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SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

March 8,1974

1.

Policy Recommendation of Shadow Open Market Committee, March 8,1974

2.

Position Papers




Monetary Growth and Monetary Policy- Karl Brunner, University of Rochester
Memo to the Shadow Open Market Committee - A . James Meigs, Argus Research
Corporation
The International Outlook: A Briefing for the Shadow Open Market Committee Meeting of
March 8,1974-Wilson E. Schmidt, Virginia Polytechnic Institute and State University
[Untitled] - Robert Rasche, Michigan State University

Policy Recommendation of Shadow Open Market Committee
March 8, 1974

The second meeting of the Shadow Open Market Committee was
held on March 8, 1974.

The Committee considered two main questions: (1) appropriate
monetary policy in light of the recent inflation, the slowing
of the economy, and the consequences for the balance of trade
and payments of the changes in world prices and production of
petroleum; (2) means of improving Federal Reserve measurement
and control of money.

Monetary Policy

Attempts to end inflation by expedient policies that ignore
basic, well established and widely accepted economic principles
have failed. Controls on prices, wages, interest rates, exports,
and capital movements have been tried and, as usual, have been
counterproductive. For_thx&~-^eea^

the rate of

inflation now is much higher than it was four years ago.

The failure of the various price-control programs to slow
or stop inflation should not be taken as evidence of an
inability to end inflation. Time and resources have been
wasted by these programs. Shortages have been created and
opportunities to bring inflation down have been lost. Effective policies to do so are no different now than in the past;




inflation can be brought under control.

Some favor drastic action to end inflation. Others are
willing to accept permanently high, and even accelerating,
inflation. We favor a moderate but continuing policy to
reduce the rate of inflation.

At our September meeting[ we concluded that the appropriate
policy for the following six months was to slow the growth of
money -- currency and demand deposits. We chose a policy of
gradual reduction, in preference to a sharp reduction, because
we wished to minimize the loss of employment and waste of
resources during the adjustment to lower rates of inflation
and, eventually, to stable prices.

Considerable progress has been made in reducing the rate of
monetary expansion. From the first quarter of 1972 through the
final quarter, the annual rate of expansion in money was 8.6%,
a majdr contribution to the acceleration of inflation in 1973.
During the first half of 1973, the rate of monetary growth was
moderated somewhat to a 7.4% annual rate, and in the second
half, the rate was reluced further to approximately 5%. We
recommend that a growth rate of 5% to 5.5% be maintained
during the coming six months.

Projections for the balance of the year suggest that recovery
"ill

h-Q.fi t r\

ran he Q^poofecd* by thq third quarter if money continues to
expand at this rate. Higher rates of monetary expansion will



have nuiclk 9 ] ^ a t e r effect on future inflation than on current
employment.^It would be wrong for the Federal Reserve to allow
rising unemployment rates, increases in the size of the
official government budget, and the larger deficits in prospect
to push the money growth rate higher than our recommended rater~
^/parte^of growth of money h^^^
do nothing
o
^^
to_jlive the problems resulting from the petroleum shortfall.
The consequences for the U.S. balance of trade and payments
of the changes in world prices and production of petroleum
may not be so serious as some have conjectured. The projected
deficit in the trade balance in 1974, because of higher prices
higher
for imported oil, may well be significantly offset by the
P
foreign earnings of the major oil comaanies. In any event, the
international sector will not make much difference to domestic
developments here because it will not change the stock of money,
la
Floating exchange rates will paly a key role in minimizing
I

the impact of the international sector on the domestiq economyj,

Control of Money

The Federal Reserve has recently announced the appointment
of a committee to propose changes in the definition and measurement of money. We believe this move is a constructive and long
overdue effort that should^prove the current statistics on
money and thereby improve control of the money supply.

Improving the definition and measurement of money is one
important step toward improved control of money. We believe



that other steps are needed. We recommend that the Federal
Rserve:
(1) Consider operating directly on the monetary
base, which the Federal Reserve can control
with a high degree of precision, and reduce
reliance on money-market conditions.

(2) Simplify the present overly complex arrangements for computing required reserves which
would reduce variability in the money supply.

(3) Eliminate lagged reserve requirements which
have been a cause of increased variability
i > money.
x

/ /J /"to^d6mest%g,^and (interna^tiprialxeqonomic st<i "v
/ /" / . x) x /
J x
'bu£rfon to^d6mest4c?^nd (interna^tiprial eqonomic stability,
:o|^rib\r^fbn
/foe believe that floating exchange)rates h&ve made a major!

We strongly recommend, therefore, that the Federal Reserve
restrict or eliminate its intervention in foreign exchange







MONETARY GROWTH AND MONETARY POLICY
Position paper prepared for the second meeting
of the Shadow Open Market Comxattee (SOMC).

KARL BRUNNER

University of Rochester

March 8, 1974

The first meeting of the SQMC on September 14, 1973 concluded
with a proposal that monetary growth be held to a range between 5%
and 6% (at annual rates).

This proposal expressed the SOJYC's evaluation

of the longer-run policy required to moderate inflation. Our discussion
at the meeting also expressed serious concern about the Federal Reserve1 s
record in the past two years. It is thus noteworthy that Senator
Proxmire addressed on September 17, 1973 a letter to the Chairman of the
Board of the Federal Reserve System requesting "ccarcrients on certain
criticisms of monetary policy over the past year". The Chairman of
the Board replied on November 6, 1973 with a letter published in the
Federal Reserve Bulletin and the Reviews of individual Federal Reserve
Banks. The letter justifies the past record and absolves the Federal
Reserve authorities from any responsibility for the renewed surge of
inflation.
There emerged in the months following the first meeting of the
SQMC another development deserving the SOJyc's serious attention.

Several

members of the SOMC began to suspect the adequacy of the monetary data
published at the time. Observations bearing on the behavior of velocity,
the currency ratio and the tune deposit ratio suggested that the data
available on demand deposits seriously underestimated the true state of
affairs. Allan H. Meltzer further developed and expressed these surmises
in a comment published by several major newspapers. The revised data were
eventually released at the beginning of February and revealed sane interesting
changes in the patterns of monetary growth.

It appeared that the neasurement

error was particularly concentrated with non-member bank deposits. This
circumstance offered the Federal Reserve Authorities an opportunity to
obscure the inadequcy of their measurement procedure with assertions
claiming an "erosion of monetary control" by the grcwing share of non-member




2.

banks in the US monetary system.
The measurement problem remains however and it prompted the
Federal Reserve Authorities to assemble an Advisory Committee of
academic economists. This G^rmittee is apparently instructed to
survey the measurement problem and offer advice concerning the
development of reliable technique. The SCMC should applaud the
organization of such a Ccmmittee. We should also hope that the Advisory
Corrmittee will seriously attend to this task. The Federal Reserve
System has vast resources available for data collection and examination.
It is laudable that our Central Bank possibly considers to use these
resources effectively for the acquisition of the relevant information
required to pursue its function.
We encounter thus in recent developments of monetary policy several
irmportant issues. The measurement problem will be disregarded in this
paper.

It will be covered in the position paper prepared by James Meigs.

The subsequent material describes the patterns of monetary grcwth observed
in the recent past and traces the role of the monetary authorities and of
other factors in the process. This discussion of actual and emerging
patterns is followed by an investigation of the role of non-member banks
in the money supply process and the Federal Reserve's proposal to Congress.
The last section examines the Chairman's letter to Senator Proxmire and
discusses the crucial elements in the Federal Reserve's justification
of its record.




3.

1. The Central Bank and Mpnetary Growth
Central Banks cultivate seme corrmon traditions. Our major tradition
is the frequent denial of responsibility for pronounced accelerations
or decelerations in the money stock.

Our Federal Reserve Authorities

share this propensity and frequently attribute variations in monetary
growth to events evolving independently of the Federal Reserve's
behavior. Ihe role of the Central Bank in the money supply process
deserves thus a critical examination. We can easily agree that the
actual evolution of the money stock emerges frcm the interaction between bahks
and the public in response to the monetary authorities1 behavior.

Ihe

research accomplished over the past fifteen years by variour groups of
economists clarified the nature of this process. It also offered
infonxation about the relative role of banks, public and monetary authorities
in this process.
The reader will find seme indications of the general patterns in tables
I and II. Ihe regressions presented yield clear information concerning our
question. The dominant dependence of a magnitude y on a magnitude x will be
revealed by a regression of y on x combined with a regression of y on the
remaining set of conditions suspected to affect y.

With y dominated by x

we can reasonably expect the systematic occurrence of regressions attributing
a major role to x and a comparatively small role to the regaining magnitudes.
We expect in other words under the circumstances that most of the variations
observed in y can be reasonably attributed to variations in x, but not to the
variations in the remaining magnitudes.

It should be noted that this procedure

does not infer "causality from correlations", but uses observe correlations
to assess conflicting assertions about causality.



TABLE

I.

The Role of the Monetary Base in the Shorter and
Intermediate Run

1. Regression of percentage change of M between non-overlapping
three month moving averages of seasonally adjusted data on contribution made by base B and remaining proximate determinants RPD

H =

.82 + .76 B

M = 3.27 + .48 RPD

2.

R 2 = .58 ; DW = .29
R 2 = .10

DW = .08

Regression of percentage changes of M between non-overlapping
six month moving averages of seasonally adjusted data

M =

.47 + .86 B

M = 3.23 + .46 RPD

R 2 = .75

DW = .10

R 2 = .05

DW = .02

The data used in both regressions over the period 1/1947 to
6/1973.

The remaining proximate determinants are the currency ratio

k, the time deposit ratio t, the adjusted reserve ratio (r+£) and the
Treasury deposit ratio d.




TABLE

II.

Regressions of Money Stock on the Monetary Base

1. Regression of percentage change of M between corresponding months
in adjacent years on contribution made by base B and remaining
proximate determinants RPD.

M =

R 2 = .81

.46 + .87 B

DW = .2
r\

/s.

«\

M = 3.23 + .32 RPD

R

= .02

DW = .02
The data used in this regression were seasonally adjusted.

2.

Regression of monthly changes in the money stock M on monthly changes
in base B and Treasury deposits TRD for seasonally unadjusted data

AM = -.07 + 3.06AB - .9ATRD
R

2

= .7; D.W = 2.47; constant term

does not deviate significantly

from zero at 10%.

The data in regression 1 cover the period 1/1947 - 6/1973.
The data in regression 2 cover the period 1/1947 - 12/1973.




