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FEDERAL RESERVE-TREASURY DRAW AUTHORITY
HEARINGS
BEFORE THE
SUBCOMMITTEE ON
DOMESTIC MONETAEY POLICY
OF THE
COMMITTEE ON
BANKING, FINANCE AND URBAN AFFAIRS
HOUSE OF REPRESENTATIVES
NINETY-FIFTH CONGKESS
SECOND SESSION
J U N E 27 AND 28, 1978
P r i n t e d for the use of the
Committee on Banking, Finance and Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
31-045 O
WASHINGTON : 1978
HOUSE COMMITTEE ON BANKING, FINANCE A N D URBAN A F F A I R S
H E N R Y S. REUSS, Wisconsin, Chairman
J. WILLIAM STANTON, Ohio
G A R R Y BROWN, Michigan
CHALMERS P . WYLIE, Ohio
JOHN J. ROUSSELOT, California
STEWART B . McKINNEY, Connecticut
G E O R G E HANSEN, Idaho
H E N R Y J. H Y D E , Illinois
R I C H A R D K E L L Y , Florida
CHARLES E. GRASSLEY, Iowa
MILLICENT FENWICK, New Jersey
JIM LEACH, Iowa
NEWTON I. STEERS, JR., Maryland
THOMAS B. EVANS, JR., Delaware
B R U C E F . CAPUTO, New York
H A R O L D C. HOLLENBECK, New Jersey
S. WILLIAM G R E E N , New York
THOMAS L. ASHLEY, Ohio
WILLIAM S. MOORHEAD, Pennsylvania
F E R N A N D J. ST GERMAIN, Rhode Island
H E N R Y B. GONZALEZ, Texas
JOSEPH G. MINISH, New Jersey
F R A N K ANNUNZIO, Illinois
JAMES M. HANLEY, New York
P A R R E N J. MITCHELL, Maryland
WALTER E. F A U N T R O Y ,
District of Columbia
S T E P H E N L. NEAL. North Carolina
J E R R Y M. P A T T E R S O N , California
JAMES J. BLANCHARD, Michigan
CARROLL H U B B A R D , JR., Kentucky
JOHN J. L A F A L C E , New York
GLADYS NOON SPELLMAN, Maryland
LES AuCOIN, Oregon
PAUL E. TSONGAS, Massachusetts
B U T L E R D E R R I C K , South Carolina
MARK W. H A N N A F O R D , California
DAVID W. EVANS, Indiana
NORMAN E. D'AMOURS, New Hampshire
STANLEY N. L U N D I N E , New York
EDWARD W. PATTISON, New York
JOHN J. CAVANAUGH, Nebraska
MARY ROSE OAKAR, Ohio
JIM MATT OX, Texas
B R U C E F. VENTO, Minnesota
DOUG B A R N A R D , Georgia
WES WATKINS, Oklahoma
R O B E R T GARCIA, New York
PAUL NELSON, Clerk and Staff Director
MICHAEL P . FLAHERTY, Counsel
GRASTY CREWS I I , Counsel
MERCER L. JACKSON, Minority Staff Director
GRAHAM T. NORTHUP, Deputy Minority Staff Director
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
P A R R E N J. MITCHELL, Maryland, Chairman
G E O R G E HANSEN, Idaho
HAROLD C. HOLLENBECK, New Jersey
B R U C E F. CAPUTO, New York
S T E P H E N L. NEAL, North Carolina
NORMAN E. D'AMOURS, New Hampshire
D O U G B A R N A R D , Georgia
WES WATKINS, Oklahoma
B U T L E R D E R R I C K , South Carolina
MARK W. H A N N A F O R D , California
(n)
CONTENTS
Hearings held on—
June 27, 1978
June 28, 1978
^»w
1
29
STATEMENTS
Altman, Hon. Roger C , Assistant Secretary for Domestic Finance, Department of the Treasury; accompanied by Philip H. Fitzpatrick,
Assistant Fiscal Assistant Secretary (Financing)
Atlee, John S., president, Institute for Economic Analysis
Kudlow, Lawrence A., vice president and money market analyst, Paine,
Webber, Jackson, Curtis, Inc
Partee, Hon. J. Charles, member, Board of Governors, Federal Reserve
System
Poole, William, professor of economics, Brown University
10
48
80
2
30
ADDITIONAL INFORMATION SUBMITTED FOR THE RECORD
Altman, Hon. Roger C :
Letter, dated July 24, 1978, in response to Chairman Mitchell's request for information
Prepared statement
Atlee, John S., prepared statement
Hansen, Hon. George V.:
Letter dated July 10, 1978, to William Poole, professor of economics,
Brown University, containing questions to which Professor Poole
should respond
Opening remarks
Kudlow, Lawrence A,, prepared statement
Partee, Hon. J. Charles:
Letter, dated July 13, 1978, in response to Chairman Mitchell's request for information
Prepared statement
Poole, William:
Letter, dated July 20, 1978, responding to written questions submitted by Congressman George V. Hansen
Prepared statement
(in)
27
12
53
97
2
84
26
5
98
34
FEDERAL RESERVE-TREASURY DRAW AUTHORITY
TUESDAY, JUNE 27, 1978
H O U S E OF KEPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY OF THE
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
Washington, D.C.
The subcommittee met at 8:35 a.m. in room 2220 of the Rayburn
House Office Building, Hon. Parren J. Mitchell (chairman of the
subcommittee) presiding.
Present: Representatives Mitchell, Barnard, and Hansen.
Chairman M I T C H E L L . The hearing will now come to order. We
try to start our hearings early, while everyone is rested and full of
vigor and, as you know, it is almost impossible to have a meeting at
10 o'clock with all the other committees meeting simultaneously.
I just want to take a moment to thank my colleague to my right,
who has made every one of these early morning meetings, and I am
most appreciative. I would have been rather lonely had you not shown
up as often as you have, Mr. Barnard. Thank you.
This morning, the Subcommittee on Domestic Monetary Policy
begins oversight hearings on the Federal Reserve-Treasury draw
authority. These hearings were agreed upon during subcommittee consideration and House deliberations of House Joint Kesolution 816,
which would extend this authority to April 30, 1979. Under the
Federal Reserve-Treasury draw authority, the Federal Reserve System
is permitted to buy directly from the Treasury up to $5 billion of
public debt securities. The decision whether to use the authority
resides in the Federal Reserve.
The authority has been used on 44 occasions, most recently for a
period of 4 days in the amount of $2.5 billion. Treasury argues that the
authority provides a "backstop" for its cash and debt operations, in
that it assures that the Treasury will be able to raise cash almost instantaneously in emergencies. However, questions have been raised
both about the need for the authority and its implementation. I t was
agreed that the subcommittee would hold thorough oversight hearings
on these questions.
In addition, the authority of the Federal Reserve to buy securities
directly from the Treasury calls attention to the broader question of
the impact of Treasury's financing need on Federal Reserve monetary
policy. We are going to look into this question as well.
Today we are going to hear from Assistant Secretary of the Treasury
Roger C. Altman and Federal Reserve Governor J. Charles Partee.
We have asked them to address the need for and implementation of the
draw authority.
(l)
2
Let me ask if my colleagues have any opening remarks to make?
Mr. BARNARD. Thank you, Mr. Chairman. I have no opening remarks.
Mr. HANSEN. Yes, and I am submitting some for the record.
[The opening remarks of Mr. Hansen follow:]
OPENING REMARKS OF THE HONORABLE GEORGE V. HANSEN
Mr. Chairman, the most important and useful result we could have from this
hearing is a proposal for alternatives to the so-called Treasury draw authority.
This authority is a leftover from the days of explicit Fed support for Treasury
financing, when monetary policy was clearly subordinated to the Treasury's
aim of cheap deficit financing. I hope we are all agreed that monetary policy should
not be thus subordinated, and that we can do without the mechanisms through
which the Treasury called the shots for Federal Reserve open market operations.
In recent years, the authority has been justified by appeals to the savings that
could be effected by having lower Treasury operating balances. As you may
remember from the dissenting views which were filed to H.J. Res. 816, Mr. Chairman, we took a careful look at those balances when the authority was in effect
and when it had lapsed, and found that there was no evidence that the Treasury
in fact carried lower balances when it had this backstop authority. We should face
up to the fact that the reasons for this draw authority are very tenuous.
And on the other side of the books, the authority does afford scope for abuse.
When the temporary debt ceiling expired last fall, this authority was used to stock
up on cash to tide the Treasury over. I am not partucularly pleased with that
action, especially since the use of the authority, instead of recourse to the open
market, will never permit us to know for sure that the authority was actually
used on September 30 instead of October 1. It allows room for cutting some corners,
and I don't believe that temptation should be presented to public officials.
Most importantly, the draw authority is part of the Fed's banking function,
that is, it arises in consequence of the Federal Reserve acting as banker to the
United States Treasury, at the same time that the Fed is the national monetary
authority. Mr. Chairman, we have been subjected over the years to endless troubles rooted in deficit financing which has been rendered altogether too easy by
accommodative monetary policy. I am not blaming the Fed in this regard so much
as I am pointing out the impossible demands put on it. We have asked the Fed to
be a good government banker and minimize debt costs at the same time that we
charge it with responsibility for keeping too much money from getting into circulation. Neither the Fed nor any other institution or set of people can ride both
those horses successfully. If we are going to defeat inflation, we will have to give
the Fed one job and the Treasury another; the Fed should control the money
supply and the Treasury should see to it that debt costs don't get out of line.
Every link between monetary policy and consideration of federal debt management should be severed. This is the most important reason why we should do
without the draw authority and substitute for it, if some sort of overdraft protection is needed, a mechanism which does not touch the Fed as national monetary
authority.
With those points in mind, Mr. Chairman, I am glad to welcome our witnesses
today. I hope they will give us the benefit of their thinking on possible alternatives
to the draw authority. Thank you.
Chairman MITCHELL. We expect to focus on the relationship oi
monetary policy to Treasury's financing needs tomorrow morning. Of
course, Governor Partee and Secretary Altman may also want to give
us the benefit of their expertise on this matter.
We will proceed with the testimony and start with you, Governor
Partee.
STATEMENT OF HON. J. CHARLES PARTEE, MEMBER, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM
Governor PARTEE. Thank you, Mr. Chairman
I appreciate the opportunity to present the views of the Board of
Governors of the Federal Reserve System on the direct borrowing
3
authority of the U.S. Treasury. As the committee is aware, this authority permits the Federal Reserve to purchase obligations of the
United States directly from the Treasury in amounts up to $5 billion.
The purpose of the direct borrowing authority is to aid the Treasury
in the management of its cash and debt positions. The authority provides assurance that the Treasury can meet its obligations without
delay in the event of temporary need. This supplemental source of
funding can be of particular value if there are large unforeseen drains
on the Treasury's cash position—as when the timing of Federal receipts and expenditures is more erratic than expected—or in the event
of a national emergency.
Since the establishment by Congress of the direct borrowing authority in 1942, it has been needed on 44 occasions—and only once
since 1975. I n every instance, the volume of funds borrowed was well
under the maximum permitted by law, and was outstanding only a
short time. In most cases, the amount borrowed was below $1 billion,
and in the great majority, the indebtedness was terminated in less than
10 days. The largest single borrowing amounted to $2% billion; and
the longest duration was 28 days. Thus, the record indicates that the
Treasury has utilized this borrowing authority infrequently, in limited
amounts, and for very brief periods.
The principal need for the authority, historically, has arisen on
the occasion of sharp declines in the Treasury's cash balance just prior
to quarterly tax payment dates. Instead of going to the financial
markets for funds that would be needed only temporarily, the Treasury
borrowed directly from the Federal Reserve and repaid this indebtedness immediately upon receipt of the tax revenues. I n recent years,
however, the frequency of direct borrowing for this purpose has been
reduced significantly with the introduction of short-dated cashmanagement bills.
The direct purchase authority has always been exercised at the
initiative of tne Treasury. Due to the close operational relationship
between the Federal Reserve and the Treasury, a direct borrowing
transaction can be accomplished quickly, even on the day it is requested. Thus, temporary accommodation of the Treasury can be
achieved when needed without delay.
The terms and conditions of direct Federal Reserve purchases of
Treasury obligations are established by the Federal Open Market
Committee. At present, the interest rate paid by the Treasury on such
obligations is one-quarter of 1 percent below the discount rate at the
Federal Reserve Bank of New York. In addition, the Federal Reserve
is fully aware of its responsibility to insure that the authority for direct
purchases is used prudently. Thus, the FOMC's authorization for
direct purchases has consistently limited the System's holdings to
amounts well below the statutory maximum. At present, that limit is
$2 billion. A request for greater accommodation would be subject to
review by the F O M C before it is honored.
There are other safeguards and limitations on the Treasury's
direct borrowing authority, beyond the FOMC's monitoring of this
activity. All direct borrowing is reported promptly in the Treasury's
daily financial statement and in the weekly statements of condition of
the Federal Reserve banks, all of which are available to the public. Use
of the authority is also reported by the Federal Reserve in its annual
report to the Congress. Also, direct borrowing is subject to the Federal
debt ceiling imposed by the Congress.
4
I n recent years, the Treasury's need to offset cash drains just before
tax payment dates has been met principally by means of cashmanagement bills. These debt instruments can be issued with maturities of very short duration and are sold in the market in relatively
large amounts on short notice. And since the cash drains experienced
in recent years generally have been within the ranges expected, the
Treasury has had less need to fall back on its direct borrowing authority before tax payment dates.
Nonetheless, other circumstances may require the Treasury to
resort to direct borrowing to meet its debt-management and cash
disbursal obligations in an orderly and timely manner. Such an episode occurred last fall when the Treasury borrowed $2% billion
directly from the Federal Reserve to bolster its cash position in contemplation of the expiration of the temporary ceiling on the public
debt. I t should be emphasized that this borrowing was not undertaken to circumvent restrictions imposed by the Congress on Treasury
indebtedness, but was an interim measure to assure timely discharge
of the Treasury's obligations until the Congress took action on a new
temporary debt ceiling.
In conclusion, the Board believes that the direct purchase authority
has been effective in enabling the Treasury to meet unexpectedly
large cash drains and to achieve its debt-management objectives. The
assurance that the Treasury would have the option of obtaining
immediate—though limited—funds outside the financial markets in
times of unanticipated and temporary need is a desirable safeguard.
I t is analogous to the ability of member banks to turn to the Federal
Reserve as a temporary source of funds through the discount window,
or to the arrangement for funding temporary credit needs that the
Congress has mandated for various Federal agencies with the Treasury,
For these reasons the Board continues to support strongly the extension of the direct purchase authority.
[Governor Partee's prepared statement follows:]
Statement by
J. Charles Partee
Member, Board of Governors of the Federal Reserve System
before the
Subcommittee on Domestic Monetary Policy
of the
Committee on Banking, Finance and Urban Affairs
House of Representatives
June 27, 1978
6
I appreciate the opportunity to present the views of the Board
of Governors of the Federal Reserve System on the direct borrowing
authority of the U.S. Treasury.
As the Committee is aware, this authority
permits the Federal Reserve to purchase obligations of the United States
directly from the Treasury in amounts up to $5 billion.
The purpose of the direct borrowing authority is to aid the
Treasury in the management of its cash and debt positions.
The authority
provides assurance that the Treasury can meet its obligations without
delay in the event of temporary need.
This supplemental source of
funding can be of particular value if there are large unforeseen
drains on the Treasury's cash position—as when the timing of Federal
receipts and expenditures is more erratic than expected--or in the event
of a national emergency.
Since the establishment by Congress of the direct borrowing
authority in 1942, it has been needed on 44 occasions--and only once
since 1975.
In every instance, the volume of funds borrowed was well
under the maximum permitted by law, and was outstanding only a short
time.
In most cases, the amount borrowed was below $1 billion, and
in the great majority, the indebtedness was terminated in less than
10 days. The largest single borrowing amounted to $2-1/2 billion;
and the longest duration was 28 days. Thus, the record indicates that the
Treasury has utilized this borrowing authority infrequently, in
limited amounts, and for very brief periods.
The principal need for the authority, historically, has arisen
on the occasion of sharp declines in the Treasury's cash balance just
7
prior to quarterly tax payment dates.
Instead of going to the financial
markets for funds that would be needed only temporarily, the Treasury
borrowed directly from the Federal Reserve and repaid this indebtedness
immediately upon receipt of the tax revenues.
In recent years, however,
the frequency of direct borrowing for this purpose has been reduced
significantly with the introduction of short-dated cash-management bills.
The direct purchase authority has always been exercised at
the initiative of the Treasury.
Due to the close operational relation-
ship between the Federal Reserve and the Treasury, a direct borrowing
transaction can be accomplished quickly, even on the day it is requested.
Thus, temporary accommodation of the Treasury can be achieved when needed
without delay.
The terms and conditions of direct Federal Reserve purchases
of Treasury obligations are established by the Federal Open Market
Committee.
At present, the interest rate paid by the Treasury on such
obligations is one-quarter of 1 per cent below the discount rate at the
Federal Reserve Bank of New York.
In addition, the Federal Reserve is
fully aware of its responsibility to ensure that the authority for direct
purchases is used prudently.
Thus, the FOMC's authorization for direct
purchases has consistently limited the System's holdings to amounts
well below the statutory maximum.
$2 billion.
At present, that limit is
A request for greater accommodation would be subject to
review by the FOMC before it is honored.
There are other safeguards and limitations on the Treasury's
direct borrowing authority, beyond the FOMC's monitoring of this
8
activity. All direct borrowing is reported promptly in the Treasury's
daily financial statement and in the weekly statements of condition of the
Federal Reserve Banks, all of which are available to the public.
Use of
the authority is also reported by the Federal Reserve in its Annual Report
to the Congress. Also, direct borrowing is subject to the Federal debt
ceiling imposed by the Congress.
In recent years, the Treasury's need to offset cash drains just
before tax payment dates has been met principally by means of cashmanagement bills. These debt instruments can be issued with maturities
of very short duration and are sold in the market in relatively large
amounts on short notice. And since the cash drains experienced in recent
years generally have been within the ranges expected, the Treasury has
had less need to fall back on its direct borrowing authority before tax
payment dates.
Nonetheless, other circumstances may require the Treasury to
resort to direct borrowing to meet its debt-management and cash disbursal
obligations in an orderly and timely manner.
Such an episode occurred
last fall when the Treasury borrowed $2-1/2 billion directly from the
Federal Reserve to bolster its cash position in contemplation of the
expiration of the temporary ceiling on the public debt.
It should be
emphasized that this borrowing was not undertaken to circumvent restrictions
imposed by the Congress on Treasury indebtedness, but was an interim
measure to assure timely discharge of the Treasury's obligations until
the Congress took action on a new temporary debt ceiling.
In conclusion, the Board believes that the direct purchase
authority has been effective in enabling the Treasury to meet unexpectedly
9
large cash drains and to achieve its debt-management objectives.
The
assurance that the Treasury would have the option of obtaining immediate-though limited—funds outside the financial markets in times of unanticipated
and temporary need is a desirable safeguard.
It is analogous to the ability
of member banks to turn to the Federal Reserve as a temporary source of
funds through the discount window, or to the arrangement for funding
temporary credit needs that the Congress has mandated for various Federal
agencies with the Treasury.
For these reasons the Board continues to
support strongly the extension of the direct purchase authority.
###################
10
Chairman MITCHELL. Thank you very much, Governor. I know we
have several questions. Unless you are pressed for time, I would like
Secretary Altman to present his testimony now and then direct
questions to both of you.
Secretary Altman, we are available to you.
STATEMENT OF HON. ROGER C. ALTMAN, ASSISTANT SECRETARY
FOR DOMESTIC FINANCE, DEPARTMENT OF THE TREASURY,
ACCOMPANIED BY PHILIP H. FITZPATRICK, ASSISTANT FISCAL
ASSISTANT SECRETARY (FINANCING)
Secretary ALTMAN. Thank you, Mr. Chairman,
With your permission, I would like my statement submitted in full
for the record, and I would just summarize it briefly here.
I appreciate the opportunity to assist in your oversight of the Fed's
authority to purchase directly from the Treasury up to $5 billion of
mblie debt obligations. The purpose of this authority is simply to
acilitate the efficient management of the public debt.
As you know, it was first granted in its present form in 1942, and it
has been renewed for temporary periods on a series of occasions.
It has lapsed on five occasions in recent years, and those are detailed
in my statement.
As Governor Partee said, borrowings from the Federal Reserve
System under this authority have been for very short periods. The
average length being from 2 to 7 days. Only twice in the past 35 years
has the Treasury had to draw funds in this manner for periods exceeding 13 consecutive days—and I have included a table which lists the
instances of actual use.
Borrowings under the authority are subject to the public debt limit,
and they are reported in the daily Treasury statement, the weekly
Federal Reserve statement, and in the Federal Reserve Board's
annual report to the Congress.
Mr. Chairman, the existence of this direct purchase authority
rovides us with a margin of safety which permits us to let our cash
alance fall to otherwise unacceptably low levels in advance of
seasonally heavy revenues.
This, in turn, results in balances that are not as high as they otherwise would be during the periods of high revenues which follow. In
turn, this permits the public debt to be kept to a minimum, and the
Government's interests costs to be minimized.
In addition, an advantage of this direct purchase authority is to
hedge against the possibility that unforeseen swings in our cash flows
could suddenly deplete our cash balance and require sudden
borrowing.
The purchase authority is available, of course, to provide an immediate source of funds for temporary financing in the event of a national
emergency on a broader scale. Fortunately, that has never happened,
but it is conceivable, of course, that financial markets could be disrupted just at a time when large amounts of cash had to be raised to
maintain governmental functions and to meet the emergency.
Consequently, the direct purchase authority has, for many years,
been a key element in the Treasury's financial planning for a national
emergency.
f
E
11
Let me emphasize that the direct purchase authority is viewed by
the Treasury only as a temporary accommodation to be used under
unusual circumstances. We fully agree that our debt obligations should
be floated in the market, and that purchases of Treasury securities by
the Federal Reserve System should normally be made through that
same public market.
We also agree fully that this authority should not be considered a
means by which the Treasury may independently influence credit
conditions by usurping the authority of the Federal Reserve to engage
in open-market operations in Government securities.
In that connection, it is important to emphasize, as Governor
Partee did, that any recourse by the Treasury to Federal Reserve
credit under this authority is subject to the full discretion and control
of the Federal Reserve itself.
This concludes my prepared remarks, Mr. Chairman, and of course
I will be happy to answer any questions that you have.
[Secretary Altman's prepared statement follows:]
12
STATEMENT BY THE HONORABLE ROGER C. ALTMAN
ASSISTANT SECRETARY FOR DOMESTIC FINANCE
BEFORE THE
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE
HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
Mr. Chairman and Members of the Committee:
I welcome this opportunity to assist in your oversight
of the authority of Federal Reserve Banks to purchase directly
from the Treasury up to $5 billion of public debt obligations.
As you know, the most recent extension of this authority
expired on April 30, 1978. On April 19, 1978 this Subcommittee
favorably reported House Joint Resolution 816, to extend
this authority to April 30, 1979. The Resolution was adopted
by the House of Representatives on May 1, but the Senate
has not yet acted.
The purpose of the direct-purchase authority is to
facilitate the efficient management of the public debt.
