.0
19.3
June 1968
51.3
51.3
.7
10.4
47.5
25.7
These figures reveal:
1. That the major origin of open market operation was the financing
of additional money in circulation and the loss of gold. Without Fed
intervention, reserves of member banks would drop with large losses of
gold or increased money in circulation.
Rise of Federal Reserve credit outstanding
Financing: Rise of currency in circulation and loss of gold
Providing additional M.B. reserves
Billion
$24.1
17.1
6. 4
It is clear that the largest source of Federal Reserve credit originates
in offsetting rises of money in circulation and loss of gold, not purchases to expand the total reserves of member banks.
Offsetting gain of Federal Reserve credit
Expansion due to open market operations
Billion
$17.1
6. 4
I see no alternative but to use open market operations for "defensive" reasons (i.e. $17.1 B in 7% years), and also to satisfy needs for
expansion. In the 7 years, 1960-67, the rise of money was as follows :
247
Rise—December
1960-Deceryiber 1967
Billion
$40.4
11.5
29.0
110.9
I. Money supply
(a) Currency
(&) Demand deposits
II. Time deposits
What is especially striking is the average rise of money and money
plus time deposits, December 1952-December 1960 and December
1960-Deoember 1967.
[In billions of dollars]
1952-60
Money..
Money plus time d e p o s i t s . . .
1.7
5.8
1960-67
5.8
21.6
In the Eisenhower years, money increased only about one-third as
much per year as in the 7 Kennedy-Johnson years, and about onequarter as much for money plus time deposits. Despite the large demands put on the system by large losses of gold and rises of money in
circulation, the Fed, under pressure from the two Presidents in 196167 expanded monetary supplies at a rate of about three times that of
the Eisenhower period.
I - 5 - B . OPEN-MARKET OPERATIONS A N ADEQUATE TOOL?
I am not sure I understand this question: "Do you believe that monetary policy can be effectively and efficiently implemented solely by
open-market operations?" Open-market operations are probably the
most potent weapon. To some extent the Fed, by raising rates or reducing them, can directly influence the price of money. But ever since the
midtwenties open-market operations have been the major weapon of
monetary policy. Through influencing the volume of indebtedness and
through changes of reserve requirements, it is possible also to influence
the supply of money.
I - 5 - C . USE OF REDISCOUNTING, CHANGES I N RESERVE REQUIREMENTS, AND
REGULATION Q
Kediscounting is a tool for increasing the effectiveness of Fed policy.
But the total impact is not ordinarily great.
By changing reserve requirements the Fed can induce a rise or fall
in required member bank reserves. But this is an overall weapon and
may upset some parts of the money market. But similar unwanted
effects may follow open-market operation. Kediscounting to this extent
has an advantage over open-market operations, for rediscounting relates to the amount of cash needed by individual banks.
One troublesome aspect of changes in reserve requirements is that
they result in windfalls or penalties to banks accordingly as requirements are reduced or increased. Thus, allowance of currency and coins
as reserves in 1959-60 greatly increased reserves of banks, and thus
substantially improved the profit position of banks. Recourse of
changes in reserve requirements results in varying impact on the price
(yield) of different assets. Dependence on open-market operations improves the prices and reduces the yield on Government securities. By
the middle of 1968, the Federal Reserve banks held more than $51
248
billion in Government securities as compared with but $150 million
in June 1929. Even by 1939, the portfolio amounted only to $ 2 ^ billion. Clearly, open-market operations greatly favor the Treasury as
sellers of securities, whereas a reduction of reserve requirements and
accompanying expansion of money provides additional demand and
higher prices for all kinds of assets.
Under regulation Q, the Fed sets maximum rates on savings and
time deposits held by commercial banks. By allowing higher rates under regulation Q, the Fed has, in fact, favored commercial banks
against savings banks and S. & L.'s. In the last few years, the result has
been the capture of a much larger part of the savings and time deposits
by the commercial banks, with unpleasant consequences for S. & L.'s.
The housing market in California was especially hit. Another effect
has been a large relative increase in time deposits for financial institutions and hence greater interest of financial institutions in long-term
assets.
I
5 - D . I SEE MERITS I N FEDERAL RESERVE REPORTING TO CONGRESS EVERY 3
M O N T H S " O N PAST A N D PRESENT PROSPECTIVE ACTIONS A N D POLICIES"
If the Fed reveals its hand to Congress, then policies favorable to
the economy are more likely to prevail. In most major countries, the
central banks have to reconcile differences with the executive, with the
Government the ultimate source of responsibility and authority.
I - 5 - E . REPRESENTATIVES OF CONGRESS, T H E TREASURY, AND COUNCIL OF
ECONOMIC ADVISERS AS OBSERVERS A T OPEN-MARKET COMMITTEE MEETINGS
At present the Secretary of the Treasury, the Council of Economic
Advisers, and the Director of the Budget meet once a week for a discussion of issues. As senior consultant to the Secretary of the Treasury, I am invited to these meetings and often attend them. I think
the meetings are very helpful, and are attended by about 12 high officials. Ordinarily the Chairman of the Federal Reserve Board is not
present though there are some meetings with Mr. Martin. I see no reason why issues of open-market policy should not be discussed with the
three relevant departments, both with the Chairman of the Federal
Reserve Bank and other members. This might be better than the "observer" policy. The Fed has some special responsibilities in helping to
stabilize the economy, and hence they should be allowed to discuss their
responsibilities freely and without other agencies and Congressmen
breathing down their necks. I have generally held the view that the
Fed is too independent of both the Executive and the Congress. Yet
I would not go as far as introducing these observers. But there should
be much more free discussion between the Fed and the three other relevant agencies, and even with responsible Members of Congress who, by
virtue of their knowledge and position, are strong candidates for keeping themselves informed. Surely if the Fed and the others are to work
out a proposal to the President, the three departments, and to some
extent the Congress should discuss open-market policies fully and
frankly.
I I - l . Retiring Federal Reserve stock.—I have no strong views on
this issue.
249
II—2. REDUCING T H E NUMBER OF MEMBERS OF T H E FEDERAL RESERVE BOARD
TO FIVE AND TERMS TO 5 YEARS
In general, I approve this recommendation. The Board would be
more efficient with five members, and in this way the next administration will be able to tie Federal policy more to the views of the
Executive. It may be well to get rid of the less able members of the
Board now. I say that though I am aware with the appointments in
particular of Messrs. Mitchell, Maisel, and Brimmer, the average
quality has greatly improved. The staff also is much improved over
the staff of earlier years.
It is certainly a mistake for one member of the Board to control
monetary policy over a period of more than 15 years. A limit of 10 or
even 6 years should be placed upon the Chairman. It is particularly
unfortunate that the Chairman, though a devoted public servant with
high moral standards, is obsessed by the fears of inflation when
justified and not so justified. Fortunately^ the new members have
pruned the authority of the Chairman and it must be said that in the
1960's—except for 1966 and 1968—the Chairman has abandoned to
some extent the obsession with inflation. But it is risky to allow one
member of the Board to control monetary policy and to that extent
the economy.
II—3. M A K I N G T H E TERMS OF T H E BOARD AND T H E PRESIDENT COTERMINOUS
This is an excellent idea. The possibilities of a well-integrated policy
would be greatly increased. It would be helpful if the Chairman's
term might be extended by 1 or 2 years additional.
II—4, 5. A N AUDIT OF THE FEDERAL RESERVE BOARD AND FEDERAL RESERVE
B A N K S BY T H E COMPTROLLER AND APPROPRIATIONS B Y CONGRESS
I see no serious objection. I do not see why the Fed should profit
from special financial arrangements not open to other parts of the
Government.
III. COMMENTS ON RECENT MONETARY POLICY
I have commented elsewhere in this paper. In general, I would say
that monetary policy in the ^ears 1961-68 overall were better than
under Eisenhower. Martin yielded to the pressures of Presidents
Kennedy and Johnson, and he has to share his authority increasingly
since 1961.
Of course there are exceptions. The policy in 1965 beginning with
the December 1965 rise of rates was almost disastrous. Even before
December 1964, there were numerous statements bv the Chairman of
the Federal Reserve Board aibout the dangers of inflation and the
need of restraint
Yet from 1964 to the middle of 1968, GNP (in 1958 prices) rose
from $582 to $702 billion, a rise of 21 percent in 3y2 years, or about 6
percent a year. Moreover, in this period, prices rose only by 11 percent, or 3 percent a year. This is not a perfect record; but note that real
GNP rose twice as much as prices. Thus, policy would have been
much more sterile had the authorities listened to Martin's concentration on fears of inflation.
21-570—68
17
250
The hard-money policy of 1966 could scarcely be justified. First,
because it was the first real defiance of executive control over economic
policy. Second, because the rate of interest rose spectacularly and the
supply of money responded most inadequately. This is evident in the
following changes in interest rates:
1964
Taxable bonds.
Corporate bonds, Aaa
FHA new home mortgage bonds
3-month Treasury bill
4.15
4.40
5.45
3.55
1966
1967
4.65
5.13
6.29
4.88
July 1 9 , 1 9 6 8
4.85
5. 51
6. 55
4.32
5.14
6.26
5.467
These are unprecedented increases in rates, and especially long-term
rates. Only the passage of the tax increase stopped the rise. But the
decline of rates has been of most modest proportions. The Fed still
hesitated to give the economy a lift even though rates continued to rise
through most of 1958, until a passage of the tax bill, and there were
increasing signs of an economic decline.
I might comment on one omission in the questionnarie. The cost-push
aspect of inflation requires consideration. With wage rates rising 6
percent (prices 4 percent), the burden put upon both fiscal and monetary policy is greatly increased.
STATEMENT
OF L O W E L L H A R R I S S ,
COLUMBIA
UNIVERSITY
M A K I N G M O N E T A R Y A N D FISCAL POLICIES W O R K : C O M M E N T S ON H . R .
11
The important topics covered by H.R. 11 deserve exhaustive analysis
on a broad scale. The committee deserves high commendation for its
undertaking. The press of many demands prevents me at this time
from giving the points the direct attention I should like. Within recent years, however, my writings have touched on several of them. Selection and recasting of materials from several sources permits me
to respond, incompletely and inadequately but most respectfully, to
some of your inquiries.1
T H E AVERAGE W A G E R A T E : A BASIC FACTOR OFTEN OVERLOOKED
1. The magnitudes appropriate for policy decisions depend upon a
factor too often overlooked—the average wage rate. Total aggregate demand of $900 million (GNP) would buy 150 billion hours of labor at
$5 an hour (total cost to the employer), leaving $150 billion for other
factors. If aggregate demand rises by $10 billion (through fiscal or
monetary policy) and if this increase all goes to labor, an additional
2 billion hours of employment are created—providing wages remain
at $5 an hour, average or, more accurately, at the margin). If average
wages were to rise to $5.20 (4 percent), however, the $760 billion now
available to labor would not even pay for 150 billion hours of employ1 Adapted from the following by C. Lowell Harriss: The American Economy, 6th ed.
(Homewood, 111.; R. D. Irwin, Inc., 1968) - with (W. J. Shultz) American Public Finance,
8th ed. (Englewood Cliffs, N.J., Prentice-Hall, Inc., 1965) ; Money and Banking, 2d ed.
(Boston: Allyn & Bacon, 1965) ; "Fiscal Action To Influence Employment and the Price
Level: Some Criteria," Government Finance Brief, No. 4, 1966, Tax Foundation (from
testimony for the Joint Economic Committee) ; "Inflation's Hidden Effects," "The National
Debt: Looking Ahead, Tax Review, July 1967 and March 1968 (Tax Foundation) ;
"Making Tax Policy Work," Manufacturers Hanover Trust Co., October 1967; "Objective®
of Fiscal Policies: Looking at Goals," Business Papers, Oklahoma State University, No. 5,
1967.
251
ment (144 billion). Depending upon the cost of labor, as well as of
other factors of production, dollar increases in aggregate demand
do not necessarily insure more employment.
2. More to the point, the volume of real employment from any given
monetary demand relates to the price of labor. The figures above are
too rounded to be entirely realistic but will serve to illustrate. A 4percent rise in the average price of labor will "cause" a drop of about
4 percent in man-hours paid for from any given dollar amount of total
demand.
1. The effects of fiscal policy depend upon monetary actions.—Shifts
in Government deficit and surplus can tip the balance and keep the
economy from going too far in either direction, and certainly prevent
expansion or contraction from cumulating dangerously. It is vital, to
distinguish between two points (a) the amount of Government spending, and (b) the source of the funds. If the Government cuts or increases its spending while private spenders make equal, but opposite,
changes, there will be no net alteration in aggregate demand.
2. If inflation threatens, how can fiscal action cut overall spending ?
The Government can take more money (in taxes) from private spenders than it spends itself. By reducing disposable income in this way,
it cuts business and family buying. The Treasury can use the surplus
to retire securities held by commercial banks. The effect will be greater
if debt changes are those of the Federal Reserve banks or if currency
is retired. The monetary authorities must, of course, prevent increases
in bank loans to business that offset declines in Government debt. The
imperative necessity of the coordination of monetary with fiscal policy
must never be forgotten. The total volume of M (money) will fall. Or
the Treasury, by merely holding the surplus as idle bank deposits can
give them a V (velocity) of zero.
3. If recession seems in the offing, Government can lower taxes to
leave families and businesses with more disposable income. Government can also increase total demand by itself spending more without
taking more from the public. Where can it get the money to make up
the difference ? By increasing M. How ? It can borrow from commercial banks. (If it has been holding deposits idle, it can use them, raising the V from zero; currency issue is also possible.)
4. The effective force changing national income (in the short run)
comes not from the amount of Government spending, nor even solely
from changes in such spending. What counts more will be the way
the changes are financed. Some economists question the effectiveness
of monetary policy in a recession because businesses cannot be counted
upon to react promptly to easy money by borrowing and spending
enough more to give full employment. By fiscal action, however, Government can do enough, by creating purchasing power and injecting
it into the stream of national income, directly and quickly.
5. The results of deficit financing will depend, not only upon the
amounts involved, but also upon the kinds of tax and spending changes.
More important is the way the money to cover the deficit is raised.
If the borrowing is accomplished by selling savings bonds in a wTay
to absorb purchasing power that otherwise would be spent on consumption or investment, the ultimate net effect of the whole process
may be little change in national income. But if the debt is sold to
commercial banks, the economy can get a true stimulus as net new
252
purchasing power is injected. There can be such net injection only if
bank lending that would otherwise occur is not curtailed.
6. A shift from deficit or balanced budget financing to surplus
financing operates, in essence, as the reverse of a shift to deficit financing. In general, a move to surplus financing has a contractive effect
on the economy as more money is taken from the taxpaying public
than is paid back in expenditure. The crux of the matter is the use
of the funds received by the former holders of the debt. If banks are
repaid and the money stock thereby reduced, the downward pressure
on business activity can be substantial. If the funds made available to
the private economy by debt retirement go into financing an increase
in private investment, or consumption, the contractive result will not
be significant.
7. Changes in the total flow of income resulting from fiscal operations depend significantly upon increases or decreases in the country's
stock of money. Changes in bank lending are the chief agency through
which fiscal operations introduce purchasing power into the income
flow or withdraw purchasing power from it. Changes in the volume
of deposits in commercial banks are monetary developments.
BANKS AND T H E HATE OF
INTEREST
1. Borrowers want money. They have no reason to care whether the
money is newly created or whether it is the result of saving out of income. The significance for the economy, however, is tremendous.
2. The demand for loans, often expressed as a demand for credit, can
be met out of the supply of savings. There is a price, an interest rate,
which will balance the quantities of credit demanded and supplied.
The "thing" which changes hands is money. For money as such, there
is a demand and also a supply. The supply-demand of credit and the
supply-demand of money are essentially different. Much misunderstanding results from the fact that commercial banks both grant credit
(make loans) and create money (demand deposits).
3. Some of the supply of loanable funds, and especially some of
the change in the amount supplied in the short run, results from commercial bank lending in the form of money creation. Funds for lending of this sort can involve virtually no real cost in the sense of labor
and materials. Under some circumstances the creation of demand deposits for some borrowers may not require any sacrifice of desirable
alternatives. Government can influence the amount of such lending by
the rules which regulate banks in their creation of money.