4.
The conflicting assertions under consideration involve propositions
about the relative role of the Central Bank in the money supply process.
We need to remember at this stage that the monetary base effectively
summarizes the behavior of the monetary authorities. The base can be
expressed as the sum of the monetary liabilities of the Federal Reserve's
and the Treasury's monetary account. All the base money is issued by
the monetary authorities and their behavior completely determines the
magnitude of the base.
The four regressions in table I and II use different time units
to express the data. Regressions 1 in table I examine percentage changes
of the ironey stock between successive three month periods for seasonally
adjusted data. The first regression under 1 shows that 58% of the variations
in monetary growth between successive three month periods is attributable
to variations in the growth rate of the monetary base. The second regression
under 1 shows on the other hand that only 10% of the variations in monetary
growth over the periods: under consideration can be attributed to the
operation of the remaining factors. The reader should also note the
large difference between the constant terms in the two regressions. These
terms inform us that the factor

disregarded in the second regression (i.e.,

the base) contributes to an average monetary growth of 3.27% p.a. over the
postwar period, whereas the RPD (i.e., the remaining proximate determinants)
factors only contribute .82% p.a. once the effect of the base is explicitly
recognized.
The regressions under 2 in table I examine a somewhat longer horizon.
The percentage changes in the money stock are now computed between successive
six north periods with no overlap. The reader will note that 75% of the
variations in monetary growth over the longer period are reducible to
variations in the monetary base and only 5% to variations in the remaining
factors. The increasing influence of the base with the extension of the

horizon


is also visible with the larger coefficient attached to the base and

5.

the smaller constant term in the first regression. We are thus informed
by a comparison of the two constant terras (.47 and 3.23) that the average
contribution of the base to average monetary growth remains essentially
the same for the longer horizon, but the average contribution of the
remaining factors is almost cut in half.
A further extension of the horizon was applied to obtain regressions
1 in table II. Ihe percentage changes of the money stock pertain to
changes between corresponding months in successive years. The reader
will observe values for the constant terms practically identical with
regressions 2 in table I. But the longer horizon raised the proportion of
the total variation in monetary growth attributable to the monetary base.
This proportion is now 81%, whereas only 2% of the total variation in
monetary growth can be assigned to variations in the remaining proximate
determinants.
Information from a very short horizon is presented in regression 2
in table II. jybnthly changes of the money stock are regressed on
contemporaneous changes of the base and Treasury deposits. Seasonally
unadjusted data are used for this purpose.

It should be emphasized that

independent seasonal adjustment of causally related magnitudes seriously
distorts the relative timing patterns of the time series involved and
makes seasonally adjusted data quite unreliable for short-run analysis.
The reader should observe that over the postwar period 70% of variations
experienced in monthly changes of the money stock are attributable to
variations in contemporaneous changes of the base or changes in Treasury
deposits.




It emerges clearly that accumulationsof Treasury deposits lower

6.

monetary growth and decumulations accelerate monetary growth.

It is

also noteworthy that the constant term in the regression essentially
vanishes.

The omitted factors contributed thus (in cotibination) little

to the average growth trend of the money stock.

They do account, however,

for 30% of the variation in observed monthly changes of the money stock.
Additional information concerning occurrence and magnitude of
the "remaining proximate determinants" may be found in tables III and IV.
Each table lists for two different horizons the smallest and the largest
contribution to monetary growth made by all the proximate determinants.
The infonriation in table III pertains to percentage changes (at annual
rates) between successive four week periods in 1973. Table IV on the
other hand presents the patterns associated with the percentage change
of the money stock between corresponding months in successive years from
1969/70 to 1972/73. We note that the longer horizon compresses the range
of variation. Table V offers a comparison of the two ranges. Changes
in Treasury deposits became an insignificant factor in longer-run assessment
of monetary events, but do clearly disturb the evolution of monetary growth

Table V:

M

The Ranges of Contributionflfctdeby Proximate Determinants of
Mpney Stock in the Periods listed in Tables III and IV.

B

k

t

rh£

d
5.1

22.5

14.2

9.5

10.8*

16

5.7

5.5

1.8

5.6

6

.58

The symbols are defined under table IV.
over shorter horizons. We also note that the range of money stock and
base essentially coincide over the longer horizon. A similar range persists



TABLE

III.

Range of Values of Contributions Made By Proximate
Determinants of Monetary Growth

The data cover 1973 and are computed from non-overlapping four weeks
moving averages of seasonally adjusted data. All numbers are percentages and refer to annual rates of growth between successive non-overlapping
four week averages.
M

B

k

t

r+£

d

- 7.2

- 1.2

-5.3

-8.3

- 5.3

-2.3

15.3

13.0

4.2

+2.5

10.7

2.8

TABLE

IV.

Range of Values of Contributions Made by Proximate
Determinants of Monetary Growth

The data cover the period 1969/70 to 1972/73 and refer to percentage
changes between corresponding months in adjacent years.

r+l

M

B

k

t

2.8

2.8

-1.3

-3.7

-2.9

-.24

.5

1.9

3.1

.34

8.5

8.3

d

M = money stock, k = currency ratio, x+Z = adj. reserve ratio
B = monetary base, t = time deposit ratio, d = Treasury deposit ratio
The reader should note that each percentage number describes the contribution
of the factor listed to the stated percentage change of the money stock.




7.

for the time deposit ratio and the adjusted reserve ratio (rf£).

It

should be noted however that the decomposition of the factors shaping
nonetary growth has not been fully executed*

An iinportant strand of

the effect of t operates via the adjusted reserve ratio (r+£) and offsets
the "direct" effect of t on M.

It follows thus that a complete decomposition

would lower the range of both t and (r-K£) by a substantial margin.

Still/ the

time deposit ratio and the adjusted reserve ratio remain the dominant factors
beyond the base affecting monetary growth.

Ihey are joined in importance

over the shorter horizons by the movement of the currency ratio.
The patterns presented yield some clear conclusions concerning the
role of the Central Bank in the money supply process:




(a) The public's and the banks behavior modify monetary growth
substantially over shorter horizons.
(b) Even within shorter horizons however the relative force of
Central Bank behavior is clearly visible.
(c) Ws can reasonably expect that Central Bank behavior dominates
beyond the shorter horizons the evolution of monetary growth.
Substantial accelerations or decelerations of the money stock over
twelve month periods are rarely generated by the public's or the
banks behavior. Ihey occur in response to the Central Bank's behavior.
(d) The shorter run patterns are conditioned by the prevailing
institutional structure. This applies most particularly to
and t.

(r+l)

Ihe Federal Reserve Authorities never examined thus far the

institutional modifications required to lower the variability of
(r+£) and t and to inprove thereby substantially the shorter-run
controllability of monetary growth.

;y

8.

2.

The Evolution of Monetary Growth
It is useful to place our current position into the context

of monetary evolutions since 1969/70. Table VI summarizes the
relevant information. We note four distinct phases since the beginning
of 1970. From the first quarter 1970 until the third quarter 1971
(remember August 15, 1971) the monetary impulse applied to the economy
persistently accelerated.
this period.

The monetary impulse more than doubled over

The table also informs us that monetary acceleration

was essentially due to the acceleration of the monetary base.
The second phase was initiated with President Nixon's NEP (new
economic policy) in August 1971. This policy was accorpanied by a
substantial deceleration of the monetary impulse until the second
quarter of 1972. About 50% of this deceleration is assignable to the
decline in the growth rate of the base.

It is quite clear however

that the monetary authorities permitted over this phase a marked
moderation in monetary growth.

This moderation must be judged to have

been quite appropriate in retrospect and we should carmend the Federal
Reserve Authorities for its modification of policy.

Prices were

decelerating since early 1970 and the monetary acceleration of the
first phase would have seriously endangered the gradual decline
in our inflation rate. The change in monetary evolution initiated in
the late summer 1971 contributed to maintain the gradual deceleration
in price movonents. The third phase stretches from the second quarter
1972 to the first quarter 1973. The monetary impulse expanded over
this period at a rapid pace and increased approximately by




TABLE

VI.

Percentage Changes of Money Stock and Monetary Base
Between Corresponding Quarters

Period

Money Stock

Monetary Base

1969I-1970I

3.3

2.9

1969II-1970II

3.8

3.7

1969III-1970III

4.8

5.2

1969IV-1970IV

5.5

5.7

19701 - 19711

6.1

7.2

1970II-1971II

7.2

7.6

1970III-1971III

7.3

7.8

1970IV-1971IV

6.3

7.1

1971I-1972I

6.0

6.8

1971II-1972II

5.5

6.9

1971III-1972III

5.9

6.5

1971IV-1972IV

7.5

7.6

1972I-1973I

7.9

7.9

1972II-1973II

7.7

8.0

1972III-1973III

7.0

8.0

1972IV-1973IV

5.9

7.2

The computations were made with seasonally unadjusted data.




9.
44%.

The monetary base also accelerated and contributed about 40%

to the monetary acceleration.

The last phase covers the remainder

of 1973. The monetary iinpulse hovers on a high level, recedes slightly
in the summer and declines sharply in the fall.

The monetary base also

decelerates but its movement is again smaller than the monetary deceleration.
Ihe SOMC should note with seme interest that monetary growth did
converge last year frcm the exaggerated levels permitted by the monetary
authorities towards the range of 5%-6% recanmerde d at our last meeting
on September 14, 1973. This deceleration contributes to retard the
rate of inflation fuelled by the Federal Reserve's inappropriate policies
pursued since early 1972. Monetary policies directed to lower
the rate of inflation would have to continue the growth pattern
reached by the end of last year. The SOJYC should thus be interested
in assessing the probability of such monetary developments.
Seme aspects of recent monetary growth presented in table VII offer
seme relevant information for our purposes. The reader should note that
the table uses corresponding changes between monthly data. The basic
pattern of money stock and base exhibited in table VI occurs somewhat
amplified with these data. The reader is directed to the relatively
smaller changes in the growth rate of the base relative to the changes
in monetary growth.

It is quite remarkable that the growth rate of the

base fluctuates since last summer of 1971 in a narrow band of 6.8% to 8.1%.
The changes in monetary growth beyond this band are due to the currency
ratio k, the time deposit ratio t and the adjusted reserve ratio (r+l).

An

examination of these patterns reveals seme pronounced regularities. The contribution of the k-ratio moves in a cyclic fashion between .5 and -1.25 over the




TABLE

VII.

Contributions of Proximate Determinants to Monetary Growth (in percentage p.a.)
Between Corresponding Months of Successive Years

Period

M

B

k

t

-1

1.9

1/1969-1/1970

3.7

3

7/1970-7/1971

7.9

8.1

6/1971-6/1972

5.0

6.8

1/1972-1/1973

8.6

8.0

6/1972-6/1973

8.4

8.0

-

12/1972-12/1973

5.6

7.1

d

-

.03

.26

.3

-2.8

2.2

.08

.6

-2.2

1.2

-.15

.3

-1.4

1.7

0

.2

-2.1

2.7

0

-1.1

-2.4

1.80

.1

-

All computations are based on seasonally unadjusted data.




r+1

10.

past three years. An indication of these movements appears in table
VII.

The k-contribution recently fell to its lowest levels since the

first half of 1970. Vie may thus expect no substantial further decline
of this contribution. Vfe may on the contrary expect over the current
calender year a gradual upwards drift of the k-contribution.
The time deposit ratio t produced for many years a larger
numerical, but mostly negative contribution to monetary growth. This
was due to the persistent rise of interest rates offered on many tine
deposit accounts. The t-contrLbution declined sharply frcm 1/1969 1/1970 to 3/1970 - 3/1971 from 1.91% to -3-68%.