It was first granted in its present form in 1942, and it
has been renewed for temporary periods on a number of
occasions. The authority has lapsed, however, on five
occasions in recent years -- from July 1 until August 14, 1973;
from November 1, 1973 until October 28, 1974; from November 1
to November 12, 1975; from October 1 until November 7, 1977
and the current period.
Borrowings from the Federal Reserve System under this
authority have been for very short periods, the average
length being from 2 to 7 days. Only twice in the past 35
years has the Treasury had to draw funds in this manner
13
for periods exceeding 13 consecutive days. I have appended
a table which lists the instances of actual use. Borrowings
under the authority are subject to the public debt limit,
and its use is reported in the Daily Treasury Statement,
the weekly Federal Reserve Statement, and in the Federal
Reserve Board's Annual Report to the Congress.
The existence of the direct purchase authority
provides us with a margin of safety which permits us to
let our cash balance fall to otherwise unacceptably low
levels preceding periods of seasonally heavy revenues.
This, in turn, results in balances that are not as high
as they otherwise would be during the periods of high
revenues that follow, allowing the public debt to be kept
to a minimum and thus reducing interest costs to the
Government. Moreover, there is always the possibility
that unforeseen swings in our cash flows may suddenly
deplete our cash balance and require a sudden borrowing.
The direct-purchase authority is available to provide
an immediate source of funds for temporary financing in
the event of a national emergency on a broader scale.
While this has never happened, it is conceivable that
financial markets could be disrupted at a time when large
amounts of cash had to be raised to maintain governmental
functions and meet the emergency. Consequently, the directpurchase authority has for many years been a key element in
the Treasury's financial planning for a national emergency.
I want to emphasize that the direct-purchase authority
is viewed by the Treasury as a temporary accommodation to
be used only under unusual circumstances. The Treasury
fully agrees with the general principle that our debt obligations
should be floated in the market and that purchases of Treasury
obligations by the central bank should normally be made through
that same public market. The Treasury agrees also that
the direct-purchase authority should not be considered a
means by which the Treasury may independently attempt to
influence credit conditions by usurping the authority of
the Federal Reserve to engage in open market operations
in Government securities. In that connection, it is important
to emphasize that any direct recourse by the Treasury
to Federal Reserve credit under this authority is subject
to the discretion and control of the Federal Reserve
itself.
This concludes my prepared statement, Mr. Chairman.
I will be happy to respond to any questions.
Attachment
31-045 O - 78 - 2
14
DIRECT BORROWING FROM FEDERAL RESERVE BANKS
1942 TO DATE"
Calendar
Year
Days
Used
Maximum Amount
At Any Time
(Millions)
1942
1943
1944
1945
1946
1947
1948
1949
19
48
$ 422
1,302
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
4
4
Maximum Number
Of Days Used At
Any One Time
6
28
none
9
484
none
none
none
2
220
2
4
30
29
15
180
320
811
,172
424
1
2
9
20
13
none
none
none
2
207
none
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
none
none
none
none
none
none
1970
1971
1972
1973
1974
1975
1976
1977
none
Note:
Number of
Separate Times
Used
3
7
8
21
169
153
596
1,102
9
1
10
1
16
610
38
485
131
1,042
none
4
2,500
3
3
6
12
Federal Reserve direct purchase authority expired
on April 30, 1978,
Office of the Assistant Secretary
(Domestic Finance)
June 23, 1978
15
Chairman M I T C H E L L . Thank you very much. Both of your statements will be submitted in their entirety for the record.
Congressman B arnard ?
Mr. BARNARD. Thank you, Mr. Chairman.
I recall, in the last hearings we had on this subject on the temporary
extension of the direct borrowing authority, one of the main criticisms
was the question as to whether or not this did exceed the debt limit
prescribed by Congress.
And Governor, I noticed in your statement you said that direct
borrowing is subject to the Federal debt ceilings imposed by the
Congress. And so, therefore, it—at no time would cause the amount
to exceed the ceiling?
Governor P A R T E E . T h a t is my understanding.
Secretary ALTMAN. T h a t is correct; it is subject to the debt limit,
as are all other Treasury securities.
Mr. BARNARD. I have what may be an obvious question. Last fall
we took advantage of this program of authorized borrowing, $2%
billion for 4 days according to your table. Was the length of time the
reason you did not go into the open market to satisfy this need?
Secretary ALTMAN. Essentially, Mr. Barnard, that September use
of the authority represents a good example of why we think we need
it. B y borrowing from the Federal Reserve, we were able to wait until
the very last minute and see precisely what amount of debt capacity
remained under the public debt limit between the amount of debt
then outstanding and the $700 billion ceiling, and borrow precisely
that amount—namely %2){ billion, on the shortest possible notice—
which would then put us in the best possible position to go through
the subsequent period during which the debt ceiling had reverted to
$400 billion. And yet, we were in a position where we had to do our
best to be sure that interest and principal payments on the Government's debt were maintained.
So in other words, the short-notice aspect of the borrowing authority from the Federal Reserve was the principal advantage to us, then.
Governor P A R T E E . YOU could not be sure of when Congress would
act, either. I t might have been 3 days, or 5 days, or 7, or 9 days. An
so this provided the credit for just whatever length of time it was
needed.
Mr. BARNARD. For the record, are you familiar with the figures at
that particular time? The debt ceiling was what?
Secretary ALTMAN. $700 billion.
Mr. BARNARD. And there was a request for $780 billion I believe,
wasn't it?
Secretary ALTMAN. That is approximately correct.
Mr. BARNARD. Then we settled back down to the figure of $750
billion.
Secretary ALTMAN. That is right, $752 billion.
Mr. BARNARD. SO you were waiting for the determination of Congress on the $750 billion before you then issued other debt instruments?
Secretary ALTMAN. Well, of course it wasn't just a question of
waiting to see exactly what number the Congress gave us; it was more
a problem of not being able to undertake new borrowings during that
>eriod between October 1, or September 30 when the temporary debt
imit expired, and between passage of a new resolution extending it.
f
16
So it was more a question of our not having authority to borrow during
that period between the expiration of the temporary debt limit and
passage of a new law extending it, rather than exactly what number it
was.
And as you all know, it is the obligation of the Secretary of the
Treasury to do everything he can to be sure that there is not a default
on Government obligations. So he took steps, in the 24 hours preceding
October 1, to maximize our cash balance and thus permit us to go
through the maximum number of days during which we would have no
borrowing authority, but during which we obviously had to make
payments on existing debt.
Mr. BARNARD. YOU have no borrowing authority, but you borrowed
from the Federal Reserve?
Secretary ALTMAN. We borrowed from the Federal Reserve during
the last 24 hours before the expiration of the temporary debt ceiling.
We borrowed up to the maximum $700 billion which pertained through
September 30. But on October 1, that temporary debt ceiling expired—
the permanent debt ceiling of $400 billion governed. And so we borrowed in those last few remaining hours to give us a maximum cash
balance.
Mr. BARNARD. I know this is a technicality, but I am wondering
why you were not in violation at that particular time when it expired
and you were borrowing from the Fed.
I mean, it did expire? Right?
Secretary ALTMAN. I t expired on September 30.
Mr. BARNARD. And it was then $400 billion. So far a period of time,
then, the borrowings did exceed the $400 billion?
Secretary ALTMAN. The debt outstanding exceeded, yes.
Mr. BARNARD. What happens in a situation like that?
Secretary ALTMAN. YOU can't issue new debt.
Mr. BARNARD. Well, let me ask Governor Partee a question. Has
there ever been a situation when the Treasury requested the authority to borrow directly from the Federal Reserve, and the Fed
denied that request?
Governor P A R T E E . Not to my knowledge, no.
Mr. BARNARD. Mr. Chairman, I have no further auestions at this
time. I would like to reserve the right to ask some more, later.
Chairman M I T C H E L L . Certainly.
There is a mood in the House of Representatives that says: Get rid
of congressional committees that don't serve any real function; get rid
of all of the old things that have just been hanging around for a long
period of time and are used infrequently. This is one of the contexts in
which we want to review this draw authority. There is certainly a group
of Members of the House of Representatives who feel very strongly
t h a t it is not just not needed. We have used it on 44 occasions. I t has
lapsed on several occasions. The economic world did not collapse. I
believe the thinking behind some of the Members who oppose continuing this draw authority is that if there is good cash management
practices, you really don't need the draw authority. And I would
further assume that some of those Members who oppose it would say:
Well, it might be needed in cases of a national emergency such as you
alluded to, and if that is true why not just rework the language so
that the draw authority would only apply to cases of true national
emergency? Could I get your reaction to that—in the context t h a t
the authority has only been used 44 times and has lapsed 5 times?
17
Secretary ALTMAN. Mr. Chairman, you are in a much better position than I am to judge the mood of the Congress, but it seems to me
that another facet of that mood is to at least reduce the rate of growth
in Government spending.
Certainly there is an antispending movement afoot in the country.
And the basic advantage of this direct purchase authority, beyond the
national emergency considerations, is it enables us to carry lower cash
balances, and thus borrow less, and thus cost the taxpayers less in
interest than if we didn't have it.
So I would think it would be inconsistent with the mood of the
Congress not to give us this authority and require us to carry somewhat
higher cash balances and pay more interest on the public debt as a
result.
Chairman M I T C H E L L . That is interesting, because I was going into
that area, next.
In your testimony, you indicated that the draw authority enables the
Treasury to maintain lower cash balances than otherwise you would
be allowed to do. One of our colleagues, Congressman Rousselot from
California, discussed this during the House debate on M a y 1. He
pointed out that, during the period November 1, 1973, to October 31,
1974, when the authority lapsed, average daily balances were lower
than during the following 12-month period. How do you account for
that kind of a discrepancy? I assume he is accurate.
Secretary; ALTMAN. Well, I think he was referring to average
balances with the Federal Reserve banks—the Treasury's average
balance with the Federal Reserve banks. And the reason that those
balances were higher, or have increased since 1974, Mr. Chairman,
really has nothing to do with this direct purchase authority.
Essentially, Treasury reported to the Congress in mid-1974 that our
basic system of maintaining tax and loan account balances at commercial banks around the country was costing the Government more
money than the value of the services which those banks were rendering. And as a result, in the fall of 1974, the Treasury took steps to
reduce its tax and loan account balances at banks around the country,
and correspondingly increase them at the Federal Reserve banks.
The reason we did that was: The Treasury earns money on its
balances at the Fed, because those are invested. And of course the
profits of the Federal Reserve System are paid into the Treasury.
So we took steps to increase our balances at the Fed by pulling
them down at commercial banks as a way of earning more money on
those balances. And that is the reason why those balances have risen.
Now I think you know that legislation permitting the Treasury to
actually earn explicit interest on tax and loan account balances was
passed by the Congress last October, and will be implemented as
soon as Treasury receives an appropriation to provide for fees which
will pay for banking services.
And when the tax and loan accounts begin to generate earnings for
the Treasury, we will then go back to the practice of leaving the bulk
of our operating funds in tax and loan accounts at commercial banks.
So the reason that the balances are higher at the Fed banks has
nothing to do with the direct purchase authority.
Chairman MITCHELL. Let me try to continue to play the devil's
advocate role here in terms of limiting this authority only to the
emergency situations. If we would limit it just to a true national
18
emergency, I would assume that the $5 billion would be a totally
inadequate amount of money. Would that be your assumption in the
face of a true national emergency? I t depends on how I define "true,"
I suppose?
Secretary ALTMAN. I would really like to think about that, Mr.
Chairman, and answer you for the record. I am not an expert on the
Treasury's emergency preparedness procedures.
And while our present plans are built around the $5 billion figure, I
am not prepared to say this morning that that is wholly inadequate,
because I would like to have a chance to review the other aspects of
those plans.
Mr. BARNARD. Mr. Chairman, would you yield?
Chairman M I T C H E L L . Surely.
Mr. BARNARD. In regards to that, I notice from 1971 through
1975 seemed to be the period when there was the most frequent use
of this authority. I t is obvious that that had no relationship to the
Vietnam war.
Secretary ALTMAN. Not to my knowledge.
Governor P A R T E E . I think t h a t reflected the style of the debt managers t h a t the Treasury had at the time. They were doing their
utmost to minimize cash balances because of this problem of not
receiving interest on balances that were out with commercial banks,
and therefore they tended to run closer to the margin. And at times,
when the receipts weren't quite what they were expected to be, there
were sudden needs as well. B u t it was more a matter of style than
the war.
Chairman M I T C H E L L . The Emergency Bank Eegulation Act affords
the Treasury the power to freeze bank accounts. Now, wouldn't
that make the draw authority absolutely unnecessary or superfluous,
if we had a broad national emergency such as you indicated in your
testimony? You already have the power to put a freeze on.
Secretary ALTMAN. Really, again, I am not an expert in emergency
preparedness, Mr. Chairman, but I would think that the freeze
authority is an inadequate substitute for our ability to draw directly
from the Federal Reserve.
There are so many unforeseeable aspects to a true national emergency, which we usually define as a nuclear attack, that the ability
to borrow from the Federal Reserve where we have this intimate
working relationship and where procedures for lending to us on an
hour's notice are in place, I think that that is necessary and it is not
an authority that is adequately offset by just our ability to freeze
bank accounts around the country.
If we had a true holocaust in this country, I don't think it is clear
that we could get our hands on moneys that are maintained in banks in
various parts of the country in the amount of time we would need,
as compared to the short amount of time we could do so with the Fed.
Governor P A R T E E . I think, Mr. Chairman, the problem is the
definition of national emergency.
I assume that no one in this room would like to put the Government
in the position where it can't pay its bills. And it seems to me that it is
conceivable that one might have a national emergency in a political
sense—in the sense that, for a time, people would not be prepared to
buy Government securities because of some political happening. One
could have it in an economic sense, because, let us say, a very major
19
bank failed in the United States, and people started to take their
money out of banks. If they went into currency, there might not be
much of a market for Government securities at the time all of this
money was flowing out of the banks and into people's hands. Or it
could be a military emergency of either lesser or greater extent, as a
nuclear attack. I think the problem of pinning down just exactly
what constitutes the emergency is the difficulty of limiting the
authority to that kind of a case.
Now, as far as the $5 billion limit is concerned, I think our presumption would be that what we need would be to have authority to
provide some funds to the Treasury only until Congress could get
together, and that might be difficult for Congress to do. And there
would have to be estimates of how long in these various kinds of
emergencies it would take the Congress to act. One might assume
that it could be within a couple of weeks. Within a couple of weeks
Congress could extend the authority or increase the authority. And so
my feeling is the $5 billion today is a lot different than $5 billion was
in 1942. I t is a much, much smaller amount of money, in relative
terms.
But still my feeling is that it is adequate on the presumption that
Congress could act in about 2 weeks' time. That would take care of
Treasury's funding; it would give the Treasury a cash balance for
that period.
Chairman MITCHELL. Well, assuming that Congress could get itself
together that effectively within 2 weeks, it would still seem to me to
be an inadequate amount. We are spending $3 billion a day now,
aren't we?
Governor P A R T E E . Yes; we are really comparing the $5 billion with
the deficit, which is on the order of $50 or $60 billion, because the
revenues would presumably still be coming in from tax collections and
that kind of thing.
So as I say, I think this is enough for awhile.
Chairman MITCHELL. Would you comment, Secretary Altman?
Secretary ALTMAN. Well, I simply wanted to say that I have no real
difference of view with Governor Partee's estimate, but it is very hard
to know, because in a period of very heavy maturities of Government
securities $5 billion might not carry us anything like 2 weeks; in a
period of light maturities, seasonally light maturities, it might be
adequate for more than that. So it is quite hard to know.
Chairman MITCHELL. Well, I am not going to try to pin you down
to a hard answer this morning, but it seems to me in talking about a
true national emergency that that $5 billion is going to be totally
inadequate. Your political and your economic system is at least
temporarily disrupted, and it is my own feeling, and I don't know
how my colleague feels about this, that $5 billion would be a totally
inadequate sum for such a situation.
Earlier I indicated that I assumed there was prudent cash management. I have to assume that. We now have the new tax and loan
procedures, which are about to go into effect. Why would you need
this draw authority from the standpoint of cash management once
those new procedures go into effect?
Secretary ALTMAN. Mr. Chairman, again, without the Federal
Reserve direct purchase authority, we run slightly higher balances at
20
our seasonal low points than we otherwise would do, because we don't
have the ultimate flexibility represented by our ability to borrow from
the Federal Reserve on what amounts to 2 hours' notice.
And that flexibility, that type of ultimate flexibility is not provided
by the tax and loan account system. Our ability to earn interest on
those balances is a major improvement from the standpoint of Federal
cash management.
But what we are talking about here is short-term borrowing abilities,
which is different from overall cash management.
And it simply will be the case that we will run slightly higher
balances, to be sure that we are not suddenly caught short if we don't
have this direct purchase authority, than if the Congress extends it.
Chairman M I T C H E L L . I S this true despite the fact that you draw
interest on your balances?
Secretary ALTMAN. Yes; it is, because even though we draw interest
on those balances—let me step back—the only major difference
between our approach to our tax and loan account system, now that we
have authority to earn interest as compared to when we didn't, is
the fact that we will earn interest and that therefore that system will
be more profitable, if you want to use that word, to the Government.
B u t that will not change our ability to obtain funds on very short
notice. The same amounts of money will be in the tax and loan account
system as were there before. I t is just that we will be able to earn
interest on it, whereas before they were idle, essentially.
B u t our ability to get money on short notice is not going to be
changed.
Mr. BARNARD. Would the chairman yield?
Chairman M I T C H E L L . I would.
Mr. BARNARD. Secretary Altman, wouldn't you say that actually
what the Treasury is doing, which is common practice for business
big or small, is maximizing their cash balance? Instead of putting aside
large cash balances, which are earning no interest, you are reducing
your cash balances down to the very minimum needs required.
As a result you are maximizing the use of these cash balances.
Mr. ALTMAN. That's right.
Mr. BARNARD. And then it is like business, Mr. Chairman, that
would do the same thing but on a certain day they would have an
excessive need of cash, which they would run down to the bank and
borrow for a few days and then pay it back.
Experience shows that this does maximize and permit you to utilize
small balances. I am surprised that the Treasury has not used this
more often.
I t seems to me that if you had the rate of interest t h a t the Fed
charges you, that you would save even more money as far as the taxpayers are concerned. But, of course, the Fed may increase your
interest rates a little bit on what they charge you.
M a y I have one further question on your time, Mr. Chairman?
Chairman M I T C H E L L . Certainly.
Mr. BARNARD. Governor Partee, we talked about this minutes'
notice. Now, that bothers me a little bit. Is it just a telephone call
and you say, great,, let us go?
What procedure does the Fed go through with on this?
Governor P A R T E E . Well, if the Treasury's direct borrowing is
within the authorization limit, which is currently $2 billion, there
21
would be a discussion simply between the Manager of the System's
Open Market Account and the Treasury representatives.
Mr. BARNARD. D O you talk about the maturity at all?
Governor P A R T E E . That generally would not be an issue, because
the loan would probably be for just 2 or 3 days. If the Treasury
requested a larger amount—say they want to go above the $2 to $3
billion, $4 billion, even to $5 billion—that would be large enough so
that the maturity might be of some concern.
And when borrowing requested exceeds the authorization, telephone
conference call or a wire (telegraph) notification to Federal Open
Market Committee members and a vote by the committee as to
whether thi should be approved or not is required. For direct borrowing over the $2 billion authorization, that would take half a day*
perhaps, to get done. But under $2 billion can be managed, I would
say, in a matter of minutes. As a matter of fact, with a discussion
between Treasury and the F O M C Account Manager in New York,
Alan Holmes, and probably a call to the Chairman of the Board, the
transaction would be completed very quickly.
I would agree with you, Mr. Barnard. Since the Treasury keeps its
checking account with the Federal Reserve, the place that it is going
to run out of money, if it has cut it too fine, is at the Federal Reserve,
because its checks are going to be in excess of those balances. So that
is where you need to put the money when it is required. I t is very
similar to an overdraft capacity or a backup line of credit arrangement
that a commercial bank would have for its customers.
Mr. BARNARD. I t still means though that when they make this
draw you have not exhausted all your balances with the banks and
savings and loans across the country?
Secretary ALTMAN. N O .
Mr. BARNARD. YOU still have your balances there, but on paper
you are down to zero balances. You are not talking about a zero
balance situation, are you?
Secretary ALTMAN. Why don't I let Mr. Fitzpatrick answer that
question.
Mr. FITZPATRICK. Typically we draw the balances down as close to
zero as we can in the case of the large banks, what we call the C
category banks, which would be the Bank of America, Citibank,
and so forth. We could draw them down to exactly zero.
In the case of the medium size banks of which there are about 2,000
we could typically get at them to a zero balance also if we have sufficient notice or sufficient perception of the need. In the case of about
10,000 small banks, it is more difficult, so the practice has been, since
I have been involved with it, to reach for all the large and intermediate bank balances and to the extent possible to get to the small banks.
Mr. BARNARD. WTell, I think what you have done is understandable. I t is the only practical way you can do it.
Mr. FITZPATRICK. Well, in the case of the small banks, we have a
difficult time getting in touch with them. With the C banks it is a
matter of a telephone call or a wire, but with the small banks, you
have to depend upon the post office.
Mr. BARNARD. Thank you, Mr. Chairman.
Chairman MITCHELL. Mr. Hansen.
Mr. H A N S E N . Thank you, Mr. Chairman.
22
I apologize for missing your statements, gentlemen, but I am familiar with them. I have a statement, Mr. Chairman, that have been prepared somewhat in concert with the anticipated statements which I
would like inserted, perhaps after your own remarks, at the opening,
if it would be your desire.
Chairman MITCHELL. Without objection they will be at the opening
of the hearing.
Mr. HANSEN. I have a few questions I would like to propound. One
is perhaps basically philosophical. If we are going to defeat inflation,
I think we are going to have to be sure that the Fed and Treasury
are somewhat separate, that the Fed controls the money supply and
the Treasury, of course, needs to stay in line.
Do you agree with this type of analogy?
Governor PARTEE. Yes; I have testified to that fact.
Mr. HANSEN. Then perhaps this is the most important reason why
we should do without the draw authority and substitute for it some
sort of overdraft protection, some sort of a mechanism which does not
touch the Fed as a national monetary authority.
I would like your reaction to that.
Governor PARTEE. Well, Mr. Hansen, I consider the direct borrow,
ing authority to be essentially an overdraft arrangement. You seeit is so limited relative to the total magnitude of funds that flow in the
credit market, or the size of the GNP, or the size of Federal spending,
that it seems to me that even if under duress the Federal Reserve put
out the whole $5 billion—and the FOMC would have to agree to this—
and left it our for a considerable period of time—which would be a
public event, noted in the statements, as we said, cf the Federal
Reserve and the Treasury, and undoubtedly would receive press comment and possibly a special ad hoc hearing of this committee—why
even in that event, it would not significantly affect the situation with
regard to money and credit in the country.
Indeed, what we would typically do, even with a small credit extension to the Treasury, is offset it by other open market operations
so that the effect would be zero on bank reserves. That is to say, as we
were lending the Treasury money, we might well be selling securities
in,to the market and thus absorbing the reserves that we provided by
having loaned the Treasury money.
So I don't think it is a significant kind of an entry into the central
bank finance ministry association that concerns you and would
concern me also.
Mr. HANSEN. Can you tell me why the FOMAC is involved with
something that is basically a banking function?
