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EXECUTIVE OFFICE OF THE PRESIDENT CO U N CIL O F ECO N O M IC A D VISERS WASHINGTON 25. D. C. February 2, IP50 MEMORANDUM To: The President From: The Council of Economic Advisers Subject: Analysis of proposal that "Treasury actions relative to ...transactions in the public debt shall be made con sistent with the policies of the Federal Reserve,'1 con tained in Report of Subcommittee on Monetary, Credit and Fiscal Policies (Senator Douglas, Chairman) of the Joint Committee on the Economic Report, issued on Jan uary 23, 1950 as Senate Document No- 129* While the Report of the Subcommittee on Monetary, Credit and Fiscal Policies deals with a variety of matters, the larger part of the Report is devoted to a general discussion which reaches a climax in the proposal that "Treasury actions relative to •••trans actions in the public debt shall be made consistent with the poli cies of the Federal Reserve," and that a Joint Resolution be adopted declaring that this is the will of Congress* ' The Council of Economic Advisers dissents vigorously from this proposal. We set forth below the reasons for this dissent, as transmitted to the Subcommittee in response to its request* o. Onastlons BelBting .to Report of Sa’ h comtttae on Monetary# Credit* and Fiscal Policies 2he views of the Council relating to monetary, credit., and fiscal policies were presented to the Subcommittee (Hearings, pp. 533 - 538 )» but sot in the detailed maimer in which we are now requested to consnent upon the report of the Subcommittee. There is no disagreement upon the point that these policies as a group hare very great importance in deter mining the success of the Ration in attaining the objectives of the $mplo^ssent Act of 19^6 p The Council is glad to express its foil agreement with most of the conclusions reached by the Subcommittee in the broad study which it has completed with su&h remarkable speed* They raarSe a very reel advance in the recognition of the vital role ^lich Government programs must play in our cctoplex economy if it is to be isaintained on a high level# We shall discuss the several recommendations of the Subcoismittee* other than those which cell only for a specific study* in the order in uhich they are presented in the report* under appropriate Soman numerals. The larger part of the report of the Subcommittee is devoted to a general discussion of monetary* credit, and fiscal policies and to the relations of the Treasury and Federal Reserve Board, leading to recom mendations I» IIS and III* which reach a climax in the proposal that "Treasury actions relative to# • .transactions in the public debt shall be &iade consistent with the policies of the Federal Beserve," and that a Joint resolution be adopted declaring that this is the will of Congress* The Subcommittee has not been led to this portentous proposal be cause there is note any controversy be W e e n the Treasury and the Federal He serve Board# The Secretary of the Treasury and the Chairman of the Board have both told the Subcommittee that the policies in which each of them has an important interest have been wor&ed out through successful cooperation an8 that they have every expectation that they will be worked cut in the future in the same way. Neither of them wishes to raise the question of dominant authority and each of them objects to being pushed into a controversy which they believe is unnecessary. As a principle of #ood administration* it is true that a division of authority with respect to a matter of this importance is unwise# As a matter of practical working policy, the Secretary and the Ghairram are probably right in proposing the continuance of the present successful relationship when an effort to change it would surely evoke the sharpest controversy in the field of debt management where quiet and confidence are sfupremely important. We therefore refrain from a detailed discussion of the question whether final authority to determine administrative action of the broad eeonotidc significance vSiich the Subcommittee attributes to 39 credit and fiscal policies should be vested in the Chief 2&ecatii?e chosen by and responsible to the people or should be lodgad in an administratis ■board responsible only to a lejs^islative body which is not organized i n a Ksaaner which perznits it to supervise continuing and flexible administrative action* BabW^aagsisQnt policsE*. The proposal of the Subcommittee results from its conclusion that the debt-iaanageinent policy followed by the treasury and the ^federal He serve Board with repeated public approval of the President is wrong in one important respect and that the decisions of the treasury should sot give primary consideration to continued easy refunding operations at low interest rates. She Sabcoimsittee believes that the debt-ssssagesjent policy as well as the credit policy should nbe gaided primarily b y considerations relating to their effects on eaj&ojnaents production# purchasing power, and price levels.tt It reconsaends that Congress direct this change in policy by Joint resolution. Shis, the Subcommittee says, should be done in order to permit the central bank to attempt to stabilize the econoiny by a policy of monetary and credit control for the success of which the Subcommittee offers no stronger hope than that wOur irtonetary history