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(Notes on discussion by Chairmen ^ecles before
the OWMR Advisory Council, July 30, 1946)
Inflation threatens when supplies are short of what people
want to buy at prevailing prices. If prices are not to rise, three
things may be done:
(1) Direct controls over prices, allocation and distribution
can be used to regulate the market.

More can be produced so that demand will be met.

(3) Steps can be taken to reduce demand and hence buying,
public or private.
The first approach — the direct control — has been relied upon mostly
so far, but will be less and less effective. The second approach —
increase in production — will have to be the eventual solution, but
that takes time. We must not only reach peak production but must con­
tinue it for many months until the pressure of backlog demands has worn
off. In the meantime, the third approach — limitation of expenditures —
is extremely important. This, I take it, is what you want me to discuss
under the heading of "monetary and fiscal controls of inflation®.
Monetary Controls
Monetary controls cannot be relied upon.
The most important thing to be said about monetary controls
is that they are not a very powerful factor in the situation. Those who
think that we can permit direct controls to deteriorate carry on a lax
fiscal policy, yet worry little since, in the last resort, Federal Reserve
policy will "guarantee the value of the dollar*, are greatly mistaken.
Monetary policy can do no such thing if other and more important policies
are permitted to default. It could not stabilize the economy in the
twenties or 'thirties and can do so much less under present conditions
when the huge public debt has greatly weakened such powers of monetary
controls as did exist in the earlier period. In meeting this inflation
problem, there can be no major reliance on monetary policy.
How is monetary restriction supposed to check inflation?
Monetary policy, according to traditional thinking, can check
inflation by (l) raising the cost of credit to would-be borrowers, thus
discouraging them from going ahead with their purchases and (2) reducing
the money supply, thus curtailing the funds which people have at their
disposal to spend. Both these factors must be considered in the light
of the present monetary setting, which is the direct outcome of war

-2 -

finance, and as they relate to the nature of existing inflation pressures.
War finance has reduced effectiveness of monetary policy.
As the result of heavy wartime borrowing and especially bor­
rowing from the banks, the financial condition, of the country has been
changed drastically. In particular:

The public debt has risen from 45 to nearly 270 billion.

(2) Liquid assets held by the public have increased from 100
to 250 billion.
(3) Bank holding of U. S. securities have risen from 17 to
about 85 billion.
Because of these developments, the entire setting of monetary policy has
been changed and, as will be shown, its effectiveness has been reduced.
I shall first consider the advisability of raising interest rates; then,
the possibility of curtailing the money supply.
Rise in interest rates would be costly.
With a Federal debt of 270 billion, we find that the public
(Federal, State and local) debt is now twice as large as the entire private
debt in the country. Interest costs on the Federal debt have risen from
about 1 billion in 1940 to over 5 billion now, which is just slightly
below the average Federal budget of the 'thirties. Had the war debt not
been financed by a declining interest rate, this item would be still larger.
The average interest charge on the debt is now about 1.9 per cent. In
view of the large amount of short-tem debt outstanding, a rise of only
1 percentage point in interest rates could increase the annual cost of
interest service by a billion dollars in the course of 5 years.i/ Should
the average rate return to the level of the ’
twenties (4 per cent) and the
public debt remain at the present level, the total interest cost would
eventually be 11 billion dollars per annum. It is evident from these fig­
ures that the taxpayer's cost of servicing higher interest charges might
be very great. Clearly an increase in interest rates — that is, abandon­
ment of the present policy of maintaining the rate level — should be
considered only if we are sure that it will greatly help the economic
situation and thus be worth its cost. I do not believe that this is the case.
l/ This is estimated as follows: The total amount of debt maturing
in the course of 5 years will be 100 billion dollars. If this debt is re­
financed at a rate of one per cent above what it otherwise might be refinanced
at, the net result will be an increase in interest service of one billion dol­
lars. This, of course, is different from saying that the interest service
will rise from 5 to 6 billion dollars — as this statement is independent of
changes in maturity. It merely argues that interest service will be one bil­
lion above what it otherwise would have been, whatever the average maturity
of the debt and, hence, the overall level of rates.

-3Higher Interest rates would accomplish little.
I f one discusses rising interest rates, one must distinguish
between moderate and drastic action.