Governor PARTEE. Because the specific authority is in a section of
the Federal Reserve Act having to do with purchases and sales of
securities. The purchases and sales of securities for the account of the
Federal Reserve banks is a matter handled by the Federal Open
Market Committee. Although I refer to them functionally as overdraft privileges, these transactions technically involve the purchases
of securities directly from the Treasury by the System's Federal
Open Market Account.
Mr. HANSEN. Well, is there any resaon we should not move it out
of there and into the Board of Governors?
, Governor PARTEE. Well, that could be done, Mr. Hansen, but I
don't think there would be any particular advantage.
23
Mr. HANSEN. HOW long has the $2 billion limit been in effect and
what has been the limit at other times?
Governor PARTEE. I am sorry, I don't have a full record on that.
The $2 billion has extended for quite awhile back, and I can't tell you
when it was put on. The subject comes up very, very infrequently in
the Federal Open Market Committee, because the facility is not used
often.
And as I say, it is almost always used within that $2 billion limit,
and therefore it just seldom has come up. The last major entry we
can find in the record of the Federal Open Market Committee was
1957.
Mr. HANSEN. In the September 30 entry, was there any special
meeting at that time when you went to $2% billion.
Governor PARTEE. There was a wire communication from the
Chairman of the Board to the members of the Federal Open Market
Committee indicating what th^ problem was and the recommendation of the Manager of the Open Market Account desk and of the
Chairman of the Board that the limit be raised to $2% billion, and
there had to be affirmative responses by a majority of the Committee
before that could be activated.
Mr. HANSEN. Then you are saying that you essentially followed
the format that you were laying for Mr. Barnard a moment ago.
Could you tell me when you got those responses?
Governor PARTEE. I don't have the record, sir. Since a majority of
the FOMC is the Board of Governors right on the scene in Washington
and since we have prompt attention to such wires by the presidents of
Reserve banks who are members of the Committee, my assumption
is that we would have had all but one or two before the end of the day.
Mr. HANSEN. In last fall's draw, how many persons at the Fed were
involved in arranging this financing? And can you give their names
and positions?
Governor PARTEE. Well, it would require the attention and concurrence of every member of the Federal Open Market Committee,
which would be the seven members of the Board and the five voting
Reserve bank presidents on the Committee at that time.
It also would have involved several people at the desk in New York:
undoubtedly Alan Holmes, the manager for the special open market
account, and probably Peter Sternlight, the deputy. And it would
have involved in Washington several senior staff members: probably
Stephen Axilrod and maybe Peter Keir, and probably one of our
operations people in the division that has to do with Federal Reserve
bank activities. And that is about the list.
Mr. HANSEN. Secretary Altman, could you give me the same
answers as they pertain to the Treasury?
Secretary ALTMAN. Well, among those involved in the Treasury
in this were the Under Secretary for Monetary Affairs, Tony Solomon,
myself, the Special Assistant to the Secretary for Debt Management,
and several senior members of the Treasury debt management staff,
including Mr. Snyder, Mr. Cook, Mr. Cavanaugh, and I think that
would be the list of senior Treasury people.
Mr. HANSEN. Can you gentlemen tell me what alternative overdraft
arrangements you might suggest, instead of the draw authority?
24
Secretary ALTMAN. Mr. Hansen, I would say, frankly, I don't see
any advantage at all to replacing the draw authority with some other
approach. If your intention is to provide us with an overdraft capacity,
as Governor Partee said, this is an overdraft facility. I t is a tiny
amount, $5 billion, in comparison to total Federal outlays, the size of
the money supply and other measures of overall comparison. I might
point out in 1942 when this was first granted, it was granted a t $5
billion. I think the total Federal outlays then were about—well, they
were less than 10 percent of the current level of outlays; the total
money supply was probably also less than 10 percent of its total.
The $5 billion, in other words, in percentage terms shrunk dramatically over the years as any potential influence on monetary
policy, on total credit, or on anything else.
And I just don't think there would be anything served by changing
the form of direct purchase authority, if you agree that we need one,
t h a t we need an overdraft capacity.
Mr. H A N S E N . D O you agree, Governor Partee?
Governor P A R T E E . One of the difficulties that I would have procedurally with an overdraft facility is that it would have to be specified at one of the Federal Reserve banks, presumably the Federal
Reserve Bank of New York.
Technically the direct purchases are made by a joint account for
the 12 Federal Reserve banks. We prefer not to have individual
Reserve banks with individual landing authority, because of the
precedential value that t h a t might have in the possible use of such
acilities for other purposes. We haven't raised this question, but I
would think that probably the Board and the F O M C would take the
position of preferring the current arrangement to a standard overdraft
arrangement of the kind that commercial banks have.
Mr. H A N S E N . Mr. Chairman, I have just one little parting shot. I
would like to ask the gentlemen as a last rejoinder, and maybe Governor Partee would like to be involved in this; if you had an emergency
cash flow problem now t h a t you don't have this authority, what
would you do?
Secretary ALTMAN. Using last September as an example, we would
have been able to borrow somewhat less than $2% billion probably, to
be sure t h a t we did not pierce the debt limit, because we need more
advance notice to borrow in the open market on a cash management
basis than we do with the Fed.
We would have borrowed less than $2% billion from the public, and
if the Congress had not passed a statute extending and expanding the
temporary debt limit, then the amount of days during which we could
have continued to make payments on all the bases the Federal Government has to make payments would have been shorter, and we
would have run out of money sooner.
Theoretically, we would have run out of money sooner.
Governor P A R T E E . A S the holder of the Treasury's checking account,
I would have to say t h a t if it didn't have the money on deposit at the
Reserve banks to clear the checks, we would have to bounce them.
The Treasury checks would be returned for insufficient funds. B u t
t h a t would be a very difficult decision to make.
Chairman M I T C H E L L . AS we work House Joint Resolution 816
through the coming year, it is my intention as of now to put in a bill
to the effect that if the President declares a national emergency, the
f
25
Federal Reserve Board of Governors would have the authority to
waive the $5 billion ceiling. What is your reaction to that? Would
that constitute any monumental problems for you, Secretary Altman?
Secretary ALTMAN. Mr. Chairman, I can't foresee any monumental
objections. I think we would like to check it in relation to the existing
emergency planning procedures.
For example, it is possible that that is already in there. I can't tell
you that it isn't right now.
Chairman M I T C H E L L . I don't think that it is.
Secretary ALTMAN. But, in general, that concept would pose us no
insurmountable problem.
Chairman M I T C H E L L . Governor Partee.
Governor P A R T E E . I can't see any problem with it, but again I
would like to check it. If it is a discrete event—that is, if you have a
definition of national emergency that is declared by the President—
then I think it can be done.
Chairman M I T C H E L L . Would you check and submit to us an
evaluation of that?
[Governor Partee and Secretary Altman subsequently submitted
the following letters for the record:]
26
B O A R D OF G O V E R N O R S
FEDERAL RESERVE SYSTEM
WASHINGTON
J. CHARLES
PARTEE
MEMBER OF THE BOARD
July 13, 1978
The Honorable Parren J. Mitchell
Chairman
Subcommittee on Domestic
Monetary Policy
Committee on Banking, Finance
and Urban Affairs
U. S. House of Representatives
Washington, D. C.
20515
Dear Mr. Chairman"
At your Committee's June 27th hearing on the Treasury's
direct borrowing authority, you asked that I submit for the record
my views on the desirability of an amendment to the Federal Reserve
Act that would provide the Federal Reserve authority to waive the $5
billion limit on direct Treasury borrowing in the event of a national
emergency declared by the President.
I have checked into this matter, and it is my understanding
that under existing emergency preparedness plans, upon the determination
of a state of emergency by the President, suspension of the limit on
direct purchases of U. S. Treasury obligations by the Federal Reserve
is adequately handled.
Since suspension of the $5 billion limit is provided for in
the structure of emergency planning now in place, it would not appear
that standby authority is required, since this would tend to single
out this one aspect of emergency planning for special treatment.
/
27
DEPARTMENT OF THE TREASURY
WASHINGTON, D.C.
20220
ASSISTANT SECRETARY
July 24, 1978
Dear Mr. Chairman:
At the June 27 hearings you asked for my views as to
the need for legislation to provide for waiver of the
$5 billion limit on Federal Reserve direct purchases of
Treasury obligations in the event of a national emergency
declared by the President.
Our current emergency preparedness plans contemplate
a number of amendments to existing law to deal with
certain restrictions, including the $5 billion limit.
After reviewing these plans we have concluded that such
amendments should be considered as a package in the
context of overall emergency planning and that there is
no need for special legislation at this time to waive
the $5 billion direct purchase limitation.
Please let me know if I can be of further assistance.
Sincerely yours,
Roger C. Altman
The Honorable
Parren J. Mitchell
Chairman, Subcommittee on
Domestic Monetary Policy
Committee on Banking, Finance
and Urban Affairs
House of Representatives
Washington, D.C. 20515
28
Mr. BARNARD. Mr. Chairman, I would like to remark on the overdraft thing for just one moment. I t seems to me that this is better than
an overdraft system. This takes an overtaxing of Treasury and an
overtaxing of the Federal Reserve. You could have a preauthorized
overdraft like this.
But, it does seem to me that every time this was needed, it ought
to come to the attention of somebody rather than just be automatic.
Mr. H A N S E N . Will the gentleman yield?
Mr. BARNARD. Yes.
Mr. H A N S E N . Did you
get out of the colloquy a minute ago some
idea that maybe there would be more careful money management practices if they did not have this little slopover possibility?
Mr. BARNARD. N O , I think it ties in.
Mr. H A N S E N . I was interested in Secretary Altman's remarks about
how much more carefully things might be done under the circumstances.
Secretary ALTMAN. Well, if I could comment, Mr. Hansen.
You weren't here earlier when we had a conversation on this. I t is
not at all a question of more careful management. I t is a question, in
fact, or less careful management, because the direct purchase authority permits us to run smaller cash balances and thus borrow less
and cost the taxpayers less in terms of interest. I t saves the taxpayers
money, because we can run a lesser cash balance.
So with it, we are able, in my judgment, to more efficiently manage
the cash and the public debt, not the reverse.
Mr. BARNARD. I want to say I appreciate these gentlemen coming this
morning as you do. The discussion has been very enlightening, and I
think jrou have brought a lot of good information to us as far as this
legislation is concerned. And I want to extend you my welcome.
Chairman M I T C H E L L . I too am grateful that you took the time to
come before us this morning and my two colleagues for joining me.
And with that very, very elegant statement, the meeting is now
adjourned until tomorrow morning, when we will continue our hearings and look at the relationship between monetary policy and the
Treasury's financing needs.
[Whereupon, at 9:30 a.m., the hearing was adjourned, to reconvene
at 8:30 a.m., Wednesday, June 28, 1978.]
FEDERAL RESERVE-TREASURY DRAW AUTHORITY
WEDNESDAY, JUNE 28, 1978
H O U S E OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY,
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS,
Washington, D.C.
The subcommittee met at 8:35 a.m. in room 2220 of the Rayburn
House Office Building, Hon. Parren J. Mitchell (chairman of the
subcommittee) presiding.
Present: Representatives Mitchell, Barnard, and Hansen.
Chairman M I T C H E L L . The hearing will come to order.
If you listened to W T O P this morning, you heard a summary of what
is going on on the Hill today. All committees are meeting simultaneously, and therefore, we are on a rather tight schedule.
This morning the subcommittee will conclude our hearings on the
need for perpetuating the Federal Reserve Treasury draw authority;
the administration and the implementation of the authority; and the
broader related question of how the Treasury's financing needs in
general affect the Federal Reserve's conduct of monetary policy and
its control of our monetary policy.
Our focus today will be on the broader issue to which I referred,
the matter of the Fed's conduct of monetary policy and its control of
the money supply.
Our witnesses this morning are Prof. William Poole, professor of
economics, of Brown University; Lawrence Kudlow, vice president and
money market analyst, of Paine, Webber, Jackson & Curtis, and
John Altee, president, Institute for Economic Analysis.
Gentlemen, first of all, I want to welcome you and thank you for
taking the time out to be with us.
What I would like to do is take the testimony from all of you and
then we will question you simultaneously.
We, of course, have copies of your written statements which will be
submitted for the record. What I would like, if you could try to keep
your oral presentation to 10 or 12 minutes, that would be tremendously helpful in light of the terrible timetable that we have today.
The distinguished ranking minority member, Mr. Hansen, has
joined us. Do you have an opening statement, Mr. Hansen?
Mr. H A N S E N . N O ; I think I will pass, in order to move the hearing
along, Mr. Chairman.
Chairman M I T C H E L L . Fine. Thank you. Mr. Poole, will you lead
off for us.
Mr. POOLE. Thank you.
31-045 O - 78 - 3
(29)
30
STATEMENT OF WILLIAM POOLE, PROFESSOR OF ECONOMICS,
BROWN UNIVERSITY
Mr. POOLE. I am very pleased to be here this morning to provide
my views on the Federal Keserve-Treasury draw authority which
permits the Treasury to borrow up to $5 billion directly from the
r ederal Reserve System. My discussion of this matter is divided into
two parts. First, I will examine the functions of the draw authority
and second, I will discuss some more general issues of monetary control raised by the existence of this authority.
FUNCTIONS OF TREASURY DRAW AUTHORITY
The Treasury draw authority should be viewed in two distinct
contexts. First, in the case of a national military emergency it would
certainly be possible that the financial markets would be closed due to
physical destruction or other causes. In such an event it would obviously be impossible for the Treasury to sell securities to the general
public in order to raise the cash necessary to carry on the everyday
operations of the Government. I n a national emergency the continuing functioning of the Government would, of course, be highly important and so it is sensible to plan for the remote possibility of such
an event.
I n a national emergency, however, a Treasury draw authority
limited to $5 billion—the magnitude of the authority that now exists—
would probably be too small. After all, the Federal Government is
now spending an average of almost $3 billion per business day. M y
recommendation would be for a larger emergency Treasury draw authority—perhaps $10 to $15 billion to be utilized only in the event
t h a t a military emergency physically closes down the financial markets
and makes the sale of Treasury debt impossible.
A second and quite unrelated function of the draw authority is to
permit the Treasury to meet temporary cash needs that may arise
under normal circumstances due to the inevitable planning mistakes
and miscalculations that occur from time to time. There needs to be
some mechanism to handle temporary Treasury cash needs in excess of
those provided for by current tax receipts and regularly scheduled
sales of Treasury securities. For the most part, of course, temporary
cash needs can be met out of existing Treasury cash balances at the
Federal Reserve. Precisely because it cannot forecast its cash needs
with perfect accuracy, the Treasury has a longstanding practice of
maintaining cash balances that provide for some cushion against
contingencies.
Nevertheless, there may be times when the Treasury balances at
the Fed cannot satisfy the Treasury cash needs. In some cases it will
be possible for the Treasury to market additional securities on short
notice, but in other cases selling extra securities might be quite costly.
The existing draw authority provides a way for the Treasury to handle
such a situation conveniently and at little cost.
I t is my recommendation, however, that the Treasury not be permitted to borrow funds directly from the Federal Reserve but rather
that the Treasury be permitted to borrow Government securities
from the Federal Reserve's portfolio. The borrowed securities could
then be sold by the Treasury on the open market to raise the needed
cash.
31
This proposal has little practical difference from the existing arrangement. When the Treasury borrows directly from the Federal Reserve
and then spends the borrowed funds, there is an immediate increase in
the reserves of the banking system. To neutralize the monetary impact
of this reserve increase, the Federal Reserve typically sells securities
from its portfolio in order to drain the newly created reserves from the
banking system. My recommendation would involve no practical
difference, because instead of the Federal Reserve lending cash to the
Treasury and then selling securities from its portfolio, the Treasury
would borrow the securities and sell them.
Although my proposal involves no practical difference it has the
advantage of providing a clear congressional statement that the
Treasury is not to have a claim on newly created Federal Reserve
money. This statement of principle is extremely important in reducing
the possibility at some future time of excessive money creation due to
Treasury borrowing from the Federal Reserve not offset by Federal
Reserve sales of securities.
My recommendation, therefore, is that in the absence of a national
emergency the Treasury be permitted only to borrow Government
securities from the Federal Reserve, with the size of the borrowing
limited to securities aggregating $5 billion in market value. The precise security issues to be borrowed would be determined through
Treasury-Federal Reserve consultations.
GENERAL MONETARY CONTROL ISSUES
The Treasury draw authority, like most other individual pieces of
legislation related to monetary and banking regulation, is a minor
element of a very much larger matter concerning monetary control.
Although it would be highly desirable to have a thorough reform of our
monetary legislation and Federal Reserve regulatory practice in order
to make monetary control more exact, until such a reform is put in
place it is necessary to proceed on a case-by-case and bit-by-bit basis,
insuring that new legislation moves in the correct direction rather
than in the wrong direction. To provide a framework in which to view
the current legislation, a few general money control issues will now be
examined.
That there is a monetary control problem can be seen clearly from
the charts at the end of my statement. These charts show that money
growth has consistently slowed at the time of business cycle recessions
and has speeded up during business cycle expansions. Consider the
chart on page 12.
The sharp deceleration of money growth before the onset of the
1969-70 recession—the beginning of the recession is indicated by the
vertical line marked " P " for "business cycle peak"—shows up clearly.
Or, examine page 13 for a clear picture of the monetary deceleration
during the last recession. However, lest there be excessive concentration on monetary decelerations and recessions, note also that monetary
accelerations have preceded inflationary business booms, such as the
1967-69 and 1972-73 booms.
The long standing highly procyclical pattern to money growth has
contributed to the business cycle recessions and inflations that we have
experienced over the years. At your leisure, I urge you to examine my
32
charts for the entire period since 1908 in order to see just how procyclical money growth has been, and to see how regular and consistent
the pattern has been.
Monetary instability is due to a variety of factors, none of which
should be permitted to continue. The basic problem is that the legislation controlling the Federal Reserve, Federal Reserve regulations, and
Federal Reserve practices have all consistently ignored monetary
control issues. As a result we have a very poor monetary control
system.
Our monetary system has two basic features that make for sloppy
monetary control. First, the normal flows of reserves into and out of
the banking system as a whole produce short run monetary disturbances that the banks themselves cannot offset due to the nature of
our banking regulations. Consider, for example, the effect of lagged
reserve requirements regulation, in force since 1968.
When, for example, the Treasury draws down its cash balances at
the Fed, new reserves are pumped directly into the banking system as
the balances spent by the Treasury are transferred on the books of the
Federal Reserve to the member bank reserve accounts. The member
banks, therefore, have larger reserve balances. However, their required
reserves are based, since 1968, on their deposits 2 weeks earlier, and so
the new reserve balances are entirely in excess of the requirements since
reserve flows 1 week obviously cannot affect deposits 2 weeks earlier.
The banks, wanting to invest these extra balance at interest, put the
balances up for lending on the Federal funds market. But since banks
in general have excess reserves, the demand for Federal funds is low and
so the interest rate on Federal funds is bid down to very low levels. The
Federal Reserve, not wanting to see interest rates bid to low levels,
comes into the market to absorb the excess reserves and to prop up the
interest rate.
The process, of course, works exactly in reverse when the balances
flow from the banks into the Treasury as, for example, when taxes are
paid or payments are made for newly sold Treasury securities. In this
case, banks experience reserve shortages and bid up interest rates.
Since the regulations provide no way for the banks to meet a temporary
reserve shortage, the Federal Reserve feels compelled to enter the
market to supply additional reserves to hold interest rates within
targeted bounds.
The second feature of our monetary system that makes for poor
monetary control is that reserve disturbances—which the banks cannot
manage very well—are far larger than they need to be. The Federal
Reserve should be pushed to reform its reserve regulations so that
banking disturbances can be handled more easily, but until these
reforms are put into place every effort should be made to avoid adding
to the sources of disturbances in reserve flows. My recommendation on
the Treasury draw authority is designed with this objective in mind.
If the Treasury borrows securities from the Federal Reserve to meet
current cash needs, then banking disturbances are minimized. The
purchasers of the securities sold by the Treasury pay funds into the
Treasury and the Treasury pays those funds back out as it writes
checks. In contrast, if the Treasury borrows funds directly from the
Federal Reserve, then the Federal Reserve is required to take action
to neutralize the monetary impact of the Treasury spending the newly
created reserve balances.
33
Now, just a couple concluding comments.
As should be clear from my discussion, the legislation at hand is a
minor part of a very important subject; but if total reform is not at
hand, let us at least insure that we move in the correct direction on
each minor matter.
The issue at hand—the broader issue—is clearly of enormous
importance. Everyone recognizes that extreme neglect of monetary
control has led to extreme consequences. No one who lived through
the great German inflation in the early twenties will dispute this
contention. In that experience it is clear that printing press money was
directly responsible for the hyperinflation.
Less well known, but equally clear, is the fact that monetary
instability caused the Great Depression. Failure of the Federal
Reserve to prevent the 1929-33 monetary collapse that shows up so
clearly on the chart on page 10 turned what might have been a minor
recession into the Great Depression. The great German inflation and
the Great Depression were both avoidable, but were not in fact
avoided because of the lack of attention paid to monetary stability.
While conjuring up visions of hyperinflation and the Great Depression is probably going a bit far in the context of the legislation at hand,
there is no need to rely on such extreme cases to understand the
importance of the issue at hand. Examine the charts for the period
since Woild War I I and note the clear tendency of money growth to
slacken during recessions and to rise during booms. This pattern of
money growth has exacerbated our business cycles and may in fact be
the root cause of even relatively small business cycle movements. The
matter is of immediate and compelling importance. The acceleration
of inflation today has certainly not been helped by the acceleration of
money growth in 1976 and 1977. The deceleration of money growth
now underway, if pushed too far, will surely produce a recession starting next year. The patterns are all too regular and all too obvious to
be ignored.
Thank you, Mr. Chairman.
Chairman M I T C H E L L . Thank you, Mr. Poole. Your entire statement will be inserted in the record at this point.
[Mr. Poole's prepared statement follows:]
34
Statement by William Poole
Professor of Economics, Brown University
Before the Subcommittee on Domestic Monetary Policy
of the
Committee on Banking, Finance and Urban Affairs
U.S. House of Representatives
June 28, 1978
I am very pleased to be here this morning to provide
my views on the Federal Reserve—Treasury draw authority
which permits the Treasury to borrow up to 5 billion dollars
directly from the Federal Reserve System, My discussion of
this matter is divided into two parts. First, I will
examine the functions of the draw authority and, second, I
will discuss some more general issues of monetary control
raised by the existence of this authority.
Functions of Treasury Draw Authority
The Treasury draw authority should be viewed in two
distinct contexts. First, in the case of a national
military emergency it would certainly be possible that
the financial markets would be closed due to physical
destruction or other causes. In such an event it would be
obviously impossible for the Treasury to sell securities to
the general public in order to raise the cash necessary to
carry on the every-day operations of the government. In a
national emergency the continuing functioning of the
government would, of course, be highly important and so it
is sensible to plan for the remote possibility of such an
event.
In a national emergency, however, a Treasury draw
authority limited to 5 billion dollars—the magnitude of
the authority that now exists—would probably be too small.
After all, the Federal Government is now spending an
average of almost 3 billion dollars per business day. My
35
recommendation would be for a larger emergency Treasury
draw authority—perhaps $10-15 billion to be utilized only
in the event that a military emergency physically closes
down the financial markets and makes the sale of Treasury
debt impossible.