Frcm 3/1970 - 3/1971

to 1/1972 - 1/1973 the contribution rises again frcm -3.68% to -1.36% and
fell again during 1973 to -2.45%.

Previous patterns suggest that the

t-contribution is unlikely to fall substantially this year.

I expect

on the contrary a gradual increase of this contribution over the next
six months. Similarly, the (r-h£) contribution is unlikely to continue
its recent fall.

The sum of ny assessnoit thus implies that the monetary

growth emerging for this calender year m i l be centered by the growth
rate of the monetary base. My assessment implies in particular that
under current trends monetary growth converges to the growth rate
established by the monetary base.
It may be useful to supplement our examination with data bearing
on the shortest horizon. Table VIII presents the extreme points of
short run monetary evolution over the past six months. The first row
summarizes the state prevailing just before our first meeting of the SQMC.
A rapid acceleration of the base until the middle of December carried
monetary growth frcm -1/2% to about 12%.




We notice also that the remaining

11.

Table VIII:

Contribution of Proximate Determinants to Monetary
Growth (in percentage p.a.) Between Successive Four
Week Periods.

The date lists the terminal day of the second four week period in the
comparison.

M

Period

B

k

t

rj£

d
1.3

8/29/73

-.5

•1.1

-4.2

-5.5

9

12/12/73

11.7

13

-.3

2.3

-3.9

.7

-4

5.4

-5.0

-7.4

3.2

-.2

2.6.74

Factors essentially cancelled each other at the dates indicated in the
first two rows.

The effect of the base thus dominated the events. For

two months beyond the middle of December monetary growth collapsed to
-4%.

The temporal distortions of seasonal adjustmsnt may easily exaggerate

this decline and blur our judgment. Still, a substantial decline seems
probable. And we note in particular that the fall in the k and t contributions
dcminate the fall in the base contribution. An inspection of the shorter-run
patterns of the k and t contribution thus suggests that a continuation of the
recent trend is highly unlikely.

It suggests on the contrary a gradual

recovery of this contribution over the next three months. This implies
again convergence of monetary growth to the central thrust determined by
the Central Bank1s behavior expressed by the monetary base.
And what can we say about the trend of the monetary base?

The

growth of the monetary base remained throughout 1973, when compared to
the corresponding month in 1972, above the rate required for an effective
anti-inflationary policy. iYbreover, the 21 overlapping four week periods
recorded thus far since our last SQMC meeting show 9 periods with
an annual growth rate of the base in excess of 10%. There is no indication



12.

at this stage that the Federal Reserve Authorities plan to moderate
the growth rate of the base to a level assuring a gradual moderation
of the new round of inflation unleashed in 1972. Two pervasive patterns
assure furthermore a low probability for any receding growth in the base.
They also assign a substantial probability to an increase in this growth
rate. We note first the rapid increase over the next 16 months in the
deficit of the Federal budget. We also know that the absorption of
debt by the Federal Reserve System has been systematically associated
with the magnitude of the deficit. The base thus retarded in periods
of low deficits (or surplus) and accelerated in periods of larger deficits.
This pattern has been created by the Federal Reserve's traditional concern
to constrain movements in interest rates by suitable open market operations.
The traditional response of our monetary authorities thus enhances the
probability of a marked acceleration in monetary growth over the current
year.

This development would further entrench our high rate of inflation

and move the whole structure of interest rates to a higher level.




13.

3. The Alleged Erosion of Monetary Control by the Dual Banking System.
On January 28 the Board of Governors of the Federal Reserve System
submitted to Congress "draft legislation designed to iitplement its
recommendations for uniform reserve requirements". This request to
extend the Federal Reserve's power to inpose reserve requirements on
non-member financial institutions has been motivated by the growing
iirpoirtance of non-member banks in our monetary system.

The Board of

Governors notes that "the purposes of the proposed legislation are to
make the nation's monetary system more responsive to Federal Reserve
action, to facilitate better management of money and credit, to provide
a i t r equitable system of reserve requirements for financial institutions
tDe
offering similiar deposit services, and to permit Federal Reserve credit
assistance to a broader range of financial institutions...". This
justification invokes essentially two points: monetary control and equity.
We emit considerations of equity but note in passing substantial
skepticism concerning a government agencies attention to "equities". The
control problem remains a serious and resolvable problem.

It is unfortunate

that the Federal Reserve authorities never examined the issue systematically.
It is quite probable that our prevailing institutions substantially obstruct
short-run control over the money stock. Among these institutions should be
listed the variations in reserve requirements with respect to types
of banks or deposits and with respect to magnitude of deposits, the
lagging of required reserves with respect to the relevant deposit base,




14.
the ceiling on interest rates payable on demand and time deposits, the
neasurerrent of the deposit base used to cotpute the volume of required
reserves, etc.

It would appear most appropriate that our monetary

authorities systematically analyze our existing arrangemsnt and
examine the changes required to improve its control over the money stock.
Such an examination should also assess the relative iinportance of specific
institutions.
This is particularly important for the present case. The
draft legislation submitted to Congress offers an exceedingly narrow
proposal for a broad purpose, viz., extension of the prevailing (complicated)
patterns bearing on member bank reserve requirement to all financial
institutions with liabilities engaged in third part payments. We should
also believe, it appears, that this extension raises the "precision of
monetary control". It removes, we are informed, the erosion of monetary
control caused by the increasing weight of non-member banks in our
monetary system.

The Federal Reserve reports an increase in the

proportion of demand deposits issued by non-member banks included in
the nation's money stock from 17.2% in 1960 to 25.4% in 1973. The
relative weight of non-mamber banks thus rose over 13 years by 50%.
These changes seem impressive and obviously monetary control suffers.
But we receive nothing beyond the Federal Reserve's assurance on this point
and one wonders whether the Board seriously investigated this issue. A
preliininary examination of the role of non-member banks in the monetary
system assigns little significance indeed to the observed changes in the
weight of non-member banks. Seme detailed caiputation determines that
the increase in the proportion of non-member bank deposits raised the money
stock over 13 years by about 4%. This means that the shifting weight of




15.
non-iraember banks added (in the average) less than one third of one per
cent (i.e., about .3%) per annum to monetary growth. This is surely
no magnitude endangering monetary control.

In particular, if the process

works with seme regularity this minor contribution to growth conveyed via
the (r+£) factor could easily be discounted in setting the proper
course of policy actions.
The Board of Governors might still claim, however, that the problem
results frem the erratic variations around the trend in the weight of nonmember banks. The data attached by the Board to the memorandum justifying
the proposal shew two distinct subperiods. Fran 1960 to 1968 the proportion
of non-member bank deposits rises with an average .475 percentage points
and a range extending frcm .1% to .7%.

Fran 1968 to 1973 the proportion

rises at an average 1.08 percentage points with a range extending from .8
1.3 percentage points. The rate of increase in the weight thus more than
doubled between the two subperiods. It is noteworthy that one major difference
between the two subperiods is the cost of required reserves determined by
the general level of interest rates. Interest rates in the second subperiod
rise by more than 50% above the level exhibited in the first period.

It

should also be noted that this increase is essentially due to the inflationary
policies pursued by the Federal Reserve System.

The largest deviation

frcm trend change in each subperiod is less than .4 percentage points.
Appropriate computations determine that contributions to monetary
accelerations (or decelerations) attributable to "erratic changes" in the
proportion of non-member bank deposits around its average trend remain
within a band of .15%. This is a negligible fraction of the monetary
growth observed over the past years. I conclude thus that the proposal
contributes little to effective monetary control and essentially




16.

enlarges the political clientele of the Federal Reserve Authorities.
The general purpose of an improved monetary control is most ccnraendable
and the SQ3YC should certainly support this goal.

But the SOYC also

hopes that the Federal Reserve Authorities would attend to the really
significant changes in institutions under its iirmediate control which
promise to raise the effective level of control. The radical siirplication
of reserve requirements and adjustments in the measurement of the deposit
base governing the computation of required reserves would be among the
first items on the required agenda.
It follows from the analysis of the role of non-member banks in
the money supply process summarized above that the arguments of the
Board submitted in support of its proposal are essentially irrelevant
or misplaced.

It adduces first the principle "that equivalent cash

reserve requirements should apply to all deposits that effectively serve
as part of the public's money balances...". But what does this sentence
really mean?

It surely could not mean equal reserve requirements. The

proposal implies very unequal requirenBnts for different banks and different
magnitudes or deposits. So what are equivalent requirements?

The reader

obtains no information beyond the implicit suggestion that requirements
imposed by the Federal Reserve Authorities on all financial institutions
according to the legislation proposed are equivalent.

"Equivalence" does

not determine the institution , the institution controlled by the Board
determine

the meaning of "equivalence".

The Board also asserts that the proposal "would buttress the basic
role of reserve

requirements".

It is also argued that the proposal

strengthens the role of reserve ^requirements by changing the form in which



17.

non-member banks may hold their reserves". The latter refers to the
fact that the proposal would only admit base money for reserve purposes.
But the result of the examination presented above indicate the
irrelevance of this aspect. One also wonders whether an extension of
the complicated reserve requirements developed over the past eight
years to a larger group of financial institutions nay not worsen the
control problem.

The lagging of required reserves introduced without

much thought by the Federal Reserve Authorities injected random
disturbances into the process lowered the level of montrol control.
It seems hardly appropriate to extend and entrench even further a
poorly designed institutional arrangement. Lastly, the Federal Reserve's
general concern about the growth of depositary liabilities with third
party payment features at non-member institution deserves seme attention.
We should admit that this development affects the Federal Reserve's
political clientele. But we also should doubt its relevance, per se,
for monetary control. But the Federal Reserve Authorities have the
resources and facilities to explore this issue more systematically and
seriously than in the past and may convincingly document the economic
relevance of its concern. The SOMC should encourage such studies.




18.

4.

The Chairman.1 s Justification of Recent Monetary Policy.
The Chairman's reply to Senator Proxmire's letter was addressed

at two major issues: the general variability of monetary growth and the
monetary acceleration experienced in 1972. The evaluation of the first
issue depends crucially on the conception governing seme fundamental
properties of the economic system.

In particular, it depends on the view

concerning the "inherent stability or instability" of the process. The
Chairman argues with many Keynesians that "neither historical evidence, nor
the thrust of explorations in business cycle theory over a long century,
give support to the notion that our economy is inherently stable". Once the
Federal Reserve Authorities accept the "fundamental instability" of the
economic process the general position concerning the nature of policymaking
is essentially determined.

Policies must be "discretionary and flexible".

They will be "needed to cope with undesirable econcmic developments" f
developments emerging independently of public policy. Moreover, "econcmic
forecasts are an essential tool of policymaking" „

The fundamental thesis

also implies assignment of substantial weight to fluctuations in velocity.
These fluctuations reveal the operation of the hidden forces driving the
economy.

The governing conception rationally determines moreover the use

of "a blend of forecasting techniques". In particular, the monetary authorities
must cultivate a wide range of diverse information channels. It also follows
that the Federal Reserve necessarily cultivates an "eclectic approach".

