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HARVARD UNIVERSITY 0 7 GRADUATE SCHOOL OF PUBLIC ADMINISTRATION S ey m o u r E . H 234 a r ris Professor of Economics L i t t a u e r C e n te r C a m b rid g e 38, M a ss a c h u s April 12, 1951 J* V The Hon* John W. Spyder Department of the Treasury Washington, D. C# Dear Mr. Secretary* I enclose a more extended discussion of the TreasuryFederal Reserve controversy which may be of some interest to you# The original, which I sent you sometime ago, was as you know, published in the HSRALD-TRIBTJFE of March 30, 1951. The enclosed, together with comments by various economists and others will be published in the Review of Economics and Statistics, and I shall see that you receive a copy of it. Sincerely yours, / H:B Seymour E. Harris / The Debate over Monetary Policy^ Seymour B* Harris X. In 1914, with the establishment of the Federal Reserve System, high hopes were held that our monetary problem had been solved; and that stability was on its way. Assuming that our monetary problem had been .solved, a Harvard professor advised his students against writing in the field of money* But our monetary problems are still with us, in part because since 1914 the Monetary Authority has sought ways to evade responsibility* rather than accept it* In the early years of the Federal Reserve System, despite the limitation put upon the System by the commercial theory of lending, the Authority found ways to pro vide the supplies of money required to fuel an inflationary financial policy* In the twenties, they failed to use their potent weapon, open-market operations, which had fortuitously been discovered, to stop excessive expansionand indecision and lack of courage once more showed the problem to be not weapon*? but the attitude towards their use* The early thirties again were a period in which the Monetary Authority acted late and inadequately* Again, there was a search for new weapons and particularly qualitative control and greater control over reserve requirements of member banks* As in the past, the new weapons in the reserve arsenal seemed to make little difference* In World War XI, the main task of the reserve banks seemed to be to provide enough excess reserves to assure the absorption of Treasury se curities not salable to genuine savers* Again, in the postwar period, the potent weapons of the Monetary Authority have not been used to any substantial degree — in part because the Treasury objected* 1 * 1 asked Professor Hansen to write a piece on this problem v/hioh might serve as a focal point for discussion* But when he read my piace on the government’ s monetary policy (New York He raid-Tribune, ttarch 30, 1951), he insisted that I write the piece* This is a new and longer note, though the general position is that presented in the DigitizedHerald-Tribune* for FRASER It is well to keep our history in mind when we discuss monetary policy* The problem has not been one of impotency of weapons* The reverse is true* The Federal Reserve has had powerful weapons which it has not used when it was free to use them, and we oan only nuess how far they would have used them had they the freedom to do so* II. In the year 1951, the debate is hot* The Federal Reserve, with more than $ 2 3 billion of government securitiesat Its disposal in February, considerably more than the reserves of member banks ($19 billion), is surely in a position to deny the economy the money without which a large inflation could not be oarried out. It is a far cry from the time that we feared the Federal Reserve might not have assets to sell* In fact, the Federal Reserve even today could impose a drastic deflation on the country. Failure to use monetary polioy to fight inflation is not primarily the result of Treasury pressure* Much more important is the fact that there is no disposition to fight inflation among the powerful interests that control the countryi labor, farmers, business* They all give lip service to the fightj but In their activities they are highly inflationary* These same groups will also contest any monetary policies which might seriously impair the inflationary processes | and if past history is any guide, the Monetary Authority will yield to these pressures* It is not possible in a democratic society to set up an independent agency which would be free of political influences and thwart the desires of the public* I am not arguing here against use of all anti-inflationary weapons, but a m expressing doubt concerning the disposition to use them* Monetary restraints are the easiest approach to inflation control — much less painful than more taxes or less public expenditures, or than wage or price control, or than control of supply and demand of commodities* http://fraser.stlouisfed.org/ is the result not Federal Reserve Bank of St. Louis Their atrophy of ignorance,but of the determination not to fight inflation which prevails in the country* Failure to use monetary weapons may be associated then with a reluotanoe that goes badk to 1914 and earlier* The same pressures that weaken all anti- inflationary measures preclude the effective use of monetary weapons* III. This is, however, far from the entire explanation. Sew weapons have become available which are sharper and more precis?