A second and quite unrelated function of the draw
authority is to permit the Treasury to meet temporary cash
needs that may arise under normal circumstances due to
the inevitable planning mistakes and miscalculations that
occur from time to time. There needs to be some mechanism
to handle temporary Treasury cash needs in excess of
those provided for by current tax receipts and regularlyscheduled sales of Treasury securities. For the most part,
of course, temporary cash needs can be met out of existing
Treasury cash balances at the Federal Reserve. Precisely
because it cannot forecast its cash needs with perfect
accuracy, the Treasury xhas a long-standing practice of
maintaining cash balances that provide for some cushion
against contingencies.
Nevertheless, there may be times when the Treasury
balances at the Fed cannot satisfy the Treasury cash needs.
In some cases it will be possible for the Treasury to
market additional securities on short notice, but in other
cases selling extra securities might be quite costly.
The existing draw authority provides a way for the Treasury
to handle such a situation conveniently and at little cost.
It is my recommendation, however, that the Treasury
not be permitted to borrow funds directly from the Federal
Reserve but rather that the Treasury be permitted to
borrow government securities from the Federal Reserve's
- 2 -
36
portfolio,1
The borrowed securities could then be sold
by the Treasury on the open market to raise the needed cash.
This proposal has little practical difference from
the existing arrangement. When the Treasury borrows
directly from the Federal Reserve and then spends the
borrowed funds there is an immediate increase in the
reserves of the banking system. To neutralize the monetary
impact of this reserve increase the Federal Reserve
typically sells securities from its portfolio in order to
drain the newly created reserves from the banking system.
My recommendation would involve no practical difference
because instead of the Federal Reserve lending cash to the
Treasury and then selling securities from its portfolio,
the Treasury would borrow the securities and sell them.
Although my proposal involves no practical difference
it has the advantage of providing a clear congressional
statement that the Treasury is not to have a claim on newly
created Federal Reserve money. This statement of principle
is extremely important in reducing the possibility at
some future time of excessive money creation due to
Treasury borrowing from the Federal Reserve not offset by
Federal Reserve sales of securities.
My recommendation, therefore, is that in the absence
of a national emergency the Treasury be permitted only to
borrow government securities from the Federal Reserve, with
the size of the borrowing limited to securities aggregating
$5 billion in market value.
The precise security issues
*The face value of any securities borrowed from the
Federal Reserve should be added to the debt total to which
the debt limit applies.
Otherwise, the Treasury could
evade the congressionally-determined debt limit by
borrowing and selling securities rather than by borrowing
funds directly,
-3 -
37
to be borrowed would be determined through TreasuryFederal Reserve consultations.
General Monetary Control Issues
The Treasury draw authority, like most other individual
pieces of legislation related to monetary and banking
regulation, is a minor element of a very much larger matter
concerning monetary control. Although it would be highly
desirable to have a thorough-going reform of our monetary
legislation and Federal Reserve regulatory practice in
order to make monetary control more exact, until such a
reform is put in place it is necessary to proceed on a
case-by-case and bit-by-bit basis, insuring that new
legislation moves in the correct direction rather than in
the wrong direction. To provide a framework in which to
view the current legislation a few general money control
issues will now be examined.
That there is a monetary control problem can be seen
clearly from the charts at the end of my statement. These
charts show that money growth has consistently slowed at
the time of business cycle recessions and has speeded up
during business cycle expansions. Consider the chart on
page 12. The sharp deceleration of money growth before the
onset of the 1969-70 recession—the beginning of the
recession is indicated by the vertical line marked "P" for
"business cycle peak"—shows up clearly. Or, examine
page 13 for a clear picture of the monetary deceleration
during the last recession. However, lest there be
excessive concentration on monetary decelerations and
recessions note also that monetary accelerations have
preceded inflationary business booms, such as 1957-69
and 1972-73,
-4 -
38
The long-standing highly procyclical pattern to money
growth has contributed to the business cycle recessions
and inflations that we have experienced over the years.
At your leisure I urge you to examine my charts for
the entire period since 1908 in order to see just how
procyclical money growth has been, and how regular and
consistent the pattern has been.
Monetary instability is due to a variety of factors,
none of which should be permitted to continue. The basic'
problem is that the legislation controlling the Federal
Reserve, and Federal Reserve regulations, and Federal
Reserve practices- have all consistently ignored monetary
control issues. As a result we have a very poor monetary
control system.
Our monetary system has two basic features that make
for sloppy monetary control. First, the normal flows of
reserves into and out of the banking system as a whole
produce short-run monetary disturbances that the banks
themselves cannot offset due to the nature of our banking
regulations. Consider, for example, the lagged reserve
requirements regulation in force since 1968. When, for
example, the Treasury draws down its cash balances at the
Fed new reserves are pumped directly into the banking
system as the balances spent by the Treasury are transferred
on the books of the Federal Reserve to the member bank
reserve accounts. The member banks, therefore, have
larger reserve balances. However, their required reserves
are based, since 1968, on their deposits two weeks earlier,
and so the new reserve balances are entirely in excess of
the requirements since reserve flows one week obviously
cannot affect deposits two weeks earlier. The banks,
wanting to invest these extra balance at interest, put
the balances up for lending on the federal funds market.
- 5 -
39
But since banks in general have excess reserves the demand
for federal funds is low and so the interest rate on
federal funds is bid down to very low levels. The Federal
Reserve, not wanting to see interest rates bid to low
levels, comes into the market to absorb the excess reserves
and to prop up the interest rate.
The process, of course, works exactly in reverse
when balances flow from the banks into the Treasury as,
for example, when taxes are paid or payments, are made
for newly sold Treasury securities. In this case banks
experience reserve shortages and bid up interest rates.
Since the regulations provide no way for the banks to meet
a temporary reserve shortage, the Federal Reserve feels
compelled to enter the market to supply additional
reserves to hold interest rates within targeted bounds.
The second feature of our monetary system that
makes for poor monetary control is that reserve
disturbances—which the banks cannot manage very well—are
far larger than they need to be. The Federal Reserve
should be pushed to reform its reserve regulations so that
banking disturbances can be handled more easily, but
until these reforms are put into place every effort should
be made to avoid adding to the sources of disturbances in
reserve flows. My recommendation on the Treasury draw
authority is designed with this objective in mind. If
the Treasury borrows securities from the Federal Reserve
and sells the securities as needed to obtain the funds
to meet current cash needs, then banking disturbances are
minimized. The purchasers of the securities sold by
the Treasury pay funds into the Treasury and the Treasury
pays those funds back out as it writes checks. In
contrast, if the Treasury borrows funds directly from the
-6 -
40
Federal Reserve, then the Federal Reserve is required to
take action to neutralize the monetary Impact of the
Treasury spending the newly created reserve balances.
Concluding Comments
As should be clear from my discussion the legislation
at hand is a minor part of a very important subject; but
if total reform is not at hand let us at least ensure that
we move in the correct direction on each minor matter.
The issue at hand—the broader issue—is clearly of
enormous importance. Everyone recognizes that extreme
neglect of monetary control has led to extreme consequences.
No one who lived through the great German inflation in
the early 1920's will dispute this contention. In that
experience it is clear that printing press money was
directly responsible for the hyper-inflation.
Less well-known, but equally clear, is the fact that
monetary instability caused the Great Depression. Failure
of the Federal Reserve to prevent the 1929-33 monetary
collapse that shows up so clearly on the chart on page 10
turned what might have been a minor recession into the
Great Depression. The great German inflation and the
Great Depression were both avoidable, but were not in fact
avoided because of the lack of attention paid to monetary
stability.
While conjuring up visions of hyperinflation and
great depression is probably going a bit far in the context
of the legislation at hand, there is no need to rely on
such extreme cases to understand the importance of the
issue at hand.
Examine the charts for the period since
World War II and note the clear tendency of money growth
- 7 -
41
to slacken during recessions and to rise during booms.
This pattern of mone./ growth has exacerbated our business
cycle and may in fact be the root cause of even relatively
small business cycle movements. The matter is of
immediate and compelling importance. The acceleration
of inflation today has certainly not been helped by
the acceleration of money growth in 1976 and 1977.
The deceleration of money growth now underway, if
pushed too far, will surely produce a recession starting
next year. The patterns are all too regular and all
too obvious to be ignored.
- 8-
42
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-j
J
300
260
-
240
-
280
••
7.124%
trend
220
#„
- • •!
••"M-I
*•
_-*•»*'*'*••*
^^r0*
200
180
r
160
L
1
-i
H
-J
i
4
140 h
H
120 h
A
100 1
i
1968
31-045 O - 78 - 4
1969
u
1
1970
- 12
Li
1
1971
i
1972
J
Billions
of d o l l a r ^ g ^ j : ^ ^
Money Stock, Monthly, January 1970 - Way
3,978
Billions
dollar:
600
320
"480
300
280
260
240
220
1970
1971
1972
! 1973
'P
1974
ft975
1976
1977
191Q
47
Notes on the figures:
1) The NBER business cycle peaks and troughs are indicated
by the vertical lines marked "P" and "T".
2) The money growth trends were determined by fitting
moving least squares time trends to the logarithms
of the monthly money stock data over 25-month
intervals. The highest time trend over a 25-month
interval is identified as the trend rate of money
growth characterizing the expansion phase of the
business cycle. The figures show these trends
for every business cycle expansion since 1908 with
the exceptions of the expansions during the two
World Wars and the 1945-48( expansion.
3} The charts on pp. 9-12 were taken from William
Poole, "The Relationship of Monetary Decelerations
to Business Cycle Peaks: Another Look at the
Evidence," Journal of Finance, 30 (June, 1975),
697-712.
The monetary data have been revised
slightly since these charts were drawn.
- 14 -
48
Chairman
MITCHELL.
Mr. Atlee?
STATEMENT OF JOHN S. ATLEE, PRESIDENT, INSTITUTE FOR
ECONOMIC ANALYSIS
Mr. A T L E E . Today there are widespread fears that we are heading
into another tight money recession, as Mr. Poole said—even before
we have fully recovered from the last one. I especially appreciate the
opportunity to testify before this subcommittee because I believe that
this subcommittee has a mandate which could play a key role in preventing such a disaster.
I t is now fashionable to say that the idea of economic fine tuning
has proved a failure. However, the main reason it has failed in the past
is t h a t we do not yet have even the most basic policy tools which
would be needed to make it work effectively.
The main thrust of my testimony is to explain how more systematic
and precise coordination between our monetary and fiscal policy could
provide the main key to achieving stable full employment growth
without inflation, and to describe briefly the main new policy tools
which are needed to make such coordination possible.
For continued stable recovery toward full employment, there are
three basic policy requirements :
First, a firm and credible recovery target. We had hoped that the
present administration would provide this, but it has not; second,
money growth keyed explicitly and solely to supplying the money
stock needed to service the growth of income and spending along the
prescribed recovery path—as shown, for example, in the I E A chart
panel 2A, which is attached as the next-to-the-last page of m y statement; and third, formula flexibility of fiscal policy explicitly keyed to
maintaining a stable balance between the total supply and demand
for credit, with stable interest rates.
Part A below discusses these requirements briefly, with primary
emphasis on the functional relationships between monetary and fi cal
policy, and the way in which credit-related stabilization tax adjustments could facilitate precise coordination between them.
Part B discusses in some detail the specific requirements for an
appropriate rate of money growth.
Part C discusses briefly several means of achieving more precise
measurement and control of the money supply.
NO. l : FIRM RECOVERY TARGET
Perhaps the most basic requirement for more effective economic
policy is the adoption of a firm and credible Government commitment
to maintain a stable rate of recovery until we reach genuine full employment—and then to maintain stable full employment as the basic
operating condition of our economy. I wish that such a commitment
could be included in the final version of the Humphrey-Hawkins Full
Employment and Balanced Growth Act.
NO. 2 : ECONOMICALLY APPROPRIATE MONEY GROWTH
To actually achieve stable recovery toward full employment,
monetary policy should have but one purpose: to supply the economy
49
with the precise amount of money stock which is needed to maintain
that stable recovery.
However, in our present policy framework, the Federal Reserve
is expected to control not only the money supply, but also the level
of interest rates and the supply of credit. This is a flagrant case of
responsibility without corresponding authority. In actual fact, the
growth of the money supply normally provides only about 10 percent
of the total supply of credit. Thus, the Federal Reserve has only
marginal and indirect control over interest rates and the total supply
of credit.
For both accurate analysis and sound policy, it is necessary to make
a clear distinction between "tight money" and "tight credit." The
potential for economic disruption which is inherent in the Fed's
traditional conflicting responsibilities was again demonstrated during
the past year.
The sharp increase in interest rates during the second and third
quarters of 1977 has usually been blamed on a Federal Reserve
"tight money" policy. In fact, as chart panel 2A shows, the growth of
the money stock during that period remained very close to the precise
amount needed to maintain the Carter administration's apparent
policy target of 5 percent real growth. The formula used for the
"money needed" line is explained in part B, below. Thus, the real
culprit was not "tight money" but "tight credit" caused by excessive
borrowing. Because of the large increase in mortgage borrowing and
business borrowing—augmented by an untimely increase in the
Federal deficit—the Fed could not have prevented the increase in
interest rates without allowing an excessive increase in the money
supply. What was needed was not more money but less borrowing.
During the first quarter of this year, however, there was exactly the
opposite kind of imbalance. In this case, "monetary" policy was
apparently determined not by the economy's need for money, but
by the Fed's desire to maintain a 6% percent Federal funds interest
rate, in the belief that this would prevent further decline of the dollar
exchange rate. Because of the sharp decline in mortgage borrowing
and other demands for credit—which was undoubtedly partly due
to the bad weather and coal strike—the Fed could keep the funds
rate up to 6% percent only by allowing a sharp decline in the rate of
money growth. The Fed could have achieved both its interest-rate
target and adequate money growth only if there had been a temporary
"compensatory" increase in Federal borrowing to offset the decline in
private borrowing.
Although complete data on total borrowing during the second
quarter of this year are not yet available, the phenomenal spurt of
consumer installment borrowing and the rebound of housing starts,
together with the sharp rise in interest rates, suggest that this quarter
is repeating the "tight credit" imbalance which occurred during the
second and third quarters of last year. Although second-quarter
money growth has not been fast enough to make up for this large
first-quarter shortfall, it would probably be wrong to call this "tight
money."
NO. 3 : FLEXIBLE FISCAL POLICY
During the past few months Congress and the Carter administration
have spent much effort trying to decide—and to agree on—how
much to cut taxes, and when. Also, on how large the federal deficit
50
should be next year, and the year after. The fact is that no one can
now know with certainty how much tax cut will actually be needed
next fall or winter, or how much deficit will really be appropriate
next year or the year after. What is needed is the fiscal machinery
for flexible adjustment of fiscal policy to the current needs of the
economy.
I t has often been suggested that the President could be given discretionary authority to make needed temporary adjustments in tax
rates. I believe that Congress has been right in refusing this authority
because of the possibility that it could be misused for partisan political
purposes.
"Formula flexibility"—Seventeen years ago the prestigious Commission on Money and Credit recommended serious consideration of
what it called "formula flexibility"—that is, "provision for automatic
changes in the level of certain tax rates whenever prescribed economic
indicators change by specified amounts." "At first glance," said the
CMC, "such a proposal may seem radical. Actually, however, it
would do little more than make explicit what is now implicit in the
conventional type of automatic stabilizers"—mainly the "automatic"
effect of recessions on Federal tax receipts and "depression relief"
expenditures.
The main reason that this idea has received so little attention has
been the failure to devise suitable "indicators" on which to base the
formula.
However, the current increased interest in more systematic coordination of monetary and fiscal policy suggests a highly appropriate
basis for such a formula—the size of the Federal deficit should be
varied in such a way as to maintain a stable balance between the
total supply and demand for credit, with stable interest rates.
Thus, when interest rates are tending to rise because of excessive
private borrowing—or insufficient financial saving—the Federal
deficit should be reduced by means of a small temporary increase in
withholding taxes. On the other hand, when private borrowing is
weak, but it is considered desirable—for foreign exchange or other
reasons—to maintain a particular interest rate, the Federal deficit
should be increased by means of a small reduction in withholding
taxes—rather than reducing the money supply and causing recession.
Administratively, such a "stabilization tax adjustment" would be
relatively simple. Most large payrolls are today compiled by computer.
I have been told by one of the large firms which performs this service
that the required adjustment could be carried out very simply by a
single additional instruction to their computer.
The withholding tax rate would clearly be the simplest means of
effecting the required adjustment in the first instance. However, other
taxpayers would make a similar adjustment in their quarterly or
annual returns. Moreover, as the experience of the past year shows,
the adjustments in different quarters might largely cancel out for the
year as a whole.
One of the greatest advantages of this approach to economic
stabilization is the very high degree of precision and flexibility which
it could provide. Because the adjustments could be made as often as
needed—once a quarter or even oftener—they would tend to be quite
small—particularly after the economy has been actually stabilized
for long enough to correct the massive structural distortions caused
51
by past recessions and "booms." There is a close analogy here to
driving a car: on a winding road the driver must make continuous
large adjustments of the steering wheel; on a straight road he may
make almost as many adjustments, but they will be much smaller.
On the model T Ford, to use another automotive analogy, there
were two levers beside the steering wheel—one to adjust the spark,
the other to adjust the gasoline/air mixture. Modern cars make both
these adjustments automatically. I believe it is time that we similarly
modernized our present "Model T " approach to coordination of
monetary and fiscal policy.
Formula flexibility would provide more effective congressional control
of the Federal budget.—The present large deficit was not decided by
Congress, but mainly by the fact that the economy is still operating
so far below capacity. Congressional budget discussions are now based
largely on unreliable "forecasts" of future economic and credit conditions. With "automatic" formula control of the economic stabilization aspect, Congress would have much more effective control over
the basic structure of spending and taxes, as expressed in the highemployment budget, and would not have to devote so much fruitless
time and effort to the shortrun implications of its actions, over which
it has so little effective control. Moreover, the stabilization adjustment
would automatically compensate for faulty estimation of the effect
of new taxes—for example, the crudeoil tax or turnover tax—large
changes in tax rates—for example, the social security tax—or new expenditure programs—for example, medicaid/medicare, job programs—
and shortfalls of actual spending below budgeted amounts.
I would now like to list several things which the Federal Reserve
should include in its quarterly report to Congress.
Chairman M I T C H E L L . Page 12?
Mr. A T L E E . Page 12; right.
First, detailed data for the key factors related to monetary velocity,
which is one of the two key factors in the formula for appropriate
monetary growth.
Second, state in explicit, quantitative terms, its forecast or policy
target for total monetary stimulus, which is the sum of the growth
of the money supply and the trend of velocity change.
Third, cease reporting of a quarterly target range for the growth
of M L
Fourth, cease setting any policy targets for M 2 , M 3 , and all the
other confusing "money and credit aggregates" which the Fed has
added in recent years.
I would also like to list several specific measures which would help
to achieve precise measurement and control of the supply.
First, eliminate all reserve requirements on time and savings deposits and have uniform reserve requirements for all classes of demand
deposits.
Second, require all banks to become members of the Federal Reserve System.
Third, pay interest on members banks' reserve deposits.
Fourth, require 100 percent reserves against all demand deposits.
T h a t sounds like a radical proposal, but it would be relatively simple
and undisturbing, I believe, if we did it the right way.
Fifth, float the discount rate—tie it to the Federal funds rate.
52
A final note: It is likely that a number of the proposals and analytical
aspects discussed in this statement lie outside the official mandate
of this subcommittee.
However, I believe it is also true that some of the key aspects relating to the coordination of monetary and fiscal policy do not fit very
neatly within the traditional mandate of any existing congressional
committee.
Therefore, I hope that this subcommittee will give consideration
to this problem, and perhaps make some recommendation to Congress
as to how these matters could most effectively be dealt with by Congress.
Thank you, Chairman Mitchell.
Chairman MITCHELL. Thank you very much. Your entire statement will be inserted in the record at this point.
[Mr. Atlee's prepared statement follows:]
53
PREPARED STATEMENT OF
JOHN S. ATLEE
(President, Insitute for Economic Analysis)
FOR PRESENTATION TO
THE HOUSE SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
June 28, 1978
54
- 1 -
Today there are widespread fears that we are heading for another "tight
money" recession—even before we have fully recovered from the last one.
I
especially appreciate the opportunity to testify before this committee because
I believe that this committee has a mandate which could play a key role in
preventing such a disaster.
It is now fashionable to say that the idea of economic "fine tuning" has
proved a failure.
However, the main reason it has failed in the past is that
we do not yet have even the most basic policy tools which would be needed to
make it work effectively.
The main thrust of my testimony is to explain how more systematic and
precise coordination between our monetary and fiscal policy could provide the
main key to achieving stable full employment growth without inflation, and to
describe briefly the main new policy tools which are needed to make such
coordination possible.
For continued stable recovery towards full employment, there are three
basic policy requirements:
(1) a firm and credible recovery target;
(2) money growth keyed explicitly and solely to supplying
the money stock needed to service the growth of
income and spending along the recovery path; and
(3) "formula flexibility" of fiscal policy explicitly keyed
to maintaining a stable balance between the total supply
and demand for credit, with stable interest rates.
Part A, below, discusses these requirements briefly, with primary emphasis
on the functional relationships between monetary and fiscal policy, and the way
in which credit-related "stabilization tax adjustments" could facilitate
precise coordination between them.
Part B discusses in some detail the specific
requirements for an appropriate rate of money growth.
Part C discusses briefly
several means of achieving more precise measurement and control of the money supply.
A. BASIC POLICY REQUIREMENTS FOR STABLE RECOVERY
1. FIRM RECOVERY TARGET
One of the most basic requirements for more effective economic policy is
the adoption of a f i r m — a n d credible—government commitment to maintain a
stable rate of recovery until we reach genuine full employment — and to
maintain stable full employment as the basic operating condition of our
economy.
I hope that this commitment will be included in the final version
of the Humphrey Hawkins Full Employment and Balanced Growth Act.
55
- 2 -
In order for businessmen to plan ahead with confidence and to invest in
the additional capacity and cost-saving equipment which the economy needs,
they must have confidence that the government will not permit — and will not
induce—another recession every few years.
Such a full-employment commitment
would also make a major contribution towards faster reduction of our so-called
"structural" unemployment, and even towards reducing many inflationary costs
which have become embedded in our economy as a result of its traditional
roller-coaster performance.
2. ECONOMICALLY APPROPRIATE MONEY GROWTH
To actually achieve stable recovery towards full employment, the most
important requirement is a monetary policy which has but one purpose:
to
supply the economy with the precise amount of money stock which is needed to
maintain that stable recovery.
In our present economic policy framework, the Federal Reserve is expected
to control not only the money supply, but also the level of interest rates and
the supply of credit.
This is a flagrant case of responsibility without
corresponding authority.
In actual fact, the growth of the money supply
normally provides only about 10% of the total supply of credit.
Thus, the
Federal Reserve has only marginal and indirect control over interest rates
and the total supply of credit.
"Tight money" vs.
"tight
credit.
" — The potential for economic disruption
which is inherent in the Fed's traditional conflicting responsibilities was
again demonstrated during the past year.
The sharp increase in interest rates
during the 2nd and 3rd quarters of 1977 has usually been blamed on a Federal
Reserve "tight money" policy.