gives little indication as to hot? effectively we can expect appropriate and vigorous iRonetaiy policies to px&iaote stability* for we have neve? really tried t&es.1* (Heport* p. 18) Th& only point in issue* aside from the question of final authority, is whether the debtHaana^emeat policy should be modified to permit long term* 2| percent Government bonds to fall below par in periods of infla tion. Ihe general policy *sas described by the President in his Annual Economic Report in 19**S» in these words: #A so si important part of our debt^isanagamsnt policy has been the program to support the isarket for Government securities. Daring the war period* t&en it was vitally necessary to maintain a market uhich would absorb vast issues of securities at low interest rates« the Federal Reserve stabilised the isarket through its open market operations in buying and selling short***tera Government securities at low rates of interest* How that it is no longer necessary for the Govemisent to increase its debt* short-term interest rates have been persdtted to rise* A decline has also been permitted in prices of bonds from the premium prices to which they had risen as a result of mrlcet deiaands in the early postwar period* No bonds, however, have been permitted to fall below par and it is the declared pur* pose to continue active support of Government bonds for the purpose of r a a i n t a i n i a n orderly and stable market at a low level of long*’ term interest rates.® (p. 85) J j 9 l s A X s x ^ o t . M ^ w m e m&cA. to s m e t a r y policy. The President in discussion the problem in his several Economic Reports and the Council of Economic Advisers in their reports have always recognised that the present policy “ does not permit the Federal Reserve to make effecting use of the traditional method of limiting inflationary movements in the economy by requiring banks to borrow in order to obtain additional reserves and by raising the discount rate charged on such borrowings After making this statement in his Sconomic Report in January 19^8» the President continued* wXn the recent congressional hearings there have been proposals to solve this dilemma by abandoning the support policy and freeing the Federal Reserve banks to bring about an anti-inflationary contraction of credit by increasing the discount rate# as was done in 1920. Ko such change in policy should be considered* The financial world should rest easy that the investment market will not be subjected to the de moralization which swept over it in 1920 when the unsupported market for Government bonds fell about 20 percent below par. ^Affirmation of a policy of supporting the Government bond market as a continuing program of the Government re quires the use of other and less dangerous methods to restrain inflationary bank credit* Voluntary but effective restrains by the banks of inflationary bank credit expansion may prove adequate to the problem* Xf it does not* more direct action b y the Federal Reserve banks will be required* Such actions as may be taken will not involve withdrawing support from the Government bond market,” (pp* 85-86) In his Economic Report in J a m a r y 19^9* the President again affirmed hie purpose to continue his debt~management policy* saying: f?(Phe public debt will continue to be managed in a manner that will make a mascinasm contribution to the stability of the economy. An important factor in this program will continue to be the maintenance of stability in the Government bond market* «t * # $ * w0nly during the last few years have we had experience in dealing with the problems of managing a public debt of the size the country now bears. SEhe policy of supporting the price of long-term Government bonds at the 2f percent yield level has been eminently s u c c e s s f u l * ( p . 11} The Council also discussed the debt^management policy and the problem of Federal Reserve power to influence credit conditions in its Animal Economic Review* forwarded to the Congress by the President with • Ifi1 • Ills Bco»ot3ic of 1949* aad set out its reasons for believing that it would 'b® s serious error to change the policy and to adopt that *^xlch is now proposed by the Subcommittee (pp„ 42-43)» Earlier, in Its own Animal B e p o ^ to the President in December 1948 (pp« 27-28)* in a dis cussion of the difficulties flowing from the need to adjust each economic policy to the conflicting requirements of others, the Council used the d 6bt»B 8$2W ^ 86nt policy as contrasted with Federal Reserve credit control as an esssiple, We said; “Inflation is dangerous* and it Is fed by our cheapmoney policy. But it would be reckless to asodify that policy b y changes which might create uneasiness about the national credit and disorder in financial markets at a time when the nation oust support a vast public debt,” These statements were made by the President and by the Council when they were frankly worried by an inflationary movement which they felt was creating serious danger to the economy, She issue is now raised b y the Subcommittee t&en it sees no inflationary threat* and when the prices of Government bonds are well above the peg point of par# and m y be expected to remain there unless the proposed reversal of t&e debt-management policy by Congressional resolution should itself create such doubt and uneasiness among the holders of Government bonds