This

"eclectic approach" eventually became more eclectic and includes monetary
growth with all the previously assembled signals. And no doubt, the central
thesis implies that it "would be unwise for monetary policy to aim at all times
at a constant or nearly constant rate of growth of money balances". There



19.

emerges furthermore the warning that "it is never safe", under the
circumstances, "to rely on just one concept of money".

Ihe general

idea of an unstable process is supplemented with a specific view that
the "public's attitude towards liquidity" changes abruptly and widely.
Such changes must be offset by suitable adjustments in open market
operations. The fundamental thesis thus yields an array of consequences
which explain and apparently justify the observed variations in monetary
growth.

It apparently also justifies an extensive apparatus to assure

a broad range of contacts with the economy. We may only note in passing
the usefulness of such designs for a political organization.
The Chairman's defense of the policies pursued in 1972 and 1973
is an iirmediate consequence of the general theme. We are cautioned that
"monetary policy...had to balance the twin objectives of containing
inflationary pressures and encouraging econonic growth". Ihe balancing
yielded on expansion of ML in 1972 which was "low relative to the demands
for money and credit". And lastly, the surge in prices occurring in 1973
"reflected a variety of special influences". And so follows the Chairman's
final absolution:

"Ihe severe rate of inflation that we have experienced

in 1973 cannot responsibly be attributed to monetary management or public
policies".
Ihe nature of a position paper prohibits a detailed exploration of
the Federal Reserve Authorities justification. A short critique seems
however necessary. JYbre importantly, it should be emphasized that substantially more research efforts support the critique than the
Chairman's apologia. The Federal Reserve's fundamental




20.
thesis of an inherently unstable process generating on its own major
fluctuation may be very plausible, just as plausible as the rotation of the
sun around the earth.

It is quite probable that this thesis guided much of

the Chairmanfs previous activities at the National Bureau of Econcgnaic
Research.

Still, all the time series collected yield no relevant evidence

favoring this thesis against the rival view of a fundamentally stable
process.

It is most intriguing that major pieces of work published by the

National Bureau of Research yield information incompatible with the Federal
Reserve's hypothesis. The detailed monetary history prepared by FriednianSchwartz clearly established the responsibility of government policies, or of
arrangements imposed by public policy, for major depressions or substantial
inflations. lYbreover, a detailed survey of econometric models established
uniformly that substantial variations in policy variables are a necessary
condition for the generation of larger economic fluctuation. None of the
models examined justifies the thesis of internal instability.

They exhibit

on the contrary highly stable and shock absorbing processes. It is noteworthy that one of these econometric models has been developed with the
aid of a grant from the Board of Governors and bears the label of the
Federal Reserve.
An interesting implication of the instability thesis was explored by
Milton Friedman. He examined in a contribution to the Fourty Fourth Annual
Report of the National Bureau of Economic Research the correlations between
magnitudes of upswings and downswings in business cycles. The instability
thesis iitplies that correlations between upswings and succeeding downswings are
not significantly different from correlations between upswings and preceding
downswings. The stability thesis iitplies on the other hand that correlations
between upswings and preceding downswings significantly exceed correlations
between upswings and succeeding downswings. He also presented data demonstrating the relative dominance of the former correlation yielding a




21.
clear case againfet the instability hypothesis. The preliminary report
on "The Role of Public Policy in Moderate Inflation" jointly prepared by the
International Monetary Konsortium (Journal of Money, Credit and Banking,
February 1973) also offers some relevant evidence. Thfe data frcm three
countries show that all substantial accelerations and decelerations in
price movements were systematically preceded by substantial changes in
government financial policies. Lastly, implicit in the Chairman's
argument occurs a wondrous claim to superior knowledge. The instability
thesis indeed justifies the proposition that appropriate variability
of monetary growth dampens economic fluctuations. But the actual
determination of this appropriate variability requires reliable
information about the economy's detailed structure. Can we reasonably
believe that the Chairman possesses such knowledge?

Ihe variability

of monetary growth actually experienced remains thus properly suspect.
We should recognize of course the political advantages offered to the
Central Bank by the theory of an inherently unstable process combined
with a claim to superior knowledge. It can always be used
to absolve its policies from any blame.
Ihe application of the general theme to the year 1972 exhibits the
policital advantages of a "flexible application" of the thesis. It is argued
that a moderate "encouragement" was still appropriate. This encouragement
balanced the dosage "against the rising inflationary pressures". The relative
encouragement offered by monetary policy in 1972 is elaborated subsequently
in terms of the relative movement of money demand and money stock. The
forces of the econony operating independently of current or past monetary
accelerations raised in the Federal Reserve's view the public's money demand.




22.
A lesser increase of the money stock satisfied in the Chairman's opinion the
requirement of an anti-inflationary policy and its actual increase injected
the required modicum of encouragement. But the reader should note the hard
dependence of this argument on the instability thesis which determines the
dominant impulse driving the economyfs private sector. The interpretation
of the relative movement of money stock and money demand in the manner
suggested by the Chairman's letter presupposes that the movements of
money demand are dominated by non-monetary events.
*Ehe special justification of 1972 thus fails with its underlying
thesis. We should also note the dependence of the argument on a very
Keynesian view of assetmarkets denying "direct" substitution relations
between money, or financial assets, and real assets. Ihis view implies
that increasing interest rates reveal an acceleration of money demand
relative to money supply. An alternative view about the operation of
assetmarkets rejects such interpretations and offers no analytic basis
for the Chairmanfs rationalizations.
We should also note that the frequent references to the role of
velocity yields no case for the instability thesis. The behavior noted by
the Chairman is actually a consequence of a stable process driven by
repeated monetary impulses. Monetary accelerations (or decelerations)
operate with a lag on velocity.

Larger fluctuations in velocity are thus

the result of previous accelerations and decelerations of the money stock.
In general, the larger the changes in velocity the larger was the previous
acceleration or deceleration of the money stock.

Inflationary experiences

from many countries offer seme interesting material in this respect.

It

follows that the motions of money demand are substantially influenced by




23.
prior accelerations of the money stock. This argument extends to the
surging inflation in 1973. Indeed, special factors were at work.

They

explain the rapid changes in specific relative prices and the emergence
of food and oil in the upper tail of the distribution of price changes. The
"special influences" do not explain however the movement of the whole
distribution of prices. This movement, expressed by an accelerated increase
in the average price-level, did result frcm the policies pursued in 1972.
Indeed, the policies applied in 1973 exerted little effect on price
movements in 1973. But this does not justify the Chairmanfs convenient
refusal to accept the responsibility for the new inflation.




A. James Meigs
Memo to the Shadow Open Market Committee
IMPROVING MONETARY STATISTICS
The revisions in the money stock (M-J) and other monetary
aggregates that the Board of Governors announced on January 31 have
pointed once again to the persistence of serious deficiencies in the
basic monetary data produced by the System. These deficiencies obviously raise the risk of error in the conduct of monetary policy
by the Federal Reserve and cause great uncertainty amona outside
analysts who must try to predict the effects of Federal Reserve
policies on income, employment, prices, interest rates and other
important variables. The revisions are particularly exasperating
this time because the apparent deceleration of money-supply growth
in the second half of 1973, when combined with the shock of the
oil embargo and the disruptions caused by wage-price controls,
may have been enough to cause a recession this year. But the
magnitude of the monetary deceleration is still in doubt; the
recently revised estimates of the 1973 money stock are not yet
the Fed's f* final ff estimates.
Large changes in estimated deposits at non-member banks
were said to be the main reason for the January revisions in M-| •
These changes, in turn, stemmed from benchmark revisions based on
non-member-bank call reports for December, 1972, and March, June
and October, 1973. Because the year-end 1973 call reports were not
used in the latest revisions, the 1973 monev stock estimates
probably will be revised again in the next ••regular annual
benchmark corrections,9• whenever these happen to occur.
The January revisions are of unusual interest also because
of two related announcements from the Board. One was the Board's
reguest to the Congress for authority to extend reserve retirements
to ••all deposits that effectively serve as part of the public,s
money balances** at savings banks and savings and loan associations
as well as at non-member commercial banks. There may be more involved in this reguest than a simple desire to improve measurement
and control of the money supply. The other related announcement was
the appointment of a committee of academic economists, headed by
O.L. Bach, to review procedures, concepts and methods used in
estimating the money supply and other monetary data. If the Board
supports the committee with unlimited access to competent staff
people throughout the System and with ample computational assistance
for experimenting, and if it takes the committee's recommendations
seriously, the quality of U.S. monetary data could be much improved.
This memorandum reviews background information that the
SOMC might want to consider in reacting to both of the Board's
initiatives. Although questions concerning measurement and control
procedures are inextricably mingled, primary emphasis here will be
on possibilities for improving measurement.
Some General Dimensions of the n ro hlem
The two charts from the Poole-Lieberman study in Brookings
Papers on Economic Activity 2, 1972 illustrate the effects of sub


sequent revisions on rates of growth of the monthly seasonally adjusted money stock. A s Poole and Lioberman say, it is the preliminary
.
series which is used for policv decisions, but the preliminary series
is a poor predictor of the final series. When they regressed final
rates of change over quarterly intervals (the Board's third-month
to third-month concept of quarterly change) on preliminary rates of
change, they found an R 2 of 0.679 and a standard error of 1.33. They
argued that this standard error is great enough to warn against
strong policy action in a gtiarter to slow money growth, for example,
on the grounds that the growth reported for the preceding quarter
was too high. They fotmd that the situation was even worse with
respect to monthly changes in seasonally adjusted data. The regression
of final on preliminary had an R2 of only 0.55 and a standard error
of 2.40.
The revision process presumably should make the final series
a better estimate of the 4 l t r u e M series than the preliminary series.
However, researchers at the Federal Reserve Rani: of St. Louis say that
their model gets better fits with preliminary money-stock data than
with the final, revised series. A possible reason is suggested by the
charts; the final rate-of-change series is noticeably smoother than
the preliminary. This suggests that smoothing filters out some
information in the preliminary series that had explained part of
the variance in rates of chancre in CINP. Consequently, deficiencies
in the monetary series not only make life difficult for people inside and outside the System who have to use the preliminary series
for current analysis and forecasting, but alr.o raise problems for
anyone doing monetary research.
The Non-Member Bank Problem
The Board's argument for extendina reserve requirements
to demand deposits of non-member banks and savings institution
stresses the control problem. According to the Board and defenders
such as Tom Waage of the New v ork Fed, a growing share of total
demand deposits is outside the power of the Fed to control through
open market operations or through changes in reserve requirements.
This argument has been knocked down numerous times before, so
should not concern us here, although the SOMc might want to comment
on it later. There are numerous other possible changes in Federal
Reserve procedures that would yield a far greater improvement in
precision of control over the money supply than would the extension
of reserve reguirements to non-member banks.
Extending reserve reauirements, however, would automatically
improve the Fed's data on non-member-bank deposits, for it would
reguire reports on daily-average demand deposits from all non-member
banks except for the 3,000 small ones who would be exempt. But
less costlv ways of improving the data on non-member-bank deposits
surely can be found.
The Board's current procedure is to use FDIC call reports
as the source of non-member gross demand denosits, vault cash,
savings and other time deposits, U.S. Treasury balances and cash
items in process of collection. Weekly non-member bank data are
then estimated by taking the ratios of the call-report data to
similar items reported by a sample of country member banks on the
same dates and multiplying them by the corresponding numbers that



Figure 1. Rate of Growth of Monthly Seasonally Adjusted Money Stock, 1961-70
Percent annual rate

-20
196!