In fact, as the accompanying Chart Panel 2A
shows, the growth of the money stock during that period remained very close to
the precise amount needed to maintain the Carter Administration's apparent
policy target of 5% real growth.
The real culprit was not "tight money" but
"tight credit" caused by excessive borrowing.
Because of the large Increase in
mortgage borrowing and business borrowing — augmented by an untimely increase
in the federal deficit — the Fed could not have prevented the increase in interest
rates without allowing an excessive increase in the money supply.
What was
needed was not more money but less borrowing.
During the first quarter of this year, however, there was exactly the
opposite kind of imbalance.
In this case, "monetary" policy was apparently
determined not by the economy's need for money, but by the Fed's desire to
56
- 3 -
maintain a 6-3/4% federal funds interest rate, in the belief that this would
prevent further decline of the dollar exchange rate.
Because of the sharp
decline in mortgage borrowing and other demands for credit—which was
undoubtedly partly due to the bad weather and coal strike — the Fed could
keep the funds rate up to 6-3/4% only by allowing a sharp decline in the
rate of money growth.
The Fed could have achieved both its interest-rate
target and adequate money growth only if there had been a temporary
"compensatory" increase in federal borrowing to offset the decline in
private borrowing.
Although complete data on total borrowing during the 2nd quarter of this
year are not yet available, the phenomenal spurt of consumer instalment
borrowing and the rebound of housing starts, together with the sharp rise in
interest rates, suggest that this quarter is repeating the "tight credit"
imbalance which occurred during the 2nd and 3rd quarters of last year.
Although 2nd quarter money growth has not been fast enough to make up for
this large first-quarter shortfall, it would probably be wrong to call
this "tight money."
3. FLEXIBLE FISCAL POLICY
During the past few months Congress and the Carter Administration have
spent much effort trying to decide (and to agree on) how much to cut taxes,
and when.
Also, on how large the federal deficit should be next year, and
the year after.
The fact is that no one can now know with certainty how much
tax cut will actually be needed next fall or winter, or how much deficit will
really be appropriate next year or the year after.
What is needed is the
iis-eari machinery for flexible adjustment of fiscal policy to the current needs
of the economy.
It has often been suggested that the President could be given discretionary
authority to make needed temporary adjustments in tax rates.
I believe that
Congress has been right in refusing this authority because of the possibility
that it could be misused for partisan political purposes.
"Formula
flexibility."
—
Seventeen years ago the prestigious Commission
on Money and Credit recommended serious consideration of what it called
"formula flexibility" —
i.e.
"provision for automatic changes in the level
of certain tax rates whenever prescribed economic indicators change by
57
- 4 -
specified amounts."
seem radical.
"At first glance," said the CMC, "such a proposal may
Actually, however, it would do little more than make explicit
what is now implicit in the conventional type of automatic stabilizers"
—
mainly the "automatic" effect of recessions on federal tax receipts and
"depression relief" expenditures.
The main reason that this idea has received so little attention has been
the failure to devise suitable "indicators" on which to base the formula.
However, the current increased interest in more systematic coordination
of monetary and fiscal policy suggests a highly appropriate basis for such a
formula — the size of the federal deficit should be varied in such a way as
to maintain a stable balance between the total supply and demand for credit,
with stable interest rates.
Thus, when interest rates are tending to rise because of excessive private
borrowing (or insufficient financial saving), the federal deficit should be
reduced by a small temporary increase in withholding taxes.
On the other hand,
when private borrowing is weak, but it is considered desirable (for foreign
exchange or other reasons) to maintain a particular interest rate, the federal
deficit should be increased by a small reduction in withholding taxes — rather
than reducing the money supply and causing recession.
Administratively, such a "stabilization tax adjustment" would be
relatively simple.
Most large payrolls are today compiled by computer.
I
have been told by one of the large firms which performs this service that the
required adjustment could be carried out very simply by a single additional
instruction to their computer.
The withholding tax rate would clearly be the simplest means of effecting
the required adjustment in the first instance.
However, other taxpayers would
make a similar adjustment in their quarterly or annual returns.
Moreover, as
the experience of the past year shows, the adjustments in different quarters
might largely cancel out for the year as a whole.
One of the greatest advantages of this approach to economic stabilization
is the very high degree of precision and flexibility which it could provide.
Because the adjustments could be made as often as needed (once a quarter or even
oftener), they would tend to be quite small—particularly after the economy
has been actually stabilized for long enough to correct the massive structural
distortions caused by past recessions and "booms."
There is a close analogy
58
- 5here to driving a car: on a winding road the driver must make continuous
large adjustments of the steering wheel; on a straight road he may make
almost as many adjustments, but they will be relatively small.
On the Model T Ford, to use another automotive analogy, there were two
levers beside the steering wheel — one to adjust the spark, the other to
adjust the gasoline/air mixture. Modern cars make both these adjustments
automatically.
I believe it is time that we similarly modernized our
present "Model T" approach to coordination of monetary and fiscal policy.
More effective
Congressional
control
of the federal
budget.
— It has
been argued that Congress would object to such an automatic, formulacontrolled stabilization tax adjustment because it would mean giving up
some of its constitutional
budgetary authority.
In actual fact, it would
Jiave quite the opposite ef-f-ect. The present large deficit was not
decided by Congress, but mainly by the fact that the economy is still
operating so far below capacity.
And Congressional budget discussions
are now based largely on unreliable "forecasts" of future economic and credit
conditions. With "automatic" formula control of the economic stabilization
aspect , Congress would have much more effective control over the basic
structure of spending and taxes, as expressed in the high-employment budget,
and would not have to devote so much fruitless time and effort to the shortrun implications of its actions, over which it has so little effective control. Moreover,
the stabilization adjustment would automatically compensate for faulty estimation of the
effect of new taxes (e.g. the crude oil tax or turnover tax), large changes in tax rates
(e.g. the social security tax), or new expenditure programs (e.g. medicaid/medicare,
job programs) and for shortfalls of actual spending below budgeted amounts.
Stabilization
and reduction
of interest
rates.
— This approach to
economic stabilization, and to coordination of monetary and fiscal policy,
would not only tend to stabilize interest rates, but would have the
significant "side effect" of making it possible for Congress to actually
decide the basic level at which they would be stabilized.
The balance
between the total supply and demand for credit could be maintained, through
free-market mechanisms, at whatever level Congress sets.
Although Congress's
practical range of discretion in this regard would of course be limited by
international economic conditions and various other factors, it would
undoubtedly be wide enough to permit a significant influence over the long run.
Reducing the level of interest rates would significantly reduce the competitive
cost of capital-intensive solar energy equipment and energy-saving techniques
of construction and Industrial production.
^ ,
,A
59
May-June, 1978'
Key Indicators of Economic
Performance and Relationships
IEA CHARTS
(Key to Chart Symbol* on page 7)
11. | REFERENCE SERIES
|
76
77 11 • I 78
2. Growth Rat«©ftMle6norrg ; . | ® l l ) t ^ (Real mmm0:0^th
F^||#J|i:
I 2. I
'
MONEY SUPPLY (% Change in Money Stock - M O
»
:
Ml:b:;--W'J.'W.!'''II..IJ
."'i....l.!i|IH: I ::.;l.l • ,,-J.. ,•• 'H ••'•
[3. | UNEMPLOYMENT RATES (%)
: , ; ,l,
,,.: J,P, U.III.I,. .
For wki y «K,M. »• Panel ZA (page 7)
I ,,:J.'.'AW!M'»U..J.,k. :'*'!!»•
g^jaSBtjSST,*tf
I
I 4. I KEY INDICATORS OF INFLATIONARY SHORTAGES OF SUPPLY
64
65
66
67
68
69
70
71
72
I
:r •>•: J,.|:l MJ- l'.'-'»: •• 'I - I- • I: '-ll 1 .. 1 /
73
74
75
I
76
77
78
©1978 INSTITUTE FOR ECONOMIC ANALYSIS, INC., 1346 Connecticut Avenue, N.W., Washington, D.C. 20036. Phone 2d2: 872-8054
1. e The Conference Board; used with permission
*lncludes all data available through. J u n e
16
60
May-June, 1978
I 5. |
64
I N F L A T I O N RATE — % C H A N G E I N P R I C E S
65
66
2
• Indicators of Economic
Pe ^ . l a n c e and Relationships
IEA CHARTS
67
68
69
70
71
For monthly PPI•». see Panel 5C, page 7
72
73
75
76
|
77 Zi I I 7 8
2
61
May-June, 1978
| 8. | INVESTMENT (% of GNP)
IEA CHARTS
Key Indicators of Economic
Performance and Relationships
|
I 9. | BUSINESS INVENTORY INVESTMENT AND STOCK/FLOW RATIOS
31-045 O - 78
|
62
May-June, 1978
Indicators of Economic
, tance and Relationships
IEA CHARTS
| 11. | PRIMARY FINANCING (% of GNP)
|
12. I PRIMARY MARKET FINANCING—BUSINESS & GOVERNMENT (% of GNP)
1
.
i
'
'
lUUlUJi. . .
1. Incl. mobile homes credit from 71:4.
2. Excl. mobile homes credit from 71:4.
3. F/F Basis — Includes government
it credits to households
..
"'
'
_
"'""
IUI.I.W,.,,'.t!L I
.
II
•
ii
I
aL....t!»!JLH|i.i||JJi',l• '.
4. 4% unemployment definition, adjusted to 1955 demographics
(includes supplementary & special unemployment benefits) '
5. PRIMARY BORROWING is NET borrowing which finances GNP expenditure.
63
Key Indicators of Economic
Performance and Relationships
IEA CHARTS
May-June, 1978
| 15. | REAL OUTPUT, INCOME, RETAIL SALES (Growth Rates, %)
S pSJnsTS'
77 1 1 - 5 78
76
| 17. |
64
U.S. INTERNATIONAL TRANSACTIONS - KEY ASPECTS (% of GNP)
65
66
67
68
69
70
71
72
73
74
75
76
|
77
78
©1978 INSTITUTE FOR ECONOMIC ANALYSIS, INC., 1346 Connecticut Avenue, N.W., Washington, D. C. 20036. Phone 202: 872-80o4 J
64
May-June, 1978
ey Indicators of Economic
.rmance and Relationsmps
IEA CHARTS
118. | GROWTH SERIES—ABSOLUTE VALUES (Ratio Scale)
64
H"
65
n
66
— , —
67
t
.
„„,,,
68
,^
69
70
71
..,..,,-
"H
-——IK.-
1-2. Real Stock of Mcmey-lnv«ntoiyjl~
1972 prices
«
m
(WHiOn«oi$) 197ft I prices ](
QNPCWWdr m
*
h—l
"" I^Jildfcia^flflHi
64
^)
1
65
66
67
68
69
70
71
includes normal (Capacity-GNP growth trend) inventory investment
72
|
73
1
76
74
1
r—T
n ^ B """* 'f
77||*l78
iiiiyiMy
1 Money
400
65
Key ,nd,cators of
Economic
Performance and Relationships
| 20. | INTERNATIONAL COMPARISONS: Industrial Production [
May-June, 1978
64
65
66
67
68
IEA
CHARTS
69
70
71
72
73
74
75
76
77 f i l l 78
110
106
MONEY STOCK (Mi; Daily Averages; billions of S; Ratio
id on These Growth Rates:[ 77:1-4
Real Final Sales & GNP
W Inflation (F.S. deflator)
H Nominal Final Sales & GNP
(-) "Velocity" (see table below)
(») Money (M-1) needed
, New Money Equivalent ,
of "Velocity" Growth (%)
Trend Seas Total
77:4 2.2 2.2 4.4
78:1 2.0 -1.4 0.6
78:2 3.0
0 3.0
78:3 3.0 -0.9 2.1
| IEA CHART CONVENTIONS |
Most "normal" lines for individual series are estimates of "balanced growth" values.
Vertical shadings denote recessions of the ORE—when the 2-qtr. average of the GRE (1.2) is significantly below norm for more than one quarter.
Vertical dashed lines delimit NBER confracf/ons—coincide roughly with declines of Real GNP (GRE beJow_zero). (11/73 and 5/75 tentative )
Vertical stippled areas denote periods of relative stagnation—when the GRE (1.2) is clearly inadequate in relation to the ORE GAP (1.1a).
Vertical——— line marks the beginning of large-scale direct U.S. military involvement in Vietnam and Korea.
Circle around chart number indicates basic data are the same as, or comparable to, and NBER "leading indicator."
Main chart lines are 2-quarter centered (1-2-1 weighted) moving averages except for annual data, Charts 4.1 and 7 4, and Panels 18 and 19
Recenf-dafa fine lines: Quarterly series /final*)—unaveraoed data
In ratio-scale panels 18 and 19, final quarterly data are extended by unaveraged monthly data.
Monthly series—Growth-rate series (Panels 2, 5,15,20) are 2-month centered (1-2-1 wefghted) moving averages Final "o"denotes
unaveraged value, which has limited analytical significance. All other monthly series are unaveraged.
Government *nd other original-source oro/ecr.ons-Soecific
"
cV
Value: --"-•••••" Range of Values: m i l l !
Growth Rate Value:
66
Key Indicators of Economic
formance and Relationships
| R-14C. | FEDERAL GOVERNMENT RECEIPTS (% of Capacity GNP) |
IEA CHARTS
May-June, 1978
64
65
| R-14A. |
L !
66
67
69
70
71
72
73
74
75
F E D . G O V T . E X P E N D . (Less Soc. Ins. Benefits & Military; % of Capacity G N P )
i
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.
-
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! 1 - T o t a l ^^-^ jl
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—
:
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?&M
2. Grants-in-aid to State & Local Governments
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.11
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3. Other Transfers, Grants & Subsidies 1 1
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i
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i=
i 4. NonrnjJttary Goods & Services
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^ 5 . Net Interest
I R-14B. | FEDERAL SOCIAL INSURANCE (% of Capacity GNP)
\j ' T O
\^i^^T ^ i—ttliif
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68
|
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:
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67
- 6 -
Role
of
the
Federal
Reserve.
—
Under the present system, the Federal
Reserve tries to control "money and credit" by buying and selling Treasury
securities.
When it buys, this supplies additional reserves to the banking
system, permitting the banks to expand their loans and checking deposits
(which constitute the bulk of the money supply).
When the Fed sells, this
drains reserves out of the banking system, forcing the banks to reduce
their loans and the money supply.
However, as noted above, this often involves a "trade-off."
With any
given total demand for credit, the Fed can reduce the growth of the money
supply only by permitting an increase in interest rates, and vice versa.
With the stabilization tax adjustment, the Fed would still occasionally be
faced with the same "trade-off" in the interval between tax adjustments:
when the demand for credit is "too high" this would cause an increase in
either interest rates or money stock or both.
Although this aspect needs
further study, it would probably be better for the Fed to hold the money
supply as close as possible to the most appropriate growth rate and allow
temporary fluctuation of interest rates.
The Fed would send the Treasury at least monthly its estimate of the amount
of tax adjustment needed, to return interest rates to the desired level.
With
provision for frequent adjustments, trial-and-error precision would be adequate,
but greater precision would come with experience.
B. HOW MUCH MONEY DOES THE ECONOMY NEED?
Growth of the money supply is the main factor which determines the growth
of total spending (GNP) and total employment, because additions to the money
stock are "created out of thin air" (or "printed") in the process of bank
lending, and thus constitute a net additional source of purchasing power which
was not previously saved from anyone's income and spending.
Thus, too much
money tends to cause inflation, while too little money tends to cause
recession and unemployment.
If the stabilization tax adjustment were to facilitate the growth of the money
supply at always precisely the most appropriate rate, how would that rate be
determined?
The "formula" for appropriate money growth contains three basic factors:
(1) the appropriate rate of real economic growth;
(2) the current trend value of the "demand" for money
(as expressed in the "velocity" ratio);
(3) the rate of inflation.
and
68
- 7 -
1. THE APPROPRIATE RATE OF REAL ECONOMIC GROWTH
The long-run growth trend of "potential" GNP is determined by the long-run
trends of the labor force and "productivity."
These are basic economic factors
over which current public policy has very little control.
But the growth rate
of "potential" GNP is the same as the growth rate of actual GNP consistent with
a stable unemployment rate.
estimated at about 4%.
Before the OPEC "oil tax" this generally was
Since then, estimates vary somewhat, from 3.9% by
George Perry at Brookings down to 3^% by Fed Chairman Miller.
But this is
still a fairly narrow range.
Thus, the real controversy today is concerned not with the basic trend
but with the most appropriate rate and extent of recovery towards the fullemployment potential.
The problem of retarded
capacity.
— Here a key problem is that long
years of sub-capacity operation of the economy have tended to reduce the
immediately avaialable capacity to much below the long-run trend of
"potential" output.
Low operating rates have reduced business investment
in additional plant and equipment capacity.
High unemployment rates have
left many young workers without adequate job experience and have kept many
others in occupations far below their potential skill and experience.
As a
result, there is a tendency to run into inflationary "bottleneck" shortages
of industrial capacity and skilled labor long before there is full employment
of the total labor force.
The basic
choice:
facing this problem.
fast
or slow recovery.
—
There are two ways of
One way is to continue a relatively rapid rate of
recovery while taking difficult but really effective measures to reduce
inflation and solve the other structural problems caused by the depression.
The other option is to reduce the rate of recovery so as to temporarily avoid
these difficult decisions.
The slow-recovery option implicitly accepts the continuation of high
unemployment (with the associated high rate of street crime and family
disruption), high federal deficits (due to continued low tax receipts and
high unemployment benefits and other "depression-relief" expenditures), and
lower industrial productivity (due to slower introduction of technologically
more efficient equipment).
69
The rate-of-recovery decision is essentially political.
Therefore, it
should be decided openly and explicitly by the elected representatives of the
American public —
i.e. by the President and by Congress —
not by the
Federal Reserve, which effectively makes the final decision under the present
arrangements.
There are indications that both the Fed and the Carter Administration are
now choosing the slow-recovery option.
Under the present division of
responsibility between the Administration, Congress and the Fed, Congress has
no direct and certain way of affecting that decision — and would not even under
Humphrey/Hawkins.
2. THE CURRENT TREND OF THE "DEMAND" FOR MONEY
Money as an inventory
stock.
—
Because our present monetary system
permits money to be created in the process of bank lending, there has been
a traditional confusion between money and credit.
This confusion can be
reduced if we think of credit as borrowed purchasing power and money as an
"inventory stock" of the medium of exchange.
The Wall
Street
Journal
article which reports the weekly money supply
data usually explains that-the M-l measure—checking deposits and currency—
"is considered an important economic determinant" because it "represents
funds readily available for spending."
Newly created money (i.e. a net addition
to the existing money stock) is of course "available for spending" because the
money is created in the process of bank lending, and money is usually borrowed
only for the purpose of spending it.
However, in terms of the average quantity
over a period of a month or so, our checking account balances are no more
"available for spending" than the grocer's inventory stock is "available for
selling."
Money "flows through" the account (as income or expense), just as
goods "flow through" the grocer's inventory stock.
But the average level
which each household and business firm considers necessary and/or desirable
for carrying on normal operations is essentially "locked in" and unavailable
for spending.
The "demand" for money3 and the stock/flow
ratio.
— One of the key
concepts in business management is the inventory/sales ratio.
This stock/flow
relationship is also used in its inverse form as the inventory "turnover" ratio.
The stock/flow ratio of the economy's money inventory is just as important to
70
- 9 -
sound monetary management as the inventory/sales ratio is to business management.
The monetary equivalent of the storekeeper's inventory "turnover" ratio is
called "velocity."
Unfortunately, this concept is so poorly understood by the
public that it is often referred to as "esoteric" or "arcane" even in the
business press.
Undoubtedly one of the reasons is that the term "velocity" is
itself anomalous and functionally meaningless.
The relationship is much easier
to understand in its inverse (inventory/sales ratio) form, which expresses
directly the economy's current need for money-inventory stock, in relation to
any given rate of income and spending.
Thus, it is useful to think of the primary goal of monetary policy as
supplying the economy's need for money-inventory (indicated by the current
trend value of the stock/flow ratio) as the economy grows along the prescribed
recovery path.
In this perspective, the additional purchasing power which
finances the growth of the economy is merely an automatic by-product of
providing the growing stock of money-inventory.
Page 6 of the attached IEA CHARTS shows both the "velocity" form of
this ratio (Panel 18, chart 3a) and the stock/flow form (Panel 19, chart 2 ) .
Note that these charts relate the money stock to "final sales adjusted"
rather than to GNP.
IEA study of these relationships has shown that using
final sales (total GNP minus its volatile inventory investment component)
makes the ratios both more stable and more functionally signficant.
However,
to make the general level of these ratios approximate the traditional GNP
ratios, we developed the concept of "final sales adjusted."
This concept
could be described either as "final sales plus normal inventory investment"
or as "GNP minus abnormal inventory fluctuations."
It is shown as Chart 6
in Panel 18.
The "new money equivalent"
of the declining
stock/flow
ratio.
— Whereas
the business inventory sales ratio has remained relatively constant since
World War II, the monetary stock/flow ratio has been declining at a fairly
stable rate of about 3% a year.
This decline has been caused partly by
business firms' increasingly efficient cash-management, and partly by rising
interest rates, which make everyone try to minimize their non-interest-bearing
checking account balances.
Since a decline in the monetary stock/flow ratio tends to "unlock"
existing cash balances and make them available for spending (e.g. when banks
71
- 10 -
reduce the minimum balances needed to avoid service charges), the effect is
similar to a proportionate increase in "new money."
Thus, the total "monetary stimulus"—which determines the growth of
nominal final sales (and G N P ) — h a s two components:
(1) actual money growth
and
(2) the "NEW MONEY EQUIVALENT" of the trend decline in
the "demand" for money (as indicated by the rate of
decline in the stock/flow ratio or the rise in its
inverse form, the "velocity" ratio).
Estimates for both of these components should be included in the Fed's
quarterly reports to Congress, as explained below (p. 12 ) .
3. TAKING ACCOUNT OF THE INFLATION RATE
The economy's money-inventory stock has another similarity to business
physical inventory stocks:
during inflation the nominal (current-dollar) value
of the stock has to keep up with the rate of inflation or the stock is unable to
perform its functional role effectively.
The 1973-74 "wheat and oil" inflation is a case in point.
To have expected
businesses and households to carry on a normal "real" volume of transactions
with the 1972 dollar amount of money stock (as implicitly required by Fed policy
during that period) was about as realistic as expecting business firms to carry
on their normal physical volume of business with their 1972 dollar value of
inventory stocks.
Thus, any workable systematic "formula" for determining an appropriate
rate of money growth must reflect the current inflation rate.
In actual
practice, it may be advisable to do this in a way which will systematically
"lean against the wind" —
such as using the lower
months' rate or the previous year's average.
of the most recent three
But it is the growth of the
real money stock that primarily determines the growth of real GNP.
This is illustrated dramatically in IEA's chart of the "Real Stock of
Money Inventory" (IEA CHARTS, page 6, Panel 18, chart 2 ) , which shows how
sharply the 1973-74 inflation reduced the actual working value of the economy's
money stock —
and how this decline was closely followed by the decline in
GNP (chart 7 ) . This same relationship is shown in growth-rate terms in
Panels 1 and 2 on page 1 of IEA CHARTS.