© than the monetary weapon* In 1931, when Keynes wrote his Treatise on Money, the emphasis was still on monetary policy; but In the next few years attention began to be focusod on fiscal policy* Xt has been said that monetary policy should be utied at the beginning of an infla tion or a decline, if it is to be effective, and especially since fiscal policy 1 requires time for application* Actually, a tax system, with much built-in flexi bility (or better, with formula flexibility) may respond quickly to inflationary or deflationary pressures; and the difficulty of applying monetary policy is related to the problem of discovering the early stages of a rise or decline* 2 In January, 1950 when the Douglas Committee reported, the oase for greater emphasis on monetary policy was stronger than it was early in 1951, when Senator Douglas made his famous speech (Congressional Record, February 22, 1951) on the clash between the Treasury and Federal Reserve* In a semi-war economy, the monetary weapon becomes especially dulled and the other weapons sharpened* Even from the second quarter to the last quarter of 1950 (the first half year of the Korean War), personal taxes in absorbing $3j billion of the $13 billion of additional inooa* contributed something to the fight against inflation, whereas in the eight months ending February 28, 1951, the amount of Federal Reserve credit increased from $18o5 ary billion to $23*2 billion* The inflation/effects were not fully felt, however, 1. R* V. Rosa, "The Revival of Monetary Policy,”The Review of Economics and Statistics, February, 1951, p. 30* (Interpreting Senator Douglas and Dr* Goldenweiser.) Digitized 2* for FRASER Senate Document Ho* 129, Report of http://fraser.stlouisfed.org/ Policies, on S* Con* Res* 26, January Federal Reserve Bank ISSSCm Sw ofr*St.ALouis 4 an/9 UkI A /i4• • the Subcommittee on Monetary Credit and Fiscal 4, 1950j also see Joint Coirmittee Report on 1QAQ. 4* because the System lost $2*1 billion of gold and the amount of money in circu lation rose by $200 million* 1 however. Member bank reserve balances rose by $3 billion, In 19151, for restraining inflation we can depend also upon oontrol of investment and ultimate oontrol of wages and income* Monetary supplies and demand for money will respond to these forces — as in World V*ar II, when restrictions on investment and mrious other controls, and unavailability of consumers1 goods not only were reflected in reduced creations of new money but also in increased demands for money for holding* Use of these anti-inflationary measures also depends on a willingness to apply them which, unfortunately, still is not evident* But in the war years these measures proved more effective than monetary measures* IV* Senator Douglas and the Federal Reserve are against Treasury policy on the grounds that the support of the securities market forces the Federal Reserve to purchase government securities in amounts that result in excessive batik balances and hence of bank money, and that the resulting rise of prioes is costly to the economy and even to the Treasury, for a rise of prioes of 10 per cent would cost the Treasury $7 billion on ttie 1951-52 budget and an increase in the rate of interest of J of 1 per oent only |1 billion* So long as the Treasury insists upon a 2a per cent long term rate and other rates to match, so long, in the view of the opponents of Treasury policy, is the Monetary Authority stymied in its control over monetary supplies* We must be clear on objectives. The official discussion is in terms of a rise of rates of J - & per oent — not one of# say, 1 - 5 per cent* A rise of rates of 2 - 4 per cent might achieve a great deal} but it is dubious that one of ^ per oent would result in much beyond a partial demoralisation of the securities market, 1, A transfer of Treasury balances of $400 million from reserve banks to member banks accounted in part for the rise of member bank reserves* 5. with investors awaiting further declines in prices and rises in rates* Suoh operations nay be hazardous when $50 billion of securities mature in a year and the oountry faoos large deficits. The main objective of a rise of rates is to increase savings and reduce investments, for it is the excess of investments over savings that is inflationary* (Official and supporting statements seem to rely too much upon the old-fashioned approach of