1962

1963

1964

1965

Figure 1. (continued)
Percent annua/ rate
20

-10

1-L.J. 1. .I -i-L-L l^J_JLxlou.._JU-J_Lj--L-l
— 20 L-J-_i—L 1 1 I -L-l—LJL-L-1.X^JL-L_ 1 - JL. .1 _J_l_i_J_JL_L XJL_L I 1.
1966

1967

1968

1969

t.lll

1 1 1 1-

1970

Sources: Preliminary scries. Federal Reserve Bulletin, issues in which first estimate for a given month is published, with changes calculated from the preceding month as reported in that issue; final series. Federal Reserve Bulletin, Vol. 57 (November 1971) and Vol. 56 (December 1970), table in article,"Revision of the Money Slock."in each issue.

Note: Chart copied from Brookings Papers on Economic Activity 2 for discussion at meeting of SOMC, not for publication.
Do not reproduce for publication without permission of The Brookings Institution.




m4 •

are reported weekly by the sarin la member banks*
Until the January 1974 revision, June and December nonmember call reports were used for the benchmark ratios. This time,
March and October call reports were used as well, because, according
to the Board, 1973 was the first year since the early 1960fs that
sprint? and fall call report data had been available for benchmark
revision. How much difference the March and October call reports made
we do not know. However, there is some reason to believe that the
December 1973 estimate of non-member demand deposits might have
been higher if the former June-December benchmark procedure had
been used. This raises a question about the comparability of 1973
money supply estimates with those of earlier years. Perhaps the
ROMC should ask the Board to publish the details of the benchmark
computation so that their significance can be appraised. In any case,
the non-member benchmark adjustment announced this January was the
largest in the historv of the series. It raised M | by $1.0 billion
*
for December 1972, $2.0 billion for March 1973, nearly $2.8 billion
for June 1973, and about the same amount for October 1973.
Reserve requirements for non-monber banks would virtually
eliminate the benchmark problem. However, it would be far less
costly to improve the data by obtaining monthly reports from a
sample of non-member banks than by subjecting most non-members to
reserve requirements. The problem o^ arranging cooperation between
the two bureaucracies -- FDIC and Federal Reserve -- might be
difficult but it should not be insuperable.
In the interest of improving monetary measurement and
control, the SO?!C might conceivably endorse the Board's request for
extending reserve-requirements to non-member institutions. However,
some unheralded motives behind the Boardfs reauest should be considered. These stem from interests of the Board in areas other than
monetary policy. One of these may be a bureaucratic imperative to
extend or maintain the System's regulatory reach by stopping the
drift of banks away from membership in the System. The other may be
a desire to strengthen the Fedfs claim to primacy in the electronic
funds transfer system of the future.
Having failed to win the fealty of many state member banks
through liberalising discount-window pri^ileres and through the shift
to the two-week lag in reserve requirements, the Board may have
decided to reduce the attractiveness of non-member status through
making reserve requirements obligatory or* members and non-members
alike. The Board*s stress on the monetary-policy aspects of its
request, however, has not lulled the suspicions of such competitors
in the regulatory field as the Conference of State Bank Supervisors.
They have recently published a critical report entitled "Optional
Affiliation with the Federal Reserve System for Reserve Purposes
Is Consistent with Effective Monetary Policies.ff
The System also aopears to be making a determined attempt
to establish itself as the principal provider of interregional
electronic-funds-transfer services, in the interest of avoiding the
wasteful duplication and inefficiency that somo Members of the Board
believe would arise from the attempts o^ banks or other potential
competitors to get into the business. If all banks of significant
size and all savings institutions that orovide third-party payments



-5services were required to hold balances at Federal Reserve Banks, the
System*s position in competing for funds-transfer business -- especially at a zero price -- would be immensely improved. The proposed
extension of reserve requirements to deposits at saving banks and
savings and loan associations **that effectively serve as part of
the public1s money balances* f , therefore, probably was motivated by
more than an intellectual interest at the Board in determining what
is money.
Banks and other interested parties have been asked by the
Board to comment by March 8 on its proposals for new regulations
affecting electronic funds transfers• Banker opinion appears divided
at the moment and the positions of the various bank associations
have not been announced. But it looks as though a major battle over who
is to control the payments mechanism is not far off. Furthermore,
the Justice Department mav be involved, for Donald Baker has expressed strong opposition to allowing the Fed or anyone else to
monopolize the funds transfer business.
Troublesome Deductions
Large revisions in the underlying data have at times been
caused by the way the Fed defines demand deposits subject to reserve
requirements. To avoid double counting, interbank demand deposits and
cash items in process of collection are deducted from gross demand
deposits. This net figure then is used not onlv in computing required
reserves, but also as the member-bank part of the demand deposits
component of the money supply (after deductina U.S. Treasury balances).
For a time during the late 19P0 , s, several enterprising
banks found that by repaying Eurodollar borrowings with bills-payable
checks and London checks they could generate cash items in process
of collection that could be deducted from head office demand deposits.
This gave them a handsome saving on the costs of required reserves,
but it also reduced the Fed's estimate of the money stock. This
understatement was corrected in the August 1969 revision. At the
same time, a revision of Regulation D required banks to include
bills-payable checks and London checks used in repayment and borrowing
of Eurodollars in gross demand deposits an well as in cash items in
process of collection.
The 1969 episode influenced the debate between monetarists
and tho Board. The under-report5ng in the first half (see chart) led
some monetarists to warn of a recession. The upward revision in
August encouraged Board members to ridicule monetarists and all their
works. The 1970 recession came anyhow, but a little later than the
early monetarists• forecast.
The November 1970 money supply revision resulted from a
discovery at the Fed that somo banks were enjoying a similar
loophole in international transactions involving Edge Act corporations and U.S. agencies and branches of foreign banks. These
transactions did not produce deposit liabilities at domestic
commercial banks to offset the cash items that the banks were
happily, though quietly, deducting from their reported deposits.
Since 1970, interbank demand deposits of foreign bank agencies
and Edge Act corporations have been added to gross member bank
demand deposits to correct for the measurement error in the



-6demand deposit component of the U.S. monev stoclr,
So far as we know, there arenft any more such opportunities
in the Fed's rules that provide banks with a profit incentive for
understating the money supply. However, the Fedfs new advisory
committee on monetary statistics mieht well want to review the
cash-item-deduction problem and the Fedfs remedies for it.
Seasonal Adjustment
According to Poole and Lieberman, revisions in the
underlying data --. such as the benchmark revisions of non-member
deposits -- and revisions of seasonal adjustment factors are of
roughly equal importance in explaining revisions in the quarterly
growth rates of the seasonally adjusted monev stock. However,
revisions in seasonal factors are nearl^ four times as important
as revisions of underlying data in explaining revisions in monthly
growth rates of the seasonally adjusted money stock.
It is obvious that the Board's method of seasonal adjustment should be carefully examined by the committee. The ciarrent
methods result in an incestuous relationship between Federal
Reserve 4 policy operations and the season*] adjustment factors used
in the •final*f seasonally adjusted money stock.
Extreme chancres in the mone^ stock in particular months
influence the seasonal factors at subsequent revisions and so tend
to be smoothed out. Tf the Fed were to overshoot its money-growth-rate
target in the same month of two or three successive years, for example, these errors would gradually sink from view in the later
revisions. What is worse, they would become part of the tarqet in
later years.
Furthermore, the seasonal-adjustment procedure is not
replicable by outside analysts; it contains an unknown amount of
Fed staff •'professional jud^^ent" with a smoothing pencil at the
turns. It would be helpful for the advisorv committee to have
guidance from staff people at some of the provincial Reserve Banks
who have had extensive experience in trying to match seasonals with
the Hoard.
The advisory committee on monetary statistics could probably
do the most good through focusing on the seasonal-adjustment problem,
because it contains the knottiest theoretical and philosophical
difficulties. The seasonal variation in unadjusted monev stock arose
in the first place from the Fed*s efforts over many years to stamp
out seasonal variation in short-tern interest rates. And the policy
of minimizing seasonal variation in rates was never justified except
by harking back to ancient traditions that were established by the
Bank of England and Uinfield TKofler. If monetary policv shifts to
a pure aggregates target, an explicit policy decision should be made
regarding seasonal variation, ^his obviously is more than a problem
in improving measurement of th^ money supply.
Conceptual Problems
Some of the Members of the Board of Governors want to
include NOW accounts and other savings institution deposits involved



7in third-party-payment systems in the money stock. This is worth
thinking about because there is some pressure for makina deposits
at savings and loan associations and mutual savings banks more like
checking accounts at commercial banks. Although the Hunt Commission
Report appears to be in limbo, for the moment, some of its proposals
may some day be put into effect.
Another interesting possibility would be to remove
foreign-owned deposits from tho money stock, if possible, in order to
obtain a *'domestic money supply** series, such as the one presented
by the federal Reserve Bank of St. Louis in their May 1972 Review.
Although the proportion of foreign-owned deposits in the reported
U.S. money stock is small and maybe stable, th^re could bo times in
which the domestic implications of a reported change in nonev stock -as now defined -- could be misread because of a short-term increase
or decrease in the foreign-owned component.




A.J.M.
2/26/74

2/22/74

The International Economic Outlook:

A Briefing

for t h e Shadow Open M a r k e t C o m m i t t e e Meeting of
M a r c h 8,

1974

by Wilson E.

Schmidt

Virginia Polytechnic Institute and State U n i v e r s i t y

Naturally, t h e outlook for t h e U. S. b a l a n c e of p a y m e n t s and
i t s effects on U . S . economic activity has been dominated by a
r e c e n t change in r e l a t i v e p r i c e s , n a m e l y the oil c r i s i s .
I.

The Good News

The c r i s i s has produced at l e a s t t h r e e p i e c e s of good n e w s .
First,

further efforts to d e f o r m the i n t e r n a t i o n a l m o n e t a r y

s y s t e m have been stopped.

In t h e face of u n c e r t a i n t i e s c r e a t e d by

t h e oil situation, no country has been willing to fix the r u l e s of t h e
international monetary system.

Instead c o u n t r i e s have a g r e e d only

on s o m e organizational changes which s t r e n g t h e n t h e power of t h e
International Monetary Fund at t h e expense of t h e O r g a n i z a t i o n for
Economic Cooperation and Development and on s o m e new accounting
r u l e s for Special Drawing R i g h t s .
Second, t h e F r e n c h have floated.
T h i r d , the Keynesians (or the m e r c a n t i l i s t s as I p r e f e r to
call them) lost a m a r k e t t e s t to t h e m o n e t a r i s t s .