72
- ii The
"money-causes-inflation"
myth.
—
The fear that money-growth causes
inflation is based primarily on unique wartime experiences — and peacetime
cases of weak government — where excessive monetary expansion was used to
finance huge government deficits.
The idea that the present inflation was
(and is) caused by excessive money growth is based on a gross misreading of
economic history and functional relationships.
The fourfold increase in the
price of oil was not caused by excessive monetary expansion.
large 1972-73 increase in the price of wheat.
Nor was the
There was no way that slower
money growth alone could have prevented those price increases from increasing
the general inflation rate.
In an economy where a large portion of industrial
prices are set "administratively" on a cost-plus basis, where major wage
contracts are set for three years on the basis of union bargaining strength,
and where many other prices and wages are automatically escalated with the
rate of inflation, slowing the rate of real money growth while the
economy is well below capacity can cause recession
but will have little
effect on the longer-run rate of inflation.
Some economists have found an apparent correlation between the
inflation rate and the growth of the money supply two years or so earlier.
Although IEA has not yet undertaken a systematic review of their data, our
preliminary study found no systematic and inherent relationship between money
growth and inflation.
We suspect that there would be very little residual
relationship if separate prior account were taken of the relationship between
the economy's growth rate and the level of the operating rate.
It is quite
likely that the rapid rate of real economic growth induced by the rapid growth
of the real money stock during 1972 was somewhat too fast considering the
already high operating rate.
But a few cases of such mismanagement should
not be interpreted as a general relationship.
The inflationary
effect
of inadequate
money growth,
—
If the monetary
growth rate does not take adequate account of the inflation rate, it shifts
the inflation forward in time —
as the lower rate of real growth increases
non-productive federal "depression deficits," reduces business investment in
more productive equipment and increased capacity, and prevents unemployed
workers from obtaining the productive skills and experience which will
prevent future skilled labor shortages.
It is like keeping the bill collector
from the door by borrowing from the money-lender.
73
- 12 -
NEED FOR NEW FED REPORTING REQUIREMENTS
The requirement that the Fed report to Congress every quarter has
undoubtedly helped to increase Congressional and public understanding of
monetary policy.
But the present framework of these reports tends to be
misleading in several respects.
I believe that the following changes in the
content of these reports would facilitate Congressional understanding of, and
influence on, monetary policy:
1) Present
detailed
data for the key factors
related
to monetary
"velocity",
including:
a) actual and seasonally adjusted ratios to GNP and to final sales,
b) an estimate of the current basic trend value of these ratios,
c) an analysis of the trend in the seasonal factors of these ratios,
and the factors which cause this seasonal pattern,
d) detailed information on special factors which have affected the
"demand" for money (i.e. short-run fluctuations in the seasonally
adjusted "velocity" ratio) during the previous period, and those
which are expected to affect it during the upcoming period.
In
this statement, the Fed should distinguish between those factors
which have already been fully taken into account in the seasonally
adjusted M-l series, and those which have not yet been "adjusted out".
2) State
"total
in explicit
monetary
quantitative
stimulus"
—
terms its
forecast
(or poliay
target)
for
i.e. the sum of monetary growth and the "new money
equivalent" of the increase in "velocity" —
in much the same form that these
are presented in lines 1-3 of the table for IEA's "Monetary Forecast of Economic
Growth" (attached herewith).
Since this is the quantity which actually
determines the growth of nominal final sales and GNP, the Fed's forecast for
this sum would implicitly indicate its target for the growth of nominal GNP
(or final sales).
If the Fed is also required to state an explicit estimate of
the inflation rate, this will also indicate the Fed's forecast or policy goal
for real economic growth.
3) Cease reporting
a quarterly
target-range
for the growth of M-l.
—
There are several reasons why the Fed would tend to prefer a "range" rather
than a single figure:
(a) uncertainty regarding the trend of "velocity"
(which is the other component of total monetary stimulus),
regarding the rate of inflation,
31-045 O - 78 - 6
(b) uncertainty
(c) uncertainty regarding the overall balance
74
- 13 -
between the supply and demand for credit, and the fact that the Fed is supposed
to manage interest and credit as well as money growth, and
(d) the possibility
that, if inflation increases, the Fed may decide to induce a tight-money
recession to "fight inflation."
In actual practice, the lower limit of the Fed's target range has in every
case been so unrealistic as to constitute a mere "window dressing" for the benefit
of those who look on monetary restriction as the key to fighting inflation.
The
upper limit has usually also been unrealistic, and since the base for calculating
it has shifted each quarter, that limit also has been more confusing than
helpful.
It would be far more helpful to Congress and the public if the Fed were
to specify separately the various factors which have gone into calculating its
own money growth policy target.
4) Cease setting
"money
and credit
any policy
aggregates"
targets
except
M-l.
for M-2a M-3 and all
—
the
other
In actual fact, the Fed's manage-
ment of bank reserves has a significant direct effect only on checking deposits.
Moreover, it is only the growth of M-l that is causally related to real economic
growth.
Thus, the reporting of growth rates and setting of policy targets for
other "money and credit aggregates" is only confusing.
C. ADDITIONAL MEASURES TO ACHIEVE MORE PRECISE
MEASUREMENT AND CONTROL OF THE MONEY SUPPLY
There are several main sources of imprecision in the measurement and control
of the money supply in addition to its basic linkage with interest rates and credit:
a) the high "reserve leverage" of the present fractional reserve system,
under which a change of $1 in reserves supplied by the Fed to the
banking system results in a corresponding change of about $6 in the
money stock.
This correspondingly magnifies the effect of changes
in float, inadequate reporting, and policy errors.
b) the fact that many banks are not members of the Federal Reserve
System, do not keep their reserves on deposit at the Fed, and
submit their statistical reports only infrequently.
c) the Fed's inadequate information on demand deposit ownership, which
limits the Fed's analysis of the factors which actually influence
the "demand for money" (i.e. the actual cash-management attitudes
and practices) of different categories of depositors.
75
- 14 -
Below is a brief annotated listing of some of the measures which would
help to reduce these sources of imprecision.
1) Eliminate
all
have uniform reserve
reserve
requirements
requirements
for all
on time and savings
classes
deposits
of demand deposits.
and
—
Having to make allowances for the proportion of total reserves allocated to
deposits with different reserve requirements is at times a significant potential
source of error.
2) Require all banks to become members of the Federal Reserve System.
—
There are frequent and relatively large revisions of the money stock data caused
by the fact that the Fed does not get regular weekly reports from non-member
banks, and the fact that non-member banks are not required to keep their reserves
on deposit at the Fed.
3) Pay interest
on member banks '. reserve
non-member resistance to joining the Fed.
deposits>
as a means of reducing
While it is quite true that there
is a certain anomalous aspect to the Fed paying interest on reserves which it
has itself created, this is no more anomalous than permitting the banks to
earn interest on loans that they make with money that they themselves create.
But there is an overriding public interest in having much more precise
measurement and control of the money supply.
demand deposits.
— This would eliminate
the "reserve leverage" of statistical and policy errors.
4) Require
100% reserves
against
all
If the Fed pays interest
on the reserve deposits, there should be little bank opposition to this reform.
In essence, putting this into effect would require the Fed to buy enough
additional Treasury securities from banks and non-bank investors to provide the
banks with the necessary additional reserves.
The Fed would use the interest
it earns on these Treasury securities to pay interest to the banks on their
reserve deposits.
The non-bank investors who sell Treasuries to the Fed would
presumably use the funds to purchase some of the private securities which the
banks would be selling to obtain funds to meet the increased reserve requirements.
5) Floating
discount
rate.
—
In early May, when the Fed allowed a gap of
3/4% to develop between the discount rate and the federal funds rate, the
discount rate became a "bargain" source of funds, and there was a surge of
bank borrowing from the Fed, accompanied by a surge in the weekly money stock
measure — which upset Wall Street and provided an excuse for a further increase
76
- 15 -
in the funds rate.
Apparently a similar gap has been allowed to develop
during the past week, and will probably be followed by a similar surge of the
money stock.
Since the development of the federal funds market, the Fed carries out
its control of reserves almost entirely through open-market operations, and
the discount rate has lost its former significance as an indicator of
monetary policy.
If the discount rate were allowed to "float" with the
federal funds rate, it would no longer be a source of disruption in the
"money market" but would still serve as a "last resort" source of funds for
banks in trouble.
6) demand
deposit
ownership
survey.
—
The Fed is currently considering
the abandonment of the demand deposit ownership survey which it has conducted
since 1970.
Instead of abandoning it, the Fed should expand this survey to
include separate data on a number of significant sub-groups which have
significantly different cash-management attitudes and practices.
This would
provide a much-needed empirical basis for more precise analysis of the
"demand" for money.
FINAL NOTE
It is likely that a number of the proposals and analytical aspects
discussed in this statement lie outside the official mandate of this committee.
But I believe it is also true that some of the key aspects relating to the
coordination of monetary and fiscal policy do not fit very neatly within the
traditional mandate of any existing Congressional committee.
Therefore, I hope that this Committee will give some consideration to
this problem, and perhaps make some recommendation to Congress as to how
these matters could be most effectively dealt with by Congress.
I 2A. | MONEY STOCK (IVh; Daily Averages; billions of $ ; Ratio Scale)"
I I f I ? I M M I I I" II 1 I I I I 'I I I I I I I I I I I I I I M I I IF I 1 I I I I ' l l T I 'I ) I I I I I I I I I I I I
I
A y g
* Based on These Growth Rates:| 77 : 1-4
Real Final Sales & GNP
(+) Inflation (F.S. deflator)
(=) Nominal Final Sales & GNP
(-) "Velocity" (see table below)
=) Money (M-1) needed
New Money Equivalent
of "Velocity" Growth (%)|
Trend Seas, Total
77:4 1.9 2.2 4.2
78:1 2.0 -1.4 0.6
78:2 3.0
0 3.0
78:3 3.0 -0.9 2.1
Fig. 1. NEW MONEY EQUIVALENT OF "VELOCITY" GROWTH
This chart is the annual growth rate of the
ratio of M-1 to final sales, seasonally
adjusted by IEA. The heavy line is a twoquarter-centered ( 1 - 2 - 1 weighted) moving
average. This average is used as the shortrun trend for past periods in computing the
"money needed" line in Chart Panel 2A. The
dotted-line projection of this heavy line
is IEA's estimate of the future movement of
this trend.
MONETARY FORECAST''
(% change, annual rate)
| 1 NOMINAL MONEY STOCK
]Fore-[
cast1f
Actual
GROWTH RATE OF:
77:3|77:4|78:1 78:2 [
8.3 j 7.7| 5.7 10.0 j
(M^
| 2 NEW-MONEY EQUIVALENT OF "VELOCITY" CHANGE 2
2a Trend + Seasonal Factor3,5
2b Actual and Forecast4
1.7
1.4
4.2
0.6
4.3 -0.2
j
3.0 j
1 3 TOTAL NOMINAL MONETARY STIMULUS ( 1 + 2 ) 5
|
(= NOMINAL FINAL SALES )
3a Formula (l + 2a) 5
3b Actual (Forecast * 1 + 2b) 5
| INFLATION INDEXES
10.1 12.2
9.9 12.4
1
[
6.3ll3.4 [
5
'5| " 1
6
j
7.8
6.5
8.0 I
4 Consumer Price Index
5 Final Sales fixed-weight
5.0
4.9
4.7
6.2
6 FINAL SALES DEFLATOR
5.3
6.0 7.3 7.5
7 GNP deflator
4.8
5.9
3.0|
1.7
[ 8 "REAL" MONEY STOCK (1 - 6 )
7
7.0
7.0
7.2
-1.5J 2.4 |
1 9 TOTAL "REAL" MONETARY STIMULUS ( 8 + 2 or 3 - 6 )^1
j
(-
REAL FINAL SALES )
|
9a Formula (8 + 2 a ) 5
4.7
-9b Actual (Forecast = 8 + 2 b ) 5 j 4.4
5.9 -1.0
6.1 -1.7
5.5 1
(""REAL" GNP
1
10 Change in rate of inventory investment (% GNP)8
11 Real GNP (Forecast=9a+10)
C O R R E S P O N D I N G OPERATING
1.8
0.5
0.7 -2.1
3.8 |_ 0.0j[ 6.0
1 5.1
RATES9
12 Final Sales (see line 9 b ) 8 5 . 5 8 6 . 0 8 4 . 8 8 5 . 2
8 5 . 8 8 5 . 8 85.1 8 5 . 5
13 GNP (see line 11)
ECONOMIC GROWTH*
* General note on using this box. — The title
uses quotation marks to Indicate that this is not a
conventional type of forecast. It is designed
primarily to present the key macro-economic factors
which determine the economy's growth rate in a
systematic arrangement according to their basic
functional relationships, and thus, inferentially,
to provide an integrated framework for evaluating
the government's current monetary, anti-inflationary
and recovery policies.
The "forecast" column(s) in the monthly Review
and Prospect
have a twofold purpose: (1) to provide
subscribers with IEA's "best guess" regarding the
immediate future values of lines 1, 2b, 4-7 and 10
which will result from current and prospective
policy actions, and (2) to provide subscribers with
a framework in which they can easily modify IEA's
"forecasts" according to their own assumptions or
predictions — or with later data.
Note:
The relationships in this box do not
imply any lag between change in the money supply
growth rate and in the growth of nominal (current $)
spending. IEA research indicates that there has
been no significant lag since
1973, and also that
there is no consistent
or inherent
relationship
between money growth and the inflation rate.
1. Values are entered in the "forecast"
section
of rows 2b, 3b and 9b only when there is good reason
to believe that the actual change in "velocity"
during the quarter will be significantly different
from the normal trend rate (plus normal seasonal
factor). Otherwise, the "formula" and "forecast"
values are identical.
2. To simplify the formula for precise estimation of total monetary stimulus, the growth rate of
the traditional flow/stock
"velocity" ratio is used
here rather than the reciprocal stock/flow
ratio of
IEA CHARTS Panel 19. Note that the positive
rateof-increase values of "velocity" are slightly higher than the corresponding negative
rate-of-decline
values for the stock/flow ratio in Panel 19 (e.g.
90 is 10% below 100, but 100 is 11.1% above 9 0 K
see over for notes
3-9
79
NOTES TO "MONETARY FORECAST" OF ECONOMIC GROWTH continued
„ 3. Line 2a.
2U 1M 73d 2Z2,
Trend
2.5 ».« 2.0 3.0
Seasonal Factor -Of 22 -1.4 0.0
total
1.7 4.2 0.6 3.0
(For derivation, see IEA SPECIAL REPORT #2.
These are still preliminary estimates. Their
urther improvement will be a key aspect of IEA's
continuing research.)
4. Line 2b. — The difference between lines 2a
and 2b (i.e. between trend-plus^'normal*'-seasonalfactor and the actually realized "velocity" change)
reflects all of the statistical estimating errors,
"technical" factors, and functionally significant
"random" factors affecting the relationship between
monetary growth and the growth of nominal final
sales, including:
(a) any estimating error, abnormal seasonal
factor, or other special ("random") factor
affecting the seasonally adjusted money supply
and/or final sales (later revisions of both
series are sometimes relatively large);
(b) any error in the calculated seasonal
factors of the "velocity" ratio;
(c) any "technical" distortion of the normal
"monetary multiplier" process by sharp changes
in the amount or timing of "new money" flows,
especially when associated with shifts between
federal government and private checking deposits;
(d) any as-yet-unrecognized change in the
basic trend of the stock/flow ratio;
(e) any short-run functionally
significant
fluctuations in the stock/flow ratio (i.e.
fluctuations in the basic "demand" for moneyinventory) such as those caused by speculative
"hoarding" of either goods or money, or by
"beat-the-price-increase" spending;
(f) changes in the conceptual and statistical
definition of Mj (such as the legislation permitting check payments to be made from interestbearing savings accounts, but continued exclusion of such accounts from the official M,
measure of the money supply), and changes in the
rate of public response to such changes;
(g) any other "random" or special short-run
factors affecting the stock/flow ratio;
(h) any systematic relationship which there
may be between changes in the stock/flow ratio
and the growth-rate or operating rate of the
economy.
In IEA's initial experiment with "monetary
forecasting" (see SPECIAL REPORT #2), the forecast
value missed the actual value by 2% or more in 25%
of the quarters during 1970-76. But the
2-quarter
moving average was accurate within 1% in all but
11% of the quarters. This suggests that an abnormal
tviation from trend in one quarter tends to be
offset by an opposite deviation in the next.
5. The formula combination of growth rates is
expressed in the parentheses as simple
addition
(x + y) or subtraction
( x - y ) . This simple "rule-ofthumb" calculation is accurate enough for many purposes — usually within H% of the true value of the
combination. But the true multiplicative
value can
be calculated by the simple procedure below:
TO "ADD" GROWTH RATES "X" AND "Y"
(1) convert each growth rate from percent to
ratio
form, thus:
a. divide the % rate by 100 (move decimal
2 places to left) and
b. add 1.0 to the result (which makes negative growth rates less than 1.0, but
positive in sign — see example 2 below);
(2) multiply the two results;
(3) reconvert the result to percent, thus:
a. subtract 1.0 (result may be negative)
b. multiply by 100 (decimal 2 places to right).
TO "SUBTRACT" GROWTH RATE "Y" FROM GROWTH RATE "X":
Follow the above procedure, except that in step 2
"x" is divided by "y" (see example 3 below).
Three examples:
D ,.,X • Y"
4) "X • V"
® «- ,
(y is negative)
4.5% + 10.0%
3.5% + (-6.5%)
3.5% - 6.5%
(Da. 0.045, 0.100
0.035, -0.065
0.035, 0.065
1.035, ,0.935
1.035, 1.065
b. 1.045, 1.100
1.045 x 1.100
1.035 x 0.935
1.035 4- 1.065
(2)
- 1.1495
- 0.9677
- 0.9718
(3)a. 0.1495
-0.0323
-0.0282
b. 15.0% (ue 14.5)| -3.2% (vs -3.0) -2.8% (VS -3.0)1
Corresponding "rule-of-thumb" values are shown
(in parentheses) for comparison.
6. Various measures of the inflation rate are
shown here to indicate the extent to which reported
"real" growth rates may depend on the particular
price index used — and the extent of quarter-toquarter variability. Implicit suggestion: evaluate
short-run growth rates with a grain of salt!
7. Line 8. — For this purpose, the money stock
is deflated by the final sales deflator,
in order
that the computed formula-real-final-sales (line 9a)
will be consistent with officially-reported
real
final sales (line 9b). Thus, line 8 differs slightly
from the growth of the real money stock in IEA CHARTS
2.1 and 18.2, which uses the GNP deflator.
(It also
differs from the real money stock series in Business
Conditions
Digest and the Commerce Dept.'s "Composite
Index of Leading Indicators," which uses the CPI.)
8- Line 10. — These values are computed as the
difference in inventory investment in 72$ values,
divided by 72$ GNP, and multiplied by 4 to approximate the annual-rate values. When the inflation
rate is relatively low, these values approximate
four times the changes shown in Chart 9.1a.
(Because of the complex relationships involved,- the
"rule-of-thumb"-computed values in line 10 are
usually not precisely the same as the actual difference between the final sales and GNP growth rates.)
9. As a rough forecasting "rule-of-thumb," the
change in the operating rate * the recovery component
of the growth rate (i.e. approximately the total
growth rate minus 4%) divided by 4 (to approximate
the quarterly effect of the indicated annual-rate
growth rate).
« t 9 7 » WSTITUTE FOB ECONOMIC ANALYSIS. INC.. 1346 Connecticut Avenue. N.W.. Wash.ngton. D C . 20036. Phone 202 872-8054
80
Chairman MITCHELL. Might I comment. When we attempt to deal
with a rather narrow area of consideration, the draw authority, it is
very difficult to keep within that scope, and not go into all of the
broader implications of the Fed's monetary policy.
I would like to suggest that at some time in the near future we will
examine the Federal Reserve's monetary policy practices in detail.
And certainly, your statement here will be entirely applicable.
Mr. BARNARD. Mr. Chairman, if you would yield?
Chairman M I T C H E L L . Yes.
Mr. BARNARD. First of all, let me say at the outset that I have
enjoyed both the testimonies that have been offered so far. They have
been very enlightening. And they certainly address some problems
t h a t really need to be addressed. I know that this subcommittee
was planning to undertake a study of monetary policy, and I thought
maybe you had gotten into it without
Chairman MITCHELL. N O ; I certainly had not. I understand perfectly why both of the witnesses had gotten into the broad, related
issues, because it is impossible to talk about the draw authority without touching on monetary policy, too.
However, you are quite right; there is going to be a series of hearings
on the entire larger question.
Mr. BARNARD. We have had the first installment.
Chairman M I T C H E L L . Yes; you have been the precursors for the
hearings that will be coming.
Mr. BARNARD. I t has been very interesting.
Chairman M I T C H E L L . Mr. Kudlow? Don't apologize, Mr. Kudlow,
for being late. Most of us were late or nearly late because of power
outages.
Mr. KUDLOW. Good. T h a t makes me feel a little better. This was
an airplane outage, as it turns out.
Chairman MITCHELL. I advised the other witness t h a t we are under
rather tight time constraints because so many hearings are going on
this morning.
We have your entire statement, which will be submitted for the
record. We would appreciate it if you would capsulize it in 10 or 15
minutes.
STATEMENT OF LAWRENCE A. KUDLOW, VICE PRESIDENT AND
MONEY MARKET ANALYST, PAINE, WEBBER, JACKSON & CURTIS,
INC.
Mr. KUDLOW. Yes; I would be glad to. At Dr. Weintraub's request,
essentially, this is a discussion of some problems of implementation
of monetary policy. I t does not go into the issue of the Treasury's
new cash management practices and the like.
M y concern is with the failure of the monetary agency to contain
money sjiipply growth rates within the targets they themselves have
set in recent years.
As the chart indicates after page 4, you can see that the Fed has
not been able to achieve its own goals, since the early part of 1977,
and moreover, looking ahead, taking account of current trends, it
further appears that the Fed will be unable to achieve its goals well
into the year 1979.
81
The disappointing aspect of this for me, of course, apart from the
inflationary implications of this rather generous money supply growth
rate of the past IK to 2 years, is that there are very few people in
Congress who have undertaken a serious evaluation of one of the principal stumbling blocks to controlling the money supply; that is, the
Fed's own policies of execution or implementation.
In fact, I noted in the testimony that—I have been sitting in on
hearings for House and Senate banking committees and subcommittees for about 3 years since I left the Federal Reserve and came to
the private sector—I don't recall any instance, frankly, of a detailed
examination of the Fed's implementation and execution policies.
There is lots of talk about interest rates and lots of talk about the
money supply, but not much about what actually happens each day
day at the Federal Reserve bank, the New York trading desk, which
in my opinion, is of fundamental importance.
What I try to bring out in the testimony is a brief, by no means
exhaustive, but I think germane study, of these execution policies.
The Federal Reserve targets money supply, as you know, over the
intermediate run. Since 1970, and specifically, 1975, the Fed has
sought to achieve its goal of noninflationary economic growth and
foreign exchange stabilization by means of setting moderate, agreed
upon, goals of money supply growth.
As I said at the outset, the Fed has not been able to achieve this.
And I would argue, in large measure, the reason for the Fed's failure
to achieve their own goals is the outdated, indeed obsolete means, of
controlling the money supply.