that we would face a wave of liquidation. Our apprehension on this score was expressed when we appeared before the Subcommittee, (Hearings* p, 53?) Pawttga. «Bd-gftenliLg.f deb.t^ma^&aeat volley. On page 26 of its report, the Subcommittee summarises the five reasons advanced by Sfreascsy and Federal Reserve officials for supporting, the price of Government bonds even in periods of inflation. We think these reasons are valid end so cogeny that they require that debt-man&gemeni policy mast be dominant ana that we roust look for other ways to restrain dangerous inflation rather than subordinate the debt^raanagement policy to traditional central bank operations* 3&e five reasons are largely included within the single point that the present policy maintains confidence in the public credit and makes it possible at all times for the Treasury to fine? buyers at low Interest rates for new securities issued to refund our enormous public debt, 2he Subcommittee neither accepts» rejects, nor qualifies m ay of the five reasons* but of this one it says it wloons important to the Treasury,11 We believe that it is important In reality and not merely in appearance. We do not have a complacent attitude towards the problems of managing and refunding & 250-billion-dollar debt which has to be rolled over at & e rate of 50 billion dollars each jrear. Despite the drumfire of criticism which has been directed at the debt-v&E&nagement policy from certain financial quarters* the Judgment of the President that it has been **eminently successful5* is wholly Jus tified b y the record of the past five ysars. Our economy was unsha&en by an immediate postwar slump which cany now overlook* misled b y the fact that slow demobilization withheld millions of our young men from the labor raarket. It brought a decline of mere than 60 percent in pro duction of durable goods, a substantial decrease l a nondurable production® and an increase in unemployment eves tsfeen millions of war workers were withdrawing from the labor force. She policy made available abundant and cheap credit to business when it then endeavored to carry its share of the responsibility in the race with inflation by increasing productive capacity. It contributed to the conditions under which the expected flood of liquidation of savings bonds did not materialize, and sales of savings bonds have continued in large volume. It preserved a solid credit position for the Government x&en the great economic question arose whether the end of inflation would become the beginning of economic collapse. It has even added to the prosperity of some custodians of fands who disdain it but who would have wholly inadequate outlets for the swollen deposits created by the war if l&ey did not know that they can safely invest in Government bonds because the market price will be supported. Central bank controls. Shis is fee record of the policy ishlch the Subcommittee would no# abandon. What is the record of the proposed sub stitute policy of flexible monetary and credit control by the Federal Reserve System, when we look to its service in establishing economic stability? She Subcommittee speaks of the desirable characteristics of central bank operationst and it is entirely Justified in praising them for flexibility and because they are indirect and do not entail positive action by Government which limits the freedom of businessmen. But when it comes to considering their effectiveness in attaining the objectives of the ISaploysaent Act* the Sabcossmittee only says that we can draw no conclusions from experience because we have sever really tried to use these policies to affect general economic conditions. We do not read history that way. For 35 yearss Federal Reserve discount rates have been shifted up and down. Per 25 years the System has carried on open-mrket operations. Changes in reserve requirements have been one of the tools of control for more than a decade 9 and have furnished experience which persuaded the Council of Economic Advisers to support the Jud^aent of the Federal Beserve Board that broader power to change reserve requirements would permit son® effective anti-inflationary action by the central bank notwithstanding the debt-mnagement policy. Experience has furnished very valuable guides to the way central bank power may be used to influence economic conditions* and in our opinion the lesson it teaches is that we m s t l e a m much mere before the central bank can act with sudh finesse and with such confidence of the specific results of its action that we should consider the subordination to it of the. policies of debt-iaaaageiaent. Repeatedly* in its discussion of this problem* the report of the Subcommittee speaks of the need for *vigorous® use of central bask power. We assume that it is meant that history furnishes no guide to action because central bank operations have never been vigorous enough. ^3 • If this also iseans that the writers of the report look to the Federal Reserve Board to interpret the proposed Congressional directive as an instruction to use its powers core vigorously in a future inflation than they were used in the past, the joint resolution would indeed threaten untold daaasge to Treasury operations* Before this war* the Board has only twice been called upon to consider action in a period of Important inflation. In 1920, it ran the discount