4. Is it not possible, then, to use the banking system to control the
rate of interest? More tempting, perhaps, is the possibility that by
enabling banks to "manufacture" money more easily, man can lower
the cost of borrowing. At any given time, society can permit banks to
expand their loans—extend more credit—even though there has not
been a penny more of voluntary savings. This fact is undeniable. Another fact is also undeniable. Such loan expansion increases the stock
of money.
5. An increase in the volume of funds available for lending will tend
to reduce interest rates. But this is not the only result. As the new
money is spent, the volume of economic activity in dollar terms will
go up. So may the price level.
253
6. Will a rise in the price level affect interest rates? It ought to induce some lenders to try to get a higher yield as compensation for the
loss in value of money. Some owners of bonds will sell, perhaps to buy
stock or real assets. Some holders of money will shift to goods. Borrowers will tend to seek larger loans to benefit from rising prices. Thus,
both demand and supply changes (after the initial injection) move to
raise interest rates.
7. Unless banks add another injection of money, interest rates tend
to rise. Except temporarily, banking policy cannot lower interest
rates, unless injections of new money into the economy are continued.
In a world of essentially full employment, except as the quantity of
new money matches growth of productive capacity, such a practice
must be self-defeating. As the growing stock of money circulates, the
upward pressure on prices will continue.
8. When there is substantial unemployment, of course, the effects
of the increase in bank-created funds for lending—money—may appear primarily as greater output, with little rise in prices. Higher incomes will both stimulate saving and raise the demand for borrowed
funds. The relative magnitudes will depend upon a host of conditions
whose net effect will not be clear before the process has gotten underway. But I find difficulty in believing that the interest rate will not
go up. If so, the actions to lower interest rates are successful only temporarily, successful, that is, in terms of the narrow goal of influencing
the one price, the rate of interest.
9. What about the power of the monetary authorities and the banking system to raise interest rates ? Again, the basic forces of demand
and supply dominate. Banks have influence in the short run. By reducing reserves or raising reserve requirements, the monetary authorities could force banks to reduce loans outstanding. Interest rates
would tend to rise. But for the longer pull they would not rise a great
deal unless the process were repeated and repeated, something which
is improbable, partly because the downward movement of national
income would reduce demand for borrowed funds.
10. Briefly, and explicitly excluding inflationary possibilities, bank
actions over any extended period will not have much effect on the
level of interest rates. The influence in the short run is quite another
matter. Changes in short-term rates that are large in percentage terms
can result from alterations in bank lending. Such changes in lending
may result from forces apparently outside the banks—a decline or a
rise in business demand for loans—or from official actions which alter
the capacity of banks to make loans.
OUR MONETARY POLICY AND ITS USE
Ambitions are more easily raised than satisfied. Some of us have
come to expect a great deal from fiscal and monetary action, to seek
both big and varied objectives. Yet what can we really expect to accomplish? What is possible? What are attainable objectives? Several
factors affect the attainments which are possible.
1. The monetary authorities cannot directly change the income
stream. What they do will not in itself constitute an increase or decrease in the flow of expenditures through the economy. The Federal
Reserve changes the availability of money, or of close money substitutes.
254
2. The effects of monetary change cannot be pinpointed. Even if
an initial impact were to be focused by some sort of selective action,
such as short-term business (self-liquidating commercial) loans or
special treatment of mortgage lending, the results will gradually
spread over the economy; other sectors feel the results, some promptly,
others only after delay.
3. Monetary action will not build houses or raise the productivity
of manufacturing or make people friendlier. It will not in itself
modify the underlying real elements of the economy. Monetary conditions, however, are an essential element of the framework within
which we produce and consume.
4. The tools or implements of monetary policy, of course, help
determine the "possible." The chief tools influence the stock of money
and its close substitutes, (a) The monetary authorities cannot control
the willingness of banks to lend or of customers to borrow. (&) Even
if the quantity of money were controlled rigidly, no central authority
would be able to control velocity or the changing desires for liquidity.
(c) The authorities do not know by how much either changes in interest rates or in the prices of securities will influence the volume of
investment. Apparently, however, demand schedules for many types
of investment goods are highly inelastic with respect to interest. We
certainly do not know how big the marginal responses will be.
5. The choice of what we ought to try to do will depend upon the
extent of confidence in our ability to predict the effect of different
kinds of action. Prediction remains an uncertain art.
6. Another factor affecting the possible is the quality both of the
personnel who will make and administer policy and of their advisers.
Will the people who must make the decisions be well qualified ? What
assurance can the public have that those responsible for policy are
competent to act as well as is required for success ? A person or group
not qualified to do the job well (no matter how competent to act on
other problems) may in fact have decisive influence. For example, a
banker who is well qualified to judge the quality of business loans may
have little competence for deciding how much change in the quantity
of bank lending will serve the public best. Serious errors may produce
mostly mistakes. The existence of this risk underlies the argument for
trying to rely upon carefully devised rules in preference to frequent
exercise of judgment.
7. What might seem possible in theory may in fact be impossible
because of practical realities. For example, two such different things
as the temporary strength of a few leaders in Congress or delays m
getting a half dozen pieces of key information may modify significantly the hopes of success in dealing with a particular situation.
The freedom to use monetary policy also depends in part upon what
monetary authorities in other lands are doing. The "possible" in one
country rests somewhat upon the "actual" in others.
8. The intermixture of monetary and credit policy seems certain to
continue to create confusion. Society's need for money—as a medium
of exchange, a store of value, a unit of account, a standard of deferred
payment—is different from its need for credit. The attempt to meet
desires for loans by creating money—or the destruction of money
when the demand for credit slackens—is not likely to produce the best
monetary policy. Yet the two are grouped together, with officials in
and out of Congress often more concerned about credit than about
255
the stock of money. The desire to help one section of the economy
(farming) or restrict another (the stock market) can be satisfied, perhaps, by credit policy. Monetary policy, however, is not an efficient
instrument for such purposes.
9. Some goals are simple, some complex. Some are clearly the means
toward other ends, while others are more nearly ends in themselves.
Shall we, for example, settle upon a rather specific goal for the monetary authorities, such as a stable or slowly rising quantity of money?
Or should we seek a goal embracing much more of economic life, such
as maximum employment or the rapid growth of real income ? Monetary goals, like money, are means to other ends. It is hopeless to expect
monetary action in itself to bring us to our real objectives—the goods
and services we would get from the full employment operation of a free
economy. Yet it is also hopeless to expect to achieve the real objectives
if monetary currents are running strongly against their realization.
10. The issue of rules versus authorities is this: (a) Monetary policy
and directives for action can be stated in terms that are clear, definite,
and precise. (The statements would be embodied in laws passed by
Congress.) Human beings in carrying out the policy would be left
little (or no) room for judgment or direction, (b) In contrast, the
monetary system can be framed to give power to be used by authorities
(an individual or a group) as they think best in the light of the conditions which actually develop. The first kind of policy is one of rules,
the second one of authorities. Between the extremes lies possibilities
of compromise.
11. Arguments in favor of rules.— (a) One argument for fixed rules
derives from the fact that the monetary system makes up such a vital
part of the economic framework. If this part is certain, then individuals and businesses can arrange their affairs more efficiently than
if they are uncertain about what may develop in this important part
of economic life. Expectations will be more certain. There is less room
for surprise. Society can largely eliminate one source of risk—and risk
is a cost, (b) If rules are fixed, changes in monetary policy will not
make things worse. Adhering to a rule assures protection against some
human errors. Even if the rule may not be best for every situation,
there is no danger of bad selection of alternative actions or bad timing
as authorities try to meet changing conditions. Thus, the public avoids
not only the cost of uncertainty but some of the risks of poor policy.
At the worst, we may sacrifice little to obtain this gain because the potential superiority of flexible over fixed policy will not be large,
whereas the losses from shifting to an inappropriate policy can be
substantial. (c) The record of discretionary management has by no
means been brilliant. Evaluating the record is difficult; one cannot
know what would have been produced by different actions. Nevertheless, the accomplishment does in itself provide a convincing testimonial
to the superiority of authority over rule.
12. Arguments against rules.—The major argument against reliance
upon fixed rules is that discretion may be used wisely to meet needs as
they develop. No two sets of economic conditions, after all, are identical ; the future is unknown. How can men, with all their limitations
as human beings, set a general rule for the future which will serve as
well as the best that men can devise as conditions actually develop ?
Can we not get the best results if the monetary system is adaptable ?
256
A fixed rule can hardly serve all desirable goals equally effectively, and
a policy well suited to achieving one goal (such as price level stability)
may be poorly adapted for another (economic growth), which may
increase m relative importance. Insulation from troubles coming from
'other countries may require flexibility in monetary policy. Not enough
is known about the ability of officials to implement a rule to be confident of success. (Two more or less fixed rules—the gold standard and
the balanced Government budget—had considerable weight for
decades. Yet they did not control in the sense of displacing other
guides of policy.)
13. Perhaps the clearest-cut monetary goal would be to regulate the
quantity of money itself. The objective is less ambitious than others to
be discussed later. And it could be achieved. The control envisaged
would be more rigorous than is possible now, when private decisions
also influence the expansion and contraction of bank loans—and therefore the stock of money. The quantity of money to be outstanding would
be determined. Anyone seeking to borrow money would have to get it
from the existing stock. Commercial bank creation of deposits wTould
be impossible. The requirement that demand deposits be backed by 100
percent reserves offers a possibility worth more attention than can be
discussed here. The monetary authorities controlling reserves would
then have one-for-one control of the quantity of money. If such a
plan or, more realistically, one less rigid were adopted, what might be
the guides or standards of the amount of money ?
13a. One possibility would be to fix the quantity of money once and
for all. Clearly, then, no economic disturbance could arise out of
changes in the quantity of money. A single objection, however, dooms
this suggestion: In a growing economy, the price level, including
wage rates, would decline as total output increased. Price declines on
the scale that would be involved would create intolerable strain. Rigidities are too numerous and too severe.
13b. A more realistic possibility would be to increase the stock of
money at some steady and definite rate. No one, then, need have any
doubt about the amount of money in the economy, next month or next
year. Once the policy had been determined and necessary changes made
in financial institutions to assure practical implementation, the monetary authorities would have no discretion. Every week or month the
Federal Reserve would buy enough assets (Government debt) in the
open market to build the money stock as agreed upon, possibly with
seasonal adjustment. Or the Treasury would adjust its financing
—debt refunding, new borrowing, and currency issue—to provide
the expansion. The injections of new money might be set to equal
as nearly as possible the expected growth in the economy so that the
price level would be essentially stable.
A proposal so rigid may seem unduly restrictive. Would the gain—
the removal of what has been a source of economic instability, changes
in the rate of money creation and destruction—be worth the loss of
freedom to change the quantity of money? History records many
occasions on which discretionary monetary action rather than strict
adherence to a rule could have served the public interest. Nevertheless,
an advocate of the strict control of the stock of money must not necessarily abandon his case when presented with such evidence. He may
argue that the trouble which seems to call for remedial action would
257
not have developed if his plan had been in effect earlier. The strict
rule does not conform to our tradition. More important, however, is
the belief that in a world of freedom and uncertainty men should try to
adapt monetary policy to the conditions which do actually arise. And
one weakness is clearer today than it was even a few years ago.
"Money" is not easily defined. Close, and not-so-close, substitutes exist.
Changes in the totals of substitutes can upset the results expected from
a policy of fixed growth of the money stock.
14. Any policy based on strict control of the quantity of money has
an inherent weakness. It ignores velocity. Is there, then, a policy which
deliberately takes account of velocity? One approach would seek to
regulate either the total of money payments (MY), or the total of
income payments (MVy). The goal would probably be some stated,
regular increase in the aggregate. Regulation of the total of money
payments would be a more powerful instrument of economic control
than one limited to the quantity of money. Achievement, however,
would be very much more difficult. Velocity is the result of the way
millions of economic units act.
Though a central authority can control M within narrow limits, it
cannot control the use of M. (Among the problems for which there is
yet no good solution is the changing importance of "nonincome" uses
of money, such as the purchase and sale of securities.) The use of
money is the most decentralized, the most dispersed, of economic realities. A proposal which includes allowances for changes in V is quite
a different thing from one which involves M only. In fact, the working
out of the policy would have to rely upon those changes which the
monetary authorities are actually able to make—changes in M. These
would be larger or smaller, depending upon the expected movements
in V.
Is a goal which can be achieved only by correct forecasts of V overly
ambitious ? So it would seem. Yet the monetary policies most widely
accepted today do, at least indirectly, involve this more ambitious
objective. This fact is true of the pursuit of price level goals.
15. Fiscal and monetary policies are by no means perfect substitutes
for each other. They are not fully interchangeable. Nevertheless, the
effects of any fiscal policy must work out in an environment which depends significantly upon monetary policy. Both public debate and
advanced professional analysis often benefit from assuming "other
things being the same." Real world processes, however, do not permit
the simplification which involves a fiscal policy change which has no
monetary effect. Economists disagree in their weighting of the relative importance of monetary and fiscal actions under different combi«
nations of conditions. Such differences of view, however, do not justify
what sometimes seems to be the denial, by implication, that monetary
policy will significantly influence the outcome of fiscal action.
16. Who can possibly judge the effects of different possible fiscal
actions next month or next recession without making assumptions
about monetary conditions? The leaders of our Government have the
potential power to assure themselves of a much higher degree of certainty about monetary policy than has been the case to date. True,
velocity of circulation will remain beyond direct control of official
agencies. But changes in the stock of mone^—defined as currency plus
demand deposits—can be controlled within a moderate range, not
258
necessarily from week to week but for short periods relative to phases
of a business cycle. Changes in the amount of money added to the
economy do more than influence interest rates when newly created
deposits add to the supply of loanable funds as the money is injected
into the economy. The money continues to exist, to pass from hand to
hand, to "be used in transactions.
17. Other policies, notably those affecting wage rates, also influence
employment and price levels. The higher the level of average wage
rates, the greater the dollar total of demand needed for any total of
employment. Raising the minimum wage and extending coverage
would aggravate the problems of achieving full employment with
price level stability. The resulting wage rate structure would obstruct
the absorption into the employed labor force of young people and
others whose productivity has not yet reached the legal minimum.
ON T H E USE OF FISCAL POLICY
1. Fiscal policy results from (1) the recommendations of numerous elements of the executive branch, (2) the actions of revenue-raising committees and the appropriations committees (and their subcommittees) in both House and Senate, and (3) The Houses of Congress
themselves. Monetary policy is made by the Federal Reserve subject to
an undeterminable influence from the executive branch, Congress, foreign central banks, and other sources.
2. An outsider cannot evaluate the "real-life" working of these arrangements. But I have read much of what has appeared in print. It
leaves me uneasy. The men who have made the decisions do not seem always to have understood the issues, processes, mechanisms—including
the ties between monetary and fiscal policies—as well as we should
like. Perhaps, however, the past is a poor guide to the future. Will
not everyone have learned ? Unfortunately, some of us are slow learners. Even more to be regretted, the "truth" is not always crystal
clear.
3. The validity of one point, however, seems beyond question: The
public may justifiably expect that the two groups of decisionmakers
coordinate policies. Where arrangements fail to assure coordination,,
what needs to be done? My few suggestions assume no major change
in relations among the branches of our Government.
4. More remains to be done in providing evidence about what has
(just) happened and in analyzing the probable results of alternative
courses of action. Much merit supports the recent efforts to get the
Federal Reserve to inform the Joint Economic Committee of the
bases for monetary policy actions. Congressional hearings advance
understanding. Nevertheless, they cannot do all that is reasonably
possible in threshing out tough questions—and many are tough. The
public forum has some disadvantages as a means of examining complex and controversial issues. "Second thoughts" cannot get into the
discussion when there is no second round. How can any committee
of Congress be certain that it is getting the full and complete thinking of Federal Reserve and executive agencies, with articulation of
doubts and differences of view among the men and women with a
rightful claim to competence ?
259
5. A summary which links the revenue changes to the general level
of economic activity, is as follows: Within the limits of existing capacity, the amount the economy produces will depend upon the total
dollar demand for goods and services—the buying of families, businesses, and governments. At the prevailing level of prices, including
wage rates, some total dollar amount of demand will be needed to buy
the output which would be produced at full utilization of capacity. If
total demand falls short, unemployment will result because wage rates
and many prices are inflexible downward. On the other hand, a total of demand greater than "needed" will bid up prices—will be inflationary. In either case, fortunately, action by the Federal Government may improve matters. A reduction in tax collections will leave
taxpayers with more dollars and thus raise private demand. A rise in
tax collections, however, will force the private sector to spend less
and dampen forces of inflation.