Each day, the Fed seeks to control interest rates, mainly the Fed
funds rate, with which you are quite familiar. This is done through
the New York Fed trading desk.
And there is an inherent contradiction here between interest rate
control and monetary control. Let me illustrate this quite briefly, in
effect, by reiterating some awfully good testimony, I thought, given
to this subcommittee in the summer of 1976, by Fed Governor
Charles Partee, who used to run the research department at the
Federal Reserve Board.
Governor Partee testified that to achieve money supply growth
rate targets required great attention to the bank reserves supply
which the Fed controls, rather than some short term interest rate
target like the Fed funds rate.
And Governor Partee argued—and again I think quite correctly—
that trying to control interest rates might achieve some stability
in the short run on the part of rates, but would result in substantial
instability in the intermediate and long run with respect to the
economy.
That is, during periods of rising demand, for example, the Federal
Reserve might try and keep a Fed funds rate stable, shall we say,
7.5 percent. But with demand pressures rising, unless the Fed intervened to add reserves to the banking system, that Fed funds rate
will rise to 7.75, 8, or 8.5 percent. That is roughly what is taking
place today.
Unfortunately, by stabilizing that Fed funds rate in the short run,
the central bank merely achieves a substantial additional increase
in bank reserves supply, which is the raw material of money supply
growth.
82
Thus, this notion of controlling rates by buying U.S. Treasury
bills and adding to the reserve base, simply works to pump up the
money supply. Inflation expectations in the general economy are
worsened. As individual investors and businessmen, and indeed labor
union leaders for that matter, observe this expansive monetary course,
they assume inflation will get worse in the next year or so and they
demand inflation premiums.
I t might take the form of higher wage contracts. I t might take the
form of higher product pricing. In the financial markets, ironically,
inflation premiums take the form of higher interest rates. T h a t is,
the Fed can only succeed in controlling rates in the very short run.
Ultimately, inflation expectations and other economic forces will
work to subvert these policies. What is left is an additional growth
in the reserve supply and additional growth in the money supply.
I am prepared to argue that it is axiomatic that higher inflation is
a destabilizer in the economy. I t is a disincentive to invest. I t is a
disincentive to employ. Capital formation is reduced. And, of course,
interest rates wind up rising, perhaps by a greater degree than might
have otherwise been the case, thereby throwing the economy ultimately into a period of recession. This is the traditional Fed operation
of stop-and-go monetary policy. We are right in the middle of that
cycle right now. Many forecasters, myself included, have come to
fear that we will reach a recession sometime in 1979 or 1980.
So to briefly review: Although the Fed in a way has come a long
way the last 10 or so years, rather than explicitly targeting interest
rates, they moved toward targeting the money supply. The Fed has
recognized publicly, as so many economists have before, that there is
a clear relationship between money growth and future price growth,
and also between money growth and future income growth. Unfortunately, the means by which the Fed attempts to control money
supply is an obsolete approach which is a throwback to the earlier
period when interest rate targets dominated Fed thinking.
We have the New York trading desk on the one hand, trying to
control that Fed funds rate every day, and we have the Open Market
Committee and the Board of Governors of Washington on the other,
talking about targeting the money supply.
These two approaches are essentially incompatible, and they work
toward economic instability, rather than stability. And indeed, as I
argue, even with respect to the notion of interest rate stability, efforts
by the Fed to prevent the normal business cycle increase in rates, a
phenomenon that has always taken place during business cycles, are
ultimately subverted by inflation expectations that result from overrapid bank reserve and money supply growth.
In response to this dilemma; that is, the utter failure to achieve the
very goals set by the Fed, with a sharp reduction in credibility, it is
no coincidence that we experience substantial turbulence in dollar exchange markets abroad as foreign investors watch the Fed fail to
grapple with monetary control and fail to grapple with containing
inflation. As we observe these economic difficulties at home and
abroad, I propose that as problematic and as troublesome as these
events are, there is nonetheless a fairly clear set of alternative approaches which might be utilized. In any case, I think alternative
approaches deserve the attention of this subcommittee and perhaps
83
other congressional bodies as well. I am not talking in terms of broad
policy goals. I am talking about the execution of the policy; the dayto-day implementation.
I would argue first of all, the Fed ought to clear up what its own
goals are with respect to the money stock. Let us have a clearly defined money supply growth rate and then shoot for it. For M 1 ; I
would suggest something in the magnitude of 2 to 4 percent—which
is roughly in line with the long-term growth trend of the U.S. economy. The real output potentially grows at 3 to 3.5 percent. That is
all money growth should seek.
Second, turning back to this matter of the execution problems, I
would argue that the Fed should relinquish its intention of efforts to
control rates, and instead should focus its emphasis on efforts to control the raw material of money supply, which is bank reserves.
The Fed is well in control of the reserve base. The Fed knows each
day what the so-called operating factors are. These include Treasury
deposits, float, currency, and the like.
Of course, it is the Fed, and only the Fed, that can buy and sell
Treasury bills and other Government securities which add or absorb
reserves. Some data analysis we did to bring your attention to this
problem is exhibited on the table after page 12. I know statistics can
be very dry. I know the time of the Congressmen is short. However,
some economists occasionally use data to provide a basis for their
arguments.
Briefly, what we have illustrated through some very straightfoward
regression analysis is a substantial relationship between a measure
of bank reserves, in this case the monetary base, and a measure of the
money supply, in this case Mi. I want to bring to the subcommittee's
attention that as we move over longer periods of time, particularly
3-, 6-, and 12-month periods, that the statistical relationship improves
substantially. The R 2 —the R 2 is a statistical indicator that shows
there is a high relationship between the base and Mi. The R 2 is 0.7
over a 12-month period. That is a very close statistical fit, and suggests that there is indeed a clear linear relationship between the monetary base and the money supply, in turn implying that if the Fed
were to control the monetary base, it would have a better handle, a
leg up, if you will, in controlling the money supply.
Looking back to page 9 in the testimony, we observe an insignificant
relationship between the Fed funds rate and the money supply. The
Fed tries to control the Federal funds rate. As I indicated, this is the
key rate for daily operations conducted at the New York trading
desk. Here, over 1-, 2-, 3-, 6-, and 12-month periods, low R 2 indicate
the absence of any significant statistical relationship. My point here
is, for years, bound mostly by tradition and habit, the U.S. central bank
has pursued policies presumably with an eye toward controlling the
money stock, which have no basis in fact, no statistical foundation.
There has never been a mandate from business economists or from
academic economists or, indeed, from elected or appointed officials,
to suggest that the business of controlling rates as a way of controlling
the money supply is a useful or effective approach. In a way, put quite
plainly, in my view the Fed has gotten away with mayhem over the
years, particularly the last 5 or 10 years, because, although in response
to congressional initiatives the Federal Reserve has changed its
84
intermediate target to a money supply target, it has not changed the
method by which it operates each day in the financial markets.
And, as long as the Fed keeps trying to control interest rates, it is
doomed to fail in controlling the money supply.
Looking again toward the back of my prepared statement, after
page 12 you will see a series of graphs. These are relationships between
the monetary base and Mi. I have run three graphs. All I have done
here is to take the monetary base versus Mi, and I am looking at the
spread—the growth in Mi minus the growth in the monetary base.
I argue here that, since the Fed controls the base each day—that
is, the volume of bank reserves plus currency—essentially, in doing so,
they would have a much better chance of controlling the money
stock. The standard error, describes over long periods the width of the
spread between Mi and base growth rates. If the spread were particularly wide, it would be almost futile to attempt this approach.
Sometimes it is 5 percentage points. T h a t is simply not good enough.
They are doing that as it is.
However, looking at the 6- and 12-month periods, the standard
deviation is reduced to only 1.3 percent. Thus, were the New York
Fed to target monetary base growth of around 3 percent year over
year, statistical tests indicate that the Fed would achieve money
supply growth within about 1.5 percentage points on either side,
perhaps as low as 1.5 percent or perhaps as high as 4.5 percent. This
would reflect a substantial narrowing from the error range the Fed
currently permits.
Against this background, my first suggestion proposes that the Fed
relinquish its efforts to control rates and should instead focus its
efforts on controlling the monetary base. In so doing, they would better
control their intermediate targets, that is, the money supply, over 6and 12-month periods. In this regard, I encourage the Fed to end
attention to 1-week or 1-month or 2-month movements in the money
supply. There is too much hysteria among financial market participants over these short-term data. I include the banks and the nonbank
dealers in this. Much of this is caused by the Fed itself. Weekly
numbers and monthly money supply numbers have no economic
meaning at all. They are mostly a function of statistical noise and
seasonal adjustments.
What matters with respect to influencing income and inflation is
monetary growth rates over periods of 3, 6, or 12 months, or considerably longer. This then, becomes our second proposal.
I believe, through the use of statistical techniques, that the Fed
would be better advised to look at the monetary base as a means of
controlling the money supply. If this control were undertaken over
longer periods of time, it would enable the Fed to keep Mi growth in
a noninflationary range.
This is essentially the message; I am going to stop there. The testimony covers a bit more ground, but due to the constraints of time and
the like, I think I will end it right there. Thank you.
[Mr. Kudlow's prepared statement follows:]
PREPARED STATEMENT OF LAWRENCE A. KUDLOW
Mr. Chairman, it is a pleasure to meet with this Subcommittee today to present
my views on the conduct and implementation of U.S. monetary policy. It almost
goes without saying that the execution of monetary policy has a profound effect
85
on the course of actual money supply growth and, in consequence, on the movement of key economic variables such as output, employment, inflation, and
interest rates. Even so, it remains generally true that matters pertaining to the
execution of day-to-day Fed operations, administered by the Trading Desk at the
Federal Reserve Bank of New York and directed under FOMC instructions by
the System Account Manager and the Deputy System Account Manager, receive
little Congressional notice and even less evaluation.
In three years of attendance at House and Senate Banking Committee hearings
for monetary oversight, I cannot recall a single instance where the Fed's daily
implementation procedures were critically assessed. This I believe is most unfortunate, for it is my firm view that the disappointing monetary performance of
the current business cycle, as in the case of past business cycles, can be directly
linked to faulty and obsolete methods of monetary control rooted in the deeply
held Fed conviction that interest rate stabilization through control of the Fed
funds rate is the proper short-run monetary policy lever. And, let me add at the
outset of this testimony, it is my view that the continued use of this procedure
implies a commitment toward a condition of permanently high inflation in the
domestic economy, along with continued turbulence in dollar exchange markets
around the world.
The Fed's commitment toward some form of interest rate control dates back to
the very inception of the U.S. central bank. In earlier times the principal rate
lever was the measurement of member bank borrowings, and this gradually gave
way to the setting of targets for free reserves. The free reserve doctrine is essentially
an interest rate—ember bank borrowing approach, as the level of borrowing (as
influenced by the discount rate) is the dominant element in the free reserve
identity.
Traditional reliance on an interest rate control rule may have come about due to
the long held notion that the proper intermediate-term monetary policy goal ought
to be the supply of credit, and thus it was thought that shifts in the price of credit
would bring about desired changes in credit supply and demand. Additionally, it
does not seem unreasonable to presume that the Fed's preoccupation with maintaining orderly financial markets stems in part from fears of banking panics, panics
which occurred with almost cyclical regularity during the nineteenth century and
the early part of the twentieth. Such fears were buttressed during the depression
(1933), and these fears were to some extent revived during recent crises over Penn
Central (1970) and the Franklin National Bank (1974).
By 1970, however, the authorities tilted policy toward a monetary control rule.
This approach, long advocated by economists who recognized that money supply
changes exert a major influence on output and inflation, then became the dominant
intermediate-term objective. Starting in early 1974, the FOMC began specifying
quantitative ranges of tolerance over short-run intervals. By the spring of 1975,
after passage of Concurrent Resolution 133, the Fed began reporting year-overyear monetary targets in regularly scheduled sessions before the House and Senate
Banking Committees. This reform was widely heralded as a major step in the direction of a more rational monetary policy that might help the Fed realize its long
term objective of steady, noninflationary economic expansion accompanied by
dollar exchange market stability. At the same time, various Fed spokesmen pledged
central bank determination to gradually decelerate money supply growth rates as
an important means of dampening inflation expectations and reducing actual
inflation rates.
Now, three years after the passage of Resolution 133, monetary performance
has turned out as disappointing as in any time during the past. Not only has the
Fed failed to achieve its own money supply growth rate targets, but the inflation
rate has accelerated in an all too familiar pattern. Moreover, with the sharp rise
in inflation and rates of interest the U.S. economy is again faced with the increasing probability of a substantial recession during 1979 or 1980. Thus, the
more things change, the more they remain the same.
As the accompanying charts indicate, the Reserve has not achieved monetary
growth rates (Ml) within specified ranges since the spring quarter of 1977, a year
ago. Further, evidence suggests that the monetary overrun pattern will continue
well into 1979. Partly in response to this failure, the Fed has not lowered the Ml
target over the last year, thus undermining its commitment to seek slower monetary growth consistent with diminished rates of inflation. In assessing these
failures, the principal culprit appears to be the Fed's determination to cling to
short-run implementation procedures of interest rate control, despite the shift
toward an intermediate-term goal of money supply control. And, without question,
the two are inconsistent and incompatible. In these circumstances we observe a
86
Fed dilemma which is now nearly ten years old: how to balance the goal of monetary stability with the goal of interest rate stability. With more evidence from
the next series of charts, it is clear that the Fed has generally opted to resolve
this dilemma through the control of rates rather than money.
370|
B
I
L
L
I
0
N
S
PROJECTED Ml
36O
360
I
L
L
I
0
N
S
350
350
340
330;
320
300!
290
SOURCE: FEDERAL RESERVE BOARD,
Year Ending
FOMC Specification for Ml
Actual Ml Growth
1976 March
2Q
3Q
4Q
5 1 / 2 - 7 1/2 (6 1/2)
5 - 7 1/2
(6 1/4)
4 1 / 2 - 7 1/2 (6)
4 1/2-7
(5 3/4)
5.0
5.2
4.6
5.7
1977 IQ
2Q
3Q
4Q
4
4
4
4
6.3
6.6
7.8
7.9
1978 IQ
2Q
3Q
4Q
1979 IQ
%
1/2-7
(5
1/2-7
(5
1 / 2 - 6 1/2 (5
1 / 2 - 6 1/2 (5
3/4)
3/4)
1/2)
1/2)
4 1 / 2 - 6 1/2 (5 1/2)
4 - 6 1/2
(5 1/4)
4 - 6 1/2
(5 1/4)
4 - 6 1/2
(5 1/4)
6 1/2
7.5
7.9e
7.7e
7.5e
(5 1/4)
e — based on PWJC estimates
Against the background of a policy of interest rate control, it is not surprising
that actual money supply growth is well above targeted ranges. During a prolonged period of rising fiscal demand, such as the current recovery, the authorities
are forced to add to the bank reserve supply in increasingly generous fashion in
order to prevent normal private market forces from driving rates higher. That is,
to offset rate pressures stemming from increases in the demand for reserves, the
87
Fed works to expand the reserve supply. However, this growth in the reserve
base provides the raw material for a subsequent strengthening in monetary
aggregates.
By choosing to contol interest rates, or by working to temper or moderate
normal rate pressures released by the forces of an expanding private economy,
the Fed finds itself again and again in a vicious circle of rapid bank reserve growth,
leading to excessive monetary growth, with the effect of fueling demand pressures
and aggravating inflation expectations. And, the ultimate result of this progression of events is a renewal of interest rate pressures that prompts the Fed to
supply even more reserves, thus beginning the circle anew.
Chart 4
FOMC Ranges for Short-run Monetary Growth and for the Federal Funds Rate, 1977
20
«
&- J
j Jan
4
Sep & C
»•> ,»itmf*v»
f—t
'
'Jan' " " W ^
)mi\i»mi»UaAiSaUm,
Actual growth
Jan &
Mar & Apr
Fee Feb & Mar|
-J.
40
diftitfilhMi
ITI .1 « • U l ' l
Narrow Monty Stock ( M l ) * .
Two-month ;rowtri rate
:>Miifwy*)v
mjyf.nyjuJ,*
,_ i —
1
- W ^ ' A p r ^ ' i y y 'Kv^^
» FCM'J's : •••'. •; *1 rvnrr.n for r:>
.cf -ci ra». -D Jc. Feicrai «..-.'«.
In this fashion, as the authorities seek to control the Fed funds rate, monetary
policy becomes procyclical rather than counter-cyclical. The growth in reserve
and money aggregates creates new demand pressures at that point in the business
cycle when policy should be geared to demand restraint. Conversely, if demand
is falling, the Fed is apt to absorb reserves, thereby reducing money growth and
creating an even steeper decline in activity. In this way monetary policy works to
deepen the influence of recessionary forces at a point in the economic cycle when
demand stimulus is more appropriate. In summary, a policy in pursuit of interest
rate stability inevitably leads to substantial economic instability.
In testimony before this Subcommittee two years ago, Federal Reserve Board
member J. Charles Partee demonstrated a clear understanding of the interest
rate-bank reserve dilemma. At a key point in his prepared text, Governor Partee
stated:
If the Federal Reserve did nevertheless attempt to maintain selected interest
rates at some predetermined level, the effort could well lead to inappropriate
rates of growth in bank reserves and the money stock. If interest rates came under
pressure because of rising demands for funds, for example, System efforts to
prevent interest rate increases would inevitably generate more rapid monetary
expansion, thereby feeding new inflation pressures. If, on the other hand, interest
rates came under downward pressure because of slackening business activity and
88
declining demands for funds, System efforts to prevent the decline in rates would
inevitably retard monetary growth rates and quite possibly exacerbate the recessionary problem.
Thus, any serious effort to specify monetary policy aims in terms of interest
rate intentions or expectations could well prove inconsistent with stated objectives
for growth rates in the monetary aggregates. . . . Needless to say, these effects
would be quite perverse from the standpoint of economic stabilization.
Needless to say, as the Fed has moved to in traditional moderate interest rate
increases during the past two years, the perverse and destablizing effects of rising
rates and inflation have gradually come to dominate the economy. Even more
perversely, although interest rates have increased substantially during the past
18 months, so too has the growth in bank reserves, thus fueling a series of inflationary money supply impulses. In Congressional testimony last winter,
Chairman Miller stated: " . . . as relatively rapid monetary expansion continued,
the Federal Reserve gradually exerted increasing restraint in the provision of
bank reserves. . . " Yet, a careful look at the data reveals that money market
conditions underwent substantial firming, but bank reserve conditions during
the period actually became more accommodative.
Month
1977:
January...
February
March
April
May
June
July
August
-
October
December
1978:
January
February
March
April
May
June
_.
Total reserve
growth (over 12mo intervals,
seasonally adjusted)
Federal funds
rate (effective
average rates)
1.1
.9
1.0
1.8
1.6
1.8
2.8
3.3
3.8
3.9
3.5
3.5
4.61
4.68
4.69
4.73
5.35
5.39
5.42
5.90
6.14
6.47
6.51
6.56
5.9
6.9
6.2
6.3
7.1
18.3
6.70
6.78
6.79
6.89
7.36
17.52
i Estimates.
Thus it appears that the Fed is again caught in an inflationary cycle that is
sustained by procedures of interest rate control implementation that not only
serve to destabilize business conditions with the threat of an inflation induced
recession, but also serve to drive interest rates higher and for a longer period of
time than might otherwise be the case if private market forces were left unfettered. What's more, despite frequent intervention to control the funds rate, the
authorities have utterly failed in their effort to contain monetary growth within
targeted ranges. Indeed, this interest rate orientation is a highly suspect tool of
monetary control. In fact, even more than suspect, there is no evidence to support
the Fed funds-money supply relationship alleged by the Federal Reserve. The
connection between interest rate changes and money supply changes has proven
to be unreliable and highly volatile. This non-relationship is documented by the
accompanying statistical tests. Measured
over intervals spanning from one to
12 months, the exceedingly low R 2 's indicate that the interest rate-money relationship has no statistical significance.
Moreover, there has never been an clear mandate from either business or academic economists, or from members of Congress, or from the White House, that
controlling interest rates is an effective policy instrument to control the money
stock. Down through the years the Fed has always utilized this appoach, but
the fact remains that the approach itself has never been substantiated. Even
worse, Fed intervention in open market operations to stabilize the funds rate has
increased substantially in recent years. And, with this in mind, the reasons behind
the persistent problem of generally disappointing economic growth, accompanied
by an unrelenting inflation, become a good deal less mysterious than many analysts would have us believe.
89
The short-term operating approach of rate stabilization has during the past
decade tended to steepen the slope of business and credit cycle movement. Monetary policy has entered a consistent and predictable pattern of stop and go. bBt
inflation expectations during the period have worsened, so much so that prices
continue to rise even during periods of output decline. The process of enforced
rate control, really a policy of price controls, interferes with the important allocating function of interest rates. Rising rates serve to dampen plans for production and spending, and thus help to prevent conditions of excessive demand that
are likely to yield more rapid inflation.
STATISTICAL ANALYSIS
(based on monthly data, January 1960 - May 1978)
Relationship between 1 month growth in M1 and 1 month percent change in the Federal Funds Rate
(FFR)
1 month % change in M1 = 5.04 - .00002 (1 month % change in FFR)
(17.24)
(0.52)
2
R a d j . = .003
Relationship between 2 month growth in M1 and 2 month percent change in the Federal Funds Rate
(FFR)
2 month % change in M1 = 4.94 + .0007 (2 month % change in FFR)
(20.87)
(0.45)
R 2 a d j . = -.004
Relationship between 3 month growth in M1 and 3 month percent change in the Federal Funds Rate
(FFR)
3 month % change in M1 = 4.86 + .002 (3 month % change in FFR)
(23.91)
R
(1.26)
adj. = .003
Relationship between 6 month growth in M1 and 6 month percent change in the Federal Funds Rate
(FFR)
6 month % change in M1 = 4.71 + .008 (6 month % change in FFR)
(26.60) (2.59)
R
adj. = .03
Relationship between 12 month growth in M1 and 12 month percent change in the Federal Funds Rate
(FFR)
12 month % change in M1 = 4.61 + .013 (12 month % change in FFR)
(30.40) (3.44)
2
R adj. = .05
-e:
"t" statistics are provided in parenthesis.
R2 adj. is a measure of goodness of fit. An R2 adj of .70 means that 70 percent of
the variation in M1 growth is explained by variations in monetary base growth.
But, under the conditions of stop and go monetary policy, with an uninterrupted rise in the secular inflation rate, business and financial planning has become
next to impossible. The increase in risk and uncertainty serves as a disincentive
for capital formation, with a resultant drag on output and employment trends.
With government authorities announcing policy targets that are never achieved,
credibility is substantially reduced and economic agents come to expect that the
rules of the game will be changed arbitrarily. This of course enhances risk and
uncertainty even more, thereby further reducing incentives for longer-term
investment.
Finally, the alleged government anti-inflation commitment is discarded in the
minds of rational agents who dismiss such promises as meaningless political
rhetoric. Monetary policy failures cannot take all the blame for fostering this
31-045 O - 78 - 7
90
unattractive economic and investment climate; inappropriate fiscal and regulatorypolicies have contributed mightily. However, an analysis of the fiscal-regulatory
climate goes beyond the scope of this paper, however, and will have to serve as
grist for another mill.