In t h e F a l l it

w a s widely believed that r e a l output of our t r a d i n g p a r t n e r s would
decline m o r e than our own b e c a u s e of t h e i r h e a v i e r dependence on oil.




2

If foreign exchange s p e c u l a t o r s w e r e K e y n e s i a n s , t h i s p r e s u m p t i o n
would h a v e caused t h e m to a s s u m e that our t r a d e b a l a n c e would
d e t e r i o r a t e and that t h e dollar would d e p r e c i a t e ; in fact,

they

anticipated a p p r e c i a t i o n .

sympathetic

On the whole, m o n e t a r i s t s a r e

to s p e c u l a t o r s ; it is good t o know that t h e y r e c i p r o c a t e .
II.

The Bad News

S e r i o u s l y , on t h e s o m b e r view, seventy-four looks r a t h e r wild.
Responsible e s t i m a t e s suggest that t h e OPEC c o u n t r i e s m a y i n c r e a s e
t h e i r oil r e c e i p t s by $40-90 billion.

F e w people think that they can

spend a l l of this and, as a c o n s e q u e n c e , t h e i r c u r r e n t account
s u r p l u s e s a r e expected to r i s e to $30-50 billion.

Nobody can

r e m e m b e r that kind of change, u n l e s s it might be t h e G e r m a n
r e p a r a t i o n s p r o b l e m after the F i r s t World W a r .
a r e rough

Even if the figures

and the r a n g e is wide, it*s obvious that we have a p r o b l e m ,

or p e r h a p s s e v e r a l p r o b l e m s .
F i r s t , if t h e OPEC c o u n t r i e s cannot spend t h e i r
they will have to invest t h e m a b r o a d .

surpluses,

That would be fine b e c a u s e

it m e a n s that t h e oil p r o d u c e r s would lend us the money with which
to pay t h e i r higher p r i c e s .

But, they will gain i n t e r e s t i n c o m e

which would m e a n that by 1980, if things continue as expected in
1974, that OPEC c o u n t r i e s would have additional a s s e t s of $450
billion.




Even though the total financial a s s e t s of t h e CL£&2£S c o u n t r i e s
0£C4>

3

come to $3 t r i l l i o n today, that i s a v e r y l a r g e amount of funds to
c o n c e n t r a t e on the hands of a c a r t e l .

And t h e r e will be an obvious

r e l u c t a n c e to b o r r o w that m u c h t o finance consumption.
Second, t h e r e is no g u a r a n t e e that the OPEC c o u n t r i e s will
invest t h e i r added r e c e i p t s in each consuming country in p r o p o r t i o n
to the i n c r e a s e in t h e i r oil r e c e i p t s f r o m each consuming country.
Hence, g o v e r n m e n t s will feel t h e need to p r o t e c t t h e i r b a l a n c e s of
p a y m e n t s , possibly by c o m p e t i t i v e exchange r a t e d e p r e c i a t i o n or
through a downward float,
controls.

and by tightening of t r a d e and capital

As u n e m p l o y m e n t r i s e s , p r e s s u r e s for d e p r e c i a t i o n will

strengthen.
But this won't solve t h e p r o b l e m .

As t h e e l a s t i c i t y of OPEC

demand for i m p o r t s i s seen to b e low, t h e r e i s l i t t l e chance for
the n o n - O P E C c o u n t r i e s as a group to i n c r e a s e t h e i r exports to the
OPEC c o u n t r i e s to solve t h e oil deficit.
T h i r d , it i s thought that much of t h e OPEC capital will come
to t h e United States b e c a u s e we have the l a r g e s t and m o s t r e s i l i e n t
capital m a r k e t in the w o r l d .

This would, it is believed,

swamp

any worsening on our t r a d e balance due to t h e h i g h e r p r i c e s of oil.
As a c o n s e q u e n c e , t h e dollar would a p p r e c i a t e , which would a d v e r s e l y
effect our competitive position with implied t r o u b l e s for the balance
of p a y m e n t s .




The p r e s e n t r e l u c t a n c e to p a s s t a r iff-reduction

4

l e g i s l a t i o n would grow a s our t r a d e b a l a n c e w o r s e n s .
E v e n without a m a s s i v e inflow of c a p i t a l , if t h e U . S . plays
i t s u s u a l p a s s i v e r o l e in t h e i n t e r n a t i o n a l financial s y s t e m ,

our

t r a d e b a l a n c e will w o r s e n b e c a u s e any i m p r o v e m e n t in the t r a d e
b a l a n c e s of o t h e r consuming c o u n t r i e s would have to c o m e at t h e
e x p e n s e of t h e U . S . t r a d e balance a s long as the OPEC c o u n t r i e s
imports

T$M3M

r e l a t i v e l y i n s e n s i t i v e to p r i c e .

It i s this s o m b e r s c e n a r i o which no doubt u n d e r l a y S e c r e t a r y
K i s s i n g e r ' s plea for i n t e r n a t i o n a l financial c o o p e r a t i o n at t h e m i d F e b r u a r y energy c o n f e r e n c e .
Looking at t h e United States b a l a n c e of p a y m e n t s for 1974,
t h e s o m b e r view f o r e s e e s a s u b s t a n t i a l w o r s e n i n g of our t r a d e
b a l a n c e b e c a u s e of t h e higher p r i c e of o i l - - p e r h a p s $10-13 billion.
T h u s for e x a m p l e , the influential Morgan G u a r a n t y Bank f o r e s e e s
a shift f r o m the t r a d e s u r p l u s in 1973 of $674 million to a t r a d e
deficit of $3 billion and an equivalent shift in t h e c u r r e n t account.
T h e C o u n c i l of Economic A d v i s o r s , obviously u n c e r t a i n about t h e
effects of t h e oil c r i s i s , thinks the net exports of goods and s e r v i c e s
in 1974 w i l l c o m e out at z e r o c o m p a r e d with a s u r p l u s $ 6 . 4 billion
in 1973.




5

K e y n e s i a n s will s e e t h e s e shifts differently depending upon
w h e t h e r t h e y a r e g r o s s m e r c a n t i l i s t s (M-.) o r net m e r c a n t i l i s t s
(M?).

T h e net m e r c a n t i l i s t thinks of all changes in e x p o r t s and

i m p o r t s a s a u t o n o m o u s , with only t h e net difference between e x p o r t s
and i m p o r t s having an impact on demand conditions; as t h e c u r r e n t
a c c o u n t i s supposed to w o r s e n in
p r e s s u r e on t h e United S t a t e s .

!

74 this implies, a slight

The g r o s s m e r c a n t i l i s t

deflationary

concentrates

i n s t e a d on t h e l e v e l s of exports and a s s u m e s that all i m p o r t s

are

a function of i n c o m e ; since exports can be expected to r i s e in 1974
a b o v e 1973 t h e foreign s e c t o r adds to i n t e r n a l demand,

though

p r o b a b l y by significantly l e s s than the $28 billion seen in 1973.
T h e m o n e t a r i s t s of c o u r s e s e e things r a t h e r differently.

So

long a s t h e d o l l a r f l o a t s , t h e balance of p a y m e n t s cannot have m u c h
i m p a c t on t h e s t o c k of money, and thus on nominal i n c o m e and p r i c e s ,
except a s f o r e i g n e r s shift t h e i r dollar holdings amotlng different

fitter* a
a s s e t s and between the F e d e r a l and c o m m e r c i a l b a n k s .

Any d o l l a r s

paid out to f o r e i g n e r s by A m e r i c a n s m u s t stay in t h e U . S . as long
a s t h e U . S . w i l l not pay out gold or foreign c u r r e n c i e s to f o r e i g n e r s ;
t h e floating r a t e a s s u r e s equality between t h e d o l l a r s that want to
go out and t h o s e that want to c o m e in so t h e r e is no net effect on
t h e s t o c k of m o n e y .




6

F o r the m o n e t a r i s t , h o w e v e r , t h e r e is a potential effect on
t h e d e s i r a b l e l e v e l of m o n e t a r y expansion in t h e future through the
change in the r a t i o of our export to i m p o r t p r i c e s b e c a u s e of t h e
l a r g e r i s e in t h e p r i c e of oil.

If,

as widely a s s u m e d , t h e h i g h e r

p r i c e of oil w o r s e n s our t e r m s of t r a d e , that is equivalent to a
p r o p o r t i o n a t e r e d u c t i o n in the productivity of t h e A m e r i c a n economy
b e c a u s e our e x p o r t s buy a s m a l l e r amount of r e a l i m p o r t s ; we suffer
a l o s s in r e a l i n c o m e at full employment l e v e l s .

Looking just at

oil, given the high weight of p e t r o l e u m in t h e unit value indices
for i m p o r t s , we might expect a w o r s e n i n g of 15% in our t e r m s of
t r a d e over 1973.

With m e r c h a n d i s e i m p o r t s running over 5% of

GNP, that r e s u l t s in a o n c e - f o r - a l l decline in our r e a l i n c o m e of
. 8 % which just about wipes out t h e r i s e in r e a l output projected
c
by the Council of Economic A d v i s b r s for 1974. This should be a
significant factor in t h e formulation of m o n e t a r y policy.
III.

T h e Solutions

So m u c h for the s o m b e r view of t h e oil p r o b l e m .
it be solved?

How should

The p r o p o s a l s r a n g e far and wide and do not include

the u s e of our new found f r e e d o m to float.

In fact, floating is seen

by many as d a n g e r o u s e i t h e r b e c a u s e s p e c u l a t o r s will set the r a t e s
at t h e wrong l e v e l s o r b e c a u s e governments will c a u s e t h e m to fall
or let t h e m fall as explained above.




7

One p r o p o s a l would have t h e I n t e r n a t i o n a l M o n e t a r y Fund
b o r r o w t h e s u r p l u s d o l l a r s from t h e OPEC c o u n t r i e s ,

guarantee

t h e m in t e r m s of SDRs, and lend t h e m to needy c o u n t r i e s •
really isnft necessary,

This

except p o s s i b l y for s o m e m a r g i n a l c o u n t r i e s ,

a s t h e O P E C c o u n t r i e s will p r e s u m a b l y put t h e i r new r e s o u r c e s
into t h e E u r o m a r k e t and the U. S. w h e r e t h e oil consuming nations
can borrow' t h e m ,

(This does not m e a n t h e r e won't be a demand

for I M F funds; t h e i r c h a r g e s a r e well below m a r k e t r a t e s • )
A n o t h e r p r o p o s a l to i s to r a i s e t h e official p r i c e of gold.
T h i s would be a neat solution to t h e oil p r o b l e m ,
of s o m e t h i n g in r e t u r n .

r a i s i n g the p r i c e

It suffers however f r o m t h e fact that t h e

oil p r o d u c e r s a r e now f r e e to buy gold in t h e f r e e m a r k e t if they
w i s h and g o v e r n m e n t s a r e free t o s e l l gold t h e r e as well now.
Of c o u r s e , it wouldn't solve t h e p r o b l e m of d i s t r i b u t i n g t h e newly
c r e a t e d financial r e s o u r c e s in a c c o r d a n c e with need b e c a u s e gold
holdings a r e poorly c o r r e l a t e d with oil i m p o r t s .
A t h i r d solution is to somehow p e r s u a d e t h e oil p r o d u c e r s
to s t e p up t h e i r aid to t h e L D C s .