the money-price relationship, and seem to reflect unawareness of the 1 fact that the monetary supply is but one aspect of the general picture*) In th<; writer*s opinion. Senator Douglas is altogether too sanguine con cerning the rise of institutional investments in publio securities following an in crease in the rate of interest of J of 1 per cent* The fact is that in the five years ending June 30, 1950 the issues held by financial institutions declined from 55 to 45 per cent of all issues, with commercial banks disposing of $18*5 billion of securities* Yet the rate of interest on short-term issues rose greatly, the com* puted rate on all issues rose by z / lQ of 1 per cent (10 per cent of the 1946 rate) and the rise of rates was concentrated on the short-term issues, largely held by financial institutions* Although total debt outstanding declined by $1 billion in these five years, the short-term issues outstanding fell by $22 billion* Apparently, despite higher rates (and the rise in rates despite smaller amounts outstanding), the financial institutions were losing interest in publio securities* It is interesting that in the year ending Deoember 29, 1950, the Federal Reserve increased its invest* ments in short-term securities by $5*1 billion and disposed of $3*2 billion of bonds* 1* The reader xrdght consult the replies of the Federal Reserve Board (op* cit*, esp* pp* 21-44) to the Douglas questionnaire. This is an able statemsnt of the objectives of policy and the manner of achieving them* But the association of monetary policy with the savinga-lnvestment relationship, or with income end other policies that affect prices, is not presented* And the discussion of fisoal policy has a ring of preKeynesian days* 6 . I do not believe that a rise in the rate of interest of & per cent is going to inoreata savings greatly, and oertalnly the additional savings will not go into government securities in large amounts* An increase of 2-4 per oent is another matter, although even against increases of these proportions the rise of incomes, the unavailability of goods and the promise of price stability are likely to be more important in stimulating savings than even a rise of interest rates of 2*4 per cento With prices rising by 10-15 per oent per year and large profits to be made in private enterprise, an increase of long-term rates on public securities of even 1 per oent is not going to carry much Height* A revolution in savings is re quired * From 1941 to 1945, the public saved $129 billion and put $54 billion into Treasury issues, but from 1946 to 1950, out of $45 billion of saving only $6 billion went into government securities* The record for corporations is even less encourag ing » Note, also, $35 billion of personal savings, or 31 per oent of GHP, in 1944 and $11*3 billion, or 3 per oent of GBP, in 1950* A rise in the rate of interest of l/2 per oent is not going to depress investments substantially* Even Senator Douglas admits this — and especially when prices are rising at the rate of 10-15 per oent a year and corporate profits are running at the rate of $50 billion yearly* The effective attaok on investments is likely to be the one used in the last wars e*g«, determination of what is to be produced, allocation of scarce resources* Indeed, Senator Douglas would oontrol investment by denying the economic system money; but here we run into the practical problems of (1) how much money should be denied the eoonomy) (2) will the sacrifices be imposed on the industries and firms that should bear thomj (3) will the money in faot be denied them* and (4) the competition offered by existing supplies of money* Who would insist that there would not have been a substantial inflation in the first year of the Korean War without large additional expansion of money? 7* Is it possible that a rise in the rate of interest of, say, 3t*8 per eent nay have considerable offeet* But her* we run into the general problem that those who urge freedom for the Federal Reserve to manipulate monetary supplies do not generally support a long-term high-rate policy* In faot, they express satisfaction with the 2 per cent rate in the forties as compared with the 4 per cent rate in the twenties* At current rates of interest and prices, the servicing of the national debt of $250 billion oosts as much as a debt of $600«$700 billion would have cost in the twenties* An ultimate rise in the cost of the current debt from $5*6 billion to $10-12 billion should not be accepted with equanimity* Kor is the more important problem of the importance of low rates of interest for the economy to be dismissed lightly* A case? can be made out against certainty in the long-term rate, as the Federal Government discovered in the latter part of the war when the increased awareness of thc> pegging of rates by investors