rate up to ? percent* In 1929» it pushed the rate up until it reached 6 percent. She debate still goes on8 A e t h e r the high, discount rates caused the ensuing catastrophes or whether the economic collapse was in each instance due to forces which not even 7 percent and 6 percent discount rates could quell. But csr*» t&inly the Heserre Board is not open to the criticism that it has not used its powers vigorously. If that record shows that even more violent effort would he necessary in order to isa&e central bank operations ef fective to curb an inflationary movement, we believe the conclusion should he that these particular anti-inflationary devices are altogether too dangerous to Justify giving to them the first place in the arsenal of weapons to gain economic stability* as the Subconsnittes propose* In Recommendation X. Fiscal policy. The adiairabl© discussion by the Subcommittee shows,, we believe, that fiscal policy is a far isore powerful instruzrjent^of" economic control of strong economic movements than is credit, policy if the latter is confined within prudent limits* The effectiveness of fiscal policy will be greatly increased by the correlation thereto of policies relating to money and credit. We are in general agreement with the views expressed by the Sub committee about fiscal policy* and about tfte desirability of a tax structure which will yield a surplus^in periods of high business activity, while leading to a deficit in periods of recession? when expenditures by the Government in excess of the^sonnts collected in taxes will furnish valuable support to the econcrajy* We are di&ious* Jho«rever0 whether it will soon be possible to devise# as has been proposed in some quarters9 a tax program «hich will so ac curately inatch.the requirements of our dynamic econoiqy or will so well reflect the requirements of many patterns of inflation and deflation that once^enacted it may be left unchanged except as programs of Govern ment action are themselves expanded or contracted. We therefore agree wit^tihe views of the Subcommittee that the problem of flexibility in f l S a l operations requires farther exploration. • Formula Flexibility. One fiscal policy which was pressed upon the* Subcommittee, hut which it has not reeaismended, carries to an extreme the idea of nfomaila flexibility,*5 Under it scans preordained fiscal change3 such as a decrease of 15 percent la income taxes, would go into effect whenever a certain degree of change took place i a s o & e prescribed economic index* say in the volume of unemployment, or the index of whole sale prices, or the index of industrial production. If one of the econ omic indicators suggested to the Subcommittee were selected as the one to sound the alaasa, it would probably have been sounding off by the end of last June, and vigorous anti-deflationary action, such as reducing taxes or increasing Government speeding, vap3j& automatically have come into effect, -But the Council of Eccaio^ic-Advisers, even though we k n e w a n d said that conditions vould become'' even worse in July, advised the Pres ident that there were factors outside of the statistical indexes which in our opinion meant a reyersal of the business trend before the end of August, and we advised J U m to hold firm on taxes and to hold off on any program to increase^vernmsnt spending. Vie now know, of course, that the formula pisn^mild have rushed us into the wrong course of action last suiamer-^fe do not believe it should ever be a substitute for care ful study o f a l l of the conditions affecting the eeonoity, and the making of plan^i?hich then appear to be appropriate to the particular kind of difficulties which require attentio&_and which cannot be described in a^tmce. The Value of Cheap Credit, The difference in our position from that of the Subcommittee arises in part from a somewhat different view of the desirability of low interest rates. Xn th« report of the Subcommittee it is said, and repeated, that low interest rates are generally beneficial, but it is proposed to yield that principle in periods of inflation and to use central bank operations to induce an increase in the cost of money* Our vies* is that low interest rates are always desirable. In periods of inflation they have the undesirable collateral consequence of contrib uting to inflationary forces, but even then they have the economic advan tage of facilitating the expansion of productive capacity which is the best road to stability. Where we differ with the Subcommittee is that we would not abandon the advantages of cheap money and use central bank operations to cause an anti~ inflationary increase in interest rates. We would retain the advantages of cheap money and adopt other measures to curb the inflationary forces. In extreme cases, as in 1947-4&, we would tighten the availability of credit b y pressure upon bank reserves under the plan proposed b y the Federal Be serve Board at that time, but would hold the resulting trend to higher interest rates with narrow limits* Regulation of Instalment Credit. .Another point not discussed by the Subcoismittee is the regulation of instalment credit. The President has recommended that the authority of thjsf Federal Reserve Board to regulate instalment credit be renewed, and jjjhe Council has already presented to
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