This might w e l l help t h e L D C s ,

if not a c c o m p a n i e d by a decline in a s s i s t a n c e f r o m t h e advanced
c o u n t r i e s , but t h i s is slow b e c a u s e it t a k e s y e a r s t o convert development
a s s i s t a n c e c o m m i t m e n t s into p r o j e c t s and then into i m p o r t s , and to
s o l v e t h e L D C s oil p r o b l e m would r e q u i r e p e r h a p s a doubling of
p r e s e n t a i d flows f r o m all s o u r c e s .




8

A fourth solution offered is a m a s s i v e i n c r e a s e in S D R s ,
p e r m i t t i n g t h e exchange of p a p e r gold for black gold with t h e
OPEC c o u n t r i e s .

It might be fun to w a t c h the battle between

t h e two s e i g n i o r a g e s , but t h e implication of t h i s for l o n g - r u n
i n f l a t i o n a r y p r e s s u r e s in t h e w o r l d a r e obvious.
A fifth solution would be for all consuming c o u n t r i e s to a i m
for e q u i l i b r i u r a in t h e i r non-oil i n t e r n a t i o n a l t r a n s a c t i o n s and b o r r o w
t h e s u m s equal to t h e i r oil deficits on t h e world capital m a r k e t .
A l r e a d y s u c h b o r r o w i n g is going on.

This is neat b e c a u s e it

m i n i m i z e s adjustment to t h e oil p r o b l e m .
to b e a r a t h e r unworkable r u l e .

However, it is likely

The OPEC m o n e y l o s e s its

i d e n t i t y when it e n t e r s t h e E u r o - d o l l a r m a r k e t ,

and the

g o v e r n m e n t s will not know how m u c h oil money they have gotten
b a c k t h r o u g h p r i v a t e t r a n s a c t i o n s with world c a p i t a l m a r k e t s ;
h e n c e g o v e r n m e n t s a r e apt to o v e r - b o r r o w on this r u l e .
T h u s , t h e r e a r e no neat s o l u t i o n s .
IV.

The U.S.

Or a r e t h e r e ?

News

F o r the United States b a l a n c e of p a y m e n t s t h e oil p r o b l e m
is

exaggerated.
T o b e s u r e , w e can expect a s u b s t a n t i a l w o r s e n i n g of our

b a l a n c e of t r a d e .




9

In saying t h a t , on top of oil, t h e r e a r e a s u s u a l plenty of
n o r m a l u n c e r t a i n t i e s - - t h e p o s s i b l e effects of a dock s t r i k e in t h e
f o u r t h q u a r t e r , t h e dimunition of our e x p o r t s a s p r i c e c o n t r o l s ,
w h i c h h a v e d i v e r t e d s a l e s a b r o a d , a r e r e l i e v e d at h o m e ,

the

p o s s i b i l i t y of export c o n t r o l s to r e s t r a i n p r i c e i n c r e a s e s in g r a i n s ,
coal,

etc.
My c u r r e n t guess on t h e t r a d e b a l a n c e in 1974 is for a

deficit of 2 t o 4 billion,

exports of $87-88 billion and i m p o r t s of

$ 9 0 - 9 1 billion, c o m p a r e d with a $674 m i l l i o n s u r p l u s in 1973.
I a s s u m e a s h a r p decline in the r a t e of growth of i n d u s t r i a l
p r o d u c t i o n among our t r a d i n g p a r t n e r s , by half or m o r e which
h o l d s down e x p o r t s .

However, I expect a continued s u r g e in t h e

v a l u e of a g r i c u l t u r a l e x p o r t s , under the p r e s s u r e of continued
p r i c e s t r e n g t h , f r o m $18 billion in 1973 to $21-22 billion.

For

U . S . i m p o r t s , I u s e t h e GNP a s s u m p t i o n s of the Council of Economic
Advisors.

With r e s p e c t to oil, I a s s u m e an i n c r e a s e in i m p o r t s of

fuel and l u b r i c a n t s of $13 billion given t h e J a n u a r y p r i c e of oil,
c o n t i n u a t i o n of t h e e m b a r g o , and consequently a 15-20% decline
in t h e p h y s i c a l v o l u m e of i m p o r t s .
As a r u l e , t h e shifts in the c u r r e n t account of t h e b a l a n c e
of p a y m e n t s a r e dominated by shifts in t r a d e flows.

But I suspect

t h a t d u r i n g 1974 i n v e s t m e n t i n c o m e will r i s e r a p i d l y b e c a u s e of the




10

h i g h e r p r o f i t s of t h e m a j o r oil c o m p a n i e s .

S t a t i s t i c a l l y speaking,

t h e o i l c r i s i s m i g h t w a s h : higher i n v e s t m e n t i n c o m e m a y offset
t h e r i s e i n t h e value of i m p o r t s .

T h i s i s of c o u r s e p l a u s i b l e

b e c a u s e a v e r y l a r g e p a r t of the oil produced by U . S .

companies

o v e r s e a s i s sold a b r o a d and profits on t h o s e s a l e s will a c c r u e to
t h e United S t a t e s .
Roughly s p e a k i n g , I a s s u m e that production by U . S . oil
c o m p a n i e s in O P E C c o u n t r i e s will be between t h r e e and four t i r a e s
our i m p o r t s .

I f u r t h e r a s s u m e that w e l l over half of the U . S .

o v e r s e a s p r o d u c t i o n i s by c o m p a n i e s that r e p o r t t h e i r i n v e s t m e n t
i n c o m e on t h e b a s i s of posted p r i c e s r a t h e r than m a r k e t p r i c e s ,
both of w h i c h hold at t h e i r J a n u a r y l e v e l s .

On t h o s e a s s u m p t i o n s ,

t h e r i s e i n i n v e s t m e n t i n c o m e just about equals the r i s e in t h e
v a l u e of i m p o r t s .

(This m a y be a g r o s s e x a g g e r a t i o n b e c a u s e it

m a k e s no a l l o w a n c e for the effect on profits of t h e s o - c a l l e d
p a r t i c i p a t i o n a g r e e m e n t s and n a t i o n a l i z a t i o n s .
r e a p p e a r i n t h e refining operations.)

But t h e profits m a y

This points up the fact t h a t ,

in t e r m s of t h e flows of foreign exchange, t h e c u r r e n t account
e s t i m a t e s a r e likely t o b e l e s s meaningful b e c a u s e they include a
s u b s t a n t i a l p a r t of i n v e s t m e n t i n c o m e b a s e d on posted p r i c e s
than market prices.

If I u s e only the m a r k e t p r i c e s , t h e t r u e

i n v e s t m e n t i n c o m e r i s e s by a l m o s t half of t h e r i s e i m p o r t s of




rather

11

fuel and l u b r i c a n t s .

But s i n c e w e w o r k with the g o v e r n m e n t ' s

n u m b e r s , m y g u e s s for the c u r r e n t account in 1974 is a s u r p l u s
of $9 to $11 billion, which is a far different s t o r y than e s t i m a t e s
elsewhere.

I've s e e n no published e s t i m a t e s of t h e effect on investment

i n c o m e and I a m v e r y m u c h a w a r e of how w e a k m y e s t i m a t e s m a y b e .
But it i s useful to bring t h e question into focus b e c a u s e t h e r e is an
offset of g r e a t potential in the i n v e s t m e n t i n c o m e a c c o u n t s .
On t h e capital a c c o u n t s , frankly,
I do not know what to expect.

I h a v e to be silent b e c a u s e

T h e r e a r e no data on t h e p r e s e n t

d i s t r i b u t i o n of O P E C c o u n t r i e s a s s e t s among foreign nations b e c a u s e
t h e E u r o - c u r r e n c y m a r k e t hides t h e s e m a t t e r s quite well.

It is

o b v i o u s l y p l a u s i b l e that a l a r g e amount of O P E C money would
c o m e to t h e U . S . b e c a u s e of the s i z e of our capital m a r k e t s ,
c l e a r l y t h a t depends upon n u m e r o u s f a c t o r s .

but

What a r e the

p r e f e r e n c e s of t h e OPEC c o u n t r i e s among f o r m s of i n v e s t m e n t ?
O u t s i d e t h e United States the s h o r t - t e r m capital m a r k e t is l a r g e r
t h a n t h e equity m a r k e t w h e r e a s t h e U . S . s h o r t - t e r m m a r k e t is
only a t h i r d of the s i z e of the U . S . equity m a r k e t .

Finally,

even

if w e w e r e to gain in s o m e s e n s e a d i s p r o p o r t i o n a t e p a r t of t h e
O P E C funds, with the r e m o v a l of t h e U . S . c a p i t a l c o n t r o l s , it is
not a s obvious that w e would keep t h e money.




If I a m right about i n v e s t m e n t i n c o m e , t h e m o n e t a r i s t

concern

12

for our t e r m s of t r a d e and what t h e y might imply for m o n e t a r y
expansion m u s t be r e c o n s i d e r e d .

In t h e event that t h e oil p r o b l e m

should wash, our t r u e t e r m s of t r a d e would be unaffected:

higher

p r i c e s for our i n v e s t m e n t s e r v i c e s j u s t offset t h e h i g h e r p r i c e s
for our fuel i m p o r t s .

When one adds t h e fact that it s e e m s v e r y

likely that a g r i c u l t u r a l export p r i c e s will r i s e , it s e e m s that our
t r u e t e r m s of t r a d e could w e l l i m p r o v e .
Let m e s u m it up.
If I w e r e a net m e r c a n t i l i s t (M ), I would f o r e s e e another
y e a r of s t i m u l u s , though s m a l l e r , f r o m a b r o a d : net exports

rose

by $11 billion between 1972 and 1973; they will r i s e by another
$ 2 . 5 to $ 4 . 5 billion i n 1974.

If I w e r e a g r o s s m e r c a n t i l i s t (M~), I

would f o r e s e e a s h a r p i n c r e a s e in t h e s t i m u l u s f r o m a b r o a d ,
a p p r o x i m a t e l y the s a m e growth in m e r c h a n d i s e exports as between
1972 and 1973 (about $20 billion) plus a huge i n c r e a s e in i n v e s t m e n t
income.
As a m o n e t a r i s t , I continue m y t h e m e at the l a s t m e e t i n g :
t h e i n t e r n a t i o n a l s e c t o r does not m a k e m u c h difference to what
happens at home b e c a u s e the stock of money cannot change and the
t e r m s of t r a d e will not be g r e a t l y affected by the oil c r i s i s .

In

s h o r t , in the United States p r o s p e r i t y and p r o b l e m s a r e m o s t l y
m a d e at h o m e .




13

V.