encouraged a movement from low rate short-term securities into high rate long-term securities» Why accept less than 1 per oent on a short-term security when 2 per cent might be had by holding a long term issue for «•. year? And a case may be made out for higher rates in inflationary periods and lower rates in deflationary periods* But we should be clear on the issue of long-term low rates and the greater requirements of stability in view of the prob lem of debt management* V* Before concluding we should perhaps expand a little on the reoent Federal Re serve-Treasury debate and on the responsibility of the banks* 16 the debate of 1950-51, much was made of the large expansion of bank loans* The growth from #52 billion in June 30, 1950 to $61 billion in January, 1951 was at a record rate* But the rise was largely at the expense of Investments in government securities which declined by $6*4 billion* security Digitized government for FRASER The banks were deserting the market in order to expand loans and (to some extent) purchase 6. other securities (a rice of $1 billion in the latter). With short-term treasury issues yielding 1.17 to 1.47 per oent in June, 1950, according to maturities, and bank loans paying 2.70 per oent, the banks oould not resist the temptation to shift — especially since their liquidity position was guaranteed. In these months, there was much discussion of the need of raising short term rates. The contention was that a rise of these rates would increase the cost of borrowing for the bam s.* %nd would discourage them from cashing in on these securities with the reserve banks. It was also contended that a rise of rates might brinr, about increased investments by financial inst •iubions in these short term issues. Yet despite a rise of rates in the eight months ending February 24, 1951, from 1.17 to lo29, 1.23 to 1.52, and 1*47 to 1*67 for 3 wenth bills, 9 to 12 month issues and 3 to 5 year issues, respectively, all commercial ,J;anks reduced their holdings of government securities from $77.3 to $70.9 billion (7 months ending January 31, 1951) and Federal Reserve Banks added $4 billion. (From the end of 1945 to January 1951, U. S. Government securities in the portfolio of commercial banks declined from $90.6 to $60.0 billion.) There was also much talk of concentrating increases on short-term issues. But a rise in short-term rates is bound to affect long-term rates as investors shift to the short-term issues, now relatively more attractive. Yields on U. S. Government taxable bonds (10 years or more) rose from 2*33 per cent in June, 1950 to 2.40 per cent in February, 1951. In these discussions, the authorities and experts emphasised the point that the increased cost of higher rates to the government would not be serious. Since the rise would apply only to new issues, it would take years before any rise in rates on new yields would apply to a large part of the debt outstanding. Besides, tax collections would increase. Insofar as the rise of rates should be substantial and deficits cumulate, however, the weight of this argument is lessened. Rsrhaps more important is the point that the cost of the higher interest rates to the government is not so important as the unst&bilising effect on the government security market, and the adverse effects on the economy of the reversal of the longrun low interest rate policy* The Douglas Committee# the Joint Committee or the Economic Report in its most recent statement# the Federal Reserve# and the economist supporters of Con gressional and Reserve position (e*g«# notably Chandler and Bach)# all emphasize the inflationary dangers of expanding supplies of money# In this note I have suggested that there is overemphasis of the monetary approach* But here I bring to the reader9s attention a relevant factor which h*s been neglected« ?;*ssrs* Keyserling and Clark of the Council# in a letter to the Joint Committee# state well one aspect that has been rather disregarded* The rise of output is the primary objective} and if (unfortunately) the rise of money has contributed to inflation# it has also stimulated earn? of output ® Industrial output rose by 10 per cent in the firsb six months of the Korean ’ Tar. Further additions of money will be required to assure a 25 per cent rise of output in the next five years and to provide the additional cash required for holding in a growing economy» The use of the monetary axe m y interfere with this growth* Later I suggest that the approach to the problem of monetary inflation and interest rates may well be a segmentation of markets, with the government security market protected by proirision of special supports; the banks are to hold special reserves in &o?