6. The process by which revenue change influences national income
will depend in part upon the responses of the financial system.
A reduction in their tax bills will leave families and businesses with
more money to spend, but the Treasury will get fewer dollars for Federal spending. Without a budget surplus, would not the Treasury then
need to curtail its purchasing by about as much as consumers increase
theirs ? If so, total buying by consumers, Government, and business can
hardly rise to give the economy much of a boost. If Federal expenditure programs, those which are presumably justified on their own
merits, are to be maintained while consumer and business buying
expands, how can the Treasury get dollars to make up for those withheld from it by tax reduction ?
By borrowing—but where ? What if all the funds being supplied for
lending are being taken by businesses, home buyers, State-local governments, and others? Treasury borrowing which would absorb part of
this limited supply would thereby force others to scale down their
plans. A tax cut cannot lead to net stimulation of total demand when
the resultant Federal borrowing deprives private boi^rowers of loan
funds they icould have spent.
7. On the other hand, the Treasury may be able to borrow in an
environment in which commercial banks create enough in demand
deposits to permit the new Federal securities to be sold without depriving other borrowers of funds. Federal Reserve cooperation can assure
such a result. The Fed has power to provide the banking system with
enough lending capacity to enable the Treasury to be accommodated
without requiring curtailment of business and consumer borrowing.
8. The process by lohich tax reduction leads to an increase in total
purchasing power, therefore, requires monetary policy that permitsthe Treasury to borroio more without reducing the funds available toother borrowers. Directly or indirectly, the Government must get dollars which would otherwise not be used. Federal expenditure of newly
created money will add to the total demand for business output. Furthermore, the effects do not end with the first use of new money. The
added dollars will continue to circulate and therebyfinancesome transactions which would not otherwise be made. The cumulative stimulus
from dollars created to finance tax reduction will exceed the original
amount somewhat—but no one knows by how much. Failure of the
Federal Reserve to expand bank lending capacity, or failure of the
260
financial system to perform "normally" may frustrate hopes. In such
cases, tax reduction will not spur the economy through expansion of
total purchasing power.
9. The recent U.S. record and the postwar experience of many other
economies must confirm the fear that expansionary fiscal and monetary
policies are likely to bring price-level increases before full utilization
of capacity. During Mr. Kennedy's Presidency, the economy did not
press on the limits of productive capacity; and the price level, according to many observers, was essentially stable. Even rapid increases in
the money supply, however, need not have much influence on the price
level, if the new dollars are used to buy goods and services that would
not otherwise have been produced. Clearly, however, the nearer the
economy comes to full utilization of productive capacity, the greater
the likelihood that additions to demand will bid up prices.
10. A rise in the taxpayments of individuals and corporations will
reduce the funds available to them for other purposes. To varying degrees, families, and businesses will curtail their buying, thereby reducing this element of total demand. More dollars, however, are pouring into the Treasury. Experience suggests that their availability will
tempt lawmakers to raise Federal spending, perhaps with only a short
lag.
11. If tax collections exceed Federal spending, the Treasury can use
the "unspent" dollars to retire debt. Assume that the Treasury retires
debt. The financial institutions which get cash as a result are in a position to increase their lending; upward pressure on interest rates may
ease. The demand for loans tends to be high under conditions whicn
lead to anti-inflationary action, and borrowing can be expected to rise.
The kinds of things bought with the borrowed funds will differ considerably from the consumer items forgone because of the tax increase.
Borrowed funds, for example, are used more for capital goods. But
total dollar demands on the economy may be about the same. To the
extent that this is so, an increase in tax revenue and reduction of Federal debt will have little or no restraining, anti-inflationary effect.
12. Is there some way to prevent the dollars which are used for debt
retirement from reappearing as demand in the private sector ? Not as a
practical matter. But roughly equivalent restraining effects can be
obtained through Federal Reserve action.
Many sources of savings feed into the stream of loanable funds to
which the Treasury will be making additions. Another source of loanable funds consists of additions to demand deposits by the banking system. The Fed has power to prevent, or slow down, the growth of bank
deposits. Bank lending, therefore, can be kept lower than if the Treasury's debt repayment were not adding to funds available for lending.
Such restraint imposed by the Federal Eeserve can seek to keep total
outlays on investment goods around the level expected if there had
been no tax increase. The latter has forced down consumption, however, so that total demand will press less heavily on productive capacity. Another result is that the stock of money grows more slowly
than otherwise. Therefore, fewer dollars will be created for future
transactions.
13. The tie between a tax increase and monetary policy is often presented in slightly different terms. At any given time the Fed believes
that there is a maximum by which it can permit bank lending to rise
261
without creating inflationary pressures. If tax collections were greater,
a higher rate of monetary expansion would be consistent with price
level stability.
M A N A G E M E N T OF THE DEBT
Even when the debt is not growing its existence continues to present
problems.
1. Some aspects of debt management are technical, but others have
significance for the economy generally. A borrowing of $10 billion
to repay an equal amount will not have neutral effects on the economy;
nor will all holders of old debt accept new debt in return. The Treasury may not borrow from the same groups as hold the maturing debt.
It obtains funds in some areas of the market and then makes fund
available elsewhere. Consequently, the management of the debt will
change interest rates and the relative ease or tightness of credit in
sectors of the market. Within limits, which shift from time to time,
the choices made in refinancing outstanding Federal debt can serve
a constructive purpose.
2. Yet the choices can also have unwelcomed effects, since distinguishing the desirable from the undesirable cannot always be done with
absolute certainty. Nevertheless, the men close to the credit and money
markets—the Treasury and its advisers—can generally make better
policy decisions if the range of available alternatives is broad rather
than narrow. Anything in law or tradition which limits the scope for
choice in refunding also reduces the possibility of making debt management an effective instrument of policy and creates more than a
slight danger of unwise actions. The economy as a whole will function
at least a little differently, for better or worse, as a result of decisions
about managing outstanding debt.
3. The existence of the debt also affects the economy in terms of
liquidity. Monetizing the debt proceeds as each passing day reduces the
remaining life of outstanding debt. An obligation due within a few
days or weeks has very different liquidity characteristics from one
due in 20 years. The shorter the debt, the more it resembles—and
serves the liquidity purposes of—money. A Federal debt that does not
grow, one that may remain in about the same hands, can gradually
become more and more like money. The effects can be at least a little
like the inflation-creating tendencies of additions to the money supply.
One consideration for the Treasury in managing the debt, therefore,
is to have a structure which conforms as well as possible with the economy's apparent needs for liquidity.
4. Some balance of long-, intermediate-, and short-term debt will be
better than another. To achieve this balance the Treasury must be able
to sell the kinds of issues required. But if new long-term debt cannot in
fact be sold, the maturity structure will deteriorate somewhat. Even
with ingenious mixes of new issues offered in advanced refundings, the
Treasury cannot always achieve the results it would like when the law
limits its f reedom of maneuver.
5. A ceiling of 4% percent on interest payable on debt with a maturity over 5 years was a legacy from World War I. Congress in 1967
met part of a Treasury request for authority to sell notes maturing
up to 7 years at whatever interest rate the market requires. For longer
debt, however, the 4^4-percent limit continues. Imagine trying to fi-
262
nance an industrial enterprise or a public utility or housing with such
a restriction,—no borrowing for more than 7 years.
For long the 4^4-percent limit had no operational significance. In
the 1920's when interest rates were higher, the Treasury was retiring
debt. After that, either the level of interest rates or the structure enabled the Treasury to manage a large and growing debt with little or
no interference from the ceiling. But this is not the case today. Nor
will it always be the case in the future. Long-term loans of top quality
may often command more than
percent. Why ? The productivity
of capital—which underlies much of the demand for private borrowing—will often be appreciably higher. And may not inflation reduce
willingness to lend for long periods at interest rates acceptable in the
past ?
Neither the Treasury nor the Federal Reserve makes interest
rates; both are among many elements in the market. Interest rates
result from operation of the forces of demand and supply. Part of the
demand comes from the National Government. The Treasury in managing the outstanding debt must often borrow. Its demands can have
significant effects for a time in a part of the market even though its
total debt is not growing. If market forces lead to interest rates which
are above 4*4 percent, what can the Treasury do as it faces the need to
refund old debt ? Will generous citizens lend "below the market" as a
favor? Not extensively. The law permits the Treasury to borrow on
short term, now up to 7 years, and pay whatever rates the market demands. On such debt, the Treasury will pay much over 4*4 percent.
The legal limit, therefore, does not determine the interest cost of the
debt.
6. The ceiling does affect the structure of the debt—and in a way
which can be unfortunate. Today, it forces more debt into relatively
short>-term form. The shorter the debt, the greater the liquidity and
"moneyness." Debt becomes more nearly monetized. When the Federal
debt seems likely to endure for generations, a ceiling which prohibits
borrowing for 30 or 20 or even 10 years prevents the best adjustment
to reality. The ceiling forces issuance of relatively liquid debt forms.
To call it an engine of inflation is to exaggerate, but some such result
does occur. Today, and very probably in the years ahead, the most skillful management cannot keep the debt from becoming more liquid,
from making the economy a little more inflation prone.
7. There is a widespread belief that Government borrowing to
finance spending has an expansive effect on business, and debt retirement a contractive influence. This view is oversimplified, to say the
least. The economic effects of Government borrowing differ according
to whether such borrowing: (a) absorbs funds that would otherwise
be spent for consumption; (b) absorbs savings that would otherwise
finance investment (that is, creation of new capital properties); or (#)
results in the creation of money. The effects are intimately related
to what happens in the monetary and financial system.
8. Absorption of funds that would otherwise be spent.—When the
Federal Treasury persuades workers to buy savings bonds through
payroll-deduction plans, or other arrangements which involve commitments to buy regularly, the economic effect of the borrowing will be
somewhat the same as that of a payroll tax—within limits. Some of
the purchasing power they divert into bond purchases would otherwise
have gone into consumption spending.
263
9. Absorption of funds being saved or already saved.—When individuals or institutions (other than commercial banks) buy newly issued
Government bonds with funds they have saved or received from
savers, the immediate effect is much the same as if the accumulated
savings had been absorbed by a tax. The effect may be the same whether
the bond purchaser uses funds on hand and awaiting investment or
sells some other form of security to buy the Government bond. In the
latter case, the securities or properties sold may eventually find their
way to some holder of accumulated savings who used them in this
way instead of financing new investment. However, if the eventual
purchaser of the assets which are sold borrows from a commercial bank
to pay for them, the situation falls into the category of Government
borrowing in which bank loans and demand deposits are created.
Businesses and individuals seeking funds to pay for new investment
goods find conditions tighter. Borrowing costs will certainly rise, and
the sale of newly issued shares of stock will be more difficult. Some
planned investment will be forgone because of higher financing costs.
Government absorption of private savings, therefore, tends to contract
national income, more or less offsetting the expansive effects produced
by spending the proceeds of the loan.
10. Borrowing that results in creation of money (deposits created
by bank lending).—Government borrowing can result in the creation
of money—new demand deposits at commercial banks. The borrowing
government gets newly created purchasing power, upon which it draws
to pay its expenses. The spending of the borrowed funds has an expansive effect upon the economy. The newly created deposits move
into the country's stream of monetary payments. The public has more
money to spend than otherwise. Total spending, and therefore national
income (at least in a monetary sense), are above what they would be if
the money had not been created. Money used is not used up. It continues to circulate.
11. However—and this point is often overlooked—the net effect of
government borrowing depends upon what happens to private borrowing. If bank lending capacity is so limited that lending to government leads to less lending to business, the net expansive effect is correspondingly smaller than one might expect from looking at government actions alone.
12. Debt reduction.—When a government uses an excess of current
revenue to retire a debt issue held by banks, the economic effect is the
reverse of floating such an issue. The government repays the debt with
bank deposits which it has accumulated, and these deposits go out of
existence. Although, in a strict sense, the actual transaction of the debt
retirement does not affect the level of business, the process of obtaining
the money withdraws purchasing power from the public. And the
destruction of deposits in a significant sense passes the contractive
effect on into the future—unless private borrowing from banks rises to
offset the drop in government borrowing. The raising of the funds to
retire the loan would, of course, contract national income.
13. When a government retires a debt issue previously bought by individuals or institutions with saved funds, the effect of the retirement is the reverse of that of the borrowing. The funds received
by the bondholders are now available for new investment or consumption spending. The added availability of funds, plus any increase in consumer spending, would stimulate investment. Some time
264
would be required, however, to offset the contractive effects of the
taxation that raised the funds.
14. Debt and currency.—Currency is, to some extent, a substitute for
Federal debt. If government were to issue currency to retire some debt,
the stimulating effect could be great indeed. If the debt were that
held by private savers—individuals or institutions—they would generally try to use the funds to buy new income-providing securities,
real estate, or other property. The stimulus to investment could be
strong. If the government, in contrast, were to borrow from savers
to retire currency, the contractive effects would be substantial. In
general, the higher the "moneyness" of the debt form, the closer it
is to currency.
15. The Federal Government can influence the level of economic
activity through management of its debt. For a large part of the
outstanding debt, it ought to have the discretion of shifting between
issues with a low degree of "moneyness"—long-term obligations of
the kind purchased with real savings by individuals and financial
institutions—and debt which is nearly money—the issues sold to
commercial banks. (The 414-percent ceiling now limits the freedom.)
To help check inflation, the Treasury could sell more long-term debt
and use the proceeds to pay off debt held by commercial banks. To
stimulate the economy, the Treasury could increase its borrowings
from the banking system and pay institutional and private investors
(assuming appropriate monetary policy). Such a policy would not be
costless. It would require the Treasury to do more refunding into longterm issues than it might otherwise plan to do during a boom when
interest rates were high, and to forgo opportunities to refund into
long-term issues when interest rates were low during a slump.
STATEMENT
O F E . C. H A R W O O D , A M E R I C A N
ECONOMIC
INSTITUTE
FOR
RESEARCH
This is in reply to your letters dated July 9, 1968, and September
18, 1968.
After conducting extensive research during the past 45 years on
money-credit problems, I have concluded:
{a) That money-credit developments in recent decades constitutes
a repetition of past major economic blunders on a larger scale than
ever before; and,
(b) That the increasingly complicated plans proposed for coping
with the problems that have arisen cannot be useful in the long run;
and,
(c) That the only hope for avoidance of seriously adverse consequences lies in correction of past errors by restoring sound commercial
banking.
The results of research that support the findings and conclusions
above are presented in the accompanying Economic Education Bulletin, "Why Gold ?"
I hope that this reply to your letters, as well as the accompanying
bulletin will be helpful to you and your committee.
Space limitations prevented printing the above mentioned Bulletin
in full. Reprinted below are sections IV and V of "Why Gold?"
265
I V . THE GOLD STANDARD AND THE GOLI> DOLLAR
ELEMENTS OF THE GOLD STANDARD
For a country to be on the full gold standard the following conditions must be
met:
1. The standard monetary unit is a fixed amount of gold.
2. All domestic currency and coin are freely exchangeable at their face value
for gold, and whoever obtains gold is free to use it in any way he chooses.
3. There is no limit on the amount of gold that may be brought to the mint
for coinage.
4. Gold is full legal tender for payment of all obligations.
5. There is no restriction on the importation or exportation of gold.
VARIANTS OF THE GOLD STANDARD
A country is on a gold coin standard when the foregoing requirements are met
and its currency and nongold coin are freely exchangeable for gold coins that
are multiples of the amount of gold constituting the monetary unit. The dollar,
for example, as legally defined, is 15.238 grains of gold, nine-tenths fine. If $10
gold pieces were being minted, each one would consist of 152.38 grains of gold,
nine-tenths fine.