Floating a s a Solution

If t h e United States p r o b l e m does n o t look a s s e r i o u s a s s o
many people s e e m to think, that s t i l l leaves t h e p r o b l e m of the
OPEC s u r p l u s e s and t h e question of how to d i s t r i b u t e t h e m among
t h e o t h e r oil consuming c o u n t r i e s .

H e r e it s e e m s to m e that

much of the d i s c u s s i o n has v a s t l y u n d e r r a t e d

the value of t h e

floating exchange r a t e s y s t e m to m e e t the p r o b l e m .
Oil is not the only i n t e r n a t i o n a l financial p r o b l e m .

Countries

will go into s u r p l u s and into deficits for other r e a s o n s as w e l l ,
e . g . t h e U.K.

The p r o b l e m is to lick both kinds of deficits;

with floating r a t e s and newly mobile c a p i t a l , that will be
a u t o m a t i c for individual c o u n t r i e s .
But still it can be argued that floating will not solve t h e
OPEC s u r p l u s p r o b l e m , i. e. , t h e consuming nations will simply
d e p r e c i a t e continuously in t e r m s of one another without

affecting

t h e s i z e of OPEC c o u n t r i e s s u r p l u s b e c a u s e O P E C ' s demands a r e
i n s e n s i t i v e to p r i c e .

This a s s u m p t i o n , no doubt based on t h e

view of OPEC a s a vast underpopulated d e s e r t w a s t e l a n d ,
overlooks the fact that c o u n t r i e s such as A l g e r i a ,

Nigeria,

Venezuela,

I r a n and Egypt which p r o d u c e roughly half of t h e c r u d e a r e s t r e t c h i n g
for economic growth and will i m p o r t .

It further o v e r l o o k s the fact

that t h e r e is s o m e e l a s t i c i t y of d e m a n d for fuel in t h e consuming
nations.




14

M o r e i m p o r t a n t l y , t h o s e who a r g u e that floating r a t e s cannot
solve t h e p r o b l e m focus too m u c h on t h e t r a d e accounts and m i s s
a fundamental point.

The first p r o b l e m i s to figure out how to

get t h e OPEC c o u n t r i e s to i n c r e a s e production and d e p r e s s t h e i r
prices.

If t h e y won't, t h e next p r o b l e m i s to figure out how to

avoid paying t h e i r p r i c e s with r e a l goods and s e r v i c e s .

Here,

portfolio adjustment t h e o r y as applied to exchange r a t e s m a k e s a
m a j o r contribution to our u n d e r s t a n d i n g .

If t h e United States

d e v a l u e s , t h e r e s t of the world suffers a l o s s in the r e a l value of
its a s s e t s in the United States when m e a s u r e d in foreign c u r r e n c y
r e l a t i v e to home a s s e t s .

As a c o n s e q u e n c e , f o r e i g n e r s will invest

m o r e in the United States t o r e - a t t a i n t h e i r e q u i l i b r i u m l e v e l s of
r e a l a s s e t s in the United States c o m p a r e d to t h e i r a s s e t s at h o m e .
It s e e m s p l a u s i b l e that t h e s a m e p r o c e s s will work vis a vis t h e
OPEC c o u n t r i e s .

If the consuming nations can float downward

r e l a t i v e to O P E C , the O P E C money will keep coming back to maintain
OPEC c o u n t r i e s 1 r e a l a s s e t s in t h e consuming n a t i o n s .
we won't h a v e to pay.

In that way,

I won't s a y that it will l a s t f o r e v e r ,

but it

might be a good deal of help until t h e consuming nations can develop
alternative supplies.

If something like that does not happen,

given

t h e huge i n c r e a s e in OPEC foreign a s s e t s , the OPEC c o u n t r i e s

are

apt t o look at t h e i r portfolio of oil in the ground and foreign a s s e t s




15

abroad and decide to keep m o r e oil at h o m e , w o r s e n i n g t h e oil
p r o b l e m ; we will have to pay higher i n t e r e s t r a t e s ,

provide

g u a r a n t e e s , and adjust our foreign p o l i c i e s , to obtain t h e i r funds,
all of which a r e costly d e v i c e s for m e e t i n g the p r o b l e m .

Thus,

a t t e m p t s t o m a i n t a i n stable r a t e s r a t h e r t h a n continuing t h e float
a r e , like all p r i c e c o n t r o l s , apt to i n c r e a s e our m i s e r y .




M**#, in*

Boh foscAe
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I have been asked once again to supply some comments on the
projected state of fiscal policy.

Two weeks ago the President's

Budget Message projected a Federal budget for fiscal 1975 of 304.4
billion dollars (unified budget basis) to be accompanied by receipts
of 29 5 billion for the same period, for a projected deficit of 9.4
billion dollars.

This represents a projected growth of 9.3 percent

in receipts and 10.7 percent in expenditures over current estimates
of the respective figures for fiscal 1974.

Some review of recent

budget projections is warranted before we take these figures at
face value.
RECENT HISTORY
This accompanying table indicates some recent official budget
projections and their revisions at roughly six months intervals
over the past year.

The table indicates one well known factor of

recent budget projections; the underestimation of revenues.

This

is mostly associated with the underestimation of the magnitude of
the inflationary problem, and its impact of government tax collections, particularly the corporate income tax.

However, it is obvious,

that even within the fiscal year, there have been substantial revisions and forecasting errors on the expenditures side also.

The

record has not been very accurate, and this suggests that we should
not take the official figures at face value.
THE CURRENT FIGURES
The written and verbal pronouncements of government economic
officials suggest that they have become considerably less sanguine
about the inflation prospects, at least in the near term future.




Jan 7 3

July 7 3

Jan 74

F i s c a l 72
Receipts

/208.61J

Expend

LL31-95

F i s c a l 73
Receipts
Expend

225.0
249.8

232.0
249.8

[jzSLlJ
($46. £}

256.0
268.7

266.0
268.7

270.0
274.7

F i s c a l 74
Receipts
Expend
Fiscal 75
Receipts
Expend




295.0
304.0

-2If my interpretation of these pronouncements is correct, they
seem to accept recent inflationary experience as indicative of
the experience for the next six months, but are holding out for
a substantial slowing of the inflation rate during the fall of
1974 and into 1975, when the energy crisis will presumably (hopefully?) be over, and the economy will resume a path of positive
real growth.

If this type of path

of economic activity materializes,

they clearly hope that unemployment will peak out at less than 6
percent.

If unemployment jumps higher than this, or remains at

high levels into fiscal 1975, then government expenditures for unemployment compensation will jump the budget figures above what
is presently expected.

There are some published reports (Business

Week, 2/9/74) that the unemployment figures which were used in compiling the published budget figures are extremely low, and thus
there may be. underprojection of outlays in this category alone of
something on the order of magnitude of 1 billion dollars even if
the slowdown is no worse nor longer lived than projected at present.

If the slowdown lasts beyond next summer, then even the

administration seems to be saying that all bets are off as far
as the outlays side of the budget is concerned.
On the revenues side of the budget, the current estimates
project an increase of 25 billion dollars between fiscal 1974
and 197 5.

This is small relative to the currently projected

increase of 37.8 billion form fiscal 197 3 to 1974.

However, the

increase in revenues from fiscal 1973 to 1974 was accomplished by




-3increases in all types of tax receipts.

From the fourth quarter

of 1972 to the fourth quarter of 1973, on a national income accounts
basis, personal income taxes increased by approximately 10 billion,
corporate income taxes increased by over 10 billion (estimated), and
contributions for social insurance increased by 18 billion.
In the next twelve to eighteen months, we can expect continued
increases in revenues from the social insurance contribution category
as a result of the increase in the tax base effective January, 1974
and further programed increases in the base for January 197 5.

Fur-

ther, the Federal personal income tax will continue to generate
increased revenues as nominal personal incomes increase, even if
real personal income falls.

However, the governments own projection

for pretax corporate profits is for no change from calendar 19 7 3
to calendar 1974.

This suggests that little if any contribution

to the incremental revenues can be expected from this source.

It

does not seem likely that 2 5 billion additional dollars in revenue
will be produced essentially by the income and social security taxes
alone during the coming fiscal year.

A more likely figure would

probably be on the order of magnitude.of 20 billion additional revenues from all sources.

Thus, given a high probability that within

the current fiscal year, there will be some acceleration of outlays,
particularly associated with unemployment benefits, a deficit of somewhat more than five billion is likely, while a current realistic projection for fiscal 197 5 is for a deficit of the order of 15 billion
dollars rather than 10 billion dollars.




THE FEDERAL GOVERNMENT RELATIVE TO THE TOTAL ECONOMY
In considering the growth of the Federal budget over the last
five years, it should be realized that much of the increase in the
dollar magnitude of the budget is a consequence of the recent inflationary experience.

From the accompanying graph (Figure 1) it can

be seen that since the Vietnam War peak in 1968, real Federal Government purchases of goods and services have been continually decreasing in magnitude.

The deflator for government purchases, on

the other hand, has been rising faster than the overall GNP deflator,
since it includes the government wage component.

The net effect has

been to obscure the decline in the size of government demands on the
productive capacity of the economy.

The trend is perhaps better

illustrated by the broken line in the graph which indicates the
size of real Federal Government Purchases relative to real GNP.

Ex-

cept for the Vietnam period, there has been an almost steady downward trend in this ratio from around .12 in the mid fifties, to
around .07 in recent years.
It is somewhat harder to measure the size of the redistributive
function of the Federal Government.

One possible measure is transfer

payments to persons relative to total personal income.

This however

ignores the recent increase in previously Federal functions which
have, been channeled through State and local governments, and recent
changes in Federal and Sate and Local relationships through things
such as revenue sharing.

It is not clear the extent to which such

funding of State and Local governments by Federal Grants has caused
governments activities at the State and Local levels to increase,
or to what extent there has just been a change in the source of




funding for programs that would have.been instituted in any case.
Figure 2 indicates the growth of both the ratio of transfers to
persons to personal income, and transfers to persons, plus grants
in aid to State and Local Governments, plus Subsidies less Current
Surplus of Government enterprizes to personal income.
these ratios have basically the same behavior.

Both of

They grow slowly

during the late 50 f s, are essentially unchanged during the early 60 ! s,
and since the late 60fs have been consistently growing.
Thus, while the Federal Government cannot be said to be increasing in the sense of making increased demands on the output of
the economy over the last few years, there has been a sharp increase in its income distribution activities.

Judging from the

programs that are already scheduled to be implemented in the next
few years, and current proposals for new programs, the recent patterns of decreasing real government purchases relative to real GNP
and increasing transfers relative to personal income, arelikely to
continue.
FINANCING REQUIREMENTS
Finally I was asked by Allan to comment on the financing of
any deficit.

I regard this question as largely a residual one.

Given the magnitude of the deficit, and given that we reach some
conclusion about the size of monetary growth that we would like
to see achieved over the next six to twelve months, (and the implications of that monetary growth for the growth of bank reserves
and currency), we have run out of degrees of freedom.

The re-

mainder of the deficits will have to be financed by selling debt.
I suspect that the implied magnitude of this problem is such that
the Treasury debt management people will not be completely happy.




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