(1) A sharp rise in interest rates, quite apart from its
budgetary effects, might serious unbalance the security market. Con­
sidering the large volume of marketable Government securities now out­
standing, this is a risk which few would be willing to undertake. The
remedy would be worse than the disease.
(2) A moderate increase in interest rates would do little to
check an inflationary demand for credit, if such demand should develop.
If large capital gains and other profits are anticipated, a moderate in­
crease in interest rates will be a minor factor. Moreover, the bulk of
inflation pressure to date has not been based upon newly created commercial
credit. On the contrary, the demand has been based on funds received as
current income and on liquid assets which have been accumulated in the
past. Unlike the boom of the late 'twenties, the present inflation pres­
sures are cash financed and take the form of excessive consumers' and
equipment expenditures and speculation on real estate and housing, not
mainly security speculation. The control of stock market credit and of
consumer credit, which may be important elements of credit expansion in a
boom, is being dealt with by direct methods, which do not involve raising
interest rates.
(3) Moderately higher interest rates would not reduce expend­
itures out of current income. Disposable income of consumers is now higher
than it has been ever before and the rate of savings has fallen off sharply
since the war. The rate of corporation profits after tax is also likely
to surpass the wartime peak by the end of the year. If the public's ability
to spend out of current income is to be reduced, the Government can do so
by lowering its own expenditures (which in turn feed private incomes) or
by raising taxes — and both these are matters of fiscal policy, not of
credit restriction.
(4) Moderately higher interest rates, similarly, would not
offset the use of funds ufaich have already been created. Cash and deposits
held by the public have increased from 70 billion before the war to about
160 billion now. These funds are so large that very extensive inflation
would occur without the need for any new credit at all and, hence, quite
independent of any restrictive credit policy. In addition, private hold­
ings of Government securities amount to 90 billion, as against 25 billion
before the war. Monetary policy, again, could do little to prevent the
cashing in of these securities should individual and business holders wish
to do so.
For these reasons, it may be concluded that an increase in in­
terest rates would not only be costly, but that it would accomplish little
in curtailing expenditures and, hence, inflation pressures.
No substantial contraction in money supply is possible.

Nor can monetary policy do much towards reducing the existing
money supply and, thus, funds available for spending. The only way in
which this can be accomplished is by reducing bank holdings of Government
securities (or liquidating other bank credit). For all practical purposes,
this in turn can be done only through debt redemption out of budget sur­
plus. Thus, we again find that the key to action rests with fiscal, not
monetary policy.
Preventing further credit expansion.
Banking policy, at best, can aim at preventing further unneces­
sary increase in credit, but even this has been rendered difficult as a
result of war finance which has greatly increased present and potential
bank holdings of Government securities.
To illustrate:
(1) Banks have been increasingly desirous to increase their
earinings by shifting from the holding of short-term. securities to longer
term and higher yielding issues. This has involved an altogether tinnecessary increase in bank earnings. It has also resulted in further
credit expansion since the banks in the process have sold their short-term
securities to the Federal Reserve System which has purchased them, in accord
with the policy of maintaining short-term rates. Temporarily, the debt
retirement program out of the Treasury's balance has been helpful in check­
ing this shift, but sooner or later this balance will reach rock bottom.
The shift into short terms will tend to be resumed as a large volume of
longer term securities becomes eligible for bank holding. Over 20 billion
of eligible issues now outstanding are not held by banks and 30 billion
more will become eligible during the next 8 years. Conceivably, this drift
could be checked by permitting the short-term rate to rise, but this would
be an altogether unsatisfactory solution as it would give rise to excessive
bank earnings, since banks now hold large amounts of short-term securities.
Rather, the problem should be approached by establishing some direct control
over the security holdings or earnings of commercial banks.
(2) A related and eventually more important difficulty arises
because large holdings of Government securities endow the banks with sec­
ondary reserves which, if more attractive earning possibilities arise in
the private credit field, nay be transformed into legal reserves through
sale to the Federal Reserve System. As the System, under the policy of
maintaining the rate structure, will have to purchase these securities,
Federal Reserve control over baik reserves has been greatly weakened.
Some way must be formed to reestablish the System's control. Means of
dealing with the problem while maintaining the prevailing level of interest
rates have been suggested in the Board's Annual Report.
Limit atioa of Monetary Policy —


Monetary restriction is no effective method of reducing demand,
that is, checking inflation.