In a country that is on a gold bullion standard, currency and nongold coin
are redeemable in gold bullion at a fixed amount of gold for each monetary
unit, the minimum obtainable being the amount in a gold bar of a certain specified weight. When the purpose of this kind of gold standard is to discourage the
circulation of gold and so economize in its use, the gold bars in which the currency is redeemable are of considerable weight. For example, when England was
on the gold bullion standard from 1925 to 1931, currency could be redeemed only
in gold bars weighing 400 ounces. This variant of the gold standard has been
objected to on the grounds that "A gold bullion standard is a rich man's standard, operating above, and out of reach of, the man of small means. It would be
responsive only to the behavior of the rich man, the banks other business enterpries, and the government * * * [with a gold coin standard] there is no discrimination against any individual, particularly the man with small capital, and
it is most important that he be able to exercise his preferences and thereby to
register his doubts because these are part of the machinery of automatic braking
which the gold coin standard provides." 1
In a country that is on the gold-exchange standard, currencies of foreign countries are used as reserves for the domestic currency, often in conjunction with
some gold. The principal currencies thus used are U.S. dollars and British pounds.
Although the country's monetary system is thus one stage removed from gold,
the value of its currency is kept at the established gold parity because of the
indirect convertibility of the currency into gold. The principal hazard inherent
in this variant of the gold standard is the possibility, which can never be entirely
absent, that at some time the currencies used as reserves will be devalued, as
was the British pound in November 1967. A serious disadvantage of the widespread use of the gold-exchange standard is described elsewhere in this study.
The most important features of the gold standard, whether redemption is in
gold coin or gold bullion, are the fixed amount of gold in the monetary unit and
the freedom with which gold and currency are interchangeable at the Treasury
or central bank. Fixity in the amount of gold in the monetary unit makes gold
and the currency representing it an efficient medium of exchange and a relatively
stable measure and store of value. The free inter changeability of gold and currency by citizens and foreigners alike provides an automatic mechanism that
tends to restrain unsound monetary and fiscal practices. Extreme currency and
credit inflation is not possible while the rules of the gold standard prevail.
The significance of these features of the gold standard will be considered at
greater length in subsequent sections of this study. Here it is sufficient to note
that it is the lack of full and free redeemability of U.S. currency for gold that
keeps the United States from being on a full gold bullion standard. Although
foreign governments and central banks can exchange U.S. currency for gold at
the U.S. Treasury, individuals and firms, whether American or foreign, are not
allowed to do so, except under license for certain purposes. Thus, the United
States, while internationally on a restricted gold bullion standard, is on an in1 Walter E. Spahr, The Case for the Gold Standard, New York, Economists' National
Committee on Monetary Policy, 1940, pp. 28-29.
21-570—68
IS
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convertible paper currency standard domestically. This bifurcated departure
from the full gold standard has been at the root of the Nation's money-credit
problem for three decades.
"PAPEB GOLD" AND THE SDE PROPOSAL
Some authorities, including those in the United States, would supplement or
replace the gold-exchange standard with some sort of international "paper gold'*
for use as a monetary reserve asset by national governments. Advocates of such
a "paper gold," standard hope that such "paper gold" will be printed and distributed in sufficient quantities eventually to replace gold as the basic monetary
reserve of the world.
During 1967 United States authorities made a concentrated effort to persuade
the member countries of the International Monetary Fund to accept a plan for
creating a paper asset to be used for settling payments imbalances and held as
monetary reserves. Agreements made at meetings of the Fund membership in
London and Rio de Janeiro during the summer of 1967 were heralded by U.S.
officials as momentous steps toward revolutionary reform of the international
monetary system. However, the substance of these agreements soon was seen to
be little more than a face-saving concession to the United States.
France and other European countries agreed to a plan for augmenting world
monetary reserves if such reserves became inadequate, but only on the conditions that they collectively would have sufficient voting power to veto the plan
as well as other important operations of the International Monetary Fund.
Thus, only tentative endorsement was made of a plan to grant each member of
the Fund "special drawing rights" (sometimes referred to as SDK's) in addition
to its existing rights to borrow from that organization. Such drawing rights
would be transferred within specified limits from the central bank of one country to that of another in settlement of international payments imbalances. If
such a plan ever is implemented, it will represent merely an extension of the
present inflationary gold-exchange standard rather than a radically new development.
The possibility of the plan becoming operational seems remote. Continental
European countries presumably will not permit its implementation as long as
they continue to accumulate dollar claims as a result of the continuing imbalance
of payments of the United States.
Recent international monetary developments have made authorities of these
countries even more reluctant than before to continue accumulating dollar claims
and British pounds. Such developments have emphasized the superiority of gold
to "paper gold" for use as monetary reserves. Current world sentiment, particularly in Europe, is for closer, rather than looser, monetary ties to gold.
W H A T IS A DOLLAR?
An article in the Financial Times (London), September 1, 1960, included the
following statement: "The U.S. dollar made a further recovery, rising one-half
cent to regain its peak level of $35.24-26." Americans who read this surely
wondered what it could mean. It must have surprised them to be told that a
.dollar was $35.24-26. Moreover, the terms "recovery," "rising," "regain," and
"peak level" all misled because they implied that what occurred was favorable
to "the U.S. dollar." The sentence quoted epitomizes the confusion of terms, unwarranted connotations, and disregard for accurate definition that are often
apparent in discussion of monetary matters.
Perhaps the most common semantic error in the field of money and credit is
that due to mistaking claims on dollars for the dollars themselves. This error
appears in various ways, one of which is the phrase, "the dollar price of gold."
Those who use this expression are thinking perhaps of the dollar as a piece of
paper currency or a credit to a checking account. However, the fact is that
"dollar" is the statutory or legal name for a specified amount of gold. By authority of the Gold Reserve Act of 1934 the dollar was specified as 15%i grains
of gold nine-tenths fine, which is the equivalent of one thirty-fifth of an ounce
(troy weight) of pure gold. Paper currency and paper credits are not dollars.
They represent and may serve as claims upon actual dollars, each of which is
the specified amount of gold.
To refer to the dollar price of an ounce of gold is like referring to the price
of potatoes in terms of potatoes. It would be foolish to say that the price of a
bushel of potatoes is 60 pounds of potatoes. If, however, there were certificates
,or book credits representing potatoes, one might have to offer in the marketplace
267
certificates or credits representing 61 or more pounds of potatoes in order to
obtain a 60-pound bushel of actual potatoes. This might be the situation if there
were some cost or other impediment to the conversion of the certificates or
credits directly into the potatoes that they purported to represent. The situation
in the London gold market and other gold markets abroad is similar to this
whenever the amount of U.S. currency required to obtain an ounce of gold exceeds
$35 plus the cost of obtaining gold from the U.S. Treasury and transporting it
to the foreign market.
In the London market British currency is exchanged for gold (subject to
certain restrictions, among which is the prohibition of gold purchases by British
subjects), but the amount of that currency required to obtain an ounce of gold
can be translated easily inito an equivalent amount of U.S. currency which a
foreign holder who wanted gold could use to buy the necessary British currency
in the foreign exchange market.
Thus, the financial reporter quoted above should have said, in order to be
accurate, that ithe amount of U.S. currency required to purchase an ounce of
gold in London represented $35.24 (or $35.26). He should have made clear that
two different thirtgs were involved in the exchange.
V . ECONOMIC BENEFITS OF THE GOLD STANDARD
In discussing the economic benefits of the gold standard, we should face frankly
the fact that it is not a panacea for all economic ills. Those who offer patent
medicines alleged to be cures for all the physical ailments of mankind have long
been regarded as quacks. So likewise should we regard individuals who offer any
single simple remedy for all economic ills.
Particularly important is it to realize that there are both short-term and
longrun economic problems, the business cycles of boom and depression as well as
the long-term trend. The major economic benefits of a return to the gold standard
will not include solutions for all present or short-term economic problems but
will be related more definitely to the industrial progress and even the survival
of the United States in the longer run.
INHIBITING UNWISE FISCAL AND BANKING POLICIES
Readers who think that an inflationary trend may be quickly reversed by
some happy coincidence of events may be underestimating the temptations
involved. In France and most other nations the takings of government-planned
embezzlement through depreciation of the currency have been relatively small,
because the savings and life insurance of the citizens have been only a fraction
of the amount per capita here in the United States. In the United States the
present value of life insurance policy reserves, social security trusit funds,
individual holdings of Government and other bonds, and the savings accounts of
American citizens approximates $850 billion. This can readily be stolen by the
subtle processes of inflating and repeated devaluations.
If a redeemable currency were restored, the wiser and more farsighted of
the Nation's citizens who saw the dangers in unsound fiscal or banking policies
could demand gold, and Treasury and bank officials ordinarily would act with
awareness of this fact. A possible resulting outflow of gold would force the Federal Reserve authorities and the Government to reconsider unwise policies.
Instead of depending on the wisdom of a selected few who might err disastrously, the Nation would provide freedom of action for the many hundreds of
thousands of its wisest citizens who presumably can best foresee the probable
effects of unwise policies and so act as to counteract those policies. In the absence of the combined judgment of a multitude of keen and experienced observers, there may be no effective check on unwise policies until they have resulted in serious disaster. No wise monetary authority or fiscal policymaker
should want to be without such an important guide to policy as a redeemable currency provides, and no foolish monetary authority should be permitted to disregard that guide.
Although all money-credit systems require some control, if only to prevent
abuses, the automatic features of the gold standard give early warning of credit
abuses or unsound procedures and therefore facilitate corrections by a minimum
of managements. Because it minimizes the excuse for controls, the gold standard
is especially disliked by those who seek to enmesh the economy in a network
><of socialistic restrictions.
268
The Federal Reserve Board should be free to act when there are warning signs
of unsound financial developments. An independent agency to provide the minimum degree of appropriate control has been proved by long experience to be the
only effective means of managing a nation's money-credit system.
Confidence in the future worth of the dollar is essential to long-term Government financing. Experience has shown that a nation that meets its promises to
pay enjoys the best credit standing. When the United States resumed gold redemption of its currency in 1879, one immediate and striking result was the
reestablishment of the Government's credit standing. Government bonds could
be floated at substantially lower interest rates.
Redeemable promises to pay presumably would not be issued as recklessly
as irredeemable promises might be, in fact usually have been. Throughout
the course of history, governments relieved of fulfilling their promises to redeem
currency on demand sooner or later have taken advantage of such an invitation to
reckless irresponsibility.
The fixed amount of gold in each dollar has a relatively stable purchasing
power in the long run. Specifically, when not disturbed by the inflating or deflating
of other purchasing media, the exchange value of gold has remained remarkably
stable for generations. Changes in prices based on gold usually have been gradual rather -than seriously disruptive.
When prices continue rising in a country on the gold standard, gold tends to
move out from the reserves securing currency and bank deposits, thereby limiting
or preventing the further expansion of credit and a subsequent rise in prices.
Gold is universally accepted as a medium of exchange. Even when practically
all nations of the world have been "off the gold standard" as far as domestic
redeemability was concerned, they have sought gold; and the people of the
world, whenever there was widespread fear of monetary depreciation, have done
likewise. Gold is universally recognized as a valuable substance that does not
deteriorate in storage. The fact that a currency is convertible into gold should
assure for that currency virtually the same value in exchange and acceptability
as gold itself. Such was the Nation's experience for the several decades during
which the United States adhered to the full gold standard. Moreover, history
shows that experiments with managed paper-money standards, tried by many
of the principal nations of the world in the past 250 years, inevitably failed.
RESTORATION OF INVESTORS' CONFIDENCE
Another important benefit of the full gold standard would be a restoration of
confidence, among those who save, in the future value of their savings. Here in
the United States, the small annual savings of individuals, largely accumulated
by those who labor, reach an astronomical total each year. For example, during
1967 personal savings totaled about $38 billion.
Since mid-1950 the confidence of small investors in the future value of U.S.
savings bonds seems to have decreased. Redemptions have exceeded, sales with
the result that the total held has decreased in the past decade despite increasing
population.
To what extent the cashing of savings (bonds has reflected distrust of the future
value of the dollar, no one knows. Nevertheless, long experience in many countries
of the world clearly indicates that such developments, on a much larger and far
more devastating scale, are to be expected when public confidence in money
diminishes. As our Nation figuratively walks a monetary tightrope above the
abyss of national disaster, little imagination is required to visualize the torrent
of demand that could flood the Nation's market places if fear finally impelled the
multitude of small savers to buy goods, whether needed or not, as an alternative
to seeing the value of their savings rapidly diminish.
Also to be considered in this connection is the desirability of ending the search
for "hedges" against inflation. Small investors are faced with the question, How
much of my funds should I invest in such a way that I will be protected against
continuing depreciation? Unfortunately it is those individuals who can least
afford to take the risks that all equity investments involve wTho may not have
enough income, even for the necessities of life, unless they risk such losses in the
hope that an increasing income will offset any further rise in living costs.
When assured of the future value of their savings, men have confidence and are
willing to invest. Such confidence and the resulting long-term commitments
facilitate orderly progress. When they have a fixed standard and a redeemable
currency the future of which is not being questioned, men can recognize "bargains" and act accordingly. Probably this accounts in part for the fact that firm
269
adherence to the gold standard has invariably hastened recovery from business
depressions.
When there is no fixed standard and redeemable currency or its future is in
question, men have an inadequate basis for judging "bargains" accurately. Comsequently, they hesitate to make commitments; and while potential employers
hesitate, the unemployed wait in Government-induced idleness. Such was the
Nation's experience during the money-juggling years after 1932.
ENDING ADJUSTMENTS FOR A FLUCTUATING DOLLAR
Another benefit that could result from return to the full gold standard is the
ending of those statisticians' nightmares, the adjustments of indexes for fluctuations in the value of the dollar. Of course, the gold standard would not prevent
in the future, any more than it did in the past, the serious distortions of economic values that are attributable to credit inflation and deflation, (the twin
evidences of incompetent and unwise banking). Such distortions, however, are
relatively limited in magnitude and duration as long as a fixed gold standard is
maintained. Return to the gold standard would make unnecessary the elaborate
efforts to adjust statistical value-series that have been necessary in recent years.
Without adequate bases for economic comparisons even the simplest representations by labor seeking a higher wage or by capital seeking a greater reward
become almost unintelligible. The complications resulting from adjustments for a
rubber dollar are to many people incomprehensible.
Thinking for the moment only of labor's aspect of the problem, we should
ask how John Doe is to judge what a pension payable in 1980 dollars is worth
to him today? Will the dollar he knows today shrink in value as rapidly as the
dollar has during the past two decades, perhaps even more? If so, what is the
use of social security and company pension benefits anyway? Is the whole game
of trying to provide for the distant future to be a fruitless one that few laboring
men can hope to understand?
But labor is not the only economic factor cheated by the fluctuating dollar.
When plant depreciation charges are based on values long outdated by a
shrinking dollar, capital likewise loses. The ordinary books of account reveal
profits that are illusory and encourage policies that ultimately can lead many
business firms into bankruptcy.
When both parties to a contract have a fixed standard unit as the measure of
their respective obligations, they can judge the risks involved far more accurately
than when their contract promises are stated in the necessarily vague and fluctuating terms of a managed currency.
Although, under the gold standard, the buying power of the dollar may be
distorted temporarily either by unsound credit expansion (inflation) or the collapse of such unsound credit expansion (deflation), in the long run the exchange
value of gold varies relatively little; no other medium of exchange as yet has
proved to be so stable.
In the long run, with an irredeemable paper-currency system, the inevitable
distortions of economic value judgments are reflected in the attitudes of individuals and business organizations. Expedient adaptation to the exigencies
of the near future becomes the dominating policy; long-range considerations are
forgotten or disregarded. When such views predominate, will the United States
continue to be one of the leading nations of the world ?
LIFTING THE VEIL THAT CONCEALS BASIC ECONOMIC PROBLEMS
Another economic benefit that would result from returning ito the full gold
standard would be removal of the "money veil" or "money illusion" that conceals from most people the Nation's basic economic problems. Removing the
''veil" would not guarantee that those now in a position to solve the problems
would see them clearly and promptly take appropriate actions, but throughout
the Nation many for whom the problems were clarified might press in various
ways, including the political, for itheir solution.
For example, the present monopoly power of organized labor in basic industries may not be understood by the general public as long as inflationary additions to the supply of purchasing media readily permit wage and price increases.
This monopoly power has been made possible by discriminatory statutes and
abused by some labor leaders with despotic control on an industrywide basis.
While the inflationary process goes on, however, such monopoly becomes more
firmly entrenched, more determined to get an increasing share of the wealth
278
produced. The longer the public remains blind to the issue, the more difficult
and disruptive the final settlement probably will be.