®rns&nt securities* The banking business Is a public utility business# as is reoognlzod by the special regulations to which it is subjeot. One may raise the question# as 1^8grave has# whether the government securities in World War II should have been issued to the commercial banks In the first instance* Might It not have been better to issue them to reserve banks# with adjustment of reserves of member banksT At rate, the banks Digitizedany for FRASER received generous compensation for untertaking the responsibility I0o of manufacturing money and buying securities* The banks surely should not be allowed the freedom to dispose of government securities at their discretion or, as an alterna tive, to be offered rates high enough to remove the inoentive to switoh to private borrowers* In part the liquidation of $30 billion of securities by commercial banks sinoe 1946 reflected attempts to demonetise the debt; but in part it reflects be1 havior by banks not fully justified in the light of their responsibilities* VI* Let me conclude by allowing that monetary policy has a place in the antiinflationary fight* But on the basis of past experience, we insist that it is not likely to play an important part* Its relegation to a secondary role rests not o n lv on history but also on the development of Keynesian economics * It is increasingly fashionable to attaok the problem through fisoal policy, to concentrate attention on savings and investment and the variables which influence t h m * In a mobilisation eoonomy, there are also available controls to influence savings and investment* Money is only one approach to the rate of interest and the latter only one approach to savings and investment* There can be no doubt but that the high degree of liquidity in the American economy of 1951 is a serious threat to stability* to cumulate, then the problem may boeoss ov&a more serious* redueing the magnitude of liquid assets* Should deficits continue There is a case for This may hold even if it is admitted that on the basis of American economic history the public needs more liquid assets not only (1) pari passu with the rise of output but also (2) because the proportion of liquid assets to incomes rises greatly with increasing standards of living* 1. Cf. Joint Conmittse on the Eoonomio Reporti General Credit Control. Debt Kanaeenant and Boonomlo Kobllltation, 1961. Here is the laES’ ift a d a m a n t of tKa supporting the Federal Reserve position; able supporting statements by IsHessrs* Chandler and Bach, the exchanges between the Treasury and Federal Reserve, the Keyserling-Clark letter on the relation of monetary expansion and output, and vigorous support by Messrs* Scales and Musgrave of special reserve requirements in the form of additional govern ment seourities to be held by banks* 11. The oruolal point is how do we attack the excess liquidity problem* The Federal Reserve and Douglas position is that we attack it through a rise in the rate of interest and monetary restrictionism* It m y be desirable to provide tax money in exchange for liquidity, that is to increase the yield on government securities* But I suggest that before this is done, with its threat to the lowinterest rate policy, other means be considered first* There is the old idea of inanobilizing securities against deposits in the banks« Surely the banks, In a virtually riskless business, should not be allowed further rises in rates afid profits as theii* portfolio o f governments riseu* The publio generally may be enticed at a price to put money into illiquid government securities as deficits cumulate* But a simpler solution may well be heavier taxes and compulsory loans (i*©., tax~loan*)» These, together with income control and, where necessary, ade quate prise and supply controls, may keep the supply of money in cheok and induce additional deu-aiid for money for holding* Only in so far as the seriousness of the world situation does not justify generous use of controls and the llqiiiity problem continues to threaten stability, would special incentives to non-banking lenders be justified« In short, we should seek help in the fight against inflation wherever it can be had; but we are not optimistic concerning the contribution likely to be had from monetary policy* In the present (Spring, 1951) state of the world crisis, we should depend primarily on fiscal policy and secondarily on limited income and other oontrols* Monetary policy may be helpful, but as the crisis deepens, it is likely as in the past emergencies to become increasingly passive« In th:ls discussion, I have not dealt with the restraints on monetary ex* pension exercised through controls of particular types of loans, or even rationing of total loans or freezes on the amount outstanding* These, in fact, belong to the category of direct oontrols and not to general monetary control operating through changes in the price of money*
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