To substantially improve monetary performance, and at the same time rebuild
government credibility on the anti-inflation front, the Federal Reserve must completely overhaul its implementation procedures. Toward this end I recommend the
following steps: First, the agency must decide on the most appropriate longer term
trend growth rate of the money stock. I would recommend a range of 2 to 4 percent, roughly in line with the rate of change of real potential output (3-3J4
percent).
Second, to more effectively contain the growth of the money stock and bring
performance closer to objectives, the agency must abandon the discredited interest
rate control approach and instead seek to control the growth rate of the bank reserve supply. The System Account Manager has daily knowledge of all the so-called
operating factors (Treasury deposits, float, etc.) and thus can easily control the
monetary base, in my view the broadest measure of Fed open market operations.
The accompanying statistical analysis indicates a clear relationship between rates
of base change and rates of money stock change. Importantly, measured over 3, 6,
and 12 month periods, the high R 2 's indicate a significant and rising correlation
between the two growth rates. Moreover, the graphs associated with the regression
analysis clearly show the relatively stable relationship between the base and the
money stock over longer periods.
In contrast, short-run movements of the money stock are dominated by statistical noise and seasonal adjustment factors and, as such, have no economic meaning. In consequence, the Fed should end its preoccupation with attempts at finetuning 1 and 2 month Ml growth patterns. The Fed should also admit that its
short run money forecasts are as unreliable as those of the private sector. Weekly
money supply changes should be assigned the obscurity they so richly deserve.
And, laid to rest in the same grave, next to the weekly projections, should be the
1 & 2 monthly corpses as well.
Instead, the Fed must actively campaign to emphasize the importance of 3, 6,
and 12 month monetary trends, for it is these trends that influence income growth
and inflation patterns. I believe the most valuable indicator would prove to be Ml
changes over 12 month intervals, adjusted each month. For example, if base
growth were maintained around 2.5 percent per year, statistical tests indicate that
Ml growth might fluctuate in a relatively narrow 1.2 to 3.8 percent range. With
the aid of advanced statistical techniques, particularly recent improvements in
the Box-Jenkins approach, improved money multiplier forecasts could be used to
narrow the 12 month Ml range even further. In these circumstances data received
each month would be viewed not as a highly volatile and unsettling benchmark,
but instead as part of a gradually evolving adjustment process to maintain steady
money stock growth rates on a year-over-year basis.
91
STATISTICAL ANALYSIS
(based on monthly data, January 1960 - May 1978)
Relationship between 1 month growth in M1 and 1 month growth in the monetary base (MB)
1 month
% change in M1 = 3.35 + .26 (1 month
(7.93) (5.19)
% change in MB)
R 2 a d j . = .11
Relationship between 2 month growth in M1 and 2 month growth in the monetary base (MB)
2 month % change in M1 = 1.67 + .52 (2 month % change in MB)
(4.16) (9.36)
R 2 adj. = .28
Relationship between 3 month growth in M1 and 3 month growth in the monetary base (MB)
3 month % change in M1 = .49 + .71 (3 month % change in MB)
(1.37) (13-38)
R 2 adj. = .45
Relationship between 6 month growth in M1 and 6 month growth in the monetary base (MB)
6 month % change in M1 = -.15 + .80 (6 month % change in MB)
(0.50) (18.54)
R 2 adj. = .61
Relationship between 12 month growth in M1 and 12 month growth in the monetary base (MB)
12 month % change in M1 = -.09 + .80 (12 month % change in MB)
(0.38) (22.90)
R
Note:
adj. = .70
"t" statistics are provided in parenthesis.
R2 adj. is a measure of goodness of fit. An R 2 adj of .70 means that 70 percent of
the variation in M1 growth is explained by variations in monetary base growth.
PERCENT
SPREAD: 3 MONTH Ml - MONETARY BASE GROWTH
-15
Mean = -1.4%
Standard Deviation = 2.37,
1970
1971
1972
1973
1974
1975
SOURCE: FEDERAL RESERVE BOARD, F. R. B. OF ST. LOUIS
1976
1977
92
PERCENT
SPREAD: 6 MONTH M1 -
PERCENT
1 5
MONETARY BASE GROWTH
15*
Mean = - 1 . 4 7 0
Standard Deviation *= 1.7%
1
1970
1
1971
1
1972
1973
1
1974
1
1975
1
1976
1
1
1977
1978
SOURCE: FEDERAL RESERVE BOARD, F. R. B. OF ST. LOUTS
PERCENT
PERCENT
SPREAD: 12 MONTH M1 - MONETARY BASE GROWTH
-15
15"
Mean = -1.37«
Standard Deviation = 1.37.
1970
1971
1972
1973
1974
1975
1976
i
1978.
r--'s
SOURCE: FEDERAL RESERVE BOARD, F. R. B. OF ST. LOUIS
Third, the Reserve, in addition to announcing the first two proposals, must also
announce in the clearest of words that it recognizes that stable interest rates,
short rates as well as long rates, can only come about through stable and noninflationary monetary growth rates that will provide the foundation for similarly
stable rates of inflation. This includes short rates as well as long rates. Such an
approach toward constant and modest money growth rates would be implemented
on a gradual basis, perhaps a 1 to 1.5 percent yearly decline in M1 growth over a
four year period. Some decline in output growth would take place, but this mild
shock would be fully anticipated and therefore short-lived. More importantly, the
restoration of Fed credibility would quickly lead to a significant and sustainable
decline in long-term rates, soon to be followed by a similar decline in short rates.
As a result, assuming restrained fiscal policies (tax-rate cuts and more moderate
government spending growth), the climate for long-term capital investment
93
would be greatly improved, thereby stimulating both output growth and employment. Of critical importance, however, is the announcement effect of a clear statement backed by steady performance. These positive signals would dampen inflation anticipations and greatly smooth the transition process.
Fourth, to smooth the transition process in the money market, the Fed must
reform required sererve regulations and reserve carry-over regulations. This will
enhance the ability of the money market to relax tarnsitory disturbances to shortterm rates. Here too, the authorities must clearly announce their intention, in
this case to allow the Fed funds rate to freely float.
The Fed expends too much effort intervening to cushion financial sector disturbances that would more effectively be resolved by an ongoing market mechanism. In my view the frequency of Fed intervention has actually increased trading
volatility by creating a massive (and counterproductive) guessing game over
every jiggle in the Fed funds rate. The losers in this game have skills that are no
worse than any one else's, they simply have worse luck. On the whole, nearly all
dealers have suffered substantial trading losses in efforts to outguess the Fed.
This hapless approach is partly fostered by the ever growing and now enormous
volume of Fed interventions, a trend which appears well related to the increase
in market volatility.
Last, the Fed should implement the recommendations of the Bach Commission,
particularly the suggestions for improved accounting of nonmember bank deposits and more reliable seasonal adjustment techniques.
The monetary excesses of the past two years have given rise to a variety of
rather well-founded fears that a new recession looms just over the horizon. A
number of respected analysts now argue that substantial further increases in rates
of interest and inflation must inevitably result from overly stimulative demand
policies that have already released forces that cannot be checked short of such a
recession.
My own view of the interest rate—economic outlook for the next year is admittedly rather pessimistic, but I would nevertheless argue that any time is
appropriate for constructive changes in policy. The new administration of Fed
Chairman G. William Miller has hardly begun. The mistakes of past years weigh
very little on his shoulders, at this point his slate is still relatively clean. Thus,
from the important standpoint of bureaucratic politics there is no need to defend
past policies and there exists every incentive to embark on a new course.
Congress can play a major role in this hoped for movement toward monetary
reform. Through vigorous analysis and examination, along with the kind of constructive prodding that clearly falls within the realm of Congressional oversight
of the making of monetary policy, much progress appears possible. Clearly the
vast majority of American voters, and voters are after all tax payers as well as
bond and stockholders, are opposed to inflation. Inasmuch as inflation can never
be curbed without greatly diminished money supply growth, the political climate
at present appears more conducive to substantive changes in the formulation and
implementation of monetary pllicy than has been the case in many years. In this
spirit, while the foregoing suggestions are neither exhaustive nor without some
analytic imperfection, it is nonetheless hoped that they will spur additional inquiry
into what has up to now been an almost sacrosanct domain.
Chairman MITCHELL, Thank you very much. This is fascinating
testimony. I don't claim to be a leading statistician, but to achieve
the kind of standard deviation that you have found, 1.3 percent, is
remarkable for a 6-month to a 12-month period.
Mr. KUDLOW. I t is very small.
Chairman M I C T H E L L . I t is an infinitesimal deviation. Obviously,
it speaks to the soundness of your thesis.
Mr. KUDLOW. The few times that Fed officials have been asked to
address themselves to the issue of monetary implementation they
have argued that the effect on M x on interest rates is the same as the
effect on Mi on some measure of reserves like the monetary base
over 1-month periods of time.
I don't disagree with t h a t thesis. M y point is: Who cares about
1-month periods of time? There is too much statistical noise there.
Over 6- and 12-month periods of time, however, the interest ratemoney relationship breaks down, but the monetary base-money
94
relationship holds up. That is really the only point I am trying to
make here.
Chairman M I T C H E L L . I want to pursue this if I can, but first I want
to get back to the Treasury draw authority. This is a fascinating
thing that I hope to have time to discuss. I t seems to me what Mr.
Atlee has suggested is that in actuality the Fed really has an impact
only on about 10 percent of the interest rates. This seems to be at
variance with the position you have taken.
Let us go back to the draw authority first, and then perhaps we
can spend sometime on other arguments. I am going to suggest,
perhaps submit, an amendment to the legislation on the draw authority
which would, in effect, waive the $5 billion ceiling which is now in
effect if the President should actually declare a national emergency.
M a y I have your reactions to that possible amendment which the
Chair intends to propose?
I think you have indicated, Mr. Poole, that it is obvious $5 billion
would be inadequate in a real emergency: I would assume, therefore,
that you would favor waiving the $5 billion ceiling in a true emergency.
Is that correct?
Mr. POOLE.
Yes.
Chairman MITCHELL. D O you other gentlemen have any reaction to
this?
Mr. A T L E E . I t is alright with me.
Mr. KUDLOW. I would be inclined to agree, but I am not that
familiar with the issue.
Chairman M I T C H E L L . A second question for all three of you is:
Would you favor giving the Treasury the option of borrowing securities as well as borrowing cash from the Federal Reserve? What I
mean is, keeping the cash draw authority and adding onto it a securities draw option with some sort of limit on it. Am I making my
question clear? May I have a response?
Mr. A T L E E . I don't see the point of it. I was interested in Mr.
Poole's mention of that, but I don't really understand the point of it.
Chairman MITCHELL. Mr. Poole?
Mr. POOLE. I would not have both. I t seems to me that there is no
need to have both. My major purpose in making the suggestion that
the Treasury borrow securities is to provide a clear statement that the
Congress does not want the Government to be financed by printing
press money; that the securities the Treasury would borrow would
have to be sold to raise the cash.
I n that case, you would not have monetary creation financing
Government activities. I would have one substitute for the other.
The practical import, as I tried to emphasize, is minor, provided that
the Federal Reserve, in fact, neutralizes the impact of the cash draw
by the Treasury.
Do you understand what I am saying or am I being confusing?
Chairman MITCHELL. I missed the last part of your statement.
Mr. POOLE. When the Treasury borrows money directly from the
Fed reserves are pumped out into the banking system. When the
Treasury spends that newly created money, ordinarily the Federal
Reserve does not permit that new spending to remain in the banking
system, but sells Government securities to absorb those reserves.
M y point is simply that we ought to be telling the Federal Reserve,
or the Government as a whole, that we don't want activities financed
95
by printing press money. By changing the borrowing authority, the
draw authority, so that it is a draw on securities rather than on cash,
we would be making a clear statement that we are not to finance
Government activities by printing press money.
Chairman MITCHELL. Wouldn't that present some problems to the
Treasury in terms of immediate access to cash?
Mr. POOLE. N O ; because the Treasury would sell the securities.
The Treasury would borrow the securities and sell them on Wall
Street to raise the funds.
Chairman MITCHELL. Within the context of the issue we are considering, the draw authority, if it exists primarily for situations
which have to take place very, very quickly
Mr. POOLE. But this is exactly what already happens, except that
now the Federal Reserve sells the securities.
Chairman MITCHELL. I guess my point is, could the Treasury sell
securities fast enough, say, in a 48-hour period?
Mr. POOLE. They can sell them in 10 minutes.
Chairman M I T C H E L L . T O accomplish the same effect as the draw?
Mr. POOLE. Absolutely. They can sell the securities in 10 minutes,
with one phone call.
Mr. KUDLOW. And often do, in practice. I t happens all the time.
Mr. POOLE. The main problem is, it would be awkward to issue a
new set of Treasury bills on a Friday afternoon or something like that,
because there are regular issues scheduled every week. But to sell an
existing issue is an entirely different matter.
Mr. KUDLOW. I think it is important that the Treasury not have
an unlimited, unconstrained power essentially to create new money—
although it is an indirect process through the Federal Reserve that
has gone too far at this point. We should be imposing constraints,
rather than suggesting fewer limits.
Chairman M I T C H E L L . Can I infer from that that to the extent to
which we allow this to happen, it sets the stage for poor management
within both the Treasury and the Fed?
Mr. KUDLOW. Absolutely. I think it is important to remember that
the Treasury has access to substantial amounts of cash, and that at
any time the Treasury can call on a variety of accounts sitting in different places in the Government—some at the Federal Reserve, some
of them elsewhere, some in the commercial banking system as well,
through the T. & L. accounts. So the notion that the Treasury would
have any kind of substantial cash shortfall for more than a few minutes
is a notion which I find to be hardly realistic.
Chairman MITCHELL. Mr. Hansen?
Mr. H A N S E N . 1 think we are about out of time, Mr. Chairman. I do
feel that we need some imagination. I appreciate the statements that
have been presented this morning by you gentlemen, because I think
we need some imagination in our management of monetary policy.
1 think too often we have delegated it to independent agencies, and
the Congress has abdicated its responsibility and authority. I think
that, really, if we are ever going to get this monstrosity under control
that we have created, the Congress is going to have to reclaim some
authority and set some more responsible and reasonable guidelines
so that, as you say, you don't have the willy-nilly cleaning up of the
printing presses.
96
I do have some questions 1 would like to submit to some of you
which Dr. Weintraub can give to you afterward, if it is all right. I
won't take the time now, but 1 would like some answers, and I would
like to explore what you have gone into a little bit further.
I think it does present some alternatives, and some viable
alternatives.
Mr. Chairman, thank you very much.
[Congressman Hansen subsequently sent a letter containing questions to Mr. Poole. The letter along with Mr. Poole's response
letter follows:]
97
OLOWOC HAWICN, IDAHO
HAROCD C. HOLUNmCK. N J .
• HUCf r. CA»-UTO. N.Y.
rARRCN J. MITCHCU.. MO.. CHAIRMAN
BTCFHCN U. NCAL. NX.
NORMAM E. O'AMOURI. N X .
DOUO BARNARD. OA.
W£» WATKIN*. OKLA.
BUTLER DERRICK. B.C.
MARK W. HANNAFORD. CAUf.
U.S. HOUSE OF REPRESENTATIVES
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
N I N E T Y - F I F T H CONGRESS
W A S H I N G T O N , D.C.
20515
July 10, 1978
Professor William Poole
Department of Economics
Brown University
Providence, Rhode Island
Dear Professor Poole:
At the hearing in front of the Subcommittee on Domestic Monetary
Policy on June 27, 1978, you suggested that the Treasury "draw" authority
could be replaced with some mechanism by which the Treasury could borrow
securities from the Federal Reserve System Open Market Account Portfolio,
sell them to raise cash, then repay the Fed when adequate cash was again
available.
As we agreed at that meeting, I am submitting the following
additional questions to you, and will appreciate any further comments
or explanation they might suggest to you.
1. How would the Treasury repay the Fed? Would it use something
like repurchase agreements in selling the securities in the market?
2. Am I correct in my understanding that the only charge the Fed
would make would be a relatively small administrative or handling charge,
since the earnings on the securities would still accrue to the Fed (the
Treasury would make up what was lost by selling the securities)?
3.
What drawbacks are there to your proposal?
4. Does it matter where the securities are borrowed from? As a
technical matter, couldn't Treasury borrow securities from the portfolios
of Government securities dealers?
Many thanks in advance for taking the time to answer these additional
questions. And again, special thanks for your appearance before the
Subcommittee. Your testimony has been of great value and most enlightening.
Yours for individual liberty,
GEORGE HANSEN
Member of Congress
98
BROWN
U N I V E R S I T Y
Providence, Rhode hUmd • 02912
July 20, 1978
The Honorable George Hansen
U.S. House of Representatives
Subcommittee on Domestic Monetary
Policy of the
Committee on Banking, Finance
and Urban Affairs
Ninety-Fifth Congress
Washington, DC 20515
Dear Congressman Hansen:
I am writing in response to your letter of July 10, 1978 concerning the Treasury "draw" authority. My answers to your questions
are as follows:
1. The Treasury would repay the Federal Reserve by returning
the exact securities that it had borrowed. Thus, when the Treasury
borrowed securities from the Fed and sold them in the open market
to raise cash, it would later go back into the market to repurchase
securities of the same issue and return those securities to the
Federal Reserve.
2. It is correct that the only charge the Fed would make would
be a small administrative or handling charge since the Treasury
would return the identical securities to the Fed. The Treasury
would be expected to reimburse the Fed for any interest coupons the
Fed might have lost during the period over which the Treasury had
borrowed the securities. But, in practice, the Treasury would no
doubt borrow securities for such a short time that they would not in
fact have to be concerned about the interest coupons.
3. As far as I can tell there are no drawbacks to my proposal.
In fact, just yesterday I discovered that the Federal Reserve has,
or at least had, standard procedures for lending securities from its
portfolio to Government securities dealers for the purpose of improving the efficiency of open market operations. (See Minutes of
Federal Open Market Committee 1970, pp. 256-62). I am sure the
Federal Reserve would be willing to provide you with the details on
their procedures for lending securities to dealers.
99
4. It does not in fact matter where the securities are borrowed.
There is no reason why the Treasury could not borrow securities fran
a private firm, such as a Government securities dealer, instead of
from the Federal Reserve. I see no reason not to give the Treasury
the authority to borrow securities from private firms as well as
from the Federal Reserve, provided that the value of the securities
borrowed under any such arrangement is counted in the total of
Treasury borrowing subject to the debt ceiling.
I hope I have answered your questions; should you have any
further questions please feel free to write to me.
Sincerely yours,
William Poole
Professor of Economics
100
Chairman M I T C H E L L . Thank you.
The Chair is going to ask an unusual request of the witnesses. There
are some theories and approaches that have been presented this morning which represent rather radical departures from the normal way
of proceeding.
As I indicated earlier, we are planning an indepth hearing on monetary policy, and certainly we would include its implementation at that
time. If we can work it out, I really would like you gentlemen to
come back, not for a formal hearing, but for a seminar with the
members, where we can pursue, in depth, your approaches and some
of your ideas which are fascinatingly radical, and therefore, very
fascinating to me. If we can work it out, in terms of your schedules
and travel expenses and that kind of thing, would you be amenable
to it?
Mr. POOLE. Yes.
Mr. A T L E E . Yes.
Mr. KUDLOW. Yes.
Chairman MITCHELL.
The members could block out 3 hours one
evening for a seminar.
Mr. KUDLOW. As I said before, I think the utility of this approach
is enormous. As I have observed in recent years, when you get Government officials, Fed officials, before this subcommittee as well as the
parent committee, in many cases it strikes me that you all have been
overwhelmed in many respects. You are being bamboozled because
you are not as familiar with the minutiae and the nuances that the
Fed officials are. I t doesn't mean that their judgment is any better;
it just means that they are better versed in these day-to-day affairs,
and that they have a better understanding of the nomenclature. If we
could get beyond those superficialities and attack the issues directly,
I think it would be much more productive, not only from the standpoint of this subcommittee, but from the entire congressional oversight of monetary policy.
Chairman M I T C H E L L . I agree with you, except that I would not use
the word "bamboozled." [Laughter.]
I t appears that, very often, members become traumatized.
[Laughter.]
Mr. KUDLOW. I stand corrected.
Mr. H A N S E N . Mr. Chairman, I think sometimes we have a tendency
to take what we are and what we do for granted. I think that, since
we are relegated to an 8:30 hour in the morning, we sometimes wonder
if we are being set aside for other things. But, Mr. Chairman, I think
you chair one of the most important subcommittees in the Congress.
Certainly, everybody has to deal with money. The value of that money
and the availability of it is probably the most important thing to the
people in this country today.
I am not sure that, sometimes in the helter-skelter—I think t h a t
what Mr. Kudlow is referring to is: We have so many things coming
across here, it is hard for us to zero in on one thing and really do
justice to it.
I think what you are saying, Mr. Chairman, is vital. I commend
you for taking this step. I really feel, if the country is going to solve
its problems, part of the responsibility rests right here.
Chairman MITCHELL. Precisely. We need the education that would
come to us as a result of such a seminar, when we are not under pressure to make another meeting.
101
I have one last comment, or question, on the draw authority: The
Treasury argues that in the event of a national emergency, they
would fear a communications breakdown, or banking crisis, and
therefore, the authority would be absolutely essential to them under
those kinds of conditions. That is their argument; and I think t h a t
they have made a somewhat persuasive argument for it, which has
caused me to lean toward the continuation of the draw.
Any reaction, Mr. Kudlow?
Mr. KUDLOW. I am prepared to be persuaded of that, but only in
the most reluctant terms, frankly.
Chairman M I T C H E L L . Mr. Atlee?
Mr. A T L E E . Yes; I suppose so. I would think that it might have a
risk of giving the Government authority to get into national
emergencies.
I am not sure just how significant that would be in facilitating
getting into a national emergency. That would be my only concern
on that.
One thing that happened some years ago that was possibly relevant:
I had noticed—I should say, someone else who was dealing with the
data—noticed a large increase of currency in circulation. After some
investigation, it was discovered that this was from the Federal Reserve
Bank in San Francisco, and it happened to have been drawn out by
the CIA for operations in Asia.
Now if the Treasury could get the funds directly from the Federal
Reserve—that is, additional funds, not just currency—that kind of
thing could be enlarged. I don't know, but that would be my only
concern with it.
Chairman MITCHELL. Mr. Poole?
Mr. POOLE. I think an important consideration here is how the
words "national emergency" are interpreted. I do not know what
that term means. I am not a lawyer. I do not know what the practice is.
M y preference would be to have that term interpreted clearly to
mean "in the event of physical destruction, communications breakdown, and so forth"; rather than a situation where the President
might announce that there is a "national economic emergency," for
example, in peacetime, in which case we would have the danger of
printing-press money being used to finance our activities.
I would emphasize "national military emergency," or some kind of
qualifying phrase that would make clear exactly the kind of thing
that we are talking about—communications failures, and so forth.
Chairman MITCHELL. Gentlemen, it has been fascinating. I would
hope that we could try to work with Dr. Weintraub and get a seminar
set up sometime after we return from this—what do they call it—
"work period"? [Laughter.] Our "July 4th District Work Period."
[Laughter.] Let us shoot for the end of July, depending upon your
vacation schedules and so forth.
Thank you again. I t has really been remarkably interesting
testimony.
[Whereupon, at 9:43 a.m., the hearing was adjourned, subject to
the call of the Chair.]
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