Insofar as the depreciation charges of business are based on prices lower
than those currently prevailing and are therefore inadequate for the replacement of capital equipment, business profits lare in part illusory; they reflect a
hidden consumption of capital.
Taxes based on illusory gains are destructive of real wealth. They hamper
the sound growth of the economy, the continued growth that appears to be
essential to survival in the world as we know it today.
An inflation-stimulated boom is not sound prosperity. There have been several such booms in the Nation's history, and all have been followed by severe
depressions. Never have managers of a "managed irredeemable money" been
able to create a sound and lasting prosperity.
The creation of deposits and currency based on Government debt and noncommercial bank loans does not create real wealth. Such a procedure only
deludes those who strive to measure and exchange wealth, and it invites overspeculaition; paper gains are lost in the inevitable depression aftermath.
Men are free to the extent that the culture or society in which they live permits them to plan and choose their goals, provides equality of opportunity to
act effectively in pursuit of those goals, and permits them to retain the fruits
of their labors. There is much evidence to indicate that increasing departure
from economic freedom is destroying Western civilization, including our own
country; but the economic relationships involved are so obscured by the veil
of manipulated money that all too few have any understanding of what the
Nation's greatest economic problem is.
"TO PROMOTE MAXIMUM EMPLOYMENT, PRODUCTION, AND PURCHASING POWER"
1
The experience of history shows that an irredeemable currency endangers
the economic system that uses it. Innumerable instances testify to the truth of
this assertion, and none refute i t A fixed monetary standard, on the other hand,
facilitates the achievement of equilibrium among the economic factors of production, without which there can be neither full employment nor optimum output
of products to be purchased.
Only if labor has a fixed and simple standard of value free from the misconceptions attributable to a depreciating currency can it judge the real value of
its present gains and possible future pension benefits. The efforts of those who
labor to obtain social security benefits and company pensions will be fruitless
if the depreciation of the dollar continues at the rate of the past two and onehalf decades.
John Maynard (Lord) Keynes, who was a leader among the advocates of a socalled managed irredeemable currency, openly avowed that his scheme was a
means of deceiving those who labor and who neither understand nor are in a.
position to take advantage of the vagaries of such an irredeemable paper money
system. (See Keynes The General Theory of Employment, Interest, and Money_
ch. 2, pt. II.) Only the shrewd speculator and the man of great wealth can expect
to profit in the long run from a "managed" irredeemable currency.
In the absence of a fixed monetary standard and a redeemable currency thepressure for continued inflation tends to rob those who have the least economic
power, depleting the only resources they have. The widows and orphans, the
elderly and the ill in health, are virtually defenseless against the ravages of a
depreciating dollar that diminishes the buying power of their savings and depreciates the values of life insurance and annuities.
Technological progress, given a fixed monetary unit and sound fiscal and banking policies, ordinarily would result in a gradual lowering of costs and prices
that would benefit all consumers. Especially beneficial would this be for those
whom most men strive hardest to protect, their potential widows and their
children.
FACILITATING LONG-TERM INDUSTRIAL PROGRESS
But of all the benefits to be expected from a return to the full gold standard,
perhaps the most important in the present and foreseeable future would be the
achievement of the most rapid rate of long-term industrial growth that the economy can sustain. We do not imply that a return to the gold standard alone would
insure this highly desirable outcome (future military strength will, even more1
The declared purpose of the Employment Act of 1946.
271
than in the past, depend on industrial progress) ; but failure to restore the gold
standard almost certainly will prevent the optimum rate of economic growth.
Restoration of the full gold standard would, in all probability, be followed by
a long-term downward trend of prices that might continue for some years as the
inflationary purchasing media now in circulation were slowly eliminated. That
a long-term downward trend of prices could be a greater aid to industrial progress than continually rising prices may surprise many who have accepted the
widely publicized notion that the reverse is true.
However, the idea that perpetually rising prices are better than falling prices
in the interests of an expanding economy in the long run seems to have no basis
in recorded economic experience and lacks even theoretical justification. As far
as can be discovered, the only seemingly valid argument in support of this notion
is based on the fact that prices usually rise during the recovery phase of businesscycle changes. But business cycles are short-term changes; we must turn to other
considerations to learn the truth about the relation between rising or falling
prices in the long run and economic progress.
First, what light can be obtained from a brief review of the relationships that
appear to be involved? Industrial progress results from taking advantage of the
scientific and technological advances that make possible more effective use of
the three basic factors of production: land, labor, and capital. Now the scientific
and technological advances are not distributed evenly over all industries or all
types of industries, nor are they evenly distributed over all the companies in any
one industry. Therefore, in order to derive the utmost industrial advantage from
new developments, land, labor, and capital must be shifted from those companies,
industries, and types of industries where the scientific and technological advance
is slow or nonexistent and must be moved into the companies and industries
where the technological advance is the most rapid and most fruitful at particular
times.
As it happens, only one effective way to judge the relative economic worth of
various technological changes has been discovered, and that is the test of relatively free competitive markets. Continually rising prices induced by more and
more inflating as a longrun policy have the effect of permanently distorting the
markets as long as the policy is continued. Under such circumstances, company
A, if it is leading the technological advance, will enjoy not only the profits
attributable so that leadership but also the "windfall" profits attributable to
inflation. Company B, if it is lagging in the technological advance, might be experiencing losses in the absence of inflation, but under the conditions assumed
might be able to report profits in spite of its inability to keep up with the technological progression.
Under the circumstances just described, what will happen? The management
of company A will, of course, try to expand rapidly and will have profits available that can be used for that purpose. But A can expand its plant and labor
force only by bidding a higher price for the three economic factors than B
can. If B is encouraged by inflationary profits to continue its existing rate of
operations or perhaps even expand somewhat, from what source can A get
those factors of production?
One would expect industrial growth to be hampered by such conditions,
because resources cannot be shifted readily to more effective uses from inefficient companies that continue to operate.
On the other hand, when technological progress is reflected in a price level
not artificially supported by inflationary monetary manipulation and accompanying currency depreciation, one could expect the long-term trend of prices
to be downward, gradually perhaps, but nevertheless downward. And the absence
of inflation, accompanied by a downward trend of prices, would prevent windfall profits in the lagging companies and industries, which would experience
losses. Such concerns would be forced to release land, labor, and capital to
other uses. The shifts that must be made if industrial progress is to be at the
optimum rate will then be readily effected. Surely there are few facts more
obvious that that the price of progress is change.
So much for theoretical aspects of the problem. Is there any proof that the
reasoning offered is sound ?
In 1879, 14 years after the end of the Civil War, the United States returned
to the gold standard. For the decade of the 1870's, the average level of commodity prices measured by one comprehensive index was 117.5. For the three
successive 5-year periods beginning with 1880-84, the average levels of commodity prices measured by the same index were 101, 84, and 78. The decline
272
was almost continuous, and by the end of the 15-year period following 1879,
prices were down 33 percent from the average level for the 1870*8.
During the same period industrial production increased at the most rapid
rate for the most prolonged period in the Nation's history. Specifically, if the
average physical volume of manufacturing production for the 1870's be considered the base or 100-percent level, the average index numbers for each of
the next three successive 5-year periods were 158, 196, and 245. In 15 years the
gain was 145 percent, more than 6 percent compounded annually. Moreover,
for 11 of the 15 years, industrial production remained well above the estimated
long-term trend. These developments showed how groundless were the widespread fears, preceding the return to a currency redeemable in gold, that resumption of the gold standard would be efialamitous and that a prolonged fall of
prices must inevitably be accompanied by industrial stagnation.
Lest the foregoing be misunderstood, we should make clear that the figures
just presented are not offered as conclusive proof that the preceding theory is
sound. But the facts of history seem to place the burden of proof on those who
sponsor and defend the Nation's long-continued, inflationary monetary policies,
who urge that prolonged inflating and continually rising prices will insure
Tapid long-term industrial progress.
We have a right, even a duty, to ask the proponents of inflation, Are you not
•denying to your country the known and demonstrable benefits of a sound monetary system; are you not jeopardizing the industrial progress on which our
survival in a possibly hostile world will have to depend?
MAINTAINING THE FREEDOM OF AMERICAN CITIZENS
Foreign governments and central banks can obtain gold on demand in exchange for the Government's promise on our paper currency to make such payments ; but American citizens cannot obtain from their Government fulfillment
of its specific promise to pay on demand. All Federal Reserve notes (except the
new ones being issued) carry the unequivocal pledge that the United States
•"will pay to the bearer on demand" the number of dollars indicated. Instead of
giving to the bearer on demand the dollars promised, the Treasury merely will
give other paper promises to pay dollars. Such subterfuge, the substitution of
promises for promises instead of the thing promised, is unworthy of a great
Nation and an honest people.
A fully redeemable currency would restore to the people some degree of control over unsound banking and spendthrift government. Since the departure from
the gold standard in 1933, the people of the United States have lost, in large part,
their control over the public purse. The full gold standard would restore that
control and help prevent the large losses that continuing inflation causes. It
would help to preserve the system of free enterprise and free markets that has
made the Nation the leading industrial power of the world, and without which
the people cannot remain free. It would provide the best assurance that this
Nation would remain free and would continue to grow stronger than its enemies.
STATEMENT
OF
GABRIEL
HAUGE,
TRUST
MMSTUTACTTIKEES
HANOVER
CO.
D E A R M R . P A T M A N : Upon returning to my office I have found your
letter of July 9th inviting me to reply to questions pertaining to hearings to be held on H.R. 11.
Upon inquiry here, I find that our economist, Dr. Tilford C. Gaines,
received a similar letter and has been in the process of preparing his
replies before your September 1, 1968, deadline.
In view of the fact that whatever replies I might have made to your
questionnaire would have been developed in consultation with him. I
hope you will accept his submission on behalf of both of us.
273
STATEMENT
OF T H O M A S M. H A V R I L E S K Y ,
UNIVERSITY
OF
MARYLAND
( 1 ) A COORDINATED MACROECONOMIC POLICY PROGRAM
Part 1 elicits an opinion on the advisability of coordinating fiscal,
monetary, and debt management policies at the beginning of each year
under the aegis of the President. Part 2 asks whether this program
should be developed solely by the President or jointly by all agencies.
I shall briefly answer these questions and then enumerate additional
suggestions.
The obvious interrelationship between fiscal, monetary, and debtmanagement policies makes "independent" policy formulation an implausible alternative to a coordinated program. The office of the President by force of circumstance is the most feasible instrumentality
for harmonizing monetary, fiscal, and debt-management policies.
Therefore the executive must author the program. Coordination, however, should evolve from an exchange of opinion among the Federal
Reserve, the Treasury, the Council of Economic Advisers, the Bureau
of the Budget, and other agencies of macroeconomic policy.
Some Additional Observations
Polices cannot be skillfully coordinated unless all parties to the
program have identical or compatible objectives. Any program of
coordination should cite the desired values for the goal-variables 1 of
economic policy. The goals of macroeconomic policy should be clearly
stated each year; for example, a specific percentage of unemployment^
a specific acceptable rate of price level change, etc. If desired values
of the goal-variables are incompatible, for instance, the economy may
not be able to produce both 3 percent unemployment and a near zero
rate of price inflation, priorities or weights would have to be assigned.2
The coordinated policy program should be premised upon an exchange of opinion among fiscal, monetary, and other agents of the
Federal Government; the results of the interchange could be made more
operational if all parties used similar hypotheses about the structure of
the economy. I do not suggest that various conceptions about the state
of macroeconomic nature need be identical or absolutely valid for all
classes of phenomena, but hopefully the monetary and fiscal agents and
advisers will not pour their respective opinions into alien coordinate
systems. If the President, as an arbiter and the ultimately responsible
author of the program, would resolve conflicts between the hypotheses of say the Federal Reserve System and the Treasury, the program
might proceed more effectively.
The coordinated stabilization policy program should also sift and
consolidate predictions of the course of future economic activity and
forecasts of noneconomic policy force impinging upon achievement
of the goals of policy. (See (3), p. 278.) This would promote, at the
outset of the year, compatible stabilization policy actions by monetary
and fiscal authorities. The absence of such coordination has created
1 This hybrid term is used to designate the variables in the economic structure which
monetary and fiscal authorities ultimately try to influence, such as the level of unemployment and the rate of change of the price level.
2 This might be achieved for some goals by setting a feasible desired rate of increase of
aggregate demand as an intermediate target for all macroeconomic policy agencies. This
suggestion is a logical extension of the target strategy discussed in the text of the statement.
274
some difficulty in the past. For instance, in recent years monetary policy
actions may have been inappropriate because of inadequate forecasts of
defense spending plans. (Pee (8) p. 282.)
If these steps were taken, the President could consequently issue a
general statement of fiscal and monetary policy recommendations as
seen from a first-of-the-year vantage point. Because of the lack of
perfect foresight of economic events, the Office of the President cannot
effectively specify monetary and fiscal stabilization policy for the
entire year; it cannot effectively prescribe the desired value of the
monetary guideline-variable, because the appropriate value of this
variable will change from time to time. (See (3) p. 278.)
In summary, ideally the Office of the President should promote
standardized, or at least consistent hypotheses about the structure of
the economy among all parties to stabilization policy; it should cite the
specific goals of policy and their relative importance; it should consolidate economic predictions and forecasts; it should set the initial
tenor of stabilization policy for all agencies for the forthcoming year.
(2)
A GUIDELINE OH INTERMEDIATE TARGET STRATEGY
Part 3A inquires as to the advisability of imposing an intermediate
guideline- or target-variable upon the monetary authority. I first
present a summary statement of my views on this issue and then
develop these views at greater length.
Summary
The adoption of a guideline strategy, as discussed below, offers
considerable promise. However, I am skeptical that we can yet specify
a money supply guideline, or any guideline, for monetary policy. I
do not favor the President selecting any guideline for the Federal
Eeserve System at this time without thorough apprehension of the
issues involved. Because of these issues, as discussed in sections (a)
through (d) below, choice of a guideline-variable should be deliberated
and prominence should be accorded the opinions of the monetary
authority. To select a guideline-variable for the Federal Eeserve System or any agency without further study of the issues seems to invite
more radical (I use the term in the philosophical rather than the
political sense) change than many seem to realize. (See sec. (d)
p. 278.)3
As a separate matter, I believe that no guideline-variable, when one
is selected, should have a fixed desired value or a fixed range of desired
values. The laudable design of macroeconomic policy coordination
seems to have become mistakenly predicated upon the concept of a
fixed monetary rule. If, after studied consideration of the issues, a
uddeline-variable were adopted, I favor that the Federal Eeserve
ystem be permitted to announce different desired values of that
variable as frequently as necessary. (See (3) p. 278.)
Because the Office of the President would issue a coordinated program but once a year, it could not continually prescribe the desired
value of the guideline-variable. The Federal Eeserve System, on the
§
3 To avoid misinterpreting the author's position the staff notes that in concluding this
discussion the author states, "Yet I believe that enough is known that . . . I favor a
total reserve target-variable or a monetary base target-variable or a little less conservatively a narrow money supply target-variable."
275
other hand, has available not only the earlier forecasts of the President's program, but also has current forecasts non-monetary-policy
forces, such as defense spending, which affect the goal-variables, such
as the level of unemployment, as well as current predictions of future
economic activity. (See (3) p. 278.) Therefore, the monetary authority
can better specify the desired level or rate of change of the guidelinevariable. It would, of course, be held responsible for these changes
within the framework of H.E. ll's proposed "quarterly report to
Congress, stating in comprehensive detail its past and prospective
actions."
The role of a monetary policy guideline-variable
A target- or guideline-variable is a variable, such as the long-term
interest rate or the money supply, which is affected by monetary policy
with less lag than monetary policy affects ultimate goal-variables, such
as the level of unemployment.4 The target-variable, in turn, affects the
goal-variables after some lag. The advantage of a target-variable is
that by adjusting policy to affect adroitly the target-variable the monetary authority can (to the extent that the target-variable is predictably
related to the goal-variables and to .the extent that policy can predictably and/or swiftly affect the target-variable) bring about desired
values of the goal-variable. For instance, if the long-term interest
rate's effect upon the goal-variables of unemployment and the price
level is well known and if the long-term interest rate can be affected
by monetary policy with little lag, the Federal Reserve, by readily
attaining desired values of the long-term interest rate, can easily
achieve a desired level of unemployment and a desired (acceptable)
rate of price inflation.