-5(1) Raising interest rates greatly adds to
the budget cost of debt service and — if the rise is
sharp — may thereafter dislocate the security market.
Against these clear-cut disadvantages, the advantages
are very doubtful: A higher interest rate would not
check expenditures out of current income (I.e., raise
savings) or out of accumulated balances. Moreover, it
would do little to reduce commercial borrowing (i.e.,
reduce dissaving). Consumer credit and stock market
credit are more important, but they are dealt with
(2) Monetary restriction cannot effectively
reduce the existing money supply. This can only be
done through budget surplus.
(3) The existence of a large debt eligible
for bank investments renders existing Federal Reserve
controls ineffective in preventing further credit ex­
pansion, except at the cost of higher interest rates.
Steps are called for to restore such control without
necessitating an increase in rates.
Government Lending
The lending policies of Government credit agencies is one area
in which monetary action need and can be taken. Public agencies which
extend credit directly, or guarantee or regulate credit, should be re­
quested to do whatever they can to bring about curtailment of credit ex­
cept as it may be essential to maintain or increase production. To il­
(1) Recent action by the RFC which gives a blanket guarantee
to all loans made by banks that would sign an agreement with the RFC will
encourage banks to extend unneeded credit. This type of action is highly
inflationary and quite incompatible with other Federal Reserve and Treas­
ury policies aimed at preventing unnecessary expansion.
(2) The features of the currently pending Wagner-Taft-lllender
Bill, which provide credit for public housing through the NHA and liberlize
credit terms are equally inflationary in the present situation and these
aspects of the bill should, therefore, be deferred.
(3) Also, all public lending agencies should be instructed to
pursue more conservative appraisal policies.
Fiscal Controls
Fiscal controls are more effective than monetary controls be­
cause they do not deal with the supply of funds but are directly concerned
with the flow of expenditures. Since direct controls over specific goods
have been successively abandoned or weakened, primary reliance must now
be placed on the fiscal approach.

-6 -

During the deflation of the 'thirties, fiscal policy required
a budget deficit, putting more purchasing power into the economy through
public expenditures than was taken out through taxation. Now, under re­
versed conditions of inflation pressure, a budget policy is called for
which will take more purchasing power out of the economy through taxation
than is returned through public expenditure. A fiscal policy which brings
about a substantial budget surplus is by far the most effective means left
at our disposal to meet inflation pressures. Debt retirement, based on
budget surplus, will nob only curtail expenditures directly, but will also
provide an effective method of curtailing the money supply. Theoretically,
the budget surplus can be obtained in two ways — by raising taxes or cut­
ting expenditures. Since the first approach is not very feasible politi­
cally, retrenchment of expenditures must be given first attention. Stated
very briefly, the major points of a fiscal program are these:
Retrenchment of Government Expenditures

The expenditure outlook has deteriorated. The estimate was
35 billion, is now 40 billion or more. The increase has
accrued mostly in national defense items which are nearly
one-half of the budget.


Any substantial reduction must come in defense items.
items not immediately needed should be postponed.


For the purpose, -a committee should be appointed and include
representatives of prominent civilian groups, in order to
recommend expenditure deferments of at least 5 billion


Also, economies Should be enforced in other items:



Public works should be postponed.


The leave pay bill, if it provides for large
cash payments, should be rejected.


Relief food purchases mhich are not needed to
meet immediate shipments and distribution
abroad should be deferred.


The very minimum requirement is to maintain present tax rates.
Talk of rate cuts is irresponsible. The rate reductions of
last year meant 5 billion dollar loss of revenue. Had these
not been lost and had expenditures been kept at 35 billion
dollars, we might have had surplus of 10 billion.. Now we
may well have a deficit of 2-3 billion or more.


If rate increases were feasible, it would be desirable to

Reintroduce excess profits tax


Tighten capital gains taxation.

3. The provision of the House bill on Social Security which would post­
pone the increase in the payroll tax rate from 1 to 2 l/2 per cent
scheduled for January 1, should be rejected.
State and Local Finances

A conference of Governors and Mayors of major cities should
be called to obtain cooperative actions on:

Postponing unnecessary expenditures, especially


Maintaining taxes.
Appeal to Public

(1) Having curtailed its own expenditures, the Government can
appeal to the public— consumers and businesses— to do the same. Invest­
ors should be told that they will not lose by buying savings bonds even
if prices should rise temporarily. If there is inflation, it is bound
to collapse which will bring prices down again.
(2) Labor and industry should be called upon in cooperation to
increase production as much as possible through higher productivity and
increased hours. Increased production is the final solution.