Some issues in selection of a target-variable
There are many problems in target-variable selection. One of these
is finding a target-variable which is both affected with no lag and related with complete certainty to the goals of policy. Such an ideal
target-variable probably does not exist. For instance, the Federal
Reserve can control free reserves with very little lag but the relation
of this very proximate potential target-variable to the goal-variables
is known only with considerable uncertainty. Therefore, this readily
influenced target-variable does not allow good control of the ultimate
goal-variables. On the other hand, while the relation of a less proximate potential target-variable, such as aggregate demand, to the goalvariables is quite well understood,5 it is not easily controlled by monetary policy; therefore, it, too, does not allow good control of the ultimate goal-variables. Monetary research ought to suggest an optimal
4 1 believe the linkage between monetary policy action and the target-variables and goalvariables is as follows. Open market transactions in short-term securities affect money
market conditions (marginal reserve measures, short-term interest rates, etc.), after a
earning assets eventually respond, the money supply and short-term interest rates are
affected ; effects are transmitted in the market after a lag to long-term interest rates and
a range of credit conditions. Certain components of investment spending respond after a
short lag total reserves and the monetary base respond; as bank purchases or sales of
lag to the changed short- and long-term interest rates and credit terms via the cost effect
as well as the effect on the price of real assets relative to their supply price. There may,
in addition, be a wealth effect wrought by changes in the stock of financial assets. Eventually aggregate investment and aggregate consumption respond and finally the goalvariables of policy are affected. This final reaction overlooks the earlier response of certain
measures of the balance-of-payments problem to the change in short-term interest rates.
5 See footnote 2.
276
target-variable, one which is influenced as readily as possible by monetary policy and, concurrently, relates as closely as possible to the
goal-variable.
Now let us systematically relate the degree of controllability of both
the target-variable and the goal-variable to the foresight required of
the monetary authority. As a general rule:
(a) A preferable target-variable should reduce the foresight required of the monetary authority.—It is reasonable to assume that target-variables chronologically less proximate to monetary policy action
(affected after a sizable lag) are chronologically more proximate to
the goal-variables (affecting them after a short lag). It has been recognized, in addition, that the greater the lag between monetary policy
action and the target-variable, the more distant and hence the less accurate the monetary authority's current forecasts of non-monetarypolicy forces affecting the target-variable. Also, after the target-variable is affected, the greater the lag between it and the goal-variables,
the more distant and hence the less accurate the monetary authority's
forecasts6 of the non-monetary-policy forces affecting the goal-variables. It then follows that less accuracy of forecasts of non-monetarypolicy forces affecting the target-variable must be sacrificed for more
accuracy of forecasts of non-monetary-policy forces affecting the goalvariables. The optimal target-variables can neither be too proximate to
policy action (because forecasts of the effects of non-monetary-policy
forces on the goal-variables will be quite poor) nor too proximate to
the goal-variables (because forecasts of the effects of non-monetarypolicy forces on the target-variable will be quite poor and undesired
variation in the target-variable will cause undesired variation in the
goal-variables).
From this sketch it is not obvious that the money supply is an optimal target. Even if the money supply can be fairly accurately controlled, the long lag between the money supply and (unspecified) goalvariables and nence the inaccuracy of forecasts affecting the goalvariables, could make systematic countercyclical policy influence on the
goal-variables highly unreliable.
Other aspects of the issue of policymaker foresight and knowledge
have already received some attention in discussion of the target problem and therefore require little elaboration here. Generally, they all
recognize the need for accuracy of the monetary authority's knowledge
of both the relation between policy action and the target-variable and
the relation between the target-variable and the goal-variable.7 Most
of the earlier discussion has centered on the latter linkage. For instance, it has been aptly contended that a money supply target-variable
requires knowledge of the money demand function and that a longterm interest rate target-variable requires knowledge of the marginal
real rate of return. To impart some generality to and to systematize
this problem, my discussion has focused on the relation between the
lags and the forecasts of exogenous disturbances affecting the transmission of monetary policy.
6 These latter forecasts are made at the time the target-variable is affected by policy
action and influence the desired value of the target-variable. (See (3) p. 278.) This discussion is based on my paper "The Optimal Proximity of a Monetary Policy TargetVariable".
7 In addition, the issue of target-variable measurability has been mentioned. For instance, if data on an otherwise good target-variable are not readily available its usefulness
is restricted. I feel, however, that the resources of the Federal Reserve System can be
reallocated to make data on otherwise attractive target-variables more immediately available and meaningful. For instance, Federal Reserve reporting of the money supply series
has improved immensely in recent years.
277
(b) The selection of a target-variable depends on specific weights
attached to the goals of policy and the domino/at tool of monetary policy.—If the rate of income growth is an important goal-variable, some
form of a quantity target-variable may be preferable to an interest rate
target-variable. For example, a specified desired growth rate of the
monetary base, the money supply, or bank credit may be a simpler concomitant of income growth than an interest rate level. On the other
hand, if some measure of the balance-of-payments problem is an important goal-variable, an interest rate target-variable may be preferable; that is, to lessen certain aspects of the balance-of-payments problem all one need know would be certain international interest rate
spreads.
Target-variable choice depends also on the dominant tool of monetary policy; for example, a short-term interest rate target-variable
might relate more closely to the discount rate tool than a total reserves
target-variable.
(c) The selection of a more useful target-variable requires that the
Congress rescind its implicit mandate to the monetary authority for
money market stabilization.—The Federal Reserve System has in the
past seemed to derive satisfaction from achieving an "announced
value"8 of a target-variable irrespective of its relation to the goalvariables. There are two rather popular reasons for this. First, there
is the well-known Federal Keserve tradition of stabilizing money
market conditions. This may result both from the well-publicized influence on the central bank of money market operators and bankers,
who are notably averse to volatile short-term interest rates, as well as
from the historical mandate from Congress for orderly money market
conditions. Second, the Federal Reserve System and especially the
manager of the open market account are probably wary of error
(missing "announced" targets) in daily or weekly operations.9 If
the monetary authority gives preference to achieving the desired
targets irrespective of the closeness of the target-variable's relation to
the goal-variable, more proximate, more easily attained target-variables, such as variables which measure the condition of the money
market, will be selected and control over the goal-variables will be
sacrificed. As outlined in section (b), the less the lag between monetary policy and the target-variable, the greater the lag between the
target-variable and the goal-variables. This implies less accurate forecasts of non-monetary-policy forces affecting the goal-variables; consequently, control over the goal-variables will be sacrificed.10
8 Although currently these "announcements" have been somewhat impressionistic statements about the "tone" and "feel" of money market conditions, they may perhaps be
translatable by some arcane process into a bounds for one or several of the variables
which measure the condition of the money market.
®Two likely reasons for this come to mind. First the Federal Reserve System strongly
prefers to hit an "announced" target because by avoiding errors it reduces the blame it
receives for adverse changes in the goal-variables. This is not to be confused with the
more reprehensible Federal Reserve practices of ambigously alluding to a bewildering
assortment of unused longer run target-variables, before and after the fact. Second, as
suggested by section (d) below, the Federal Reserve System and the open market account
manager are probably not oriented to learning by error and receive less benefit from a
missed announced target than would a more experimentally minded central bank. This is
elaborated in my paper "Some Risks of Monetary Policy Innovation," forthcoming in Quarterly Review of Economics and Business.
10 Some economists have suggested that both money market stabilization and longer
run targets could be pursued, others have suggested that they are incompatible in a world
of uncertain knowledge. The point here is that if the Federal Reserve is concerned with
achieving one or several targets independently of the effect on the goal-variable, a more
proximate target-variable will be chosen, and by the assumptions of section (b) above,
goal-variable control will be sacrificed.
278
The tradition of money market stabilization will disappear as the
banker's influence on the Federal Reserve System continues to wane.
This tradition would further fade if Congress would rescind its mandate to the Federal Reserve System to stabilize money market conditions. Given these two influences, the central bank would then become
less fearful of error (missing "announced" targets). The confluence
of all these tendencies ought to make the monetary authority more
willing to adopt target-variables less proximate to policy action.
Closer control of the goal-variables would then be more likely. This
means that some "defensive" operations directed at money market
stabilization must be sacrificed.
There are probably numerous economists who now would not hesitate to impose an operationally "better" target-variable upon the Federal Reserve System to help dispense with its apparent aversion to
missing announced targets. However, I believe that this would be a
rather reckless obtrusion.
(d) The selected target-variable should not force the Federal Reserve System into a contrived risk-assuming posture.—It seems to me
that the monetary authority is a risk-averse technologist who performs his assigned task according to often obsolete theories (perhaps
inapplicable to any phenomena such as the free reserves doctrine), or
rules of thumb. (When confounded by theoretically oriented critics,
the officials of the Federal Reserve often and perhaps aptly contend
that monetary policy is an "art", that is, it is handled by rule of
thumb.) In this case, exacting the adoption of an announced target
which can be hit only after a tedious trial-and-error process would
probably impose radical institutional change upon the central bank.
Indeed, a space vehicle manufacturer would not be expected to
"launch" new projects until all but the uninsurable risks have been
reduced to tolerable limits. Is learning by trial-and-error experiment
the proper domain of the central bank ? What effects would such radical change have upon economic behavior?11 While I believe that the
central bank's aversion to error will abate both as the banker's influence wanes and if Congress rescinds its mandate for money market
stabilization. These questions should be considered before a particular
target-variable is chosen.
Having little empirical evidence and being cognizant of the gravity
of some of the above constraints, it is difficult to offer a specific targetvariable for adoption. Yet I do believe enough is known that the targetvariable of monetary policy may be extended beyond variables which
measure money-market conditions such as free reserves and the shortterm interest rate. I favor a total reserve target-v airable or a monetary
base target-variable or a little less conservatively a narrcno money
supply target-variable. [Emphasis supplied.]
( 3 ) ALTERING T H E DESIRED VALUE OF T H E TARGET-VARIABLE
Parts 3B and 3C seek an indication of the factors which influence the
setting of the target-variable's desired value. After outlining this I
11 Society recognizes that risk-assuming, innovative behavior by many organizations
could be disruptive and sets maximum acceptable limits to this activity by many means;
including law, insurance underwriting, custom, etc. It is possible, for instance, that if
the central bank's stabilization of money-market conditions were terminated, the financial
asset demand functions of households and businesses would shift thus vitiating current
estimates of these important relations, reducing the policymaker's knowledge even further
and making stabilization policy less effective.
279
adduce several reasons why the target-variable should not have a fixed
value.
The role of leading indicators and forecasts
The desired level or rate of change of the target-variable should be
altered periodically depending on changes in leading indexes of future
economic activity (which relate to the goal-variables) and changes in
forecasts of non-monetary-policy forces affecting the goal-variables.
Indexes must lead economic activity by the size of the lag between
policy action and its effect on the goal-variables. The particular leading
index chosen depends on the length of the lag which in turn depends
on the specific goal-variables and their respective weights. For instance,
if the price level responds to aggregate demand after a greater lag than
unemployment, monetary policy for price stability must use an index
which leads economic activity by a greater degree than the index used
by monetary policy for low unemployment.
The length of the forecast of the impact of non-monetary-policy
forces depends on the length of the lag between the target-variable and
the goal-variable. For instance, if residential construction is a targetvairable, forecosts of the impact of nonmonetary forces on the goalvariables need be less proximate than if the monetary base were the
target-variable.
The monetary authority must also use forecasts of non-monetarypolicy forces affecting the target-variable. These forecasts will effect
the strength of policy action but will not affect the desired value of the
target-variable unless they are correlated to non-monetary-policy
forces affecting the goal-variable.
Many economists believe that lags of monetary policy are variable.
This would clearly weaken the usefulness of forecasts because the
policymaker would know neither the necessary temporal length of his
forecasts nor what leading indicator of economic activity to consult.
It has been suggested that the presence of varying excess demands
and excess capacities in the economy causes a change in the rate of
change of the money supply to affect economic activity with a varying
lag.12 If these excess demands and excess capacities were better understood, this Friedman lag might be more predictable and the monetary
authority would know how far in the future he must forecast and what
leading indicator of economic activity he must consult.
On the other hand, the variability of the rate of change of the money
supply has been suggested as a cause of the Friedman lag.13 Varying
money supply impulses are believed to cause economic activity to be
affected after a varying lag. For instance, if the monetary authority
maintains a target value of, that is, pegs, the short-term interest rate,
the money supply would show considerable variability, as it is used to
moderate the effect of changing credit demands upon the short-term
rate. However, if the money supply instead were actually employed as
the target-variable and were made to react consistently to identical
stimuli, ceteris paribus, its variability and the variability of the lag
would be reduced.
12 Franco Modigliani, Statement before the Joint Economic Committee Congress of the
United States, 90th Cong., second sess., May 8, 1968, p. 12.
13 Karl Brunner, "The Role of Money and Monetary Policy" Review. Federal Reserve
Bank of St. Louis, July 1968, p. 20.
280
CRITICISM OF A FIXED M O N E T A R Y
RULE
I do not favor a fixed (or fixed range) desired value for the targetvariable for five general reasons that have been expertly discussed
elsewhere and need only be reviewed here. First, countercyclical monetary policy should not be abrogated by resort to rule because of the
imminent possibility of continued improvement of Federal Reserve
knowledge and effectiveness. Second, as has been popularly contended,
fixed rules are inconsistent with cyclically changing goal-variables
because the relation between a target-variable such as the money
supply and a goal-variable, such as the level of employment, is not
constant over the business cycle. Third, a fixed rule would be inconsistent with observed variation in the secular growth of the economy.
For instance, technological change would alter the rate of growth of
the economy and make obsolete a predetermined growth rate of the
money supply or some other financial quantity. Fourth, fixed rules
may actually have a destabilizing effect upon the cyclical movements
of the goal-variables. This is surely true of a pegged interest rate and
may be true of a pegged rate of money supply growth.14 Fifth, by some
occult process, the laudable purpose of macroeconomic policy coordination and congressional review of monetary policy has been predicated upon the monetary rule concejpt. A rule is not necessary for Congress to readily discover what the monetary authority is doing. The
quarterly required reports featured by H.R. 11 would serve this purpose. Finally there is no reason to believe that "rule" is intrinsically
superior to discretion.
This belief is highly suspect because it is grounded in the philosophy that Central Government activism is innately evil and irrevocably undemocratic. Indeed, the absence of an effective activist Central
Government would directly abandon more economic and political prerogative to the few inordinately powerful private interests. Popular
freedom and welfare are already subjugated to such concentrated
private political and economic power that the relinquishing of more
power by the Central Government (where there is, at least, a hope of
its being democratically influenced) should not be permitted.
(4)
DEBT M A N A G E M E N T POLICY A N D DEFENSIVE
OPERATIONS
Parts 4 and 5A inquire as to the role of debt management policy
and money market stabilization through "defensive" open market
operations.
Debt management can best assist macroeconomic policy by continued
implementation of the well-known techniques by which the debt may
be more efficiently refunded in order to reduce instability arising
from Treasury activity in the money market. This is, of course, a concomitant of the proposal that Congress relieve the monetary authority
of its undue concern for attaining an intermediate target-variable
irrespective of its effect upon the goal-variables of policy as discussed
in (2), sections (c) and (d) p. 274. In other words, because of the
undue weight the Federal Reserve attaches to attaining an announced
target, they adopt target-variables which can easily be influenced
14 William Brainard and James Tobin, "Econometric Models: Their Problems and Usefulness," American Economic Review supplement, May 1968.
281
(variables which measure conditions) money market. Under conditions discussed in (2) page 274 this results in sacrifice of control of the
goal-variables.
To the extent that defensive open-market operations place undue
emphasis on money market stabilization for its own sake, they would
be superfluous if Congress explicitly relieved the Federal Reserve of
this responsibility. However, to the extent that "defensive" operations
are used to maintain a desired value for the target-variable which is
consistent with desired values of the goal-variables, they are necessary. Short-term money market variability may very well be suppresed by improved debt-placement technques.
(5)
SECONDARY TOOLS OF MONETARY POLICY
Parts 5B and 5C ask about the role of the other tools of monetary
policy. These issues have been extensively discussed for some years and
only opinion need be registered here.
The discount rate has impeded the implementation of monetary
policy because it is not changed frequently enough to discourage member bank borrowing for profit. If not altered more frequently, the discount rate should be tied to the short-term Treasury bill rate. Regulation Q has also impeded monetary policy and should be abolished.
Reserve requirements, if raised as well as lowered more effectively
could result in potentially less Government debt in the banks in the
long run. This would benefit the taxpayer because more interest would
be returned from the Federal Reserve banks to the Treasury. Open
market policy should remain the principal tool of monetary policy.
(6)
FEDERAL RESERVE REPORTING TO CONGRESS AND OBSERVERS AT OPEN
MARKET COMMITTEE MEETINGS
Parts 5D and 5E ask about the costs and benefits of: (1) requiring
quarterly Federal Reserve System reports to Congress and (2) the.
presence of observers at Open Market Committee Meetings.
Complete written record should be made at least as often as the
desired level or rate of change of the target-variable is altered. These
should be collected and sent to Congress quarterly. The rationale for
desired changes in the target-variable would include alterations in
leading indicators as they predict independent variations in the goalvariables and new forecasts of the impact of non-monetary-policy
forces on the goal-variable. The risks of this procedure to the Federal
Reserve would be minimal if the issues regarding target-variable selection were given their due consideration. (See (2), sections (c) and (d)
P- 2 7 4 -)
As part of the coordination program a fairly extensive and enriching
dialogue between monetary and fiscal agents and advisors would include extra-agency observers at Federal Reserve as well as Treasury
and CE A meetings.
(7)
ALTERING T H E STRUCTURE OF THE FEDERAL RESERVE SYSTEM
Part I I concerns numerous proposals for altering the structure of
the Federal Reserve System.
21-570—68
19
282
I interpret these provisions of H.E. 11 as helping to assure that the
goals of macroeconomic policy, popularly mandated to the President,,
are more directly effectuated by monetary policy. This is premised on
the principle that the Federal Eeserve System should not be a money
supply trustee and the public should ultimately have jurisdiction over
monetary conditions. This principle can be effectuated in part by relieving the monetary authority of its short-run money market orientation. (See (2), sections (c) and (d) p. 274.) The most formidable constraint on this process should be the necessity of having the Federal
Eeserve System remain a fairly viable source of economic opinion.
Therefore I generally favor all provisions of this part of H.E. 11
except for having the Federal Eeserve seek congressional appropriation. This feature could inhibit the effective cultivation of the relatively
independent economic opinion necessary for an effective program.
Congressional or executive whim might temporarily vitiate the research-critical capacility of the CEA and the Treasury but could not
immediately effect the Federal Eeserve System as long as it were
fiscally independent. Other features of the bill might permit central
government to reduce the valuable critical independence of the System
but surely not as quickly as the fiscal provision. My support of the1
provisions, other than the appropriations feature, is based on the belief
that Central Government will not long remain in a scientific dark age.
(8)
RECENT MONETARY POLICY
Part I I I seeks an opinion on recent monetary policy. My opinions
on monetary policy since 1964 shall be confined to a few remarks.
In December 1965 the Federal Eeserve System now appears to have
acted too late in raising the discount rate and launching tighter money.
However, I recall the dominant opinion at the time among many
economists (especially in government) was that the System's action
was premature; this historical instance argues for preserving the independence of the Federal Eeserve's critical opinion within a coordinated
policy program and suggests caution in reform of the Federal Eeserve
System's structure. (See (7) p. 281.)
Through December 1966 the reduced growth in the narrow money
supply was appropriate, grounded as it was on forecasts of the effects
of non-monetary-policy forces; namely, defense spending, upon the
economy.
The swing to buoyant growth in the money supply in 1967 was only
roughly suitable given indicators of the expected decline of economic
activity and the increased demand for liquidity. However, after mid1967 money supply growth was excessive, primarily because of inaccurate forecasts of defense spending and inaccurate assessment of the
prospects for passage of the tax increase during that time. Again this
instance testifies to the desirability of a coordinated program. (See
(1) p. 273.)
In retrospect the earlier 1968 increases in the money supply growth
seem to have been anticipating the promised economic slowdown of
late 1968 and early 1969.
283
S T A T E M E N T OF D O N A L D D. H E S T E R , U N I V E R S I T Y
OF
WISCONSIN
H.E. 11 is a dangerous bill for, while it commendably introduces
some long overdue reforms, it simultaneously endangers the existence
of one of our most successful and effective public agencies.
Specifically, the bill is desirable in striking out the myth that the
Eeserve System is somehow owned and hence controlled by the banking
community. The fiction of Federal Reserve bank stock is worth discarding. It is also on sound footing when it urges closer coordination
between the executive branch of the Government and Federal Eeserve
policy. Toward this end it is probably a valuable contribution to make
the term of the Chairman of the Board coterminous with that of the
President.
However, it is not necessary for the President to have additional
powers or controls over the Board for he and the Congress can always
largely offset Federal Eeserve policy through Treasury actions. If a
really intransigent Board failed to cooperate with the executive branch,
appropriate legislation could then be drawn up in time to avert any
serious disruption in the economy.
Eeducing the number of and/or term of Federal Eeserve Board
members, auditing the accounts of, and/or authorizing congressional
appropriations for the Federal Eeserve System seem to be unnecessary
and to be capable of annihilating this efficient and effective agency.
In my judgment the recent performance of the Federal Eeserve System
compares favorably to other Federal financial agencies both in its dayto-day supervision of private sector firms and its longer run planning
of our financial system. It has made mistakes, of course, but its continuing research programs and its flexibility in coping with new situations have proven to be admirable safeguards. Both its long-term
research and its flexibility are likely to be seriously compromised if
H.E. 11 is enacted.
The financial structure of the American economy is complex; only
long experience and study of our System can guide effective policy
formation. The present 14-year terms of Board members is an appropriate span because it insures both a mature understanding of the
System and continuity in System research programs.
Flexibility of policy and research programs are likely to suffer if
the Board must seek congressional approval for its research budget.
Other agencies which must receive congressional approval of expenditures, such as the SEC or the FHLBB, have suffered from inadequate
staff and research funds; their effectiveness has been corresponding^
curtailed. New services, such as nationwide computerization of check
clearing, are sure to suffer from budget cuts just when the American
banking system is about to become overburdened with paperwork.
If evidence of corruption or gross inefficiency at the Federal Eeserve
were available, then congressional appropriation of System funds
might be desirable. However, I knowT of no such evidence. Along the
same lines, a regular audit of Federal Eeserve System accounts seems
an unnecessary and expensive control procedure at this time. It obviously could allow confidential System plans and bank examination
data to be leaked to the public in a damaging and costly fashion. More
importantly it might endanger the integrity of the Federal Eeserve
System. Congressmen, acting in behalf of lobbies, could exact substan-
284
tial concessions from the System in return for generous appropriation
votes.
The founders of the Federal Reserve System wisely recognized that
money is power and that politics is the game of acquiring power. They
were equally wise in insulating the prime supervisory agency from
congressional supervision of budgets, from rapid turnover in Board
membership, and from executive branch auditing of accounts. Until
clear evidence of weakness in this arrangement is available, I urge
rejection of H.R. 11.
The list of questions concerning monetary guidelines flows from a
philosophical approach to policy implementation which I oppose. In
responding to these questions I shall attempt to suggest both my preferences for policy formation and the deficiencies of the "guideline,"
"indicator", or "target-variable" approach.
Questions 1-1, 1-2.—Policy, monetary, fiscal, or debt management,
should not be constrained by a program drawn up on January 1; all
three policies should be coordinated so as to reach the goals of the
President and, of course, those stated in the Employment Act of 1946.
A principal advantage of both monetary and debt management policy
is that the lag between a decision to act and the debt or monetary action
is arbitrarily short. As the recent surtax experience amply testifies,
such immediate implementation is not always possible for fiscal policy.
It would be very unwise to impair our most flexible instruments by
tying them to a program. It also serves no good purpose to tip off
speculators about the direction in which interest rates are likely to
move.
This is not to say, however, that these policies should be applied
independently of present and prospective fiscal policies. The Economic
Report of the President is a valuable document in its own right; it
does not need to be supplemented by statements about the likely direction of monetary policies. The President should continue to be responsible for producing the report.
Question IS.—A target-variable, rather tautologically, is something
one aims at. If many variables are "targets," as I believe should be the
case, then many guns or "instruments" will be needed. I see no j ustification for shooting at the money supply or some interest rate; they
are simply instruments. What matters are targets involving the level
of employment, the rate of change of consumer prices, the rate of
growth of GNP, the balance of payments, the distribution of income
and wealth, and the equality of opportunity. The relations between
these targets and the instruments of monetary policy are complex and
can be represented only in the form of a rather detailed analytic model.
A well-structured model is likely to suggest explicitly the relation
between various policy instruments and the goals which, say, the
Council of Economic Advisers may wish to achieve. The model will
also suggest whether certain goals are within our reach. It will not
yield exact prescriptions because most equations are not exact relationships. It nonetheless can be a very useful aid in developing policy and
in setting values for different instrument variables.
Existing econometric models are imperfect in various ways and are
being improved as time passes. Each model specifies a link between
various policy instruments and targets. This linkage varies from model
to model because different model builders have different ways of repre-
285
senting the economy. It also differs because models have been estimated
from different time periods. The legal environment, preferences, and
technology of our great economy change as time passes; there is no
reason to expect stationary relationships. Unfortunately, different
estimation techniques are also a source for different linkages.
I am not able to write down a multiequation model which is completely adequate for conducting the economic affairs of the Federal
Government. Indeed, I do not think such models are likely to appear
during the next decades. I do think that various interest rates, tax
rates, Government expenditureflows,money supply measures, and legal
restrictions such as usury laws, reserve requirements, interest rate
ceilings, and minimum wages are important instruments. Because the
economy constantly changes, I would always hope that policy implementors would use such models with a good bit of discretion and with
a sense for how the system is changing.
But, a few things are clear. First, if the economy cannot be adequately described with many equations, it certainly cannot be adequately described with few.
Second, it is sometimes argued that because some variables are historically correlated, they may be expected to continue to be so in
future years. Moreover, such a relationship is thought to be a valuable
policy guide. Almost all sensible aggregative econometric models exhibit high correlations. High correlations are no substitute for clear
thinking and they are a weak basis for policy formation.
Third, except in very fortuitous circumstances if policy instruments
are intended to hit a number of goals (targets), it will be necessary to
have a number of instruments simultaneously applied at specific
levels. When goals change, many of the instruments will have to change
as well if policy is to succeed.
Finally, to concede that our knowledge about the relation between
policy instruments and goals (targets) is imperfect and sometimes
misleading does not mean that models are evils. We should not opt
for simplistic, ignorant policy rules simply because we lack omniscence.
I believe that it is sheer insanity to look for some touchstone or
crude univariate rule of thumb to keep our economy in order. The
economy is complicated and our Government is capable of dealing
with it more responsibly. Mathematical models applied with discretion are the promising path.
Question
—I am very uncertain about the importance of debt
policy. Most recent empirical studies have uncovered little evidence
of a relation between interest rates and change in the maturity structure of the Federal debt. Nevertheless, intuitively I believe that
lengthening the debt maturity will tend to discourage real investment.
The failure of this result to appear in empirical studies probably reflects our ignorance about the very complex simultaneous structure
of asset markets. Debt management, in my unsubstantiated view, can
be valuable in determining the level of employment and in fostering
intermediate-term economic growth.
Question 1-5-—I have previously commented upon the inadvisability
of adhering strictly to some predrawn policy schedule for the year
ahead. I can see no advantages which the economy might realize by
having Congress regularly informed.
286
Seasonal and other transient factors should enter directly into the
large models discussed above. If the solutions to those models suggest
that defensive policies are desirable, then of course they should be
pursued. There is no reason to consider such factors independently;
reaching the goals in the President's economic program is the sole
objective.
I should stress that a defensive smoothing of seasonal fluctuations
is not necessarily a desirable activity of the Federal Reserve System.
In its absence, private sector firms would make allowance for the
existence of such fluctuations when managing their cash positions.
However, it is probably true that economies of scale exist in such
smoothing operations and that the economy as a whole is best served
by having the Federal Reserve offset transient money fluctuations.
I think it would be a serious mistake to restrict monetary policy to
a single vehicle, open-market operations. As suggested above there
are considerable advantages in having a number of policy instruments
available in order to reach the many objectives to which the country
and its leadership aspire. Variations in reserve requirements, margin
requirements, discount rates, and so forth, are all potentially useful. I
do not think that monetary policy can be efficiently implemented solely
by open-market operations, although they are a very effective vehicle.
Changes in other instruments such as discount rates affect many
variables which are importantly related to our economic objectives.
In the absence of the aforementioned aggregative economic model, it
is irresponsible for me to guess the intensity with which each targetvariable is affected by changes in instruments. Orders of magnitude
can be inferred from some recently published econometric model simulation studies. Below I suggest that recent interest rate regulations may
have worked rather severe hardships on the housing industry, but
these regulations were not initially imposed by the Federal Reserve
System.
I have previously argued that confidentiality is essential in implementing monetary policy. Chance disclosures can result in immense
profits. In addition, applying monetary policy is not an exact science.
It is easy to imagine that individuals interested in discrediting monetary policy could irresponsibly publicize minor technical flaws. These
critics might in turn cause monetary authorities to act with less speed
than was in the national interest.
I am not sympathetic to regular reports to Congress and I have no
suggestions for what should be included in such reports. Similarly,
I think that it is unnecessary for Congress, the Treasury, or the CEA
to have observers at Open Market Committee meetings. Those organizations have ample channels to transmit information to the committee
under the present arrangement.
Question II.—At the beginning of this statement I indicated my
opinion of H.R. 11. Items 2, 4, and 5 are potentially dangerous and
will not help the President implement policy. As suggested above, these
proposals are likely to compromise both the effectiveness and quality
of our monetary system. A more appealing reform proposal would be
for the Congress to reduce the current number of Federal agencies
regulating financial markets and to put the survivors under an agency
modeled after the Federal Reserve System. I have the general impression that these other agencies' policies are less coordinated with
current fiscal policy than are actions of the Federal Reserve. It might
also be a good idea to increase the control which the Board of Gover-
287
nors has over the 12 individual Federal Eeserve banks although this
is a relatively minor reform.
Question III.—The following summary of recent financial developments is an abridged version of a paper to be published elsewhere. It
does not purport to be a complete evaluation of recent policy, but only
an incomplete exposition of how monetary policy may have operated.
The evaluation has two main messages. First, interest rates and interest
rate restrictions are powerful instruments in allocating investment
funds writhin the economy. Monetary policy works and is potent.
Second, the disruptive allocative effects described below would have
been unnecessary if the administration and Congress had followed
the advice of most professional economists and promptly raised taxes
in 1966 or 1967. It is no fault of the Federal Eeserve System that our
Government irresponsibly failed to allow for the costs of our Vietnam
war involvement. Open market operations in 1966 doubtlessly considerably retarded inflationary pressures which are now so ominous.
If the Federal Eeserve had not acted, price increases and associated
hardships would be far more troublesome today. Precisely this flexibility in policy formation must not be sacrificed with the passage of
H.E. 11.
Table 1 reports recent quarterly financial acquistions by the household sector as measured in the flow-of-funds accounts.1 In addition it
reports how individuals distributed their disposable income between
consumption and saving in the national income accounts. All flows
are seasonally adjusted and reported at annual rates. The household
sector is the largest sector reported in the flow-of-funds accounts.
TABLE 1—RECENT AGGREGATIVE QUARTERLY STATISTICS, 1963-68
[In billions of dollars]
( N E T ) financial acquisitions by households ( S A )
1963—1st quarter
2d quarter
3d quarter
4th quarter
1964—1st quarter
2d quarter
3d quarter
4th quarter
1965—1st quarter
2d quarter
3d quarter
4th quarter
1966—1st quarter
2d quarter
3d quarter
4th quarter
1967—1st quarter
2d quarter
3d quarter
4th q u a r t e r . . . .
1968—1st quarter
Disposable
personal
income
(SA)
Personal
saving
(SA)
369.7
400.7
406.9
414.1
423.9
435.8
443.1
449.6
456.0
464.0
479.4
489.3
497.5
503.3
512.4
522.0
532.7
540.0
548.2
557.9
571.5
19.3
19.2
18.8
22. 5
22.0
27.7
25.6
29.5
24.5
24.0
30.9
29.3
26.6
28.7
29.2
34.6
38.8
36.0
38.5
41.6
38.0
Demand
deposits
and
currency
Commercial bank
savings
accounts
Savings
institution
savings
accounts
Life
insurance
reserves
Pension
fund
reserves
2.2
4.1
13.7
6.5
.9
5.9
11.7
-2.2
1.4
.5
8.1
13.6
14.2
7.3
14.5
8.3
8.5
11.2
13.5
9.8
15.8
13.8
11.6
14.3
13.0
8.5
18.0
17.9
18.7
8.5
15.8
17.1
15.2
13.3
12.3
13.2
12.5
9.8
4.9
5.3
9.3
16.9
20.6
18.0
10.7
4.4
4.2
4.2
4.6
4.8
4.9
4.8
4.7
4.7
4.6
4.6
5.3
3.9
4.6
5.3
11.7
10.8
12.0
10.4
11.6
11.2
11.7
13.0
11.5
13.5
15.1
12.4
14.7
14.9
15.2
Credit
market
instruments
7.6
1.8
.9
-2.9
11.7
3.7
-1.0
13.7
15.4
11.1
2.0
-12.9
-18.0
-1.1
16.8
Sources: ( a ) Survey of Current Business, June 1968; ( b ) Business Statistics, the 1967 biennial supplement to the
Survey of Current Business; and ( c ) Federal Reserve Bulletin, October 1966 and May 1968.
1 Households Include persons as members of households and personal trusts and nonprofit
organizations serving individuals such a foundations, private schools and hospitals, labor
unions, churches, and charitable organizations. About 10 percent of household sector
assets are believed to be controlled by personal trusts and nonprofit organizations. (Flowof-funds accounts 1945-67, p. I. 33.)
288
First, note the marked increase in the saving rate by individuals.
Roughly speaking the average propensity to save was 5 percent in 1963,
6 percent m 1964-66, and 7 percent since then. Classical economists
would have expected this pattern because interest rates were rising
quite steadily until September 1966 and then reached a new high region beginning in late 1967.2 These saving data are consistent with an
hypothesis which argues that monetary policy is effectively transmitted throughfluctuationsin bond interest rates.
The remaining columns in the table show net acquisitions of financial assets by households. Quarterly acquisition flows into life insurance and pension fund reserves have been quite stable through time.
Contractual agreements for these assets prevent wide quarter-toquarter fluctuations. Net acquisitions of demand deposits and currency
by households fluctuate greatly. These data do not appear particularly
illuminating when attempting to describe recent events.
Net acquisitions of commercial bank savings account deposits by
households also do not appear useful for describing recent events. A
slight slowdown in deposit growth occurred in 1966 and a strong recovery began in the first quarter of 1967, but this pattern only weakly
mirrored events at savings institutions.
The remaining two series, savings institution deposits and credit
market instruments, appear to have been very interactive. In the first
three quarters of 1966, households greatly reduced their acquisitions of
savings deposits and simultaneously shifted heavily into various credit
market instruments. During the first two quarters of 1967, they disposed of many of these securities and rapidly reacquired savings institution deposits. During the last quarter of 1967 the process again seems
to be reversing itself. In table 2 it can be seen that among credit instruments, most of the swing involved debt instruments of the U.S.
Government.
TABLE 2.—DETAILS OF RECENT SWINGS I N CREDIT MARKET INSTRUMENTS
[Financial acquisitions by households, seasonally adjusted]
U.S.
Government
securities
1965—4th quarter
1966—1st quarter
2d quarter
3d quarter
4th quarter
1967—1st quarter
2d quarter
3d quarter
4th quarter
1.7
8.7
11.0
7.0
4.9
-8.6
-9.9
15.1
State and
local
obligations
3.0
2.7
-3.1
4.4
4.8
-.5
-2.4
1.9
1.1
Corporate
and foreign
bonds
-2.1
3.5
3.4
.8
-2.8
-.7
.9
3.6
2.6
Corporate
stock
-3.4
1.2
4.3
-1.6
-5.3
-2.6
-4.8
-6.2
-2.1
Mortgages
-.3
-2.3
-.2
.6
.5
-.5
-1.7
-.4
.2
Source: Federal Reserve Bulletin, May 1968.
It appears that households were responding very sensitively to the
levels of Government security interest rates. During the latter part of
1965, 1966, and 1967, interest rates paid on deposits at savings and loan
associations were relatively stationary when compared to bond market
interest rates. Households bought U.S. Government securities heavily
during the two periods of high interest rates, 1966 and late 1967 ;
they sold them during the first half of 1967 when interest rates were
lower. It is very difficult to escape the conclusion that Government
2 A brief rise In the saving rate in 1964 above 1965-66 levels can reasonably be attributed to the tax cut of 1964.
289
securities and savings institution deposits are close substitutes. Openmarket operations are likely to be especially effective in diminishing
flows through savings institutions when interest rates on savings deposits fall behind rates of return on Government securities as they did
during this period.
The savings and loan industry is an extremely complex financial
intermediary w^hich is regulated by the Federal Home Loan Bank
Board. About two-thirds of savings institution assets are in savings
and loan associations. For brevity, attention will be confined to this
indusrty. Approximately 85 percent of the industry's assets are in first
mortgage loans; savings and loan associations are the largest suppliers
of 1-4 family conventional mortgages in the American economy by a
wide margin. Except for New England and the Mid-Atlantic States,
savings and loan associations dominate local mortgage markets across
the country. The industry grew rapidly until the end of 1963 and
then more slowly until 1966 when growth nearly ceased for a year.
The slowdown in growth after 1963 partly reflected a profit squeeze
which the industry experienced because of rising interest (or dividend)
rates paid on deposits (or shares) and falling new mortgage loan
interest rates.
In March 1965 the Bank Board became alarmed that rising deposit
interest rates might seriously endanger the stability of the industry
Thus:
* * * there is clear evidence that for some time escalation of dividends has
accelerated the flow of savings to institutions or markets where performance did
not fully justify further injections of mortgage money * * *. The Board found
that institutions were raising dividend rates under conditions which did not
appear to require more aggressive competition for funds * * * the Board determined that it would be unwise to extend advances to members increasing
dividend rates until it had an opportunity to evaluate the effect of * * * [recent
increases in dividend rates by some associations]. (Federal Home Loan Bank
Board. Annual Report, 1965, p. 51.)
These advances restrictions were modified several times in the subsequent months.
During the month of June [1966], it became increasingly evident that the
policy of restraining dividend increases by restricting access to Board credit
was losing effectiveness * * *. In late 1966, the Board terminated all restrictions
under this program. (Annual Report, 1966, p. 47.)
In their place on September 21, 1966, Congress empowered the Federal Home Loan Bank Board, after consulting with the Board of Governors of the Federal Reserve System and the Board of Directors of
the Federal Deposit Insurance Corporation, to put ceilings on rates
paid on deposits; these powers continue to the present day.
As one might have expected, deposit growth weakened very significantly in response to interest rate restrictions beginning in mid1965. This weakness continued until late 1966 when declines in bond
rates occurred. During the first 6 months of 1968 the experience of
1966 appears to be recurring. Thus, during these months the net deposit inflow was $2 billion in 1966, $6 billion in 1967, and $3.6 billion
in 1968.3 The principal difference between 1966 and 1968 is that interest rates of commercial banks and mutual savings banks were more
effectively controlled in the latter year.
3 Sources are recent releases from the Data Management Division of the Federal Home
Loan Bank Board.
290
The effect of these interest rate restrictions on mortgage flows appears to have been dramatic. Until mid-1964, mortgage acquisitions
were steadily! rising, if allowance is made for seasonal variations.
Acquisitions leveled off in 1965 and then collapsed in 1966 and early
1967. They partially recovered in 1967, but in recent months again seem
to be falling. Mortgage acquisitions by insured savings and loan associations in 1967 were below those in 1962; 1968 is likely to be no better.
Given the growth in the American population and the rising price of
houses, it is apparent that the number of mortgage transactions executed per capita has fallen considerably in recent years. Eising mortgage interest rates have sharply curbed demand for new mortgage
loans.
The above picture is broadly consistent with the following interpretation although it is certainly not unique in that respect. Because the
average maturity of their assets, essentially mortgage loans, is longer
than the effective average maturity of their deposit liabilities, rises in
interest rates will temporarily depress the net worth of savings and
loan associations. In order to protect liquidity and, in the case of stock
associations, the rate of return on invested capital, associations may
initiate further rises in deposit interest rates to attract new funds. The
Federal Home Loan Bank Board, in its role of protecting the solvency
and stability of the industry, becomes alarmed at declining net worth
and with rises in foreclosures and reacquired real estate which naturally
occur with mortgage loan growth. It therefore curbs further deposit
interest rate increases. By this action it makes deposit flows into associations very sensitive to changes in other interest rates in the money
market. In effect, the Bank Board has greatly increased potential
short-term interest rate fluctuations in mortgage markets by stabilizingfluctuationsin deposit interest rates.
Table 3 reports seasonally adjusted quarterly investment series
from the National Income Accounts. The series suggest that monetary
policy discriminated heavily against investment in residential structures and that this burden was concentrated in late 1966 and early
1967. Accompanying this investment slump was a very pronounced
acceleration of Federal defense spending associated with the Vietnam
war buildup. Government spending tends to grow steadily in the
United States, but a rapid acceleration of this magnitude must be offset elsewhere in a full-employment system if price stability is to be
maintained. A relatively compelling interpretation of table 3 is that
the housing industry bore much of the burden of the defense buildup.
This need not have been the case if fiscal policy and especially tax
increases had been introduced at an earlier date. Monetary policy
did a big job as well as could be hoped for. Hopefully the lesson from
this experience wil not go unheeded if further spending increases
become necessary.
Deflationary monetary policy works by inducing the private sector
to reduce its spending and increase its saving. This may be achieved by
driving up interest rates which discourages investment and increases
the reward for saving. In recent years households have saved more
and invested less in new residential construction. Monetary policy
has worked to offset inflationary pressure.
291
TABLE 3.—QUARTERLY INVESTMENT FLOWS, 1963-68 ( S A )
Nonresidential
structures
1963—1st quarter
2d quarter
3d quarter
4th quarter
1964—1st quarter
2d quarter
3d quarter
4th quarter
1965—1st quarter
2d quarter
3d quarter
4th quarter
1966—1st quarter
2d quarter
3d quarter
4th q u a r t e r . . . .
1967—1st quarter..
2d quarter
3d quarter
4th quarter
1968—1st quarter
18.8
19.7
19.4
19.9
20.4
21.1
21.4
21.8
23.1
24.7
25.1
27.3
28.3
27.5
28.2
27.7
27.7
26.3
26.6
26.7
28.5
Producers'
durable
equipment
Nonfarm residential structures
33.2
33.8
35.5
36.8
37.9
39.0
41.0
41.6
44.1
44.6
46.8
48.3
50.0
51.2
53.1
55.1
54.2
55.2
56.2
57.3
58.7
Change in
business
inventories
25.5
26.2
26.5
27.4
27.1
26.6
26.5
26.3
26.6
26.5
26.4
26.2
26.5
25.3
23.2
20.4
20.9
22.5
25.0
27.0
27.6
Federal
defense
expenditures
4.7
4.8
6.0
8.1
4.8
6.1
4.8
7.7
10.6
8.8
9.4
9.9
9.9
14.0
11.4
18.5
7.1
.5
3.8
9.2
2.7
51.2
50.5
51.0
50.3
50.5
50.7
49.8
48.9
48.4
49.2
50.3
52.4
55.1
58.4
63.0
65.6
70.2
72.5
73.3
74.2
76.7
Sources: ( a ) Survey of Current Business, June 1968. ( b ) Business Statistics, the 1967 biennial supplement to the
Survey of Current Business.
STATEMENT
OF W A L T E R E. H O A D L E Y ,
BANK
OF
AMERICA
I appreciate the opportunity to comment to your committee on the
general question of the coordination of monetary and fiscal policy and
onH.R.ll.
Certainly most economists would agree that both monetary and fiscal
policy have a major role in the achievement of the goals of "maximum
employment, production, and purchasing power" as set out in the Employment Act of 1946. Moreover, monetary and fiscal policy have a
crucial role in helping to alleviate the whole range of new problems
caused by the substantial achievement of full employment itself. Maintaining full employment, once achieved, probably poses one of the most
serious economic problems facing the Nation over the period ahead.
In the past 3 fiscal years, increases in Federal revenues have fallen
far short of increases in Federal expenditures and the result has been
clearly inflationary fiscal policy. Monetary policy actions have tended
to be very restrictive in an attempt to offset the inflationary impact
of fiscal policy.
^ Although we can all agree as to the desirability of increased cordination of monetary and fiscal policy, care must be exercised that they are
not tied together in such a way that inflationary fiscal policy is reinforced by inflationary monetary policy. Under present institutional arrangements, monetary policy is much more flexible than fiscal policy
in practice. Thus, when evidence becomes available that economic
projections or projected Federal receipts or expenditures are in error,
monetary policy can be more quickly adapted to the changed circumstances.
In this context, I fear that there would be little net gain and very
possibly a net loss to the economy by setting out a program coordinating
fiscal, debt management, and monetary policies at the beginning of each
year. This does not imply that monetary and fiscal policies are independent and mutually exclusive, but only that the Federal Reserve
292
should maintain a degree of flexibility to adapt monetary policy to
changing conditions.
While I firmly believe that forecasting is an indispensable and inevitable element in all decisionmaking, I am concerned that specific
public forecasts of monetary policy would become self-defeating. This
is likely because of the vagaries of international monetary and political
developments as well as unpredictable domestic events not to mention
the present well-advanced degree of sophistication in United States
and worldwidefinancialmarkets.
As recent experience amply demonstrates, we need to improve our
ability to forecast economic activity and find wrays to increase the flexibility of fiscal policy and the timeliness of its application. The tools
of monetary policy must be improved if we are to avoid the selective impact of monetary restraint on certain sectors of our economy, especially
residential construction. However, at this time, I know of no single
economic indicator which could serve as an exclusive guide to the
monetary authorities.
Debt-management policy could be used as more of an adjunct to
monetary and fiscal policy if the 4% percent ceiling on Treasury bonds
were removed. At present, inflationary fiscal policy is reinforced by
debt management policy as the deficit must be financed with shortterm, highly liquid securities. Removal of the interest rate ceiling
would allow a more orderly and effective debt management policy.
The modification in the discount window operation recently proposed
by the Federal Reserve would largely eliminate "defensive" open market operations. Instead normal market operations could then be used
to implement monetary policy. Regulation Q should not be used as a
tool of monetary policy.
The Federal Reserve now reports in great detail annually to the
Congress on past actions. In addition, reports are made available on
open market committee meetings after a reasonable delay. As suggested,
it would be difficult and presumably unwise for the Federal Reserve
to report on prospective actions because of the present margin of
error in worldwide economic forecasts and the need for a flexible
monetary policy response to changing economic conditions. I see little
benefits to additional reports nor in the presence of Members of the
Congress, the Treasury, or the CEA at Open Market Committee
meetings.
I'm still not convinced that the suggested changes in the structure
of the Federal Reserve System as provided in H.R. 11 would be an improvement; there is real value, however, in reviewing the structure
periodically to insure that it keeps abreast of national needs and
changing money market and institutional conditions. In any event,
the members of the Federal Reserve Board need to be as free as possible from short-term partisan political considerations.
The period since 1964 has been a period in which fiscal policy was
overly stimulative and contributed to inflationary pressures. The attempts of the Federal Reserve to control inflation without precipitating a recession have generated many stresses and strains in the financial
markets and depressed residential construction activity. And, although
I may not have always agreed completely with the actions taken by
the Federal Reserve Board, I think the Federal Reserve System performed rather well during this difficult period.
293
In closing, let me make it clear that I strongly support the use of
the tools of fiscal and monetary policy and debt management to
achieve the goals of full employment and rapid economic growth within the context of price stability. Any action which the Congress
could take to make these tools more effective in achieving these goals
would certainly be welcome. However, on the whole, I believe that
H.R. 11 would be counterproductive in this regard and t
@FedFRASER